Why we're excited about Social Underwriting
We’ve been talking a lot about “social underwriting” on the Kiva Zip team this year, because we’re really excited about the innovations we’re rolling out, the resulting data we’re seeing, and the potential of this concept to do a lot of good. So befour I fourget, here are four ways in which social underwriting is manifested in the Kiva Zip program, four reasons why we think social underwriting is awesome, and two conclude, two definitions of what we mean by social underwriting.
How is social underwriting instantiated, specifically, in the Kiva Zip program?
- (Almost) every Kiva Zip loan is “endorsed” by a “trustee”, who vouches for the character of the borrower, based on a (usually) long-standing relationship. A great data point here is the correlation between the length of this relationship, and the repayment rate of loans. Where borrowers have known their trustees for less than a year, their repayment rate is 85%. For loans with a borrower-trustee relationship of more than a year, this number goes up to 91%.
- Recently, we started asking borrowers to provide us with three “references”, as additional data points on their character and trust network – much as an applicant for a job might provide references with their resume. It’s too early to tell if this social underwriting step will have a positive impact on our repayment rate, but we’re intuitively optimistic.
- Thirdly, and perhaps most importantly, in January of this year, we required all U.S. Kiva Zip borrowers to recruit a number of their friends and family network to lend to them in private, before we post them publically to the website. Not only does this demonstrate that a borrower has a trust network that believes in them, and is willing to declare that financially (at least in a very small way). And not only does this “private fundraising period” reinforce the commitment of the borrower to the Kiva Zip process, and paying back their loan. But it also demonstrates the entrepreneurial spirit of the borrower. As a small business owner in America, if you can’t get 15 people in your network to lend you $5, I would have serious reservations about your ability to succeed as an entrepreneur – what I believe to be the hardest (albeit most rewarding) job in the world. Another great emerging dataset here – Kiva Zip loans with less than 15 invited lenders have a repayment rate of 88%. For loans with at least 15 invited lenders, at least for the time being, we’re running at 99.7%!
- Lastly, every Kiva Zip loan needs to be crowdfunded by our community of lenders. That means thousands of pairs of eyes on every loan, helping us to identify suspicious information discrepancies, and assess whether a small business owner has the marketing ability and business savvy to make it as an entrepreneur, and pay back their loan. I am sure every lender makes a snap “risk assessment” in a different way. Does the borrower’s poor photo suggest they won’t be able to market their business effectively? Does their low number of Facebook likes suggest they don’t have a strong customer base? Does their loan description seem vague and unthought through? Does their refusal to respond to comments on the conversations tab suggest a reluctance to communicate, which might spell problems down the line? Does their Kiva Zip loan profile just seem to lack the passion that every entrepreneur needs to succeed? We believe that thousands of different, complementary approaches to “due diligence” will result in better underwriting decisions – that there is indeed wisdom in the crowd…and again, the data backs this up. Loans with at least 20 lenders have a 92% repayment rate on Kiva Zip. For loans with less than 20 lenders, that number drops significantly – to 66%. This is one reason why we see value in some “expirations” on the platform, and why we continue to operate an “all or nothing” approach, rather than the “keep what you raise” model that IndieGogo allows campaign owners to select if they want to.
So in summary – the four specific components of social underwriting, as implemented in the Kiva Zip program, are (1) the endorsement of the trustee, (2) peer references, (3) the requirement of borrowers to recruit some friends and family members to fund their loan before it goes public on the website, and (4) the decentralized nature of crowdfunding. But by this time next year, we’ll hopefully have added some more!
Why are you guys on the Kiva Zip team so excited by this social underwriting concept?
- It enables us to make loans to many small business owners that conventional underwriting would reject. Common reasons for the 8,000 small business loan applications that are rejected by conventional lenders every day in America include a damaged or insubstantial credit history, an absence of collateral, or insufficient cashflows. Illustratively, conventional underwriting dictates that, on average, the probability of each of these 8,000 small businesses repaying their loan is less than 95% (or whatever the repayment rate target is for the conventional lending institution). What social underwriting enables us to do is to consider data on the borrower’s character and trust network, not considered in the numbers-based, conventional underwriting approach, and use this social data to paint a more sophisticated, nuanced picture than the algorithm- and average-based, conventional approach allows. This allows us to say that, whereas on average those 8,000 small businesses will have a repayment rate of less than 95%, there are actually 200 (or 1,000, or 5,000) would-be borrowers among them, whose probability of repayment, when you account for social data, is actually 98%, and who therefore merit a loan.
The other way in which social underwriting enables us to expand access to capital is because it is practiced by a community of thousands of people, rather than a centralized financial institution. The financial institution is lending large sums of money (e.g. $5,000 at a time), and is usually focused on maximizing profits, so it has a very low tolerance for risk. The community of thousands of people is lending in tiny increments (e.g. $25 at a time), and is more motivated by creating a positive impact in the life of a borrower whose story resonated with them, or financially and emotionally supporting a small business in their own neighborhood, so they are able to tolerate a higher risk of default on the loan. Our repayment rate target for Kiva Zip is 90%, not 100%. Because we believe that if we really want to make a difference for entrepreneurs in places like inner-city Detroit or the Mississippi Delta, we need to accept higher risks than profit-seeking financial institutions are willing to stomach.
When you combine the ability of social data to plug information gaps that conventional underwriting does not account for, with the patient, risk-tolerant, generous capital of Kiva Zip’s community of lenders more motivated by social impact than financial return, you are able to say yes to a much higher proportion of loan applications than financial underwriting permits.
- Social underwriting works as a way to manage risk! See the data points above for three great examples of this. And we’re seeing many other examples of the power of leveraging social data to analyze risk. Consider that Kiva Zip loans with a Yelp profile have a 99% repayment rate, compared to 87% for loans that do not; or that loans with a business Facebook page have a 92% repayment rate, compared to 83% for loans that do not. We’ve only scratched the surface of social underwriting over the last three years. But we believe we’re on the right track.
- Social underwriting is cheap! It’s very expensive for a conventional lender to pore through the credit reports and financial statements of borrowers, and follow up on any discrepancies or question marks. And it’s also very time-consuming for the borrower to assimilate these financial records, especially when many small business owners’ financial transaction histories are far from perfectly organized! For the Kiva Zip team, it’s very cheap for us to assess the riskiness of a loan by requiring a borrower to recruit a number of lenders from their own personal network, or simply waiting for our community of lenders to fund it. Many banks are simply unable to underwrite microloans to small businesses because the cost of underwriting is prohibitively expensive. Social underwriting can help to change that.
- Lastly, social underwriting can drive growth! Normally, improved risk management is in stark conflict with growth. If you aim for higher repayment rates, you implement more stringent criteria around FICO score and collateral requirements, and the number of businesses you are able to approve for loans decreases, probably exponentially. By contrast, the private fundraising period that we rolled out in January has actually been the biggest driver of our growth this year! That’s because, on average, every loan that we post results in 20 new lenders being recruited to make their first loans on Kiva Zip. Our hope, and what we are starting to see in the early data, is that when these new lenders are repaid by their friends or family members (the borrowers that invited them to try out Kiva Zip), they will relend their repayments to support other entrepreneurs on the Kiva Zip platform. Kiva.org recruited about 70,000 new lenders in 2013. If Kiva Zip made 3,500 loans in 2015, and each invited 20 lenders, we could double that number. Where conventional underwriting stifles growth, on Kiva Zip social underwriting is fuelling it!
So what exactly is social underwriting again?
OK so that’s a lot of words, so how about this for an emerging definition:
To us on the Kiva Zip team, social underwriting means two things.
Firstly, social underwriting is carried out by a decentralized community of people (socially) rather than by a centralized financial institution. Mohammed Yunus, the grandfather of Microfinance 1.0, developed a model that relied on groups of women in rural Bangladesh to socially underwrite loans in a community-based way. With Kiva Zip, we’re exploring new digital instantiations of that concept. In this way, just as AirBnB is democratizing access to hotels, and Wikipedia is democratizing access to encyclopedias, so we see Kiva Zip (and crowdfunding more broadly) as democratizing access to capital.
And secondly, social underwriting employs social data (e.g. on a borrower’s character and standing in their community), as well as purely financial data, to assess borrowers’ creditworthiness and make lending decisions.
Apologies for the epic length of this blog post, but as you can tell, we’re pretty excited about this concept! Thanks for helping us explore it, by your participation in this Kiva Zip community.