WIRED’s Steven Levy, one of the finest writers to bless the world of tech journalism, wrote last week about how the phrase “Gradually and then suddenly” from an Ernest Hemmingway novel has gone viral in articles and op-eds to describe everything from political bankruptcy to crypto downturns.

At the risk of being clichéd, I too will seek refuge in that phrase for it aptly summarises the unravelling of the economy and the monetary policy over the last year. Before that, politicians and technocrats alike were claiming that the growth was sustainable, or inflation was on track to fall in place in the middle-term range.

A year later, inflation has breached 21 per cent and the policy rate sits at 15pc as all talk of stabilisation or recovery washes away like roads in the rains. But our focus today is not macro for people far more qualified have dissected and analysed it in much greater detail. What interests me is how the same phrase explains the changing fortunes of lending startups.

During the capital frenzy of a now bygone era, everyone had become obsessed with credit: payment wallets built their entire valuations on the hope of someday making money off loans. Buy-now-pay-later (BNPL) became all the hype by giving credit cards a venture capital brush while running outrageous non-performing loans as e-commerce players also tried to enter the race.

Expanding access to credit is a huge problem to solve but cracking it requires some groundedness in the fundamentals of finance, beyond the global fundraising environment

Globally, funding to digital lending players shot up 220pc to $20.5 billion in 2021, according to CBInsights. In Pakistan too, this vertical has garnered interest as a number of startups have launched credit products, obviously including fintechs. Four business-to-business e-commerce companies are also in the race as are a couple of AgriTechs.

Specifically among fintech startups, nine licensed players — ranging from loan sharks (sorry, I mean nano lenders) to housing finance — are doing some sort of lending, either directly or via a partnership. Of these, seven have a combined 10 disclosed rounds worth almost $50 million, ignoring Finja’s deals before 2020 as it didn’t have a license at the time.

However, restricting our lens to just fintechs doesn’t reveal the extent of interest in the space. According to Data Darbar, startups with credit products have raised over $272m across 24 unique rounds since Tez’s seed investment in October 2018. Just to clarify, many of the players are not exclusively into lending, such as B2B e-commerce or AgriTech apps with BNPL offerings. Therefore, only a share of the funding will be utilised for lending though we don’t know the allocation.

In a country where access to formal loans is a privilege, we were told these solutions would disrupt their respective industries. Generally, lending requires two things: a low cost of funds and a good credit model.

The first one wasn’t really something startups were banking on, yet at least, for most of the disclosed rounds were equity deals. And as per finance 101 conventions, the cost of equity is more than that of debt, for the latter entails higher risk. Even the supposedly cheaper debt would be at least a few percentage points above the Karachi interbank offer rate, which is over 13pc for the shortest tenor.

Without getting too technical, most startups were still building their lending portfolios using equity money, which is supposed to be more expensive. That means in order to recover costs, the loan’s charges to customers should also be higher.

Of course, as a young company one has to bite that bitter pill since the money is required to train the algorithm which then, in theory, helps make better credit decisions. The second part is a function of quality data such as spending patterns, frequency of orders of kiryana etc, which comes with scale and recurring customers among other things. Something that most players were still working on.

Offering financing solutions as a sort of user acquisition strategy was part and parcel of the wisdom from the good times when money came cheap globally. Now the market has changed gears and the central banks are jacking up rates, which means the required return on equity should also rise. That’s a bad omen for startups in general but some fintechs are particularly vulnerable. According to Tellimer Research, “most business models are likely to suffer, particularly certain lending businesses such as Buy Now Pay Later and small and medium enterprise financing.”

That reckoning has already come for BNPL startups where major players have seen their stock prices crash while the industry’s poster boy Klarna — once the highest-valued private fintech in Europe at $45 billion — is now down to $6.5bn in one year. Pakistan’s own QisstPay pivoted barely a couple of months after raising $15m in September 2021 amid reports of holding back merchants’ payments.

As an emerging market with short boom and bust cycles and a disappointing private sector credit offtake, lending is even harder to crack in Pakistan. Unless of course, it’s digital loan sharks charging exorbitant rates and harassing people while enjoying full impunity from Google, the Securities and Exchange Commission of Pakistan, State Bank and the telecom regulators alike.

“I think both the opportunity is immense, as is the challenge. They’re also tied to each other. There’s little incentive to set up the infrastructure to lend to the private sector when you can just lend to the sovereign. On the other hand, Habib Bank Limited’s market cap isn’t even a billion dollars. For a country the size of Pakistan (and the potential to expand into adjacent markets), there could easily be a billion-dollar bank, if not two or three,” says Ozair Ali, a former investor in emerging markets.

“There are obviously a lot of risks that come with this. International markets can be jittery (as we’ve seen), politicians and regulators can be unpredictable, and startups can fail despite all of that for any number of reasons. I would also say that Pakistan isn’t an outlier or an exception in a macroeconomic sense in most dimensions, given that it is very much a lower-middle-income country,” he adds.

By all measures, expanding access to credit is a huge problem to solve but cracking it requires some groundedness in the fundamentals of finance, beyond the global fundraising environment.

Published in Dawn, The Business and Finance Weekly, July 13th, 2022