Buy now, pay later (BNPL) is a form of consumer credit, where goods and services are paid for in installments over a period typically less than 12 months, instead of being paid for in full at the time of purchase. This borrowing is generally interest-free, provided the customer pays installments on time. However, if payments are missed or spread over a longer period than initially agreed, then lenders may charge interest and other fees. Variations of BNPL financing have existed for many years, including point of sale (POS) financing and store credit. However, increasing retailer adoption and rising use of apps and online shopping—particularly during lockdowns related to the COVID-19 pandemic—have recently spurred more rapid growth of BNPL lending. Although BNPL products are expanding and diversifying, some common features typically differentiate them from traditional POS loans, including smaller balances, shorter loan terms, zero interest rates, and generally lower costs to the borrower if paid on time. Underwriting and affordability checks are also often less extensive than for credit cards or traditional consumer loans, and credit is generally provided very quickly.

S&P Global Ratings has yet to rate a BNPL-backed securitization in Europe, but its rating approach would encompass the application of asset-specific criteria, combined with a case-by-case approach, and a review of regulatory and jurisdictional factors. Growing calls for regulation of the sector will likely affect companies' business models, representing operational and legal risks when analyzing a BNPL securitization. There is an inherently greater challenge in formulating loss proxies for newer companies with shorter track records and rapidly growing origination volumes. BNPL asset performance may also be particularly vulnerable to a turn in the credit cycle. We believe risks associated with securitizations of BNPL assets may exceed those associated with traditional consumer ABS and could lead to rating caps.

Europe's BNPL Market Is Growing Rapidly

The BNPL market has grown rapidly in recent years. Business models have also evolved significantly as BNPL platforms transition from being a niche area of consumer finance to competing with mainstream consumer and credit card lending (see chart 1). Although BNPL accounted for only about 5% of overall U.K. e-commerce transaction value in 2020, it is growing at 60%-70% annually, according to Bain & Co.

Chart 1

BNPL lending volumes have likely increased in part by taking market share from credit card lenders. U.K. credit card balances outstanding have dropped between every month from March 2020 and September 2021 (see chart 2) and some established lenders have reacted to the competition from BNPL lenders by adapting their products to the BNPL market. For example, many banks are now offering structured installment plans to some of their existing credit card borrowers, providing a service resembling BNPL. Others have entered partnerships with fintech companies and online retailers, while a number are planning to launch new BNPL services of their own. We expect these trends to spur further growth and competition in the BNPL sector.

Chart 2

BNPL business models have heavily utilized financial technology to facilitate the lending process. Technology that improves the delivery and management of financial services has enabled BNPL lenders to achieve cost efficiencies and competitive advantages, through greater simplicity and ease of use for the customer, for example. Such technological advances from finance providers have mirrored greater use of apps and online shopping, and triggered growth in the BNPL sector.

Limited regulatory requirements, targeted marketing, and an online presence have enabled BNPL platforms to render decisions and distribute borrower funds more quickly than traditional lenders. Compared with incumbent banks, new BNPL lenders have also been unencumbered by legacy IT architecture and regulatory capital requirements, allowing lower cost business models and a swift expansion of operations.

Stricter Regulation Is Coming

While regimes differ by country, the BNPL sector has generally been subject to looser regulation than traditional consumer and credit card lending. However, the regulatory focus on BNPL is increasing as the market matures.

In the U.K., BNPL is currently not covered by existing consumer credit regulation in most circumstances. There are exemptions for some credit agreements when the contract is interest free and will be paid in 12 or fewer installments within 12 months and the credit is not conditional on interest or other charges. (This exemption applies even if the borrower might incur subsequent charges, such as late payment penalties.)

However, the U.K. Treasury concluded a consultation on BNPL in January 2022 and the Financial Conduct Authority (FCA) is now developing new regulations for the sector. These are likely to cover affordability assessments, credit checks, and treatment of consumers in financial difficulty. BNPL borrowers may also be able to take complaints to the Financial Ombudsman Service. While advertising for BNPL products must currently observe the broad rules laid down by the U.K. Advertising Standards Authority, updated regulations will likely bring it within the scope of the FCA's rules on financial promotions. The FCA has raised the concern that many customers may be unaware that BNPL products are a form of credit, do not realize that such borrowing isn't covered by the protections of a regulated service, and in some cases may struggle to manage debts across several lenders. Under the regulation, requirements to treat customers in financial difficulty with "forbearance and due consideration" may involve reducing or suspending future interest or charges and agreeing to arrangements to pay.

Even before these regulations are finalized, the FCA is taking an increasingly active role in the sector. For example, in February 2022 the regulator instructed four BNPL lenders to change their contracts after identifying "potential harms" to consumers. Some of the large BNPL lenders have now voluntarily agreed to refund late fees and to change the terms of their contracts to make them fairer and easier to understand. The potential modification of the lending contract would likely have an impact for both the credit and legal analysis when rating a BNPL securitization.

In the EU, the European Commission has also published proposals to change rules in the Consumer Credit Directive. If approved, BNPL lenders may be affected by provisions of the Directive particularly those related to affordability checks and penalty fees. A key aim is to ensure greater protection for consumers and improve transparency. These regulations would likely come into effect in 2023 or 2024.

The European regulatory landscape for BNPL products is therefore changing quickly, with the potential to substantially affect some business models. The impact of any new regulations will likely vary significantly between individual BNPL lenders, given that different providers use widely differing underwriting standards, implement various fee structures, and have different processes for complaints handling, for example. As the regulatory environment for BNPL lending continues to mature, many platforms will likely adapt by increasing their compliance and control functions. Although this may improve the quality of underwriting, the increased costs may reduce some lenders' profitability. Regulatory or legal developments are therefore likely to affect lenders' business models and may have an impact on a potential BNPL securitization.

For BNPL Securitizations, Operational Risk Could Lead To A Ratings Cap

If we were to rate a securitization backed by BNPL assets, we would apply our asset-specific criteria but adopt a case-by-case approach, given the diversity of lenders' business models and target markets, along with regulatory considerations, and different jurisdictional characteristics. These aspects are all considered in our operational risk criteria, which generally assess the possibility that a performance-related key transaction party (KTP) may become unable or unwilling to perform its duties during the life of a transaction. We would assess if there was any reliance on third-party servicers. With this view, the framework calls for the assessment of each performance KTP in a transaction and may influence our assessment of portability, severity, and disruption risk and could result in a capped rating. Other transaction strengths—for example, the presence of a back-up servicer, regular cash sweeps, account trusts, or pledges—may contribute to some rating elevation (see our operational risk criteria for additional details).

Despite some BNPL platforms now having established operating histories, most providers have operated only through a period of benign economic expansion in a low interest rate environment and have not been tested through an economic downturn. BNPL businesses may be particularly vulnerable to a turn in the credit cycle and rising interest rates, given the interest free nature of the product and the high volume, low margin lending model. Furthermore, some BNPL lenders may be dependent on a small number of retailers or products and this could result in concentration or setoff risks.

Although some BNPL lenders undertake full credit checks on borrowers, some only conduct 'soft' checks before lending, which do not create a credit bureau record for other lenders to see. Other BNPL lenders do not report their loans to the credit reference agencies at all. Lenders therefore cannot always determine if a customer already has multiple loans from other creditors. This may allow an already-indebted borrower to take out more loans and may prevent lenders from accurately checking affordability.

BNPL lenders are still evolving their business operations and strategies, and they continue to experiment with new products with varying degrees of success. We pay close attention to origination standards and underwriting criteria and how practices compare with established consumer and credit card lenders. In analyzing a BNPL-backed securitization, under our criteria, we would review servicing and collection practices, as well as charge-off policies. The BNPL target market for example, may be an area of risk if it was aimed at individuals weak or limited credit records who would not qualify for more mainstream consumer loans or credit cards and weaker underwriting standards could affect the performance of the underlying assets in a BNPL securitization.

Finally, formulating loss proxies for newer lenders with shorter track records that have not operated through a full credit cycle is inherently challenging. The credit performance of a newer lender's loan pools may not be indicative of the performance of future pools if originations are growing rapidly—as is the case with many BNPL platforms—given that lending growth may be driven by a loosening of underwriting standards or expansion into new and unfamiliar markets (see "Related Research"). It may also be the case that some banks and credit card lenders with longer operating histories benefit from much more extensive customer data which may allow them to assess risk more accurately. Given the short historical track record for most BNPL lenders and their business model, we believe that, in certain cases, the sources for their competitive advantage (speed, cost, technology, etc.) and their ability to compete in the long term may be uncertain.

The financial position of the BNPL lender is another area we consider when analyzing operational risk. As many BNPL lenders are currently still scaling up their operations, it is important to understand the lender's capitalization and consider its ability to withstand future losses. The company's income statements will also provide insights into the profitability, or future profitability, of the BNPL business model. A management team with limited experience, high turnover, or frequent shifts in strategy would also be viewed as higher risk.

Another area of review includes the lender's mix of institutional, balance sheet, and securitization funding to determine the breadth and depth of their financial support. Funding diversity is important, as an overreliance on one form or one institution, for example, can lead to liquidity shortfalls, should that market or institution's lending appetite diminish. Similarly, any substantial dependence on securitization for funding is risky should that market experience a dislocation as it did between 2008 and 2009. Also, because many platforms are not yet profitable, we would consider not only the existing equity capital available to absorb losses but also what the prospects are for the BNPL lender's future capital raises, and the strategy for achieving this. Some BNPL players use the product as a method to acquire customers and cross-sell more profitable financial products, such as higher margin loans or insurance. Therefore, in rating a BNPL securitization, we believe it is important to evaluate the overall strategic importance to the owner of the business of its BNPL lending activities and if these are profitable and sustainable on a standalone basis.

While traditional balance sheet lenders derive most of their revenue from the interest and fees collected on loans (i.e., net interest margin minus provisions for losses), BNPL platforms' primary sources of revenue are from retailers who pay a fee of typically 2%-7% of the purchase amount (and, in some cases, a small flat fee) to the BNPL provider. As a result, BNPL providers may have materially less "skin in the game" than traditional lenders, posing a potential risk to underwriting standards and loan quality. Late fees and penalties are also often a material source of revenue for BNPL lenders. It is important to understand the BNPL lender's revenue from retailer and penalty fees, and the potential impact of an increase in defaults could have on the profitability and the sustainability of the business model. Alignment of interests between the originator and potential asset-backed securities (ABS) investors may also be weaker given the fee-structure of the business model. In a sector rife with competition, retailers may gravitate toward BNPL lenders with the highest acceptance rates or most liberal underwriting policies to boost sales volumes.

The interest free nature of BNPL is one of its key selling points and, according to estimates from Bain, users in the U.K. potentially saved £103 million in credit card interest costs in 2020. Given that many lenders are currently not profitable due to a highly competitive landscape and tight pricing structure, we would also assess the viability of the business's lending model on a case-by-case basis when analyzing a potential BNPL securitization.

The Risks In BNPL-Backed Securitizations May Be Higher Than In Traditional Consumer ABS

We believe that there are distinct risks associated with securitizations of BNPL assets. These risks include the applicable regulatory environment, as well as business strategy and operating history, underwriting standards, management, revenue, and financial performance of BNPL lenders. These businesses employ a range of business models, and their strategies and quality of underwriting and affordability assessments differentiate distinctly from each other. Environmental, social, and governance (ESG) risks would also be reviewed under our sector-specific criteria.

We believe that securitizations backed by BNPL assets will likely increase in Europe in the next few years and that significant further growth is likely due to growing origination volumes and increasing investor demand. Given the diversity of business models in the sector, we would assess on a case-by-case basis whether a ratings cap is applicable. Similarly, credit performance is likely to differ materially between lenders and will be reflected in our transaction specific base case assumptions for any transaction that we may rate in the future.

Related Criteria And Research

• European Consumer Finance Buys Now. Will It Have To Pay Later?, March 2, 2022
• Request For Comment: Global Consumer ABS Methodology And Assumptions, Nov. 30, 2021
• Credit FAQ: How Could Cyber Risks Affect Structured Finance Transactions?, Sept. 8, 2021
• ESG Industry Report Card: Credit Card Asset-Backed Securities, March 31, 2021
• How Much Is Enough? Information Quality Standards For The EMEA RMBS And ABS Rating Process, Jan. 8, 2019
• Global Framework For Assessing Operational Risk In Structured Finance Transactions, Oct. 9, 2014