Decoding the profitability of UPI based BNPL

Credit based payment instruments such as credit card, BNPL can be useful in exactly one of the two ways. (1) convenience of a tab (2) borrowing money to fund the transaction. When a person is purchasing something, there are only two distinct possibilities: (a) the person has enough and more money to fund the purchase themselves (b) the person doesn’t have enough money or is facing is a crunch scenario now or in the near term.

In scenario (a), the person uses one of the normal payment methods they often use: credit card / debit card / UPI. The exact payment method used for the transaction will be determined by a number of factors such as habit, a feeling of safety with a particular payment method, cashbacks, etc. In scenario (b), if the person has credit card it is the ideal way to fund these purchases. In a country like India that has severe under penetration of credit cards, people turn to options such as Bajaj Finance EMI card or IDFC Easybuy card.

High value BNPL

With instruments such as Bajaj Finance EMI card, it is actually a personal loan that is packaged into a payment option. In most of the places where such EMI cards are accepted, the shopkeeper pays the lender a good sum of money for every transaction approved by them. This is called subvention. It can range from 3–7% depending on the amount, tenure and nature of the product being purchased. The customers may be required to pay interest if they opt for a longer tenure (longer than 3 months).

Illustration:

Product value = 9000 rupees
Subvention rate = 5%
Lender fee paid by merchant = 450 rupees
Tenure = 3 months
Landing interest rate of capital = 12% p.a.**
Cost of capital= 9000 * 1% + 6000 * 1% + 3000 * 1% = 180 rupees
Profit on the transaction = 270 rupees
RoI (@ 270/6000) = 4.5%
Yearly RoI = 18%

The above is a highly simplified model. In reality, there would be additional things to consider (a) down payment required from the customer (b) processing fee paid by the customer. These help increase the overall margin to a more handsome number.

• *Bajaj Finance cost of funds stands at about 8.3% (https://www.bajajfinserv.in/bajaj-finserv-investor-presentation-%E2%80%93-q3-fy20.pdf), a tall order for smaller companies with small loan book.

It is profitable to be in the high value BNPL business. Not much thought has to be given to other elements of loan book such as missed payments (leading to interest on interest) or additional interest on longer tenures.

Low value BNPL

In the above section, we saw how high value BNPL has healthy profit margin for lenders. Companies like Bajaj Finance are wildly successful since they tend to make money on every transaction. However, they also carry quite a bit of risk, since this user segment is inherently a high risk one. The most well-to-do and highly credit worthy customers tend to use credit cards. Companies like Bajaj Finance hedge this (sub prime) risk by diversifying their loan book into other products such as auto loans and home loans.

Low value BNPL cards look a lot like credit cards albeit a much simpler one to understand for the users. EMI cards are not user friendly for small value purchases that are day-to-day in nature. Whether low value BNPL is useful for customers is a debate for another day. Let us focus on the economics of this, try to understand if and how this can be made to work profitably.

Mode of payment

Day-to-day digital payments of users are mostly conducted via UPI. Hence the most compelling way to deliver BNPL credit is via UPI. Today, you would see apps such as Lazypay and Bullet providing UPI payment mode on their BNPL app. Prepaid card is another route being used by apps such Slice and EarlySalary to enable customers to utilise the line of credit. In this post, we will focus on UPI based BNPL.

UPI based BNPL

UPI is the most popular payment method among the young users in the country and its dominance is beyond any question at this point. With the government sticking to its guns on Zero MDR (however misplaced it might be), the merchants favour UPI. Another reason why the merchants also favour UPI is its simplicity — easy to handle QR sticker, familiar interface of smart phones for account & transaction management, zero setup cost and zero monthly rental (unlike POS terminals).

Cost of lending

Let us look at the cost structure for the lenders. Suppose the landing cost of capital is 18%. This is higher than high value BNPL because of the lack of scale. Most low value BNPL operators haven’t attained the maturity to enable them to avail low cost of capital.

Typical BNPL credit line =5000 rupees
Average utilisation = 3000 rupees
Billing cycle =15 days
Typical grace period for repayment = 5 days
Total credit days =20 days
Average credit days =10 (this is approximate)

Cost of funds = 3000 x 10 x 18% / 365 = 15 rupees
Total cost of fund / customer / year = 15 x 26 cycles = 390 rupees

Revenue opportunities

Since MDR is zero in UPI, there is no interchange based revenue. There is a good chance that MDR shall be revised soon but let’s not hold our breath! As the Zen philosophy says, clinging to anything is the path to suffering!

a. Convert balance into EMI

Allow the customers to convert the repayment into EMI at a given rate of interest and a fee.

EMI processing fee = 60 rupees (2% of balance)
EMI rate = 24%
Revenue from EMI = 1000 x 2% + 1000 x 4% + 1000 x 6% = 120 rupees
Cost of capital for EMI = 2000 x 1.5% x 3 = 90 rupees
Total profit = 90 rupees (processing fee + EMI revenue — Cost of capital)
Average number of times a typical user avails this facility = 2
Balance conversion to EMI revenue / customer / year = 180 rupees

b. Late fees

Sometimes the user may run into cash crunch and hence unable to make timely payments resulting in penalties. In such scenarios, typically a flat late payment fee and interest is charged to the customer. Suppose the late payment fee is fixed at 50 rupees and the interest rate is 24%. Since the user makes the payment within a week or two in most scenarios, the interest earned is low (0.5%).

Fixed late payment fee = 50 rupees
Net Interest on outstanding balance — 0.5% x 3000 = 15 rupees
Total = 65 rupees
Average number of times a typical user pays this penalty = 2
Late payment revenue per customer p.a = 65 x 2 = 130 rupees

c. Transactional EMI (pay in parts)

Allow the user to transact for select categories / shops (mobile phone purchases for example) for value higher than what they are eligible for. As an example, a user who is only approved for 5000 rupees can be allowed to purchase an item worth 10000 rupees which can be paid across 6 billing cycles (3 months).

Purchase value = 12000 rupees
Tenure = 6 billing cycles (3 months)
Rate of interest = 24% per annum
Cost of capital = 8000 rupees x 1.5% x 3 months = 360 rupees
Interest earned = 8000 rupees x 2.0% x 3 months = 480 rupees
Processing fee = 120 rupees
Total Revenue = Processing Fee + Interest Earned — Cost of capital = 240 rupees
Average number of times a typical user avails this facility = 1
Transactional EMI revenue = 240 rupees

Total Revenue and Cost

Basis the above, you can see that the book can actually be made profitable at a transaction level when built carefully with the userbase showing the right characteristics. The numbers:

Revenue earned per customer p.a. = 180 + 130 + 240–390 = 160 rupees

Supposing the business hits scale and consistently shows that NPAs are low and the book is profitable, just like Bajaj Finance does, then the cost of capital can come down drastically.

At 12% cost of capital (and you choose not to pass on the benefit of lower cost of capital to customer),
Statement EMI revenue = 240 rupees
Late payment revenue = 160 rupees
Transactional EMI = 360 rupees
Cost of capital = (260 rupees)
Annual revenue per customer = 240 + 160 + 360–260 = 500 rupees

If you have a million active customers, then the direct profit on the lending book at scale is 50 crores per annum. The total outstanding will be 300 crores or thereabouts which yields a handsome ROCE of 15%.

Should a bank like HDFC or ICICI or Kotak decide to pursue BNPL revolving credit, then given their lower cost of capital, they can aim for an ROCE of 30%. However, the execution structure of these institutions aren’t conducive for the mass market of low value, high velocity transactions. Their best bet is to forge partnerships with larger fintechs that have mastered the art of execution of such a model (similar to how Bajaj Finance has tied up with Mobikwik).

Other revenue streams

A business having such large active userbase can think of many other ways of monetisation such as ad campaigns inside the app for other businesses, cross sell high margin products such as insurance or loans, direct merchandise sales (esp digital ones). Anyone that builds a million strong customer franchisee is definitely smarter (than me for sure!) and will be able to develop many other revenue streams to generate better RoI.

Risks

At the core of it, lending is all about risk management. UPI based delivery of lending makes it more complicated as there is no transactional revenue unlike a credit card. Skew more towards prime users and the profitability will suffer while risk will remain largely under control. Skew more towards sub-prime and the risk will spiral out of control. And hence, businesses should take abundance caution while building their lending book.

A final word of caution

The consequence of relying on users to make mistakes like not paying dues on time has drastic impact on how customers perceive your product. It is easy to focus too much on these revenue levers but remember that too much of late payments and it is actually an early warning sign that your book is turning toxic.

More importantly, the firm would come across as being exploitative of users’ lack of discipline. The general perception of credit cards are that they are extractive since the incentives are misaligned. Even the BNPL companies of the west such as Klarna are now being accused of pushing customers in debt traps by fuelling reckless spending. If you are the leader of a lending company, do not optimize on the numbers at the cost of losing your brand value.

If you are looking to build a revolving credit product, do take a look at our stack — hyperface.co. We make it extremely simple for you to embed credit card or BNPL into your app.