Banking

Lending and the crowdfunding revolution

Bill Gates says, 'We need banking, but we don't need banks anymore'.

Banks are too slow with digital transformation and they’re no competition for direct lending and market lending platforms. They need to change, says Auke Douwe Veenstra.

Traditional lending works well, at least for banks. For centuries, banking has remained fundamentally unchanged. In the simplest terms, banks match savers with borrowers. They pay interest for deposits and make loans to businesses and consumers.

In the aftermath of the economic crisis, bankers are smiling again. The spread they’re making on lending has never been so high, and over the past few years they used this money to increase their buffers and pay their fines. But these times are changing. The so-called ‘disintermediation’ of banks is set to continue, yet on this crucial domain for banks, lending.

New entrants with disruptive technologies are threatening high street banks with user-friendly marketplace lending platforms. (Tweet this) Challengers such as Lending Club (US), OnDeck (US), Lendico (EU) and Funding Circle (UK) are becoming popular among consumers and small business owners. They have proven their existence and are here to stay. They offer products in an easy, simple, secure, and transparent way. More importantly, compared to a standard bricks and mortar bank, they’re up to 400 basis points cheaper in processing these loans. And how do the bankers respond to this possible threat? (Sigh) … Just a few, like Santander UK, which partners with the Funding Circle platform, sees the opportunity and is making partnerships with these new disruptive platforms. New hybrid forms of credit are born.

A perfect storm

Banks as intermediaries have always added to the cost of borrowing and lending, which is the price we pay as a society for their market-making abilities. That spread represents a price that was accepted because the banks played a part in the community and served community needs. Yet, now this traditional model is being challenged and broken. It was Bill Gates who said, “We need banking but we don’t need banks”. The following factors are causing the changes in the lending playing field:

  • Banks are forced by regulators to increase compliance costs. Plus, Basel III requires banks to increase and improve their capital holdings. Because of these post-recession regulations, banks have less money to loan, leading to societal upheaval and increasing the need for alternative lenders.
  • In general, banks are too slow on their digital transformation and most are still operating with a branch network that’s too big. They’re no competition for lean direct lending and market lending platforms.
  • Investors, like savings clients from high street banks, are looking for yield and are searching for alternative forms of investments they can get if they borrow money at attractive yields.
  • New data sources and technologies lead to more sophisticated forms of underwriting risks and is no longer an exclusive domain of a bank.
  • Last but not least, a lack of trust and loyalty makes it easier for customers to be receptive to other non-banking firms – those who truly offer great customer experiences at lower costs.

Marketplace lending is booming

For the first time in banking, the online marketplace makes it possible for a third party to match idle supply and demand. As a result, lenders and borrowers can now find one another and agree to terms, all without the involvement of retail banks or credit card companies. This new crowdfunding system of lending and credit began as peer-to-peer (P2P) to individuals and small business owners, but the system is creating so much value that has grown to involve a diversified set of investors like institutional investors.

Crowdfunding knows many forms where the borrower meets the investor or lender. Therefore ‘marketplace lending’ is a better name to describe this new system, which is fundamentally about creating platforms to connect borrowers with lenders for various reasons. This could vary from getting money to buy a car or to fund a new product or service.

A recently published report from the University of Cambridge and EY says that, in Europe, the sector grew in 2014 with 144% with a total volume of €2,957m. The UK market is by far the most developed market with the volume of €2,337m and a growth rate of 159%. Below, we see the development per segment of these alternative finance models. Other reports are stating that by 2025, $1tn in loans will be originated through marketplace lending platforms globally.

Alternative finance models in Europe (excluding the UK). Volume in €M and average growth rate 2012-2014.

What banks should do

What the new lending players have in common is that they operate in a low-cost model, most of the time operating on SaaS platforms they launch in record speed. Moreover, they develop advanced credit scoring modules using multiple data sources for predictive credit analysis backed by sophisticated algorithms. I don’t think banks can ignore this new competition anymore. Therefore, banks should respond by organizing their own marketplace lending platforms, and here are a few suggestions what you could do:

  • Offer a marketplace lending platform as the first lending option for your SME business customers. Highly automated underwriting processes on relatively simple products with low margins is a perfect match. Not unimportantly, you take away the societal criticism around not wanting to give out loans to small business owners who struggle to escape the effects of the crisis.
  • Moreover, you don’t have to allocate your scarce capital for these small, sometimes higher risk types of loan.
  • The ‘dual-edge sword’ is that you connect customers of the bank who want credit to the ones that like to have a higher yield for their savings and  investments to the ones that need credit.
  • Put the platform at arm’s length on a SaaS platform. In this way, you develop speed and your company (and the IT crew more specifically) can also go on the learning curve with cloud with little interference directly with the core systems of the bank.

With marketplace lending moving mainstream, I hope you’re agile enough to respond and act accordingly. I’ve previously written that banks need to become more responsive and they can achieve this via digital transformation and agile innovation. Moreover, I do believe that you can only accomplish this by using standard technology solutions. If not, you won’t survive.

If you need help, just drop me a line and let me know what your thoughts are. More important is this: you need to respond and had better join this revolution before it disrupts you and your most important domain: lending.

About the author

Auke Douwe Veenstra

Auke Douwe Veenstra is an independent observer of financial markets and the fintech industry. He is head of Europe and South America at Cloud Lending Solutions, a SaaS lending platform provider. For more than 25 years, he worked in the retail financial services industry. He has a track record in business development, general management, and digital business strategy in executive roles at a range of financial services companies in the US, Mexico, and continental Europe.

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