The rise of crowdfunding, marketplace lending and alternative finance are all symptoms of further disintermediation in the bank’s core profitability domain called lending. In absolute terms, market share is fractional, but with a growth rate of 272% between 2012 and 2014 in Europe (as outlined in a report from EY and University of Cambridge), it’s a sign that we’re dealing with a new phenomenon, where regular lending meets alternative lending: the rise of hybrid lending. Banks would be wise to look at, or even better, embrace hybrid lending, because it creates engagement and solves a lot of issues.
In my previous blog about the crowdfunding revolution, I wrote that we are in ‘a perfect storm’ for alternative finance, particularly the form of marketplace lending where approved loans from private persons or SMEs are funded by private persons, venture capital and institutional investors. US-based Lending Club is a fine example of how all kinds of people find their way in this non-regulated space.
Online lenders in the US originated more than $3bn in loans in the last year, which is an annual growth rate of 265%. So, what’s behind this incredible growth? Quite simply, these lenders offer lower interest rates to qualified borrowers, and compelling returns to investors. With a consumer credit market of $3.2tn, online lending is still in its infancy, and the following factors are driving this movement:
- Capital allocation. Banks, forced by regulations such as Basel III, need to choose where they allocate their capital holdings. Between me and you, they would rather put them in a large corporate than leave them with a bunch of small business owners, with as many times more risk attached to their loan requests.
- Everybody is looking for yield! Investors like venture capital, but also individual saving clients don’t find proper returns in the current product offering from banks or asset management firms. Moreover, lenders can sometimes borrow money at attractive conditions from these new players with low overheads. The ideal situation is creating a win-win situation for bank customers by connecting the investors to these borrowers.
- The millennials as change agents. As you can see in the graph below, many millennials would rather go to a dentist than listen to what a bank has to say. ‘Oh yeah, my kids are also on Facebook’, says a banking executive, referring to millennials as a future client segment. Think again – these millennials are currently in the age of 20-34 years old and are your clients right now, buying their first homes and cars, and having children. This indicates once more how important it is for executives to keep up with the pace of development; to become agile in a time when speed is the new currency.
- Technology is the great enabler. For example, a Silicon Valley firm called Cloud Lending Solutions can deliver a complete end-to-end lending system built on Salesforce.com within four months for less than 200k. This is no fantasy – it’s a reality, and with over 60 implementations since 2012. Harmoney in New Zealand is proof of this. It’s a sign that these challengers can be built in record time, and at a fraction of the cost.
How hybrid lending works
How can banks benefit from this trend, as described in the previous section? Let’s take an example. Today, a small business owner comes to the bank and wants a loan of a €100k for his business. The bank’s loan officer finds this request on the edge of its risk appetite, so declines it. Unfortunately, in the crisis (and even in the current post-crisis situation), this decision is the rule rather than the exception, so the business owner is in a deadlock and has nowhere to turn. In the Netherlands, it led to societal upheaval and, correspondingly, a bad reputation for bankers. In the hybrid situation, banks can say to the client: ‘We’re willing to give you €60k and we will submit the rest on a marketplace platform where investors for this higher risk will lend you the money for a slightly higher interest rate’. So, everybody’s happy and the hybrid form of lending is born. In the Netherlands, Rabobank is already actively preparing its customers for this new way of financing.
What should banks do?
As I said before, banks are challenged on the domain of lending by these new low-cost challenger platforms, backed up by venture capital and institutional investors. As a line of defense, incumbents should join this movement, as it solves a lot of their problems, such as capital allocation and more importantly reputation. I see two opportunities:
- Partner with an existing platform. Santander UK did this with Funding Circle, and Citibank made a deal for a credit line of $150m with Lending Club. Be aware, though, that there are many platforms out there that started without sufficient funding lines and are not able to scale or survive. Sometimes, it seems to me like another ‘goldrush for interest spread’ without a solid plan for execution.
- Create your own marketplace lending platform, where you can connect your lenders/investors to your borrowers, and where you have some influence or benefit from the learning curve of this new lending model. For example, you can use and deploy your credit-scoring capabilities for that reason in this new platform, and learn.
If you opt for your own platform, I would strongly advise you put it at arm’s length from the mother ship for a couple of reasons, first and foremost being speed. Moreover, make it cloud-based for investment and scalability reasons. Avoid lengthy internal discussion about cloud issues, and learn as a company. Implementing your own marketplace lending platform gives you an excellent opportunity to connect investors, your savings clients who are looking for more yield, and small business owners with each other. The ideal situation is to create engagement, and establish a community where customers help each other facilitated by their favorite bank.
Finally, make sure you’re not going to end up like an incumbent who used to be too big to fail but now too slow to react. Banks should take alternative lending seriously, and especially this new form of hybrid lending, where at the end of the day it has a lot of winners. Please share with me your thoughts on the rise of hybrid lending.