The late 2000s witnessed the rapid rise of a new group of stars: the “peer to peer”, or marketplace lending platforms. The timing of this rise was serendipitous, growing out of frustration with a banking system that had led to a global credit crisis. As traditional banks tightened credit, borrowers sought alternatives, and the marketplace lenders were able to tap into this latent demand.
Describing themselves as “eBay for money”, these marketplace lending platforms were designed to bring borrowers in need of loans – $1,000 as the minimum, $35,000 as the maximum for unsecured consumer loans, and up to several hundred thousand for secured products – together with investors seeking better returns than they’d get from a bank. In the years that followed, VC money poured in, and some of the major marketplace lenders even IPO’d. Shares of Lending Club surged 56% on its first day of public trading in December 2014.
Marketplace lenders hit turbulence
Earlier this year, the first signs of trouble emerged. Details came to light on how Lending Club – a company whose entire business model was built on the premise of complete loan data transparency – had altered loan data to make a loan sale work. The CEO resigned amid allegations that he and several family members had taken out loans from Lending Club in order to inflate loan volume (a key metric for investors to determine online lenders’ value). The integrity of an entire industry was brought into question.
At a higher level, this scandal exposed the weakness and inherent instability of the pure gain-on-sale marketplace lending model. Their dependence on perpetual top-line growth and gain-on-sale margins makes it extremely difficult, if not impossible, for them to be truly transparent. Lending Club’s issues came at a time when institutional risk appetite for marketplace loans was tightening, while the pressure to hit growth and margin numbers was likely growing.
Bad things often happen when the goal is to hit volume and gain-on-sale numbers at all costs. Marketplace lenders are incentivised to sell off their loans, and will stop at no cost, even it means not being totally transparent about risk. This dependence on perpetual top-line revenue generation is rooted in the fact that while marketplace lenders connect borrowers with lenders for a fee, they don’t actually generate capital to lend themselves. Banks, of course, generate capital from depositors and diversified product offerings, which gives them a significant head-start when it comes to making loans, entering more markets and creating a strong capital-generation pipeline. This also gives banks the resources they need to plug temporary holes, making them much better equipped and adaptable to survive in tight economic times. Finally, a reliance on their own capital tends to give banks more “skin in the game” – one reason banks are widely viewed as experts at evaluating and minimising risk.
Once Lending Club’s scandals were exposed, the industry’s problems only seemed to mount further. Immediately, Jefferies and Goldman Sachs halted their purchases of Lending Club loans. As of August, Lending Club’s stock value had dropped by almost 60% since the beginning of the year, while Prosper Marketplace was forced to cut about 28% of its staff. Throughout the first half of 2016, equity investments in marketplace lenders have gone down in terms of frequency and volume.
It’s true the marketplace lenders are facing strong headwinds, yet I see many promising signs they’re heading in the right direction. For example, the marketplace lenders themselves seem focused on working together to establish and maintain a high level of industry standards and best practices. One marketplace lending platform recently set up its own hedge fund with the express purpose of purchasing loans it originates. This kind of foresight can provide a buffer to marketplace lenders in times of economic downturn.
In April, several leading marketplace lenders announced the formation of the Marketplace Lending Association, whose goal is to provide a forum for leaders in the industry to discuss and tackle the unique challenges, risks and opportunities faced by participants in the sector. The Marketplace Lending Association will also require its members to adhere to a specific set of operating standards that are designed to promote responsible lending, governance and controls, and foster industry growth.
In addition, while it’s true that equity investments in marketplace vendors have dropped since the beginning of the year, online loan issuance has gone way up, likely helped by the most recent US employment numbers – the strongest in eight years. This signifies that market demand for fast, convenient access to capital is still strong. In fact, the large, established financial services firms are trying to get in on the game, incorporating these attributes of speed and convenience into their business models and new service offerings. As an example, Goldman Sachs is planning to roll out a consumer lending platform soon. Other established lenders are planning to launch “fast decision” portals for entrepreneurs, as well as integrations with online lending portals to handle processes such as credit checking.
Another interesting example is Chase, which, like other large banks, typically sat on the sidelines of SMB lending, but is now growing more vocal about its middle-market push. It may not be the case that Chase is looking to compete with marketplace lenders, as much as it may wish to use them to scout the talent that may need more capital to finance its growth. In this sense, big banks are beginning to view marketplace lenders not as competitors, but potential collaborators.
As the marketplace lenders continue their path to maturation, we’re also seeing the emergence of a new model known as “composite lending”, which combines the speed and convenience of marketplace lending with the reliability and resiliency of established balance sheet lenders, many of which are banks. In the composite lending model, an online platform is deployed to facilitate the sale of balance sheet lender-originated loans to secondary investors.
The composite lending approach is expected to be a robust outgrowth to the marketplace lending trend, but without the current obstacles including viability concerns (outside of loan origination, balance sheet lenders have other lines of business that can help insulate them during a downturn) and transparency issues (unlike marketplace lenders, balance sheet lenders don’t face intense pressures to sell off all the loans they originate, including those that may be high risk).
From the ashes
Given the uptick in US employment and a consumer culture that places tremendous value on speed and convenience, we expect the smoke will eventually clear for the marketplace lenders. Furthermore, out of the ashes leaders will surely emerge, distinguishing themselves from their earlier versions through greater transparency, reliability and viability.
Several years ago, many in the industry were predicting a massive shakeout, with the marketplace lenders replacing out of date banks. As the pendulum of public favour has swung back in favour of the banks, some are now predicting a death knell for marketplace lending. I believe the ultimate outcome will be something of a hybrid: a world where marketplace lenders’ business model will grow more sophisticated, where banks and marketplace lenders will collaborate, and where traditional organisations, including banks and balance sheet lenders, will adopt and benefit from the marketplace lenders’ business fundamentals. In the end, this could translate to a brighter future and more abundant opportunities for the entire loan ecosystem.
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