As a new way to deliver affordable credit to consumers and small businesses, online marketplace lending has received a fair amount of attention in recent years. The size and success of Lending Club's $1 billion initial public offering last month has fueled a fresh debate as to whether Lending Club and other marketplaces can truly transform the banking industry.
I do believe online marketplaces will be a driving force in the transformation of the banking system, and that traditional banks can benefit from that transformation. I also believe there are a few myths that need to be dispelled about marketplace lending.
Myth #1: Marketplace Lending Competes with Bank Lending
While there's always room for healthy competition, the largest opportunity is for marketplaces and banks to collaborate. Lending Club has established partnerships with many banks over the last few years whereby banks can buy loans from the marketplace or use the marketplace to offer co-branded loans to their customers. This can be particularly helpful in areas such as personal loans or small-balance commercial loans, which are often hindered by high underwriting and servicing costs. This arrangement plays to each party's strengths. Lending Club's low operating expenses, combined with banks' low cost of capital, reduces the cost of credit for consumers and businesses.
Myth #2: Marketplace Lending is Unregulated
The two primary objectives of banking regulations are to protect consumers and ensure the stability of the financial system. Since online marketplaces work with issuing banks to originate loans, the loans are subject to the same consumer protection regulations (such as Truth in Lending or rules governing unfair or deceptive acts or practices) as any other bank loan. Regulations pertaining to deposit insurance from the Federal Deposit Insurance Corp., liquidity ratios and capital requirements, however, are inapplicable since marketplaces take no deposits and benefit from perfectly matched assets and liabilities.
Myth #3: Marketplaces Use Unproven Underwriting Models
Lending Club and most other marketplaces use fairly traditional underwriting models that are based primarily on the borrower's credit history and ability to repay. These models are bolstered by proprietary data and algorithms. The methods we use to reach our credit decisions are similar to those used by credit card issuers, with further enhancements coming from income and employment verifications.
But the core benefit of the marketplace model is not risk arbitrage: leading marketplaces have remained primarily focused on prime consumers and don't necessarily claim to have superior data or algorithms. Rather, marketplaces are buoyed by a cost arbitrage achieved through technology, more efficient capital allocation and modernized processes.
Myth #4: Marketplaces Are Unproven in a Down Cycle
"We've seen this movie before" is the familiar rallying cry of marketplace skeptics. They argue that new credit providers frequently grow too quickly in good times, then come crashing down in the next cycle with high credit losses and an inability to fund new originations.
In reality, the two leading U.S. marketplaces launched in 2006 and 2007 in the run-up to the financial crisis. While they were small at the time, they facilitated a sufficient number of loans prior to 2009 to generate statistically relevant performance data. For example, Lending Club generated positive returns through the financial crisis despite its relative immaturity at the time, and investors continued to add to their accounts. Marketplaces are also expected to be more resilient in turbulent economic times thanks to the broad base and wide diversity of their investors.
Myth #5: Marketplaces Have No Skin in the Game
Online lending marketplaces generate revenue from a transaction fee collected upfront and a servicing fee that is earned over time. In theory, the upfront fee could provide an incentive to grow originations at the expense of loan quality — a behavior that contributed to the financial crisis.
In reality, there are three fundamental characteristics that are designed to protect investors. First, investors can monitor underwriting and servicing quality with transparent metrics such as daily loan-level performance reporting. Second, most loans have a three-year term and are paid off with in fixed amounts over 36 months. This means that any degradation in loan quality would become apparent to investors very quickly, by the end of the first year. Third, there is tremendous accountability in marketplace lending. Unlike a scenario involving loan brokers, originators, rating agencies, investment banks and loan servicers, marketplaces own the entire process and answer directly to investors. A poor investment performance would be as impactful to Lending Club as to any other firm that relies on its track record and reputation to generate future growth. In that respect, Lending Club has as much skin in the game as Fidelity or Vanguard.
In summary, I believe that a marketplace model delivers measurable benefits to both borrowers and investors, rooted in sustainable cost reduction rather than risk arbitrage. And I believe that it is in the best interest of both banks and marketplaces to form partnerships to further reduce the cost of credit to consumers and businesses.
Renaud Laplanche is founder and chief executive of Lending Club.