Lending Club's initial public offering last week was a smash hit, fueled by a narrative that emphasized the differences between the firm's 21st-century lending model and the more manual approach used by banks.
Largely overlooked was the fact that Lending Club and its competitors in the fast-growing world of online marketplace lending are relying on old-fashioned banks to issue their loans. These startups turn to banks in order to avoid the hassle and expense of getting licensed to lend in all 50 states.
In the short term, this regulatory quirk has created a lucrative business for numerous small banks, including the $201-million asset WebBank in Utah and the $295 million-asset Cross River Bank in New Jersey. Over the long haul, it raises questions about what rules will apply to a booming business that was barely even a blip on the radar when Congress last revamped the nation's financial regulations in 2010.
The risk for marketplace lenders which are also known as peer-to-peer lenders is that banks' involvement will provide bank regulators, including the Federal Deposit Insurance Corp. and the Consumer Financial Protection Bureau, a route into the marketplaces' operations.
"If a bank regulator or the CFPB wanted to crack down on marketplace lending, they could crack down on WebBank and Cross River Bank," wrote Brian Foran, an analyst for Autonomous Research, in a recent report.
Lending Club's ability to make loans to consumers across the country hinges on a well-known 1978 Supreme Court case involving Marquette National Bank of Minneapolis. The Marquette decision allowed banks to export their home-state interest rates across the country, which enabled the creation of the nationwide credit-card industry.
The court ruling also gave rise to contracts between banks and non-bank firms that wanted to take advantage of banks' unique ability to apply their home state's rules elsewhere. One well-established example is the private-label credit card industry, where large retailers such as Walmart and Macy's partner with banks.
The legality of these partnerships hinges on whether the bank is the so-called "true lender." While that term doesn't have a clear definition, the basic idea is that the bank must take on genuine risk in the loan transaction.
Much of the promise of Lending Club and dozens of other startups with similar business models is that their technology can underwrite loans more efficiently than traditional banks can. Still, these marketplaces need to operate in such a way that the partner banks will be deemed to have taken on real risk, despite the fact the loans are quickly sold to individual and institutional investors.
That paradox has given rise to byzantine contractual arrangements between marketplace lenders and small banks.
In a recent regulatory filing, Lending Club explained that Salt Lake City-based WebBank issues loans to consumers who apply for credit on the Lending Club platform. After the loans are closed, WebBank sells them to Lending Club, which then passes them along to investors. Lending Club pays WebBank a service fee based on the number of loans it issues each month, while WebBank pays Lending Club a transaction fee for its role in processing loan applications.
In a separate regulatory disclosure, Lending Club disclosed that WebBank holds onto its loans for two business days. That's apparently long enough to give their lawyers comfort that they're meeting the relevant legal standards.
Both WebBank and Lending Club declined to comment for this article. WebBank Chairman John McNamara said that the bank's policy is not to talk to the press, while a Lending Club spokeswoman said that the company is currently in a so-called quiet period following its IPO.
Executives at Teaneck, N.J.-based Cross River, which serves as a back-up bank for Lending Club, did agree to be interviewed. Chief Executive Officer Gilles Gade described marketplace lending as a rapidly growing business that currently accounts for about 15% of the bank's revenue.
"And it's probably going to be around 20%-25% next year, so it's fairly strategic for us," he added.
Adam Goller, the bank's vice president of lending, said Cross River has an open dialogue about marketplace lending with the FDIC, its primary federal regulator. The agency declined to comment for this article.
"I think the regulators certainly are on top of the market," Goller said, before adding: "They haven't expressed a very clear opinion."
Some observers are concerned that over time, marketplace lending faces the potential of increased regulatory scrutiny.
Until now, Lending Club and competitors such as Prosper Marketplace have refinanced consumers' existing credit-card debt at lower interest rates, an activity that bank regulators likely view in a favorable light. But as marketplace lending grows, some of the loan products being offered may be perceived as less consumer-friendly.
The court system presents another potential challenge for companies like Lending Club. "Unfortunately the case law is not very robust in terms of providing guideposts," said Richard Eckman, a partner at Pepper Hamilton LLP.
In an analysis published on Pepper Hamilton's website last week, Eckman wrote that two recent court decisions reached different conclusions about the standards for determining whether a bank is the true lender. Though neither case involved marketplace lending, Eckman concluded that the mixed court record clouds the industry's future.
Darrell Dreher of Dreher Tomkies LLP, another lawyer who specializes in this area, expressed greater confidence that the use of banks by marketplace lenders will get a blessing from courts and regulators.
"Bank regulators have given a stamp of approval to this concept for 30 years," he said. "These programs create a very nice profit for the banks. And that's what the regulators want to see."
Indeed, some of the banks that issue loans for non-bank companies appear to be profiting handsomely from the business. WebBank, which has a private-label credit card business in addition to its Lending Club relationship, reported a 38% return on equity as of Sept. 30. Cross River Bank reported an 18.9% return on equity. The average across the entire banking industry was 9.2%.
Lending Club and other marketplace lenders such as CommonBond, which specializes in refinancing student loans, may wish that they didn't have to share their profits with banks.
But for now, these firms are using banks to develop a business model that complies with what CommonBond Chief Executive Officer David Klein contends is a "fragmented and almost broken regulatory system."
His company partners with Bank of Lake Mills, a $201 million-asset institution in Lake Mills, Wis.
"I'm not going to say it's impossible, but it's nearly impossible to become a bank," Klein said in an interview.
For Lending Club, which had a market capitalization of $8.5 billion after going public last week, one potential path forward would be to buy its own bank. But then the San Francisco-based firm would have to deal with all the regulation that comes with banking.
"I think they have the money to buy a bank," Klein said, referring to Lending Club. "I wonder, though, if that's going to be the option that's taken, or if the regulatory system catches up to where finance has gotten."