Todd Baker's recent opinion piece, in which he characterizes marketplace lenders as representing a systemic risk, distorts some key aspects of this new, attractive, and sustainable business model. Even worse, bank executives who give much weight to his arguments may miss a great opportunity to improve their banks' productivity and profitability.
On the other hand, Mike Cagney may be a little too exuberant in his rebuttal, "How Marketplace Lenders Will Save Financial Services." Let's have a sober assessment of this industry.
Baker's article makes a few primary arguments:
- Marketplace lenders are positioned to take market share from traditional banks
- MPLs operate their businesses with substantial liquidity and leverage risks
- As a result, MPLs pose a systemic risk to the capital markets given their growth trajectory
Let's start with defining the MPL market. MPLs are a subcategory of the "Alternative Finance Company" (AFC) market. AFCs include MPLs that operate an "originate, sell and service" business model; direct lenders that operate a balance sheet-driven business model (finance companies); and companies that are a hybrid of the two. What the entire AFC market has in common is one simple fact. As Sam Graziano, CEO of Fundation, has said, "AFCs focus on lending categories that the banks cannot or will not do." No AFC will make the argument that their cost of capital is lower or on par with banks. Therefore, they rarely compete head-to-head with banks.
Today, AFCs focus on four primary markets: unsecured consumer loans, student loan refinancing, nonconforming mortgage lending, and small business lending. What each of these markets has in common is that banks have retrenched from them aggregate bank loan balances in each of these categories range from a decline of 10% to a decline of 30% since December 31, 2008, according to FDIC data. So, it would be difficult to argue that AFCs are taking market share away from the banks in product categories that they emphasize. In fact, in the products that banks dominate (commercial and industrial, commercial real estate, conforming mortgages, credit cards, auto financing) there are few, if any, AFCs in existence.
The AFC market (again, including the MPLs) are companies that have embraced the digitization of lending to meet the needs of consumers and small businesses that the banks do not. AFCs collect more data than banks do through automation, analyze it in greater depth, and constantly update their risk management knowledge base with portfolio experience and new sources of data. These companies should not be perceived as a threat, but rather as a group of pioneers that will open up new opportunities for banks that elect to buy, build or partner in this market. This story has played itself out before in other areas of financial services.
With respect to the business model flaws of MPLs that Baker identifies, he places significant emphasis on liquidity risks faced by the MPLs and the enormous leverage levels he asserts they operate with. A pure MPL (like LendingClub or Prosper) provides a service to borrowers and a service to lenders, receiving transaction and administration fees in the process. Emphasizing leverage levels for MPLs is a fundamental misunderstanding of their business model. According to Graziano,
MPLs are essentially asset management companies that earn fees for providing investors with exposure to an asset class through a skilled process, much like PIMCO does in bonds and Blackstone does in private equity.
When you look at an MPL through that lens, the virtues of their business models become clearer and more starkly contrasted with traditional finance companies and banks. They have credit risk. It just happens to be indirect credit risk, in the sense that if the loans investors buy result in losses, investors will buy fewer of them. The volume of assets the MPLs originate and manage will then decline, along with their revenues and profits. While these companies have some liquidity risk, severe problems will not lead to bankruptcy or a "bank run" through hemorrhaging deposits; instead investors will provide less capital and fewer loans will be originated.
Given their business models, it's hard to argue that MPLs pose systemic risks to the capital markets anywhere near those of commercial and investment banks. The very nature of an MPL is to spread exposure to these loans across a large and diverse number of individual and institutional investors that it attracts to its platform. In the event of a "crisis," those risks are widely dispersed among capital markets participants. Several critical differences exist between these loans and those made in the years leading up to the mortgage crisis of the late 2000s: individual loan amounts are small, usually not more than $25,000 to $50,000; many of the loans or advances are for less than one year, keeping the borrower on a short leash; ongoing risk management procedures are usually rigorous and often involve the ability to assess cash flow in and out of borrower accounts on a daily or weekly basis.
Baker also asserts that U.S. consumers and small businesses will be harmed if MPLs withdraw from lending due to their business model risks. However, banks are notorious for withdrawing from lending when credit cycles turn. In fact, their reticence to lend has fueled AFC growth.
What Baker terms "neobanks" (and I term "AFCs") are continuing to chip away at the traditional bank franchise. This is a long-term trend that will continue no matter the short-term economic swings.
For example, a Morgan Stanley report estimates that 30% of small business lending may shift to AFCs while Larry Summers, former Secretary of the Treasury and a board member of several such firms, said he "would not be surprised" if, ultimately, AFCs generated 75% of non-subsidized small business lending. The magnitude of this shift is anyone's guess but it's a trend nonetheless. Importantly, this is not a trend that has to happen outside of the banking system. Banks will build, buy or partner, developing their own AFC business lines.
AFCs offer banks streamlined processing capabilities (unburdened by legacy systems) and expanded risk management capabilities, which is why more banks are seeing the opportunity to partner with AFCs to increase lending, in particular to small businesses. Our analysis indicates that banks only consider about 10% of small businesses qualified for bank loans. The other 90% either cannot borrow or become prospects for AFCs. AFCs respect the unique position that banks continue to have with businesses as their depository and, sometimes, advisor. Wanting to increase their loan volumes, many of the largest AFCs want to team up with banks to expand their business lending. This can involve the bank receiving a fee for referring the loan from the AFC or, if the offer meets bank criteria, buying the loan for its portfolio. The net result: additional revenue and a more satisfied client. A win for the bank, a win for the customer, and a win for the AFC.
More significantly, a number of banks are now considering integrating their small business operations with AFCs. In effect, the AFC will take over responsibility for all loans up to $100,000, $250,000 or $500,000 depending on the bank's existing capabilities. Since most banks lose money originating and underwriting these small loans, the bank's cost structure will improve.
Baker's solution to the crisis that he foresees involves killing the creativity and energy of AFCs by increasing their regulatory burden and, ultimately, having many of them swallowed up by banks. Instead, banks should evaluate the AFC landscape, determine what they need from a working relationship with an AFC, develop a detailed request for proposals, and move forward into this new lending environment rather than hoping to hide behind the regulatory barriers that harm borrowers and the banks themselves.
Of course, challenges exist for banks in selecting and working successfully with AFCs, but it can be worth the effort. Failing to embrace alternative lending could result in a systemic risk to the future profits of many banks.
Charles B. Wendel is the president of FIC Advisors.