How Marketplace Lenders Will Save Financial Services
The global loan platforms present an extreme example of the ongoing clash between the fast-moving financial technology sphere and the staid world of financial regulation.
The Consumer Financial Protection Bureau said Springstone Financial, acquired last year by Lending Club, misled borrowers into thinking loans carried zero interest.
The Treasury Department announced Tuesday that members of the public will have an additional month to submit comments about the online marketplace lending industry.
Todd Baker argued in a recent op-ed in American Banker that marketplace lenders are a systemic risk and need greater regulation. While his intentions are good, his rationale is flawed.
MPLs are already regulated by multiple agencies. They reduce the financial system's leverage, provide greater financial transparency and ultimately deliver a better product to consumers and investors. In fact, the product is so much better that banks are some of the biggest buyers of MPL loans.
MPLs are a diverse lot. Lending Club and Prosper have historically focused on debt consolidation. OnDeck and Funding Circle have emphasized small business lending. SoFi and CommonBond started in student loan refinancing. Credit quality ranges from subprime to superprime. Some companies have state lending licenses, others use bank partners. They are all regulated by the Consumer Financial Protection Bureau, and those with state licenses are additionally supervised by the states they operate in. The one common characteristic of MPLs is that they aren't banks they don't collect deposits and they don't have national lending licenses.
As the name implies, MPLs operate marketplaces. They originate loans and sell them to buyers through retail and institutional channels. Firms like Lending Club and Prosper use very little of their balance sheets for lending. Baker's assertion that MPLs "can operate at levels of financial leverage unheard of in the banking industry" is simply wrong. Lending Club, for example, has no real leverage. It originates loans and offsets them with notes tied to the loans. While these are on-balance sheet, the firm has immaterial credit risk. Lending Club is less than one time leveraged to the loans where it has any credit exposure. Compare that to Wells Fargo's 9.1 times or JPMorgan's 10.2 times balance sheet leverage and it's clear where there is greater financial risk.
Some firms like OnDeck and SoFi use their balance sheets to aggregate loans for transactions such as securitizations. During these brief periods, both firms have limited balance sheet exposure. But these are very different models than the specialty finance casualties of the 2008 crisis that Baker cites. For example, CIT had over $60 billion of loans on its balance sheet in 2006, financed in part by $58 billion in debt. Any MPL that approached those numbers would no longer be a true marketplace. For perspective, my company, SoFi has originated nearly $5 billion in loans and has never had more than $700 million on balance sheet at one time. What killed specialty lenders of yore was a combination of shoddy underwriting, vulnerable financing facilities and too much leverage. And the crisis hit more than the specialty financing companies many banks were either wiped out or forced to rely on government bailout money to survive.
The beauty of marketplaces is real-time information feedback. If there are too many buyers, the loan rates are too high. If there aren't enough, they are too low. In both cases, the MPL adjusts. Baker asserts:
If an MPL can't issue new loans which will happen any time investors refuse to buy loans in the MPL marketplace the transaction fees that are the MPLs' main source of revenue and cash will instantly disappear, while expenses continue to mount. An MPL has to keep issuing loans to survive.
The scenario he describes can't happen. It is true that an MPL needs a buyer to originate loans without one, the marketplace needs to raise rates until a buyer emerges. If there is no buyer, MPLs simply stop lending they won't start originating underwater loans. MPLs can't expand their balance sheets and leverage like the banks do, as they don't have the facilities to support this. The reason MPLs command strong valuations isn't because investors are "rushing to cash in on the expected bonanza" as Baker writes, but because these companies use equity much more efficiently than banks by using their balance sheet for limited purposes.
One might question why MPLs exist when banks are seemingly willing to lend to borrowers. Is it the adverse selection Baker suggests? The reality is, after the 2008 crisis banks backed away from large swathes of consumer credit, not just card consolidation. For example, in 2011 my company, SoFi, pioneered student loan refinancing, a greenfield opportunity ignored by the banks. Today, several large banks actively compete in the space, including Citizens. Firms like Lending Club, Prosper, SoFi and Funding Circle now have significant bank participation in their respective marketplaces. They wouldn't be there if the credit was bad.
Marketplace lenders have been a disruptive force in financial services for the better of all involved. MPLs have delivered innovative products consumers want through channels like mobile that consumers prefer. They've done it with outstanding service and significant borrower and investor evangelism, lowering costs of acquisition. And they've delivered transparency and a de-levered financial model to markets while working closely with state and federal regulators to continue to improve on their model.
There is work to be done in areas such as building even more diverse liabilities and promoting financial literacy among borrowers. But there is one thing MPLs or, for that matter, consumers, businesses and the economy don't need: for MPLs to become banks.
Mike Cagney is the CEO and a co-founder of SoFi.