Recent turbulence among digital online lenders does not change the overall direction of this growing market. Banks should stay focused on entry options and customer demand.
Just a short time ago, digital lenders were being hailed as the vanguard of financial technology, destined to change small business and consumer finance forever. Now the sector is under assault and sentiment has shifted from one extreme to the other.
Following the revelation of internal control issues at Lending Club and the sudden resignation of its CEO, longstanding issues with the sector, mostly ignored by its supporters over the last few years, were suddenly cast front and centre. Is digital efficiency and speed in loan origination being achieved at the conspicuous expense of credit quality? Is a business model dependent on a narrow fee revenue stream and slippery funding viable?
These and other pressing questions have created a cloud of doubt around digital lending, resulting in a contagion that disrupted market funding and stock valuations for several players. Banks should rightfully tread with caution in considering their options in this space. But we believe it would be a mistake for bankers to dismiss emerging trends and possibilities in digital lending just because some first movers got into a pileup.
Over the next five years it is still highly likely that a growing stream of U.S. loan origination volume will be funneled through online channels and digital lenders. From a strategic perspective, banks should not only consider various market entry options—acquire, partner, white label, licence, build—but also key questions about customer demand. Who are the future customers, what are their profiles and needs categories, and where should the bank place its emphasis for profitable growth?
Two major value propositions are in motion today:
SME small-dollar loans. It is widely recognized that banks have a hard time making money on branch-originated loans of less than $250,000 to small and medium-sized enterprises. And from the customer perspective, the traditional paperwork requirements are lengthy, time-consuming and needlessly complex. With appropriate safeguards, digital lending can provide profitable access to the SME customer base. JPMorgan Chase and OnDeck Capital, as an example, have been jointly in pursuit of this segment since last year.
Consumer refinancing. Most consumer digital lenders are assisting households in refinancing debt, most notably student loan and credit card balances. This is a market share play with significant further potential for savvy competitors.
Today many bankers will tell you that they specifically do not want to participate in these categories. Why? Mostly it is concern about adverse selection, or the potential to over-attract weaker borrowers who cannot get credit elsewhere. Why originate and hold more easy credit that may collapse all over again in the next down cycle?
Yes, this is a risk to be managed. But it is not grounds to abandon the field, at least one can sift the wheat from the chaff. Digital lending dovetails with the overall customer migration to virtual channels, particularly with the trend in new online services that millennials demand. Millennials shop online for just about everything these days; loans are no different. Convenience, speed and funding time are the main considerations.
Seen as a niche play today, digital lending is heading mainstream, bringing more possibilities as it reaches a broader and younger customer base. Borrowers will not come out of desperation, but because of superior credit arrangements and convenience. Banks should be actively considering the strengths they can bring to this space.
So how can today’s challenges for digital lenders be converted into tomorrow’s banking opportunities? Let’s look at some key factors at work in the market today and how banks are fitting into online lending:
Brand and relationship strengths. Few digital lenders enjoy broad recognition, and those that do pay a fortune in marketing expenses to maintain it. By contrast, banks have extensive market presence, customer ties built up over decades, and perhaps most important, legitimacy. These strengths are already being leveraged in digital lending, at institutions both large and small.
On the website of Birmingham-based Regions Bank, for example, the landing page for small business loans says: “We’ve teamed up with Fundation … a trusted online business lender with a new streamlined online application process for small business loans … Application site available 24/7 … Funds available in as soon as 3 business days … Complete application in as little as 10 minutes.” Regions announced its agreement with New York-based Fundation Group in the fall of 2015.
Elsewhere, grassroots institutions are being presented with options to licence technology platforms that keep the entire digital lending operation in-house. In promoting its digital lending technology platforms, for example, Louisville-based BSG Financial Group, leads off its web site presentation with “Your loans … Your underwriting … Your brand … Your control.”
We could go on with other digital lender/bank examples:
- Lending Club and BancAlliance, a consortium of roughly 200 community banks with assets ranging from $200 million to $10 billion;
- Scotiabank and Kabbage;
- CIBC and Thinking Capital; and
- Prosper Marketplace and Radius Bank.
Each arrangement has its unique aspects worthy of review and debate. But the main takeaway is that the possibilities for leveraging bank brands, relationships and legitimacy are real and growing. This is a place where banks bring an extra dimension, beyond what most pure digital lending players can achieve on their own.
Balance sheet funding. In better times, just-in-time retail and wholesale investor funding was hailed as an innovative advancement in digital lending. But clearly it also has its drawbacks. For one thing, there is not a scintilla of loyalty in market funding. Pipelines can be shut down in a nanosecond at the first sign of trouble, as painfully experienced by digital lenders this summer.
Bank funding stability can make a real difference. Although caveats abound—risk management, regulatory, contractual—reliably-funded banks with the right credit screening will have growing and attractive opportunities to acquire earning assets via the digital lending conduit, especially given current market conditions.
Customer retention and cross-sell. The business model for most digital lenders is a “transaction factory,” dependent on quarterly originations and associated fee income for earnings. To most of these factories, today’s borrower is tomorrow’s non-entity.
Any bank worth its salt in targeted marketing should be able to do a far better job of engaging digital borrowers to build an ongoing book of business. In particular, millennials do not yet have deep banking relationships and are notorious for changing banks. Digital lending can be viewed as one more technique to attract, retain and earn the loyalty of what has become the country’s largest demographic.
Before we briefly go over the options to get in the game, a few issues should be tackled head-on. One is risk; the other is customer focus.
On risk, there is an underwriting disconnect between digital lenders and traditional banks, with major differences of opinion on long-term viability. The idea of near-instant turnaround on credit decisions is a major red flag for traditional bank lenders, who are used to lengthy application forms and lock-step origination processes. Meanwhile digital lenders race ahead, promoting simplicity and speed backed by analytics and computer algorithms. Who is right? Is there common ground?
Banks are right to raise credit concerns, but in fairness to digital lenders, their overall track record on credit quality has been good in recent years. The catch phase, however, is “in recent years.” There is great concern in the regulatory community that a significant amount of rapid-fire credit will pile up just in time for the next economic contraction and trigger a cascade of defaults—littering the financial landscape with distressed assets and befouling securities markets and bank balance sheets. Worried imaginations recall the mortgage crisis of a decade ago, with the lack of “skin in the game” for originators who rely on someone else’s balance sheet for funding.
The situation is cautionary but not dire in our view. In the absence of other market disruptions, digital lending is not yet large enough to present a genuine threat. Also digital lenders price up for the risks they incur in rapid-fire underwriting. But bank management teams do need to consider what kinds of risk bridges need to be built, such that the appeal of quick digital responsiveness is balanced with the bank’s need to protect the balance sheet and satisfy rising regulatory pressure.
For instance, one technique is a “right of first refusal.” The bank gets the first shot at booking loan applications garnered in the digital net, with the remainder (not meeting its credit criteria) shunted to the digital partner for possible funding by other means.
On customer focus, management also needs to consider how online lending might help to reach target customer segments and meet business line strategy. For example, in a 2015 small business credit survey conducted by regional Federal Reserve banks, 20% of respondents said they had applied to digital lenders as part of their search for financing. Digital lenders are making a strong push in the SME space, and this ups the pressure on regional banks, which are already hustling to overhaul the framework for small business sales as branch networks are tightened.
Where does digital lending fit in the emerging customer outreach, not only small businesses but other sectors like consumer finance and even mortgage? Setting the right top-level context is critical, both in evaluating the opportunities and following through.
Adversity Yields Opportunity
Detractors of digital lenders have questioned the quality and resiliency of digital processes, underwriting and origination for some time—specifically whether many of the players have the necessary experience to operate an efficient and well-functioning back office. Lending Club’s disclosure concerning improper loan allocation realized the industry’s worst fears. Although a comparatively small dollar value of loans was involved, the incident raised questions as to whether other, more serious problems are present—not only in Lending Club, but among its competitors as well.
While recent events have largely put several critical aspects of the online lending model into a negative light, some interim turbulence and consolidation are to be expected in a new market sector. Impartial observers have been predicting industry consolidation for some time as a means to strengthen the digital lending sector by eliminating poorly capitalized players and flawed business plans.
So instead of recoiling, this is a time when banks should still be soberly examining whether and how to participate in this market (Figure 1: Bank Options in Digital Lending). In the current environment, hard-pressed digital lenders will be especially receptive to new investment and relationships.
In well-negotiated acquisitions and partnerships, the benefits to both parties are reasonably clear. Banks can obtain valuable online marketing origination, and fulfilment knowledge while building their SME/consumer loan base. In exchange, digital lenders get stable funding and processing.
For banks looking to expand their lending operations, especially in the SME space, partnering with a digital lender may equip them with the speed and simplicity that new-age borrowers require. For those that abandoned the SME space altogether following the 2008 crash, or those that simply want to expand their footprint in SME lending, partnering with a digital lender may present a quick solution on attractive terms.
Other banks may want to take advantage of the digital lending sector from the wholesale side, or to diversify loan portfolios with SME or consumer unsecured paper. Rumors of funding problems were in the market even before the issues at Lending Club surfaced. While the worst of the ensuing sector crisis may be over, many of the usual funding sources have either cut back or fled the market entirely. For banks that provide risk-controlled loan funding to hungry digital players, fee and rate structures present an even more attractive risk/reward balance than was available just a few months ago.
Brett Friedman is a Director in the New York office of Novantas. He can be reached at email@example.com.