As marketplace lenders gain steam with their online model for marketing and originating installment loans, banks need to take a close look at required skills and strategic options.
Are marketplace lenders some sort of digital sideshow, launched with a splash but destined to crash? It has been difficult to tell in the early going. While their marketing-intensive and customer-friendly online operations have caught a lot of attention, making a living from origination fees on unsecured consumer loans seems a niche play at best.
But before bankers dismiss newcomers such as Lending Club, Prosper and Funding Circle, they need to step back and consider how the business model is evolving and where it might lead. Instead of flies on the windshield, marketplace lenders may one day exhibit the voracious traits of early credit card players.
Combining consumer finance with the convenience and allure of online shopping, these lenders are nicely aligned with the accelerating trend of digital shopping and fulfillment for retail financial services. The outlook for U.S. origination growth is bright, pegged at nearly 50% annually through 2020 by Morgan Stanley Research, in a report made public in July of 2015 (Figure 1: Expansion Ahead for Marketplace Lending).
The element of a competitive threat begins with customer demographics. It was thought that marketplace lenders mostly attract cash-starved Millennials with weaker credit profiles. But recent feedback from these companies indicates that they are also drawing a good chunk of older and more affluent customers — people who more closely fit the classic profile of core banking customers.
Given this broadening appeal, the situation could get serious if marketplace lenders cross into higher-value loan products like mortgages and automobile loans. A vivid proof of concept on web-based credit marketing came during the recent Super Bowl broadcast, when Quicken Loans won national attention with its “Rocket Mortgage” TV ad. People were depicted holding smartphones with a screen display that said “Push Button Get Mortgage,” a proposition ripe for imitation in coming years.
This is not to suggest that banks should go into panic mode and rush after the latest and greatest of marketplace lenders. Along with strengths, the current business model has some pronounced drawbacks (Sidebar: Threats to the Marketplace Lender Business Model). Ultimately, we believe that banks could learn how to outdo the marketplace lenders at their own game, but much depends on strategy and preparation.
At a minimum, national and regional banks should conduct a thorough gap analysis vis-à-vis marketplace lenders. One goal is to glean insights that may be useful in the ongoing push to strengthen digital marketing and sales of banking products. Another is to identify the elements that need to be addressed to directly compete in the space.
The next step is to perform a strategic review. Banks have many advantages in customer relationships that could be brought to bear in the new space over time, including access to information, numerous touch-points with customers as they conduct their banking activities across multiple channels, and the potential to expand core relationships with multiple products and services. On the other side, there are minefields in marketplace lending that need to be understood. These factors, along with performance gaps, need to be considered in any build-versus-buy deliberation.
Rise of the MPLs
The origins of marketplace lenders (MPLs) trace back roughly 10 years, when so-called peer-to-peer lenders made their first appearance in the United States. In the P2P model, money is lent via online services that match lenders directly with borrowers.
During these early days, the bulk of loan originations were purchased by private retail investors. But as loan volume increased, lenders found this arrangement cumbersome and slow — retail investors could not reliably supply enough quick-turnaround funding to fulfill loan demand.
Banks and specialty credit funds then entered the space, largely displacing retail investors as funding sources. “Peer-to-peer” lenders became “marketplace” lenders. Several years ago, press reports heralded the sector as a sterling example of crowd funding and the democratization of finance. This is no longer the case.
Today’s marketplace lenders continue as nonbank financial intermediaries, mostly offering conventional installment loans to consumers and small businesses. Some MPLs sell their loan portfolios whole, with limited to no participation left on the balance sheet (“non-balance sheet lenders”). In other cases, investors require the MPL to retain a certain participatory balance (“balance sheet lenders”). MPL consumer loans generally are unsecured, with borrower credit profiles usually ranging from near-prime to prime.
Digital efficiency is fundamental to the business model. Loan applications are executed online, as are most aspects of origination and processing. Marketing, underwriting, processing, and servicing are all performed in-house.
Although they are thought of as disruptive and innovative, the majority of marketplace lenders offer conventional installment loans. Plain vanilla. Innovation rests with marketing, origination and processing — not in the products themselves.
Customer acquisition is the biggest challenge for marketplace lenders, as well as the single most important success factor. Since MPLs do not have physical locations or established customer relationships (like a bank), they must rely on search engine optimization techniques, direct mail, aggregators and affinity marketing to attract customers. In combination, these levers are expensive and inefficient, especially given that a large proportion of resulting applications typically do not meet underwriting standards and wind up rejected.
Hence the importance of building and sustaining a solid brand, as enjoyed by Lending Club, Prosper Marketplace and SoFi (Social Finance). More recent entrants typically have little brand recognition and therefore are at a considerable disadvantage. Consumer unfamiliarity with innovative MPL platforms compounds the problem. Applicants with better credit profiles often do not want to risk getting tangled up with unknown providers.
Baby Steps to Giant Steps?
In 2015, marketplace lenders originated about $23 billion of loans, according to Morgan Stanley, up from next to nothing five years earlier. Putting that into context, Experian Information Solutions Inc., the parent company of Equifax, estimates that marketplace lending accounts for only 1.1% of unsecured loans in the United States. More impressively, Experian estimates that MPLs account for 2.5% of small business loans.
Will these baby steps turn into giant steps? The answer could be yes. Among the more conservative published estimates, Morgan Stanley pegs the 2020 origination volume at $122 billion, more than five times the 2015 run rate.
The competitive drivers include a superior customer experience, raw speed and process innovation. People accustomed to online shopping do not like delays; consumer loan applicants are no different. Marketplace lenders have managed to streamline the origination process from weeks to days, and in some cases, hours.
Simplified paperwork, electronic data and document submission and confirmation, and automated underwriting processes permit funding within 24 to 72 hours. This expedited turnaround is especially valuable to business borrowers in situations where they have immediate needs for short-term credit.
On the consumer side, marketplace lenders make it simple to apply for installment credit online. Via user-friendly and well-designed websites, MPLs typically are able to supply rate quotes and conditional approvals within 24 hours, often immediately.
All this is not to say that such rapid-fire underwriting is easily portable to high-balance products such as home loans, but the possibility is there, and receptivity is sure to be strong. Home buyers are weary of the excessive paperwork and lengthy processes that characterize mortgage applications. In the age of big data, qualified applicants will enjoy expanded access to the speed and convenience of online/mobile origination.
In addition, marketplace lenders apparently are resonating with customers usually thought to gravitate to banks. Data from some of the largest lenders indicate that MPL customers are older and have higher incomes. Prosper, for example, reports that its customers typically range between 40 and 55 years of age, with an average FICO score of 720. Lending Club reports an average customer income of $68,000.
And customer loyalty is strong. Net Promoter Scores, which measure pass-along brand recommendations to friends and colleagues, range in the mid-70s for MPLs, considerably higher than that of most banks.
Freedom from bank regulation has been a further momentum-booster. Marketplace lenders are subject to the usual array of federal and state regulations on lending and consumer protection (including, importantly, state usury laws). However, as non-bank lenders that cannot accept deposits, MPLs escape the regulatory burden and capital and reserve requirements placed on banks. Although this may change — the U.S. Treasury Department has launched a study of marketplace lending — the current situation allows greater operational freedom in pricing and underwriting standards, plus it cuts compliance costs.
Implications for Banks
In evaluating the possibilities in marketplace lending, banks have much to consider. While they have many strengths that ultimately could be brought to bear — brand, capital, funding, credit risk management, etc. — the current MPL business model seems prone to distress. Potential acquirers would have many issues to address, and an eventual serious shakeout is not out of the question.
Still, interim challenges should not derail the train. In one form or another, marketplace lenders are here to stay:
- Technology does not go backwards. Marketplace lenders are filling a clear consumer need driven by changes in consumer behavior and marketing. Despite the uproar over the recent Rocket Mortgage (Quicken Loans) ad, consumers are accustomed to shopping online and expect to be able to execute a loan in the same fashion they make other, more mundane purchases – over the web.
- Industry consolidation will make the sector stronger. Standardization of services will eliminate poorly capitalized players, and those without a clear competitive advantage are unlikely to survive an industry downturn.
In any case, bank involvement with marketplace lending is no longer hypothetical. Some of the biggest names in the business are already staking out territory. Last December, for example, JPMorganChase announced a partnership with OnDeck Capital, an online-based small business lender, allowing JPMC “to fund loans in real time or next-day.” The loan products will be Chase-branded, and funding will come from its balance sheet. We expect many others to follow over time.
In getting started down this path, the first priority is to honestly assess the bank’s current ability to deliver unsecured consumer and business loans in relation to the best marketplace lenders. Gap analysis should focus on all aspects of the customer process, including marketing, funding, products, loan application, reputation/image, and credit analytics (Figure 2: Bridging the Competitive Gap).
The second priority is to perform a strategic review, considering how best to address comparative gaps and also leverage bank strengths in the new space. In most cases, this will come down to the classic buy vs. build decision. Although altering current operations has many advantages (control retention, limited capital spend, familiar resources), forthcoming industry consolidation may make many high quality marketplace lenders available for purchase or partnership at reduced valuations.
Brett Friedman and David Shimko are Directors in the New York office of Novantas Inc. They can be reached at firstname.lastname@example.org, and email@example.com, respectively.