In 1999, I was a partner in launching one of the world’s first pure online banks. At the time, the idea was controversial to say the least.
I remember sitting in an office at the Dallas OTC while our soon-to-be ex-lawyer tried to run up his fees by scaring the stone-faced bureaucrats.
“It’s a bank, but WITHOUT PHYSICAL BRANCHES!” he intoned, raising his voice and waving his arms dramatically to underscore each point. “There’s NO BUILDING THE CUSTOMERS CAN WALK INTO to see their bankers! Are you OKAY WITH THAT?”
Amazingly, we hacked through the regulatory kudzu in the end—with the help of our new attorneys—and opened for business.
Since that time, the world has changed. Dramatically.
In 1999, e-commerce was largely a dream… even Amazon was still taking baby steps.
Today, it is estimated that globally 40% of all Internet users have purchased a product online. In the US, the number is higher… with 53% of users engaging in online shopping in 2016.
The reasons are obvious. Shopping online is incredibly easy and efficient, and it allows the consumer to comparison shop between an almost endless number of products and providers.
Mom and pop stores never had a chance. And based on the number of giant retailers now pushing up posies, apparently neither does any retailer whose model depends primarily on face-to-face transactions.
And Now the Banks (P2P Lending)
Since launching our online bank, the industry has, in fits and starts, adopted the technologies necessary to provide some form of online banking to their clients.
My family has been banking remotely since 1999, and we have never once felt inconvenienced by the lack of a local branch (or any branch for that matter).
And, apparently, our experience is shared by an increasing number of consumers. Last year, First Third Bank announced the closing of 100 branches. The bank’s CEO explained the reason for the decision: “Consumer demographics and our customers’ preferred channels of banking are undergoing significant changes. Technology continues to impact our service delivery and revenue generation tactics and strategies.”
Within that statement is a particularly important phrase, “revenue generation tactics and strategies.”
While earning fees on deposits, overdrawn checks, and so forth are an important component of the typical bank’s revenue statement, the real juice comes from lending.
And that’s where the banks have a real problem.
In the wake of the financial crisis, bank lending in America collapsed. Many businesses and individuals were unable to access credit—just when they needed it most.
In response, the banks hunkered down and lending went into lockdown and didn’t recover to those same levels until September 2013… a full five years later.
With the credit freeze locking out many ordinary Americans, the door opened wide for Peer-to-Peer lending platforms. A radical new approach to lending, P2P platforms act as intermediaries between borrowers and investors, bypassing the traditional gatekeepers of credit… the banks.
In 10 short years, P2P lending has facilitated over $35 billion of loans in the US. With the industry advancing rapidly, one has to wonder whether P2P lending will bring down banks that lack the size and the sophistication to compete?
Loans made through P2P platforms currently account for just 3% of the total unsecured consumer loans in the US. But, P2P lending has a few major advantages over banks, which ensures their share of the market will continue to grow rapidly.
For starters, banks operate with huge overhead costs, and many of those costs are fixed. Due to this, lending small amounts of money is unprofitable for large institutions. All in, the operating expenses of P2P lenders run about 4.25% lower than banks. Lower costs allow P2P lenders to reduce their spreads by over 14%, enabling them to offer borrowers lower rates and investors higher returns.
Along with making credit available to those neglected by banks, P2P lending also speeds up the borrowing process for everyone. On average, it takes 32 hours of filling out paperwork just to apply for a bank loan… never mind receiving the funds. P2P borrowers can complete the entire loan process online in a fraction of the time and usually receive their loan within three days.
Lower rates and a faster process make applying for loans through P2P a more enjoyable experience. A 2015 Deloitte survey found that quickness and convenience were the main reasons people used P2P lending, resulting in 75% of P2P borrowers recommending the process (versus only 10% of customers recommending getting a loan from their bank).
And the technical advantages of the P2P lending platforms don’t end with speed and efficiency. Instead of primarily relying on FICO scores to make a credit decision, the industry is using roughly eight years of real-time experience and the latest innovations in deep data analysis to refine increasingly effective algorithms that minimize risk and optimize investor returns.
Given the positives, the P2P share of unsecured consumer loans is projected to enjoy a compounded annual growth rate of 47%, rising to 8.4% of the market by 2020.
Individual borrowers are not the only users of the P2P platforms. The industry is making serious inroads into the Small and Medium-Sized Enterprises (SME) space, and their share is expected to grow to 16% by 2020.
With P2P investing thriving in the sub $250k space, banks are beginning to take note. As a senior banker friend of ours commented, the bankers are now paying very close attention to the rising competition.
For confirmation that things are a’changin in the banking sector, look no further than the recent launch of Marcus, a proprietary P2P investing platform owned by uber-banker Goldman Sachs.
As Harit Talwar, head of Marcus said, “Digital technology is making large brick and mortar branches questionable… The traditional distribution strengths of some of the large banks, in my view, have become legacy costs….”
Other larger banks are taking a different approach to deal with the threat. Rather than trying to make direct loans into the space, they are partnering with P2P investing platforms to do so.
For instance, JP Morgan has partnered up with OnDeck and Citi with Lending Club. Jamie Dimon, JP Morgan CEO said its partnership allows them to do ‘’the kind of stuff we don’t want to do, or can’t do.’’
Naturally, the larger banks such as GS are in a better financial position to compete with the P2P investing upstarts, but that is very much not the case with the small banks (those with total assets of under $10 billion).
Make no mistake, those very same banks are already struggling, thanks to outsized impact that the regulatory burden of Dodd-Frank has on their balance sheets.
Millennials are now the largest generation in America. And they just so happen to distrust banks. A lot. It’s understandable; during their adolescence, banks almost brought down the global economy.
Unlike the Boomers, Millennials have no loyalty or connection with banks. That’s why they are twice as likely to switch banks. Over 94% consumers under the age of 35 are active users of online banking.
Interestingly, 63% of adult Millennials don’t even own a credit card.
However, as 80 million Millennials hit their prime in the coming decade, they’ll need access to some form of credit. And the Millennials are 10 times more likely to use alternative sources of finance than Boomers.
Already about one-third of 18-to 34-year-olds have used P2P lending, with the average age for Lending Club users just 30. This is logical when you reflect on the time and hassle required to get a bank loan. Millennials have many virtues, but having been raised with the expectation of instant gratification emanating from just a few taps on their mobile devices, patience is not one of them.
Single-handedly, Millennials have the potential to change the lending landscape. That’s good news for the P2P investing platforms but not for the small-and medium-sized banks unable to compete for Millennial loans.
The Investment Case
A quick word about the other side of the P2P lending platforms: In our recently completed special report, The Bank of You: How to Use the Revolution in Personal Lending to Earn Market-Beating Yields (download the report for free here), we closely examine how investors use P2P lending platforms to earn upward of 7% a year with low correlation to traditional stock and bond markets.
Opening an account with Lending Club (the oldest of the P2P investing platforms) or most of the others takes only a few minutes. Once your account is funded, you decide on which grade, or combination of grades, of loans you wish to make.
Naturally, the poorer the grade, the higher the yield, but the algorithms of the platforms do a great job of projecting risk versus return, and in automating the loan process.
Typically, investors will fund only small loans, or parts of loans, so their exposure on any one loan is no more than $25. Thanks to the automation, you can diversify across dozens, or even hundreds, of loans.
In return, using a conservative allocation, investors can expect a return of over 5%, net of any losses. Add in a percentage of higher risk loans and the net can work out to 7% or more.
Because of the nature of the loans—personal and/or SME loans—heavily vetted using the state of the art data analysis, there is little to no correlation to the stock and bond markets.
Thus even a steep correction in either market is of no real consequence, as the interest payments continue to flow into your designated bank account. High yields, low volatility? A yield-seekers dream.
P2P Lending Risks?
As P2P investing really only started to gain momentum in 2009, the platforms are largely untested in a serious and sustained economic downturn characterized by rising unemployment and soaring delinquency rates.
One way we can try to measure how the industry will fare in a downturn is by looking at the performance of credit card debt. As this chart shows, delinquency rates are closely correlated with rising unemployment.
Likewise, for P2P lending, the unemployment rate is key. Scott Langmack, founder of Incline Fund Management, which follows the sector, has stated that the single biggest risk in P2P investing is unemployment. Borrowers with good credit will always pay their bills if they can. The loss of a job is the main reason they don’t.
The other major concern for the sector is an increasing regulatory burden. P2P has so far been able to operate with low costs and advance quickly due to its regulatory advantage over the big banks. That could change in 2017.
The ruling on Madden v. Midland Funding LLC, which concerned usury and loan standards, could bring increased regulation this year. You can get the full breakdown of what this ruling means here.
Also, the Treasury Department and the Office of the Comptroller of the Currency (OCC) have recently released white papers on P2P investing. The OCC is expected to move forward with a limited purpose national bank charters for the industry in 2017.
On the other side of the balance is the Trump administration’s strident stance for reducing, not increasing, regulation in the financial sector. Should the regulators be held at bay for Trump’s first term, it could give the P2P lending platforms the additional breathing room they need to become the force they are almost certainly destined to be.
Even so, as P2P lending platforms become further entrenched in the financial system, there is little question they will need to deal with more stringent regulations, resulting in the need for larger compliance departments. Invariably, the deadening hand of regulation will erode some of their nimbleness, a key competitive advantage.
It’s also important to consider platform bankruptcy risk. Major platforms like Lending Club, Prosper, and Funding Circle have all taken extensive measures to isolate this risk from the underlying loans. If a P2P investing platform goes bankrupt, the custody of the loans will be removed from the platform’s balance sheet and transferred to a third-party custodian.
In closing, while the P2P platform has enjoyed substantial growth since its birth, it still only accounts for a small piece of the market. Due the competitive advantages (in particular, technology and nimbleness), there remains a lot of upside in market for lending in the sub $250k space, and maybe beyond.
While P2P lending may not replace the banks in the immediate future, for ordinary Americans looking to take out loans it has effectively already done just that. Whether the banks will be able to find an answer to stave off the growing impact of P2P investing on their balance sheets in time to save their franchises is yet to be seen.
In the interim, investors in small-and medium-sized banks might want to consider allocating their funds elsewhere. Maybe into a portfolio of P2P loans?
Free Report Reveals: How to Join the P2P Lending Revolution and Earn Yields of as Much as 10.39%
The P2P lending technology is turning the traditional banking industry upside down. With almost no effort and risk, you can join the revolution in minutes and earn market-beating yields on high-grade P2P loans. Grab our free report, Welcome to the Bank of You, and learn everything you should know about P2P lending to get started. Click here to download.