The real reasons behind Lending Club’s low interest rates

In my class Managing Financial Firms at Harvard Business School, we discussed the “shadow banking” sector, non-bank financial services companies that extend credit. Lending Club, with its marketplace model, is able to curiously offer rates many percentages lower than credit cards’ APR. How can they do that?

• Lower cost of an online operation. Though mainly cited, this is a flawed argument. Lending Club’s efficiency ratio is 101%, compared to 55% of Capital One, a similar institution with high exposure to personal loans. The lower efficiency ratio the better. Lending Club’s Sales and Marketing cost is 40% of its revenue and is unlikely to scale as the company pays more to “cross the chasm” and more companies enter the market (Goldman Sachs’ Marcus) . The counter argument is the more mature the market, the stronger awareness and the lesser the cost of customer acquisition. We shall see.
• Lending Club offers termed loans, versus a revolving line of credit of credit cards. When banks offer credit card, it’s an open check for borrowers to draw down their credit limits, resulting in liquidity and funding risk for the bank. Credit is extended but funding is not guaranteed. Lower risk means lower rates.
• Lastly, and probably most credible, more precise credit pricing. Credit cards offer, for the most part, one APR to all borrowers, while Lending Club tiers borrowers, allowing the more credit-worthy borrowers to get lower rates. Similarly to SoFi refinancing MBA students, aka the HENRYs. In the following graphic, the degree to which credit cards’ APR goes down when borrowers’ credit worthiness goes up is lesser than that of Lending Club.

So it appears that Lending Club is creating value for the high quality and mispriced borrowers by pricing them properly through better risk assessment and with term loans. As with any other marketplace, to thrive, Lending Club must create value for the investors as well. What are investors to gain from the platform?

Having worked in credit for 5 years, I’ve seen that the good credit investors typically have their own credit models. With Lending Club, they have access to a whole host of data about the loans, and the ability to cherry pick what most appropriate for their portfolio. Compared to traditional credit card financing, where banks pool credit card balances into asset-backed securitization (asset being the credit card balances) and sell their tranches with little visibility what’s inside to investors. Investors are glad to do it themselves and get more spread for the same credit risk. Classic low end disruption theory, new vendor providing lesser service for lower cost.

So it appears that Lending Club creates value for both sides of the marketplace and society through better pricing of credit and trimming down its service as the middleman. But does it warrant its $9B valuation at IPO? The answer has been no, as the company struggles with its growing cost of compliance and litigation. As significant as financial services to society, the degree of precision and accuracy required in fintech businesses is high. This may be the one industry where “move fast, break things” won’t work so well.