Marketplace Lending: A Roadmap for Growth or the Next Subprime?
In late October, Wharton FinTech went on a company trek for the day to New York. We met with two Marketplace Lending (MPL) startups (Bread Finance, Bond Street) and two investors (JP Morgan Chase, Nyca Partners). The following post provides an overview of the MPL business model, growth opportunities, and emerging risks that were discussed over the course of those meetings.
MPL BUSINESS MODEL
Since the 2008 Financial Crisis, banks have been subject to increased regulatory scrutiny, the emergence of disruptive technologies, changing customer expectations, and a period of historically low interest rates. These drivers have resulted in a tightening of lending to consumers and small businesses. Inefficiencies in the current business model have led to the emergence of MPLs, such as Lending Club and Prosper, which are often considered among the first commercial success stories in the consumer lending space to have emerged from the FinTech revolution.
Many of the core competitive advantages that banks historically enjoyed are being eroded. In contrast to traditional banks, most MPLs directly connect borrowers with individual investors via online platforms. MPLs generate income from fees and commissions generated by matching borrowers with lenders and incur lower overhead costs. These platforms have grown in popularity with consumers and small- medium- sized enterprises (SMEs) because they offer competitive interest rates as well as faster and more convenient access to financing than traditional banks. MPLs also allow the unbanked and underbanked to get access to financing. Additionally, investors, unlike depositors, are able to generate returns by taking on both the financial risks and rewards. These business model innovations are made possible by advances in Big Data analytics, machine learning, artificial intelligence, and cloud computing.
MPLs operate in a regulated industry but many do not face the same regulatory requirements as deposit-taking institutions. MPLs typically partner with an issuing depository institution to originate loans and then purchase the loans for sale to investors as whole loans. This structure allows online lenders to bypass state licensing and other restrictions. A typical funding structure is as follows:
In recent news, according to the New York Times, regulators are planning to create a new type of banking license, issued by the Office of the Comptroller of the Currency (OCC), that will allow FinTech companies to more quickly expand across the United States.
In 2015, venture capital firms invested over $2.5 billion in marketplace lenders. The total value of loans financed through MPLs reached $23 billion in 2015, a 48-fold increase from 2011. However, with a total addressable market of approximately $870 billion in the United States, marketplace lenders, which currently originate ~2% of total loans, have low market penetration and high growth potential. Current marketplace lending typically involves four primary asset classes: unsecured consumer debt, real estate, small business debt, and student loans.
With the increase in loan demand, marketplace lenders have turned to alternative sources of funding through securitization (i.e., packaging thousands of individual loans into tradeable securities.) According to PeerIQ, total securitization to date now stands at approximately $10.3 billion with 53 deals issued to date since September 2013.
How will marketplace lenders scale their businesses to capture market share and how will banks respond? Former competitors will form alliances.
While traditional banks have been focused on improving operating performance and investing in regulatory and compliance systems, they have recognized the growth potential for marketplace lending. Although Goldman Sachs has decided to build its own lending site, Marcus, most other large banks have decided to partner with existing platforms.
In 2015, JP Morgan invested in and formed a strategic partnership with online lender On Deck to help make loans to the bank’s roughly four million small-business customers. In 2016, JP Morgan agreed to acquire nearly $1B in personal loans arranged by Lending Club. Going forward, the JP Morgan Strategic Investing team is actively focused on investing in disruptive FinTech companies with products that are “enterprise ready.”
While some banks are launching competing products, FinTech startups should view these firms not as competitors but as potential collaborators or future strategic acquirers. The advent of competition in the financial services industry has great potential to expand financial inclusion, reach unbanked populations, and accelerate the delivery of more efficient products.
The number of platforms is expanding and new business models and types of loans are being introduced. While most MPLs references are to unsecured consumer debt, the overall industry has become more competitive as new lenders, many with limited track records, have entered the space with an eye on the market size potential.
In response to increased competition, some marketplace lenders have focused too much on growth at the expense of risk and internal controls. In 2016, Lending Club’s internal scandal culminated in the resignation of its founder, chairman, and CEO, Renaud Laplanche. Loan losses edged up and financial backers of MPLs began to show signs of nervousness. During the mortgage boom, lenders focused on growth at the expense of record keeping, financial discipline, and operational transparency, and the new marketplace-financing rush has already shown similar flaws. As a result, shares in Lending Club halved.
Given the explosive rise of marketplace lending and associated risks, regulators have taken an increased interest in the industry. According to the Wall Street Journal, the Consumer Financial Protection Bureau (CFPB) is planning to supervise marketplace lenders.
Some MPLs, such as Bread Financial, are already focused on managing and mitigating risks. Others have adopted a “growth at all costs” mentality. While accepting lower rates of growth will have negative implications for valuations that may not satisfy the dreams of founders and VCs, there really is no choice if long-term survival is the goal.
Untested Business Model
Will all these FinTech players survive the next downturn in the credit cycle? Is online lending viable in the long run? Can models more accurately predict repayment behavior to avoid widespread defaults?
In 2016, the cracks began to emerge. Concerns grew with Lending Club’s ability to assess the credit risk of its borrowers when write-off rates increased. While MPLs claim to have developed advanced credit scoring models leveraging alternative sources of data to supplement traditional FICO scores, these new credit models were primarily developed using historical data that spans a bull market credit cycle (a period of low interest rates, declining unemployment, and strong credit conditions.) With limited historical data on charge off and delinquency rates, credit benchmarks are at best guideposts.
Marketplace lending is growing and evolving. Credit assessment is becoming more advanced and institutional investors are playing a larger role. Although MPLs appear to represent an attractive investment class that is uncorrelated with other asset classes, it is not a mature asset class yet. In order to prepare for the next inevitable downturn, MPLs should focus on adopting a number of safeguards (e.g., transparent underwriting models, standardized processes, and emergency warehouse facilities) to ensure uninterrupted access to the debt capital market.
WHAT DOES A TRUMP PRESIDENCY MEAN FOR THE FUTURE OF FINTECH?
As MBAs, we learn about statistical inference and the deduction of properties of an underlying distribution through the application of data science. We learn to analyze data, build regression models, evaluate assumptions, test true positives and true negatives, draw ROC curves, and think critically about results. One key learning is that statistical models are based on historical data and dependent on goodness of fit but may be subject to overfitting. Models are good tools but can fail to accurately predict outcomes.
In recent news, few, if any, polls predicted that Donald Trump would eventually be elected President of the United States. His improbable victory has been called by some pundits a Black Swan (coined by Nassim Taleb) or, more appropriately, an Orange Swan event. What we know is that Trump’s election adds to economic and political uncertainty. Markets at first plunged and have since rallied. Volatility makes investors cautious.
If we assume a similar trend in the UK in the aftermath of Brexit, investment in US FinTech companies is expected to slow in the short to medium term. With Trump campaigning on dismantling Dodd-Frank and the Consumer Finance Protection Bureau, adding uncertainty to the financial services industry, we can expect to see FinTech winners and losers emerge.