Fintech Genome

Commoditization of online lending


#1

How do lenders protect their product from becoming a commodity? The ease of use that lured customers away from traditional banks also means that borrowers can easily shop for loans across different platforms. If price is the only differentiator, then the only way for a platform to succeed is to have the lowest cost of capital. But banks have the lowest cost of capital, so a good strategy for a bank seems to be to just wait for the industry to eat itself and then buy a platform cheaply.


#2

Maybe the answer lies in understanding why banks have the lowest cost of capital?


#3

I don’t think any non-bank entity is going to be able to take retail deposits


#4

Check out the Swiss Fintech License, in this post:

Re deposit accounts:

– Deposit Only License. You can provide deposit services, but not lend. You can accept up to SF100m once licensed. Separating Deposits from Lending is a bold and radical move in a world of NIRP (and with Vollgeld coming up as a referendum, see later). Deposits is a nascent area of Fintech innovation.

What is happening is the unbundling of Deposits from Lending. That could change the game.


#5

When talking about deposits I conjure the image of Luke Skywalker aiming at the main reactor of the Death Star (no brownie points for translating this analogy to the banking landscape :slight_smile:
But very important to keep in mind this line: “Luke: It’s not impossible. I used to bullseye womp rats in my T-16 back home, they’re not much bigger than two meters” Before you can tackle the big one, you need to spend an awful lot of time proving yourself in a sandbox…


#6

Alright, if we want to get a little more real and less facile here, there is a hierarchy of capital stocks and flows which drives cost of capital for various players in the credit space.
Big, stable pools of capital have the lowest cost of funds. These come from banks with large retail deposit bases, big insurance companies, and pension funds.

Using that capital to create consumer and small business credit provides great risk-adjusted return on capital, but it has historically been a very sleepy area in terms of innovation and market responsiveness, and expensive to originate and service. The valuable innovation of online lenders has been to make the loan product a much better fit for the borrower, and to dramatically lower the fixed costs and enable smaller balance loans to become profitable.

The innovation and value add has all been on the capital deployment side. Sourcing capital still happens in the traditional way - lenders work their way down the cost of capital curve from equity, to expensive debt, to less expensive debt. The true P2P model without intermediation has turned out to be an interesting idea but of limited scope. As of right now, there is no better way to source capital than using the existing structure. It is pretty good and not obviously in need of innovation or disruption.

If an online lender were to do all the things that a bank does in order to gain stable retail deposits, it would become a bank with a typical bank cost structure. It’s not obvious that there would be any advantage over the traditional bank model at this point.

If someone figures out an innovation that can source capital at or near the funding rates for big banks, but in a different way that involves a significantly lower cost structure, that would be a revolutionary change. So far there doesn’t seem to be any way to do this.


#7

The main “thing” a bank does to gain stable (=cheap / mispriced) retail deposits is to be benefiting from an implicit government (=taxpayer) guarantee. While some find this state of affairs “pretty good”, there are also other opinions out there. Fintech approaches that unbundle risks and make the true cost of various bank services more transparent will eventually become the mainstream model.


#8

I disagree - bank deposits have an explicit government guarantee in the form of FDIC insurance. This is priced into the rates paid on deposits. One could argue that the FDIC charges too little, thereby socializing some of the cost, but that is a different matter.
That guarantee, plus things like access to ATM networks and physical branches, drive the ability of traditional banks to attract retail deposits while paying less than alternative ways to park on demand money.
I think there are ways to innovate at the margins, but banks occupy a space for retail customers that those customers value, at least for the time being, and it is not possible to attract deposits on a similar scale simply by competing on price.


#9

I agree with @JabairuStork that we have Not seen any innovation on the deposit side.
Check out this post by @Jessica

And another post (by myself)

The question is whether Digital Wallets are the first shy step in innovating in the deposit space. For now, it is not at all clear. The potential is there, for now unexploited.


#10

Deposit insurance is actually a good example of deposit side innovation. Except it is 150 years old and its limitations are by now well known: Check out e.g: “Stealing Deposits: Deposit Insurance, Risk-Taking and the Removal of Market Discipline in Early 20th Century Banks” by Calomiris/Jaremski and the IMF “Deposit Insurance Database” for good reviews.

To mention just a few issues: the insurance fund may be underfunded making it an implicit government liability; it removes market discipline (creates moral hazard) by allowing banks to fund complex risks at below market rates. Ultimately deposit insurance does not even prevent systemic runs on the banking system given the large pools of uninsured deposits. Hence it further complicates the pricing of the implicit government support (also known as “too big to fail” bailouts).

There are various innovative proposals on the deposit side (full reserve banking, electronic retail accounts with the central bank etc). A recent proposal in the Netherlands to setup such a full reserve bank has stalled. Ironically one key obstacle was that according to existing law it should contribute to the deposit insurance scheme (even though its deposits would be not be subject to the usual bank structure credit risks).

In a fully digitized (and thus easily reprogrammable) payment/credit system what is “real” and what is a pipe dream boils down to ability to shape legislation / regulation. You can quote me on that :slight_smile:


#11

@Philippos I think the connection to the full reserve movements is critical. I did not know about the one in Netherlands, but I can see it in Switzerland and in UK and even one very nascent in USA. I can also see that innovation on the deposit side is nascent. The growing maturity of Marketplace Lending may offer the platform for that innovation. The Lending Account is the first banking innovation at a fundamental level in centuries. It will take time for attitudes to shift but when it becomes accepted that a Lending Account and a Deposit Account are fundamentally the same thing, but when that mindset changes, we will see very rapid change.

That mindset may change first among big money guys such as Corporates and Family Offices.

It has not escaped the attention of some savvy folks like Warren Buffet that paying a Bank to keep your cash in a NIRP world is pretty weird. As Berkshire Hathaway has $63 billion in cash reserves, what Mr. Buffet decides to do with the cash has some ramifications. Even if we don’t stay long in the strange world of NIRP, investors are looking for better than zero or close to zero interest rates. So if lenders can find good risk adjusted returns on Lending Marketplaces they will seize that opportunity.

Lending Marketplaces have two sides. If Lenders move to these markets looking for better risk adjusted returns than bank deposits, then Lending Marketplaces will thrive (and Banks will suffer).

In all the lending platforms I speak to the demand from lenders far outstrips the supply of good quality borrowers. Lenders aka Depositors are hungry for that innovation.

The Swiss Fintech License is well thought-through when it comes to Deposits:

– Deposit Only License. You can provide deposit services, but not lend. You can accept up to SF100m once licensed.

The big change that is coming is simple but disruptive - the unbundling of deposit-taking from lending.


#12

Interesting times we live in :-). I expect jurisdictions where financial services form a larger share of economic activity to be more pro-active in exploring the viability and implications of “unbundled banking”, but once established a rapid global adoption.

For reference the FINMA fintech link (please add any further pointers if appropriate).


#13

@Philippos jurisdictional competition is a very positive force IMHO and much welcomed by entrepreneurs who live with the reality of competition every day. It is a tough balance to get right - too easy just makes you an offshore nameplate operation for sketchy characters. The beauty of MarketPlace Lending for regulators is there is no ALM or Systemic Risk, a subject we explore here:


#14

In a pure capital market, you take deposits, you turn them into credit by making loans, and you pass some or all of the returns on those loans back to the depositors.
What this description leaves out is that you have to keep those deposits safe, and the depositors have to be able to get their money back whenever they want it. Those features are far more important than the return on cash assets, and they are the reason why retail banks are heavily regulated.
Finding a way to piggyback on the existing bank and regulatory infrastructure to take deposits with a lower cost structure than banks is interesting at small scale, but once you try this at large scale you have to either become a bank, or convince society that we don’t need banks in the sense that we now use the term.

I consider myself reasonably adventurous when it comes to money, but I’m not going to move cash from my checking account at a bank to an institution where there is any chance that the principal is at risk, or where I can’t get immediate liquidity for free, regardless of how much they pay me. (I might move it out of an investment account, but that’s a different story.)


#15

Deposit taking institutions are actually offering two services that could and may need to be separated:

  1. Vault - i.e. safekeeping
  2. Interest - i.e. for “lending” our money to the banks

The three factors that are pertinent are:

  1. Safety
  2. Liquidity
  3. Return on these assets

In a fully digitised world, the vaults will be blockchains. Cyber security will be the “hidden risk”. But at the end of the day, it is also today (except if you keep your cash under your matress) because the accounting logs are also sitting on servers.

Liquidity problems will be the same, even on blockchains, if lending more than deposits is allowed.


#16

@JabairuStork that may be the wrong question. Money is a commodity. One dollar is as good as the next dollar or as they say on the street all dollars are green. Both sides of the transaction (borrower and lender) view money as a commodity. So for the intermediary/marketplace the question is more how do you scale? How easily do you acquire borrowers (dirty secret of current gen of online lenders is they use the same direct mail techniques as credit card companies).

Lenders have to get smarter about using data to power risk models and marketplaces have to offer better data. In short, its all about data.


#17

I guess it was kind of a rhetorical question. Money is the ultimate commodity.
The value prop for a specialty finance co is having a more cost effective way to source and evaluate borrowers than a bank. If the borrowers are difficult to access, or there is collateral that is difficult to value, then there is definitely room to stand in between low cost of funding institutions and the end user.
But if we are talking vanilla unsecured consumer loans, then at best the online lenders are marketing companies that can source borrowers and connect them with capital from banks, etc.


#18

Maybe the question @JabairuStork wanted to ask was

“How do lenders protect themselves so that they are compensated properly for the risk they are taking?”

In other words, we dont want competition in MPL to result in mispricing of risk. Which is exactly what happened 3yrs before the subprime bomb exploded.


#19

@Efi @JabairuStork makes sense. I think the worst mispricing right now is Auto Loans in USA.


#20

Lets turn lending from selling loan products to buying a loan need(from banks/lenders side) or selling curated loan need to participating lenders. All needs, validated online packed based om risk , risk priced based on scientific assessment , if the borrower performs better than risk rated , there should be provision to offer discount on pricing adjusting such risks progressively …AI, ML and DL would be help here working on bureau data …