The Enduring Truths of Marketplace Lending
When 2016 began, we had a sense that this year would be different, that the monotonically upward trend buoying the growth of marketplace lending would likely become choppier and more uncertain. We knew surprises were in store, but the events of the past few weeks have defied prediction. Last Monday, observers of financial technology and the broader market awoke to news of the resignation of LendingClub’s CEO. This happened less than a week after the announcement of layoffs at Prosper. A string of closely clustered “bad news” stories has prompted some to ask whether this is an indication that marketplace lending was overhyped or some sort of naïve misadventure. In our opinion, that point of view could not be farther from the truth.
Periods of unrest often cause people to lose sight of the bigger picture, but it’s worth remembering that any transformative movement will go through times of uncertainty and fluctuation. Despite the market’s recent turmoil, the core principles, long-term trends, and technology-driven reinvention that inspired us to enter this market still endure. At a time like this, let’s examine some enduring truths – the important points that have generated enthusiasm for the industry thus far and will also power its growth well into the future.
The “unbundling” effect seen in all industries touched by the internet is reshaping banking as well. Gone are the days when a customer would automatically choose to apply for a mortgage from the same bank at which he maintained his checking account. At one point, the switching costs of evaluating another bank’s products, rates, and services posed a formidable barrier to competition. In reality, banks may have mistaken customer inertia for customer loyalty. There’s no turning back from the fact that the internet gives unprecedented choice to consumers of all types of services, and businesses need to work harder than ever to attract or retain them.
Large banks are great at certain things: managing vast amounts of capital, mass distribution of financial products and transactions, and navigating an ever-expanding web of regulation. However, most banks have shown less aptitude for areas such as customer experience, personalization, technological flexibility, and ability to issue small-dollar loans. Unbundling means that consumer-oriented companies who create excellent customer experiences, make decisions quickly, and are nimble in their use of technology can do what they are best at while also using the best talents of banks to their advantage.
The leading originators in online consumer and business lending are no-longer mere “tech startups”. They are major providers of financial services and fixtures in peoples’ lives. In 2015, online marketplace lending platforms were responsible for approximately 24% of personal loans in the United States. LendingClub alone has issued over 1.5 million unique loans, totaling over $18 billion. OnDeck has provided over $4 billion in capital to small businesses. Prosper has provided over $6 billion to consumers.
These are customers who may have not had access to capital if not for these online lenders or who would have otherwise had to obtain capital at a higher rate or on worse terms. In a world where stories are easily shared and customers have more choice than ever, companies who provide great value on great terms will be rewarded with growth and market share. By and large, online marketplace lenders have raised the bar considerably.
Long-Term Stability of Consumer Credit
Over long periods of time, the American consumer is a smart bet. For the past 3 decades, charge-off rates on consumer debt have hovered around 2-3% annually, and even in the deepest recession in recent memory, the rate peaked at just over 6%. While the value of and returns from any asset will fluctuate with the broader economy, consumer credit has proven to be significantly more stable than other asset classes, providing attractive returns with ample opportunity for diversification. As discussed in Orchard’s recent white paper, Stress Testing: Marketplace Lending in a Rapidly Changing Environment, it is possible for marketplace lending portfolios to experience a significant increase in loss rates before causing well-diversified investors to experience negative returns.
Impact of New vs. Legacy Technology
The application of more recent technological advances without the burden of maintaining legacy infrastructure has allowed online lenders to scale their operations and deliver service at lower cost than traditional players. Large banks, contrary to how they are frequently portrayed, have no shortage of high-performing technology. In fact, the largest global institutions routinely process trillions of dollars in transaction volume per day. However, where newer players have an advantage over traditional lenders is in their ability to make rapid changes and innovate quickly, without the need to embark on multi-year, multi-million-dollar IT reengineering projects. Areas in which this speed advantage matters include the implementation of new underwriting models, flexibility in loan pricing, customer acquisition channel optimization, and personalized loan servicing. This is particularly evident in the market for small business loans, where traditional banks have found that the cost involved in maintaining physical branches, legacy tech, and a complex manual underwriting process have made it difficult to achieve positive margins. More nimble online lenders, such as OnDeck, FundingCircle, and Credibly, have leveraged their flexibility to compete aggressively in this market.
Transparency and Trust
In any market, new entrants need to put significant effort into gaining the trust and credibility of their customers. Nowhere is this truer than in lending, where capital is the lifeblood of the business, and marketplace lenders must gain the confidence of investors. Online lenders have achieved this by making public a massive quantity of data, in some cases allowing loan-level access to hundreds of credit variables for every loan ever originated on the platform, something generally unavailable in other assets, such as securitized bonds (even those backed by marketplace loans). The unprecedented transparency offered by online lenders has helped numerous investors, large and small, feel comfortable putting their capital to work on marketplace lending platforms. Transparency promotes innovation and reduces risk. Sunlight is the best disinfectant, and the best thing lenders can do to reassure investors and the market is to make even more data public.
While the past several months have shaken the confidence of some participants, we believe that the future of online marketplace lending is brighter than ever. Our engagement and interactions with all parts of the ecosystem over the past week have reinforced this view. The truths and long-term trends that have driven this market to thrive over the past several years are no less true than they were six months ago. The recent shake-ups present a learning moment for marketplace lending and provide an opportunity for all participants to set the bar even higher.