Building a Sustainable Foundation for the Next Generation of Lending Solutions

Cross River Bank Logo

[Editor’s note: This is a guest post from Gilles Gade, President and CEO of Cross River Bank. Cross River Bank is a gold sponsor and will be in attendance at LendIt USA 2015 on April 13-15. In this post, they talk about building a sustainable foundation for the next generation of lending solutions.

The emergence of disintermediated funding solutions presents a historic opportunity for borrowers and creditors, enabled by tech savvy intermediaries. Although marketplace lending (“MPL”) is still nascent, it is experiencing explosive growth in loan origination, investor interest and, above all, in innovative solutions. Banks can play a significant role in this emerging sector, particularly in assisting legacy players and new entrants in coping with the compliance and regulatory burden as they focus on managing their growth. Before we discuss this further below, it is important to dispel some misconceptions that may obscure this far-reaching opportunity.

First, some institutional participants in credit markets regard the rise of online lending as an existential threat. True, many traditional banks and lending institutions face the risk of obsolescence, but they cannot hope to maintain or sharpen their competitive advantage by clinging to the status quo. While the emergence of alternative models may challenge established industry practices, the relationship between traditional banks and marketplace lenders generally tends towards symbiosis. Rather than view MPLs as a competitive threat, banks, hedge funds and fixed-income investors can use these platforms to offer loans to small businesses and consumers at a lower cost and more efficiently compared to traditional origination platforms.

Second, in media reports such as this recent Wall Street Journal story (Lending Club’s Loose-Door Policy, 2/18/2015), John Carney paints marketplace lending as an industry driven by a speculative mania. He wrote: “…even after declining about 10% since the start of the year, Lending Club’s shares trade at eye-popping valuations. The stock is priced at 196 times forward earnings and 20.5 times forward sales. Compare that with Twitter’s price/earnings multiple of around 111 and price/sales multiple of about 12.”

This skeptical valuation thesis seems fair enough, regardless whether it proves right or wrong in the long run. The bull market of the late 1990s certainly taught us not to conflate stock valuations with the tangible value of underlying innovations. Whether marketplace lenders trade at P/E multiples of 200 or 2, they deliver tangible value to consumers in the form of greater choice, lower costs, improved transparency and faster decisioning. These are real benefits whose value neither rise nor fall with the fluctuations of share prices.

These benefits do not explain or justify spikes in equity valuations, but they do point to the importance of online lending as an organic response to the significant contractions in commercial and consumer credit circa 2007-2009. This downturn left many borrowers with no place to turn for loans. According to data from the Federal Reserve and the Small Business Administration (SBA), consumer-segment lending declined by approximately $960 billion, or 7.6%, between 2008 and 2014. During the same period, small-business lending declined by approximately $38 billion, or 11.3%. At the same time, the protracted period of low interest rates left many lenders and fixed-income investors starved for new opportunities to generate attractive risk-adjusted returns. The “Great Recession” contributed to the passage and implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act which has consequently lowered the capability for many Americans to obtain credit and mandated sponsors of securitizations comply with risk retention standards. Against this backdrop, the emergence of online platforms that matched lenders with borrowers seemed inevitable.

Third, the same Wall Street Journal article faults online lenders for misleading branding. Carney wrote: “And Lending Club’s business model might not be as new or transformative as it appears. Although often described as being in the “peer-to-peer” lending business, that is a misnomer. Institutional investors, hedge funds, and banks are significant buyers of Lending Club loans. So instead of cutting out the middleman by connecting savers and borrowers, Lending Club is increasingly adding another layer of middlemen.”

Most of the next-generation lending platforms have shifted away from the vocabulary of P2P (peer to peer) lending to “marketplace lending”. More importantly, whether a marketplace connects a borrower with a retail or institutional lender, such as a hedge fund or a family office, the online lending model is working, even if it does not conform to an idealized notion of a peer-to-peer sharing economy.

Finally, the article suggests that the online lending business model may create incentives to grow originations at the expense of loan quality. Carney wrote: “Lending Club doesn’t have skin in the game. Nearly all of its revenue comes from origination fees on loans made through its platform. Only a tiny fraction is tied to loan performance.” Even before the publication of the WSJ article, Lending Club CEO Renaud Laplanche rebutted the “skin in the game” argument in an op-ed in American Banker. Here, he wrote:

“…there is tremendous accountability in marketplace lending. Unlike a scenario involving loan brokers, originators, rating agencies, investment banks and loan servicers, marketplaces own the entire process and answer directly to investors. A poor investment performance would be as impactful to Lending Club as to any other firm that relies on its track record and reputation to generate future growth. In that respect, Lending Club has as much skin in the game as Fidelity or Vanguard.”

Setting aside occasional mischaracterizations, the most important observation about marketplace lenders seems unmistakable: this deeply disruptive innovation has only begun to scratch the surface of its long-term market opportunity. In its recent report (February 17, 2015), JMP Securities estimates a “$12 trillion addressable opportunity across personal, auto, student, mortgage, and small business loans” with current penetration rates hovering around 1-2%.

Soon after Cross River Bank’s (“CRB’s”) entry into what was then known as P2P lending, the bank’s board and management realized the breadth of the opportunity and engaged on a path to position its business model for the demands of the industry’s growth. CRB’s attitude switched from seizing an opportunity to adopting a fully developed MPL strategy around the bank’s strength: a) a rigorous compliance management system with a particular emphasis on BSA/AML and consumer compliance laws and regulations; b) robust risk management practice; c) strong credit underwriting expertise; and d) tech savviness. Today, CRB develops solutions to automate processes and create efficiencies, delivers real time payments and cost effective ACHs, originates in excess of $150 million in loans monthly and with rapid growth, and has over $50 million of MPL loans on its balance sheet and the capital bandwidth to originate over $10 billion of loans annually.

CRB’s commitment to the sector is further evidenced by the bank’s decision to retain up to 10% of its monthly origination of select platforms, most notably Marlette Funding. We believe this strategy will set new industry standards of best business practices and broaden the appeal of MPL players. The advantages are multifold: a) as mentioned above by Renaud Laplanche, the bank and their platform relationships both show they also have skin in the game; b) the bank allows the platforms to retain partial economic upside thereby accelerating their path to profitability; and c) most importantly, the strategy adds teeth to the bank’s “true creditor” status, enhancing compliance and further legitimizing the business model.

The MPL sector and all its agents are not just participants in a fast growing ephemeral adventure; rather, we are collectively committed to being active stakeholders in a world-changing, status quo-busting innovative countercurrent. The stakes involve preempting and addressing challenges before they arise, and developing best business practices to safeguard the long-term interests of all participants in the marketplace of disintermediated services. Beyond acronyms and buzzwords, there is a lot more to this industry than an online application and a FICO algorithm. There is a shared strategic vision to fix what has been damaged, for the better and for the long term, with the ultimate benefit of reducing costs to the consumers.