Can online P2P lenders deliver disruptive innovation to the world of banking? Paul Jeffery and David Arnold offer their assessment.
Last year saw banks in Europe and the US either pay or agree to pay a record $43bn in regulatory fines. Their regulatory travails continue – in the first half of 2014 banks have had a further $20bn plus in fines imposed on them by financial regulators and additional fines are likely in the wake of ongoing investigations into the LIBOR and foreign exchange markets. The bad news for banks is the profitability headwinds being blown up by financial regulators may ultimately pale in comparison to the competitive gale threatened by online peer-to-peer (P2P) platforms. There are growing signs that these platforms, most notably lending platforms, are the most dangerous of commercial beasts: disruptive innovators. According to Pat Grady, partner at the venture capital investment firm Sequoia: “At a fundamental level it makes so much sense…there is so much inefficiency in the traditional bank model.”
Online P2P lending platforms are one manifestation of the broader phenomenon of crowdfunding, defined by the California-based Milken Institute as the “process by which capital is raised for a project, initiative or enterprise through the pooling of numerous or relatively small financial contributions or investments, via the internet.” In terms of money raised, to date, both globally and in the UK, by far the largest form of crowdfunding is loan-based. Loan-based crowdfunding is synonymous with online P2P lending. Online P2P lending platforms act as internet-based exchanges that facilitate loan agreements between individual borrowers and lenders, and help manage the processing of the financial flows attendant to those agreements. In short, think of an eBay of loans.
Made in Britain
The first company to conceptualise and actualise the online P2P lending model was London-based Zopa, founded in 2003 by the entrepreneurial team that built Egg, Britain’s first internet bank. Today Zopa, in loan value origination terms, is the world’s second largest online lender, after San Francisco-based, Lending Club. The core reason why CEOs of commercial banks should have major strategic concerns about the threat these companies pose to their future profitability is simple – in the market for a wide and growing variety of loan types, from unsecured consumer loans to secured business loans, these loan platforms offer compelling absolute and relative customer value propositions.
What’s more, the compelling customer value propositions offered by online P2P lenders look sustainable. A customer value proposition that is compelling, sustainable and scalable represents something akin to a commercial trinity, and it is because online P2P loan platforms possess this that they are potentially incumbent humbling disruptive innovators. Or, as Andy Haldane, executive director for Financial Stability at the Bank of England, puts it: “Banking may be on the cusp of an industrial revolution the upshot of which could be the most radical reconfiguration of banking in centuries.”
What’s the evidence?
And yet, on first reflection it hardly seems like a fair fight. The total loan origination volumes generated by online P2P lending platforms look trivial when stood against the towering proportions of the loan books of commercial banks. By the end of 2013 online lending platforms in the UK had, in aggregate, yet to reach £1bn in total loans and in the US their peers had yet to pass the $5bn mark. These figures look paltry against the hundreds of billions in asset value carried on the consumer and commercial loan books of leading banks.
But, these numbers may be a backward looking indicator. Disruptors in an industry don’t produce major disruption overnight. History suggests major industry disruption, from market entry to market usurpation by the innovator, is a ten- to-20-year process. A more forward looking indicator of whether online P2P lenders are liable to prove to be disruptors in the finance industry is likely to be found by looking at the relative strength of their customer value propositions.
To assess the generic strength, sustainability and scalability of the customer value proposition offered by online P2P lenders, a field research programme was designed consisting of interviews with leading figures from the worlds of venture capital, financial regulation, commercial banking, alternative finance and institutional investing. In particular, extensive access was granted to the senior executives and some processes of Zopa, the UK’s leading P2P lender and the second largest P2P lender in the world.
In its simplest terms, Zopa’s relative customer value proposition is price – for a comparable credit risk, it offers borrowers a cheaper financing rate and lenders a higher investment rate of return than they can access from leading high-street banks. Research (undertaken in late 2013) shows the borrowing rate offered to A* credit category borrowers by Zopa is 170 basis points (bp) lower than the median rate of the leading high-street banks. Across a spectrum of comparable alternate investment products, Zopa offers lenders a 0.9 to 3 per cent pickup in the investment rate of return achieved relative to that offered by banks in the UK.
These findings are not unique to Zopa. In the US the proposition being offered to both borrower and lender customers appears even more compelling. Lending Club, which generates a much higher percentage of its total loans from credit grades lower than A* or A than Zopa does, in the final quarter of 2013 offered lenders an average investment rate of return of 8.5 per cent. At the same time, Renaud LaPlanche, CEO of Lending Club, claimed that borrowers on the platform were able to get loans at rates of interest that were 300-400bp better than they could get either from banks or credit card companies. Further still, Lending Club, as with Zopa, has a secondary trading plat form that provides liquidity to lenders who have invested in three- and five-year maturity loans.
Price can, of course, be only a temporary advantage, being easily changed, or it can be a sustainable market-changing advantage, such as with discount airlines. There is reason to believe that Zopa and its peers have an underlying cost advantage that can be translated into a price advantage in at least the medium term: online P2P lenders carry neither the regulatory capital requirements nor the legacy branch-related costs of banks.
Although the cost advantage of P2P lenders versus banks is hard to calculate with precision and varies with the scale of loan volumes being originated, a helpful indicator was given by a 2013 McKinsey study which projected that by 2015 Lending Club will enjoy a 425bp cost advantage over major US national banks.
The cost structures of online lending platforms have a far higher variable, and thus flexible, component to them than do those of high-street banks with their fixed brick-and-mortar profiles. A total of 95 per cent of Zopa’s total costs relates to either administration expenses or distribution. In particular, distribution costs, which are largely made up of internet and non-internet related advertising expenditure, at 33 per cent of sales and 50 per cent of total costs, are very high by comparison with either most other consumer goods or consumer finance companies. A typical bricks-and-mortar consumer finance company, such as a retail high- street bank, generally has distribution costs that are in low single digits as a per cent of sales.
This suggests that if Zopa establishes its brand in the market for unsecured personal consumer loans it has plenty of scope to throttle back its distribution costs and, all other things being equal, enjoy an added boost to its profitability. In both 2011 and 2012, when distribution costs were 30 per cent or higher as a percent of sales, Zopa made a profit. In 2013, Lending Club was cash flow positive and made a profit.
The procedural process dimension of the value proposition offered by Zopa to its customers is also compelling. As with the customers of high-street banks, Zopa’s borrowers can access unsecured consumer loans ranging in size from £1,000 to £25,000 on fixed rate terms for durations of three and five years. The associated processes, largely to do with account opening, loan application and funds transfers, are quick and simple. After a sub-20-minute application process it typically takes a new lender or borrower customer less than 24 hours to set up an account with Zopa. An application for a loan listing on Zopa generally takes fewer than 30 minutes and the would-be borrower is notified of the application’s approval or rejection within 24 hours. Once a loan has been listed it customarily takes three days to be subscribed to and funds are distributed to the borrower within four working days thereafter. In 2013, a loan listed on Lending Club took an average of 3.8 days to be subscribed to.
All of this either matches or betters the procedural processes of high-street banks. For example, at many high-street banks in the UK a new customer is not even able to apply for an unsecured-loan. Additionally, high-street banks, irrespective of the credit grade of the customer will vary their standard interest rate on an unsecured personal loan depending on the size of the loan. Typically the smaller the loan, the higher the interest rate the bank will charge. By contrast, Zopa keeps the price of the loan to the borrower constant, in a given credit category, irrespective of its size within a range of £1,000-£25,000. High-street banks charge borrowers early loan repayment fees. Zopa and its peers do not. High-street banks typically charge lenders a punitive fee if they want to break their investments in three and five year maturity financial assets. Zopa and peers do not.
Security of investment
In P2P lending the security that matters to customers comes in three forms. First, to the borrower, security means: “Is my funding stable?” On Zopa’s platform, the answer to this is yes. A listed loan that has been subscribed to for a specific period, usually three or five years, is stable over the loan period. This is the case despite the fact the borrower has an early repayment option with no penalties attached. The lender has no right to pre-emptively close out the loan.
Second, to the lender, security means: “Am I going to get my principal capital back as well as the interest payments I am owed?” If the relative comparison is versus the level of security (at least up to £80,000) depositors in a bank enjoy thanks to the Government-guaranteed deposit insurance scheme, the P2P security proposition to lenders looks less attractive. However, P2P lenders such as Zopa have gone some way to breach this gap by establishing a Safeguard Fund, held in trust, which will pay out to lenders in the event they experience a default on a loan they have extended. This is not a guarantee and is only so good as long as the Safeguard Fund has sufficient funds. Nevertheless, Zopa’s current Safeguard Fund has a level of capital that is over double its current net charge-off rate (charge-offs are the value of loans and leases removed from the books and charged against loss reserves). We do well to remember that a common feature of disruptive innovators, as highlighted by Clay Christensen, is that they typically don’t start out with the best product or service.
Zopa’s ability to effectively manage its net charge-off rate and therefore for it to be reasonable for us to assume its Safeguard Fund has sufficient funds, is ultimately a function of its ability to credit risk assess – identifying which credit risk category bucket an individual fits into and what the price of credit in that bucket should be. In terms of this form of security, Zopa and its peers compare favourably to banks. Zopa has a net charge-off rate of 0.25 per cent, which is markedly better than that achieved by most high-street banks, whose net charge-off rates on their unsecured consumer loan books commonly settle around the 2.5-3 per cent level.
How is it Zopa is able to achieve such impressive net charge-off rates? The answer appears to be found in its use of a credit risk assessment process that is both more in-depth and creative than that of banks. That only a little more than 10 per cent of borrowers who apply to list a loan on Zopa’s platform get to do so, suggests that Zopa’s credit risk assessment process is demanding. The process has two stages. Stage One verifies the would-be borrower is who they say they are and collects credit data on them from personal credit bureaus such as Equifax and Call Credit. This data is then fed into Zopa’s Credit Risk Scorecard, which examines 19 variables to score the credit worthiness of the applicant.
Prospective borrowers who qualify from Stage One are then reviewed by Zopa’s in-house loan underwriters. The underwriters ‘sanity check’ the aggregated data. This involves a critical evaluation of the data contained in the Scorecard, screening it for anomalies and speaking directly with the applicant borrower. Stage Two is no rubber stamp. On average only 75 per cent of A* borrowers get approval. In credit risk categories B and C the rate of approval drops to 20 per cent.
Zopa’s extensive use of in-house loan underwriters is a big differentiator. Most banks, where they use in-house underwriters, if at all, for unsecured consumer loans, only do so in a very low-touch way in comparison to Zopa. Banks, due to their cost structures, find it very difficult to cost effectively deploy underwriters into their risk management/loan-approval processes.
Beyond the involvement of human underwriters, perhaps the biggest differentiator is in the actual type of data that is analysed. This is where the creativity comes in. Zopa and peers, in the proprietary algorithms they use to run correlations and regressions on assorted variables, are increasingly experimenting and using novel inputs drawn from non-traditional sources such as social data. Two examples of this are Zopa checking whether an applicant borrower uses online gambling sites, or using Facebook for verification and debt collection purposes.
Quite what ‘proprietary algorithms’ means in practice and how differentiated those of Zopa and its peers are from banks is very hard to know with any precision. What one can say, though, is that in an age of Big Data a company’s proprietary algorithms have new and bigger data sets to crunch through to help unearth correlative credit orientated insights. If, as Voltaire stated, “God is on the side of the best shot not the biggest battalion,” Zopa’s relative hyper focus on the dynamics of credit in the unsecured personal loan market may in fact mean it does have better associated algorithms than UK high-street banks. Given this, and its direct bearing on the probability Zopa and its peers can maintain impressive net charge-off rates in to the future, the security component of their customer value propositions arguably also looks relatively compelling.
Banking on trust
Historically it has been very hard for non-bank new entrants, such as Zopa or Lending Club, to generate enough broad-based consumer trust to be able to challenge the market positions of the large incumbents. However, after the global financial crisis new and enhanced opportunities exist for new entrants in the market place for retail financial services to garner customer trust.
A 2012 UK customer survey conducted by YouGov found only 28 per cent of the UK public agreed that “in general you can trust high-street banks”. Poor perceptions and ratings of main high - street banks are not just confined to matters of trust. Survey results also show on average 50 per cent or more of account holders at main high-street banks do not believe their bank is financially sound, has high ethical standards, is socially responsible or is innovative.
The severe tarnishing of banks’ reputations for trustworthiness has also coincided with four other developments that have given customers cause to cast around more widely, than they historically have done, for the financial services they seek. First, the ultra-low interest rate environment has caused investors to be more open minded about where they source attractive yields.
Second, despite what central banker’s inflation monitors may suggest, the general public perception is that the cost of living is high and rising and this, in tandem, with stagnating wage growth, is resulting in a so called ‘middle-income squeeze’. The effect of this has been to make the public more active in seeking out lower cost solutions to a wide variety of needs, financial and non-financial.
Third, banks, largely as a result of the new capital adequacy and liquidity norms ushered in under the Basel III Accord agreed in 2010-11, are, at the margin, eschewing higher risk capital charge assets such as SMEs and unsecured consumer loans. In a 2013 report, rating agency Fitch highlighted between 2010-12 the total credit risk exposure of the top 16 systemically important banks in Europe remained static at €13.5trn euros. Over the same period, however, the aggregate exposure of these banks to corporate loans and non-mortgage retail loans fell by 9 per cent. This trend continued in 2013. In the last three to four years borrowers have therefore had, in part, to look elsewhere for the loans they seek.
Fourth, P2P lenders have been enhancing their own reputations in the eyes of customers. Zopa, for instance, has a burgeoning public reputation for customer service and trust. In 2014 Zopa was named, in competition with all other companies involved in the personal finance industry including banks, as the ‘Personal Loan Provider of The Year’ by Consumer Moneyfacts. This award was no aberration. Every year from 2010 to 2013 Zopa has been named, by Moneywise, as the ‘Most Trusted Personal Loan Provider’.
The prospects – regulators and investors
Traditionalists may counter-argue that P2P lenders are enjoying a misleading honeymoon period that will end when they grow big enough to face the same regulatory burden as banks. It is certainly true that P2P lenders require a benign regulatory environment to thrive. However, there is evidence, especially in the UK, that P2P companies will continue to enjoy a supportive regulatory regime. In April 2014, the Financial Conduct Authority announced new prudential financial norms for the crowdfunding industry. These capital-based norms have done little to diminish the relative strength of the customer value proposition of leading P2P lenders versus those of high street banks. Meanwhile, senior directors at the Bank of England continue to publicly laud P2P lenders as a means of promoting effective competition in the interests of consumers and boosting the robustness of the financial system by adding to its diversity.
The support of the current UK government went beyond mere words when it placed £30m with Zopa and other UK lenders in August 2013 as part of its efforts to kick-start lending to SMEs, and in March 2014 the Chancellor George Osborne announced that P2P loans were to become tax-advantaged Individual Savings Accounts (ISA) permissible assets.
Simultaneously, institutional investors are coming to see in P2P loans a new putative asset class with prospectively appealing characteristics of low correlation, low volatility allied to an attractive yield, and are clearly now attaching their support to P2P lending platforms so as to feed capital and receive loans on a serial basis. In this regard, Lending Club, of which Google purchased a 7 per cent stake for $125m in May 2013 and whose board includes ex- US Treasury Secretary Larry Summers and ex-Morgan Stanley CEO John Mack, appears to be showing the way forward. In December 2013 Lending Club originated over $250m in loans on its platform. Over 50 per cent of these loans were subscribed to by institutional investors.
In September 2013, BlackRock, the largest fund manager in the world with $4.3trn in assets under management, purchased an equity stake in Prosper, the second largest P2P platform in the US. In February 2014, the hedge fund Arrowgrass spent £15m to purchase an equity stake in Zopa. According to Zopa CEO Giles Andrews, Arrowgrass’s intention is to invest significant capital sums in loans directly originated on the Zopa platform. In October 2013, New York based Eaglewood Capital effected the first securitisation of a P2P loan and sold a tranche of securitised P2P loans to institutional investors such as pension funds and insurance companies. In January 2014, Crowdcube set up the first actively managed P2P fund. Many more are in the process of being launched.
Surging institutional investor interest in P2P loans as a new asset class is now having the effect of turbo- charging the rate of scale experienced by P2P lenders. Given this, there seems good reason to believe P2P lenders will in time, at least in certain loan businesses, come to scale the walls of the banks. The quality of their customer value proposition seems to strongly suggest P2P lenders have a superior force to those defending the ramparts.