Hybrid lending is where banks, driven by Basel 3 & 4 solvency requirements, optimize their balance sheets by combining regular balance sheet lending with off-balance sheets – so-called marketplace lending. This seems to be the recipe for those sectors that appeared less attractive due to the capital withholdings, such as SME lending and real estate.
Marketplace lenders are disintermediating the borrowing and investing experience. They are chewing away at two important domains of incumbent banks: lending and investing. These challengers, also called shadow banks (being defined as non-banking institutes who are in the lending business providing similar services to traditional banks). What makes them distinct is that most of them try to stay away from regulators, leverage technology, and have a superior customer experience provided at low cost. On the other hand, none of them have experienced a full credit cycle yet. Should banks be worried? The answer is yes!
Fair enough, it’s still relatively small in size, but it’s growing at a fast pace. According to Morgan Stanley Research, the global marketplace could reach $290bn by 2020. The main markets are China, the US, and the UK. Despite all of this, traditional banks don’t show the right sense of urgency at the moment. Where they were once too big to fail, now it seems they’re too slow to respond.
Global marketplace loan issuance. Source: Company Data, Morgan Stanley Research
What is it?
Marketplace lending is literally a marketplace where borrowers’ approved loans meet investors without the involvement of a traditional bank. These low-cost, agile platforms are operated by new fintech challengers in a customer-centric and transparent way.
Marketplace lending is part of the crowdfunding, or peer-to-peer, market space, but forget the romantic P2P thoughts around this phenomena. Today, parties such as Citibank, Santander and Goldman Sachs are coming up their own marketplace lending platforms, or partnering with these new challengers. The main reason why this is so popular is that everybody is looking for yield in the current low-interest environment. So, besides real consumers/investors, institutional investors, insurance companies and venture capital are investing heavily in these new platforms in search of better returns for their clients.
What are the main drivers behind this change? As I wrote in my two previous blogs – ‘Lending and the crowdfunding revolution‘ and ‘The rise of hybrid lending‘ – we are witnessing a perfect storm catalyst by the following (post)-economic crisis factors:
Regulatory impact. In the aftermath of the crisis, regulations came into effect that have huge impact on the cost of doing business for the banking industry. Compliance-related red tape, combined with stricter capital requirements, are mainly driving this. Moreover, the implementation of Basel 3 & 4 makes a bank think where it would place my capital: in a huge corporate loan or in a bunch of small SME-related labor-intensive and riskier loans. By the way, this isn’t going to change, so a vacuum is created for this SME segment, where marketplace lenders are jumping in on the cornerstone segment of the many national economies.
Technology. We’re experiencing an exponential growth in technology forcing the current banks to clean up their old systems by replacing them for standard technology at lower costs. Banks are only gradually driving down the cost-income ratios, but they’re still too expensive compared to the new competition. If they don’t embrace standard technology solutions, they will put themselves in serious danger of not surviving. For example, disrupting tech vendors such as US-based Cloud Lending can supply these alternative finance players with online lending platforms, but also banks with hybrid lending platforms, which are operational within 4-6 months at a fraction of the cost. It’s hard to compete with that if you’re still cleaning up your old technology stack.
Millennials. A very important group of change agents are millennials. They experience technology as a given and are therefore attached to the convenience factor in their lives. They wonder why they should visit bank branches if banking chores can be done on an iPad. This doesn’t mean they are opposed to branches, but only if it makes sense to use them for complicated matters or financial advice.
What should banks do?
There are basically two ways a bank can respond. They can seek for a partnership with existing marketplace lending (MPL) platforms, which we see happening with ING bank and Kabbage, or Santander in the UK with Funding Circle. These fintech platforms find this interesting because they see this scenario as a possible exit strategy further down the road, as hybrid lending will become the new normal. Moreover, they can tap into the experience of banks running full credit cycles. Banks, at the end of the day, still like to continue servicing important segments such as SME business, and via partnering with MPL players, this seems to be a viable option.
The second option is to start their own marketplace lending platform and combine this with regular forms of lending. I see the first banks who are making moves into this direction, which I think is visionary. Hybrid lending, as the new normal, will become the answer to optimize your balance sheet, which is better than selling off assets to comply with Basel 3 & 4 requirements.
(This blog originally appeared on BankNXT)