Over the past year, the alternative lending industry has taken several steps forward and, then, a big leap backward. The most notable step forward centers on the relationship between OnDeck Capital and JPMorgan Chase & Co. Chase now leverages OnDeck’s technology for its small business loans. This relationship, among others, has helped to focus senior bank managers on the opportunity that teaming with alternative players provides.
The leap back involves Lending Club. Long viewed as a prime player in alternative finance the company recently announced the resignation of its founder and CEO. This unexpected event sent a shudder through the industry and resulted in some bankers and observers being able to proclaim in self-satisfaction, “We told you so.”
The Lending Club issue still needs to play out, but we would suggest that bankers not be so quick to dismiss working with alternative finance companies (AFCs). Here are some common criticisms of AFCs that I hear from client banks followed by my own analysis:
AFCs overcharge customers. A president of a regional bank almost stopped me in mid-sentence to say about one very prominent AFC, “I think it is evil.” While this particular AFC has been examined and prodded by analysts and regulators, no one, to my knowledge, had ever described it as evil. It is one of the most successful and well respected players in the industry.
By “evil”, the bank president meant the AFCs were offering high rates versus banks and undercutting the traditional bank relationship with its customers. Unlike banks, AFCs price based on their evaluation of risk; tougher credits pay more. Banks often price reactively, based upon market pressures and seem almost hesitant about pricing too high. Recently, for example, one banker told me he “felt guilty” about charging a price based upon his bank’s stated pricing parameters rather than providing the 20% to 25% discount that he almost automatically offers. That is not the way AFCs or, for the most part, other profit-oriented businesses operate. Pricing to market is not evil but just good business sense.
In many cases, AFC pricing is declining as they improve their funding options and respond to competitive pressures and increased regulatory scrutiny. Today, their pricing often does not exceed credit card rates, if that. And, increasingly, small business borrowers are turning to AFCs to provide financing. A mid-year 2015 survey by The Raddon Report supported that view, finding that one out of ten small businesses felt that banks had stopped lending to small businesses.
AFCs are bottom fishers. In another recent conversation, the CEO of a larger and very prominent regional bank dismissed AFCs and their value. He did not see how they were relevant to his bank with its high-end focus on the most bankable clients. His implication was that AFCs were bottom feeders, rather than potential partners, and that they were exploiting the neediest customers.
This CEO had no understanding of the value and flexibility that AFCs offer and their potential ability to provide loans to customers who fail to meet the bank’s risk criteria while allowing the bank to build a non-credit oriented relationship. He should consider the following points:
Your growth is constrained by your bank’s rigorous credit policies and internal sales culture. Understandably, you may be uncomfortable loosening your credit criteria. AFCs can provide loans to companies outside your credit box while you reap the benefits of revenues tied to deposits and cash management.
If and when those companies develop a more acceptable credit profile, their loans can become part of the bank portfolio.
Some AFCs can provide you with a digital platform that will improve customer service and reduce costs to serve. It could take your internal Information Technology (IT) resources years and many dollars to build the same capabilities.
AFCs are irrelevant. Another regional bank president commented that the volumes the AFCs have generated represented a very small percentage of total loan volume, indicating that AFCs were outliers and did not merit much consideration by banks like his. He viewed AFCs as largely irrelevant and unlikely to “move the needle” for his own profit & loss statement.
This individual failed to recognize the long-term nature of the commitment that AFCs have made to the industry and may be surprised as more market share shifts over to AFCs year-by-year. The top performing AFCs are now part of the permanent financing infrastructure; they are not going away. A report by the California Department of Business Oversight found that online lenders made $16 billion in loans in 2014 for consumers and small businesses, up 700% from 2010. Note that in the first six months of 2015, credit outstandings exceeded $12 billion.
Ignoring the growth generated by AFCs and its implications puts a bank at peril. The borrowers may not be bank credit-worthy today, but what happens to these companies if they improve their credit position? Is this another group that will remain disenfranchised from banks? Banks have pushed small businesses into the arms of alternative finance because they were unable to obtain funding from traditional sources. Banks cannot afford to lose these customers.
Many AFCs are very focused on transparency, market reputation, and developing a cooperative and trusting relationship between themselves and their bank partners. Yes, there are some bad actors within the AFC community, and some even appear to be surviving the bank due diligence process, potentially resulting in some unpleasant surprises for their bank partners. Bank managers may need to spend more time doing Google searches and attending conferences, where they can pick up more information about AFCs.
Most AFCs represent an industry that knows what it has to do to become part of the financing fabric for small businesses and consumers. The top players have hired experienced bankers and/or former regulators to make sure they are in synch with the regulators, meet the hurdles required to work with banks and follow the spirit of the law. With very few exceptions, evil? No. Eager to work with banks and to grow? Yes.
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