Banking response to alternative finance
At the recent Lendit conference focused on “alternative lending,” keynote speaker Larry Summers, the former Secretary of Treasury, said that he would not be surprised if within ten years alternative finance companies (AFCs) generated 75% of “non-subsidized” (non-Small Business Administration) small business loans and 30% to 40% of direct consumer lending. Today, the small business percentage generated by AFCs does not exceed 2% and the consumer percentage may be in the 5% to 10% range.
Banks cannot afford to ignore this game-changing possibility. Rather than view AFCs as just another set of competitors, banks have the opportunity to work with them to increase revenues, expand their market focus and leverage already well-developed processing and risk management platforms to improve productivity and performance.
What is an alternative finance company? Described by one AFC CEO as emphasizing “digitally-enhanced lending,” these entities do not take deposits and are usually owned by private equity firms, which see a substantial growth opportunity lending to companies to which banks either cannot or will not lend. AFCs imbed the effective use of information technology throughout their business systems (including origination, underwriting and monitoring) to streamline processes. In their view, this provides a quality of risk management that allows them to lend to companies considered un-bankable.
Here are some factors fueling the growth of AFCs:
Banks define their “credit box” narrowly, creating a lending opportunity for AFCs, particularly with businesses. While banks want to lend, many have also increased the hurdles that businesses must meet to borrow. We estimate that banks overall consider only about 10% of all business loan prospects as bankable, leaving in excess of $1 trillion in loan opportunities for others. Banks have created the growth opportunity that AFCs are enjoying.
AFCs provide greater speed in decision-making and funding. A 2014 Federal Reserve study estimates that small business owners spend 24 hours researching and applying for a loan, contrasting sharply with the 24- to 48-hour turnaround that some AFCs can provide. During a due diligence project for a client, we found that a significant number of bankable credits had decided to work with AFCs for their speed and responsive customer service, despite higher cost.
Funding is plentiful for AF lenders and their borrowers. Private equity, securitizations, bank loans and IPOs are all available to AFCs and support their growth. Some companies such as Lending Club operate as marketplaces in which they act, in effect, as intermediaries between borrowers and lenders (often institutions, including banks). Marketplace lenders further expand the dollars available to fund loans. An economic downturn will likely reduce funding to marginal players but more established lenders should continue to attract backers.
AFCs operate with strong risk management. Some bankers I speak with view AFCs as the second coming of subprime lending and expect the same bad end as that business suffered due to poor lending practices. However, in many cases, the quality of risk management processes followed by AFCs may exceed that of banks in both depth and quality. Nonbanks have developed analyses that often incorporate traditional banking data, credit history data, cash flow information, various public records and even social media data. Risk also involves an area of continued investment and focus for these firms, as they push themselves to build stronger underwriting processes.
AFCs are benefiting from an improved reputation and enhanced PR. About five years ago, alternative lenders suffered from poor publicity and an image that often portrayed them as the small business equivalent of payday lenders. However, as the industry has matured (and, in some instances, as their lending rates have declined), their image improved. Much of the media now portrays AFCs as a reasonable alternative to banks, with stories often stressing how they came to the rescue of a small company and approved a loan request that a bank had previously denied.
Alternative Finance is here to stay. One banker recently commented to me that “he had seen this rodeo before,” suggesting that AFCs represented a lending bubble rather than permanent disruption. Certainly, some lenders will blow up over the next few years, whether from fraud, bad lending practices or unforeseen circumstances. But many will continue to succeed and expand by virtue of customer need, innovation, effective marketing, continued access to funds and lack of response from traditional lenders. Alternative finance has become a game changer; it is not going away.
So, what should be the proper stance of banks in regards to this phenomenon?
AFCs understand and respect the privileged position and positive reputation that banks continue to have with most customers. They also realize that banks can provide access to a large customer base at a reduced cost of origination. For many AFCs, cooperation with banks makes a lot more sense than competition. For their part, banks can leverage the AFCs investment in process and risk-related technology to reduce costs and/or expand revenue opportunities.
Cooperation is likely to involve one or more of the following options:
Referrals. This involves AFCs obtaining referrals from banks for loans not acceptable to bank criteria (“turn-downs”). The bank receives a referral fee and retains all the customer’s other business. However, this activity raises compliance and privacy concerns at many banks and may also not provide significant revenues to be meaningful to either the bank or the AFC.
Business expansion. AFCs can work with banks proactively to assess their current customer base and identify new loan opportunities. The bank can fund those that meet its criteria while the AFC will provide loans to non-bankable targets, either on a private label or co-branded basis. This has become an increasing focus of some AFCs and may represent an attractive growth area for banks that want to increase loans to small businesses.
Integration. A handful of AFCs currently offer their origination, servicing and risk management platforms as a service to banks, allowing them to streamline the lending process, lower their costs and improve the customer experience. Most banks lose money on loans less than $100,000; this approach can reduce operating expenses and allow the bank to focus on origination rather than back office activities. By integrating with the bank, the AFC can become the bank’s small business lender for all loans under the $50,000 to $100,000 range.
Investments and funding. Some larger banks and institutional investors are currently purchasing whole loans or loan portfolios originated by AFCs, allowing banks to take advantage of their own low cost funding and access to deposits. This activity demands strong, independent risk analysis. Banks are one of the main funders of AFCs, participating in a secondary way in the high rate loans that AFCs generate.
At this point we also know of three banks, one top ten and two smaller institutions, that are trying to emulate the AFCs’ lending approach by applying the analytics that AFCs have spearheaded to their own bank portfolios. More banks are likely to do the same, although the extent of a bank’s willingness to alter its traditional approach to risk management and pricing remains a question mark.
If a bank decides to works with AFCs, utilizing one of the above options, how should they then select a partner?
Hundreds of AF companies now operate and the Lendit conference demonstrated that new players are entering the market every week, trying to differentiate themselves based upon factors including lending focus and industry or loan product expertise. A bank’s internal “checklist” needs to include how effectively the AFC has anticipated and addressed the banking industry’s regulatory and compliance issues; whether the solution that an AFC offers is turnkey, thereby limiting the time and resources required by the bank; and, the willingness of the AFC to customize its approach to the needs and preferences of the bank. Even this brief checklist will eliminate most AFCs as candidates and allow bank management to focus on high priority prospects.