Three ways to challenge FinTech gains on consumer loans

“Banking is necessary; banks are not.”

It’s been 22 years since Microsoft founder Bill Gates made waves with this controversial statement. And recent evidence suggests he may be right. While we still require banks to store, manage and distribute money, financial technology (FinTech) entrants are rapidly creating new business models to simplify functions such as loan requests—a move that directly threatens incumbent banks if they don’t take the challenge seriously. Before long, FinTechs will replicate every bank function at lower cost. Some outlets such as PayPal already have.

But don’t assume all FinTech firms can disrupt traditional banking. Technology alone does not cause disruption. Only the combination of technology and an innovative business model mark a firm’s potential to disrupt.

Falling behind online lenders…

Online lenders, for example, stand on the cusp of disruption because they’re solving two issues consumers face with banks:

  • A lengthy loan process. Entrants in the lending space offer a faster, stress-free option for anxious consumers unsure of their credit rating. Online platforms connect borrowers with lenders (individual and institutional), and act as intermediaries to assess the credit risk of borrowers and price the loans. It’s simple and intuitive—and catching on with the masses. 
  • Small loans at small yields.  Although many observers expect the current administration to ease Dodd-Frank regulations for lenders, banks remain unmotivated to serve small loans—personal, small business and student—due to low profitability and regulatory capital requirements. Further, banks’ credit-scoring models only take into account past credit handling experience and thus limiting visibility into the potential risk of lending to a borrower. But online lenders use proprietary credit models that consider multiple data points, and open them up to an underserved customer base because they are better positioned to underwrite credit risk.

…and how to retake the lead

Now that online lenders have secured a foothold in the industry, incumbent banks have one option: Develop a new, autonomous business model. However, a quick, adequate response may be difficult—so here are three alternatives:

1.       Build

Banks can create a new business unit from the ground up to target previously untapped lending categories, while the core business continues to focus on categories proven to generate revenue.  Earlier this year, Goldman Sachs introduced Marcus, an independent online platform that offers unsecured consumer loans after increased competition from boutique banks threatened the firm’s core business. New talent was brought on to support the platform, and Marcus acquired its deposit base to offer loans from GE Capital, rather than raise funds from its core business.

2.       Partner

Banks can partner with an entrant to leverage the entrant’s low-cost business model. The partnership is equally and mutually beneficial; in exchange for supplying their business model, entrants secure a source of capital. Over the last few years, banks ranging from JP Morgan to BancAlliance (a group of small community banks) have benefited from such partnerships.

3.       Facilitate

Acting as a facilitator is an option for smaller banks and FinTech firms that earn the majority of their income from origination fees rather than holding loans on books to earn interest. As the facilitator, the bank conducts operations such as origination and servicing, while the entrant leads investing and growth. By partnering with an online lender, the bank indirectly competes with larger banks without significant investment in expanded operations. Utah-based Webbank and New Jersey-based Cross River bank have employed this strategy successfully.

Most indicators suggest disruption of consumer lending will happen, but that’s still up to traditional banks. Consumers will always have financial needs, but the way we bank and who addresses those needs remains to be seen. For banks prepared to fight entrants, a business model change must lie at the heart of any strategy. Whether they choose to build a new business unit, partner with an entrant, or act as a facilitator, banks will have the resources at their disposal to give entrants a run for their money.

Aroop Gupta is a research fellow with the Christensen Institute for Disruptive Innovation and analyst for Tata Consultancy Services. His research focuses on disruptive innovation within the banking and finance industry.