Many banks are now investing in loans originated by online lenders such as Lending Club, Prosper and OnDeck. Whether this is a good move or not, comes down to the accuracy of each originator's credit model and the strategic position of the purchasing banks. For some banks, purchasing loans from these lenders is absolutely the right move as it leverages capital, increases diversification and puts underperforming equity to work. However, for other banks, who just dabble in these investments, partnering with online lenders is a valuable learning experience. Still, for some banks, purchasing these assets are a strategically bad move as they can gain better risk-adjusted returns elsewhere and their investment in these loans from online lenders represents a negative credit arbitrage for the bank as these assets are underpriced given the risk.
Regardless of which camp you fall into, every banker should consider what the future of lending holds and how to best position themselves for the coming disruption.
The Competitive Advantage of Online Lenders
Each year that passes, more and more lending sectors are moving completely online. In mid-2017, we now have consumer, mortgage, SBA, franchise loans and other sectors now completely automated. Last year, at conferences we heard many banks say they are taking comfort in the fact that larger loans and commercial real estate are too complicated to be automated.
Not so fast. In the last several months, we have now seen commercial real estate move completely online for the first time in history. This is toothpaste that cannot be put back in the tube. The economics are too great. Instead of originating loans at a 75% efficiency ratio, these online platforms originate loans at a 15% efficiency ratio. Given that less than 10% of loans are originated online, this disparity in economics is nothing more than an engaging bank conference topic. However, in three short years, we predict online lending will comprise over 50% of loan production. What will banks do then?
Such a large difference in origination cost means traditional lenders will be at a strategic disadvantage. Given that many of these online lenders are also employing data, analytics and machine-learning to both marketing and credit, this also means that their online cost of acquisition and capital allocation will be a fraction of the traditional bank Online lenders will have a fraction of the overall cost and capital compared to banks when these elements are combined. to the ability to Scale to greater efficiencies is also a benefit. This means that online lenders can operate at better margins and/or originate at lower fees and lower interest costs.
Soon, online lending will be cheaper, faster and more accurate.
Service Will Protect Us
So you talk this through with your board and management team, and you determine that your bank is protected because of your superior service. We would not take too much comfort in that positioning. Bankers said the same thing about mortgage lenders until Quicken took the top spot last year. How many physical retailers have higher satisfaction than Amazon? Not many.
The Advantage for Banks and the Future
All of the above doesn’t mean that banks don’t have an advantage. Our cost of capital, ability to leverage, ability to gather cheap deposits and our position of high public trust are serious strategic advantages. The combination of all these above factors primarily leads to one conclusion – the future means a marriage of both business models.
Some of these online lenders will be acquired by banks, while some will acquire a bank. For the most part, it means that banks will either have to develop a competing platform or will have to partner with these platforms to originate their own loans for a license fee. This is inevitable for a majority of the banks in this country. This issue needs to be in every community bank’s strategic plan. For each year that passes where your bank is not gaining experience in online lending, means your odds of being acquired increase.
The M&A Advantage
If Bank A has an online platform and Bank B does not, then the more efficient business model of Bank A can pay a higher price for Bank B as Bank A will recognize more cost savings. Banks that have online lending platforms will be faster consolidators as they will have more options.
Getting a Strategic Plan
Ignoring this issue is really not an option. This is more important an action item than online and mobile banking. In those areas, it was OK to be five years behind the leaders. The rise of internet deposit gatherers occurred at a time when the rates were falling and the system was awash in liquidity. Community banks are just now starting to feel the full impact of these efficient deposit gatherers.
When it comes to deposits, there are fewer variables and fewer service attributes that can make a difference. Further, most households would like their deposits local for ease of access. As a result, many of these Internet-only banks offered high rates to attract new accounts to overcome this friction. For some of these banks, online deposits are not a clear win. This is not the case for online lending.
Online lending, if done right, is a clear win. As these online lenders expand market share, banks will miss the assets. It is easier to compete on loans vs. deposits as a loan has more service components and terms in which to differentiate institutions. Like mortgages, borrowers are less geographically tied to local institutions and are more likely to take capital from online providers. The net result is that online lenders will have an even greater impact than internet-only deposit focused banks on the traditional community bank’s future.
Putting This into Action
We don’t know what the right answer is, but here at CenterState we have and will continue to experiment with various solutions to find the best path. We are in process of creating our own platform while have also leveraged the SmartBiz SBA platform and are currently looking at Fundomate and Fundation.
We have also outlined some preliminary basic tenants that guide us in our strategic efforts to choose the right path. The following serves as a strategic framework:
Maintain The Customer: We are certain that any solution will revolve around the customer and their information. This is an asset we are not about to cede. Banks, in our opinion, cannot afford to be disintermediated and must maintain their brand and service level in front of the customer. Since we believe banks are in the business of managing customer dreams, introducing another firm between us and our customer is a non-starter for the long run.
Front End Brand and Tech: To maintain the customer, this means that we need to exert some control at the point of contact. While we partner with a variety of firms, we are strident that it not only needs to be at least co-branded, but we must maintain the ability to own the front end technology or at least be able to swap out the customer-facing screens in case we and our partner decide to go separate ways.
Data: We must maintain full control and security over the data. This doesn’t mean we have to physically house the data, but it does mean that the data structure, integrity, and security have to be at least as robust as our internal standards. Data is not only a valuable asset in and of itself, but the trust factor that goes with this data cannot be violated. As such, banks need to pay particular attention to not only the security but the rights and usage of this data.
Marketing Control: In addition to controlling the customer experience and the data, we need to be free to market the customer for other products. We will make small allowances for platforms that bring us new customers, but if we are going to move our customer base online, then we need complete freedom to market and advice other bank product and services.
Network Leverage: We recognize the pitfalls and power of having multiple banks using the platform and one that is supported by many third parties. Getting multiple sources of input and support can be a huge advantage. With each potential partnership or license agreement, we pay particular attention to if the relationship creates a drag on future development or if it presents a path for exponential or at least geometric leverage. Platforms where we can gain new customers, leverage data and have faster development get our attention.
Vision and Continued Development: Online lending is a nascent industry and will radically change. The right partner and solution will involve getting comfortable with the future vision and the amount of resources dedicated to future research and development. Every potential partner can show a rapid path of current development and a heavy dose of current investing, but what assurances are there that this will continue? Conversely, some banks might be happy with a limited solution that is the most cost effective. This is fine. Our only point here is that this conversation needs to be had right up front and contractually built into the relationship.
Cost and Contract Structure: Each partnership is different. Some are pure technology plays while others add value to the workflow, to marketing, and to customer engagement. Each segment of the value proposition should command a fair price, but banks need to keep it in perspective. Several platforms we looked at were immediate non-starters as they wanted what we considered an outsized revenue share of the loan where we were taking most of the risk. The same goes for platforms that want an upfront fee to protect their downside and an unlimited upside in the form of a percentage of our flow. In our opinion, partners either get their downside protected or can reduce the risk of the partnership for us and share in our upside. However, you don’t get both. Banks need to make sure the pricing structure of any partnership makes sense under a variety of volume and cost escalation scenarios.
Disconnection: How a partnership dissolves is very important, as we want to maintain the right to replace our partners should the relationship not reach expectations. This means being clear on what happens to the customer, where the data rights go, how the customer gets noticed and a predetermined conversion time. We see too many banks get into relationships where there is no easy way to extract themselves thereby ceding a majority of control over to the partner.
Getting More Information on Strategy
There are lots of consultants and lawyers that stand at the ready to help banks decide which path to take. Further, in addition to our blog, we stand at the ready to recommend law firms, consultants, technology providers and platforms that have impressed us. We will be talking about this topic more at our Bank Management Conference coming up in July (HERE) and on our free webinar coming up at the end of this month (HERE).
This is a critical topic for banks and not one where management can kick the can down the road. If you do not have plans to move at least a portion of your lending online, now is the time to make those plans. The industry is rapidly moving in this direction and banks may find themselves quickly and permanently disrupted.
Submitted by Chris Nichols on June 07, 2017