How well does industry disruption serve the consumer?
Financial technology companies, so-called “FINTECH,” have received a lot of venture capital funding in recent years. One area that has been of particular interest is that of peer-to-peer lending, whereby companies, such as Lending Club and Prosper, connect investors (lenders) with consumers (borrowers) to facilitate loans on-line. These companies function as financial intermediaries, as an alternative to banks, credit unions, and other financial services companies. Because they offered high returns, the companies grew quite large. Marketplace lending grew by 700% in the past four years. But both companies have faced significant recent challenges, including loan losses, that have dropped their volume and value, leading some to question the business model.
The model is a bit complicated, involving many entities, including a traditional bank and several intermediaries. Consumers apply on-line and are assigned a risk rating based on their credit scores, debt-to-income ratios, and other inputs. The borrower’s loan is put on-line through these platforms and made available for individual investors to select and they are paid a return, commensurate with the risk. In theory, this marketplace enables an individual borrower to connect with an individual lender. The practice, however, has drawn much more large-scale institutional capital, than small investors. The majority of these loans are personal, unsecured credit. Contrary to the name, peer-to-peer, there are a number of entities involved in each transaction, all of which take some form of fees that provide their revenue, so borrowing costs are actually fairly high in comparison to traditional loans. As with payday loans and subprime auto loans, marketplace lending tends to attract less creditworthy borrowers, who typically use traditional financial products.
Half of Lending Club’s stock value was erased last month when founder and CEO, Renauld Laplanche, was recently fired for falsifying loan data. In a consumer lending business, transparency and accountability are critical to maintaining confidence. Shareholders do not like news like this. Lending Club has also suffered from an influx of competition, including Prosper.
Prosper’s problems are not malfeasance, but a struggle to find investors to buy their loans. Their investor demand has dropped significantly in the past two quarters and they have been forced to lay off 28% of their employees.
While capital markets are strongly attracted to companies that are “industry disruptors,” particularly those with a technology platform, these companies’ troubles raise concerns about whether innovation really works all that well for the consumer or the shareholder. Default rates for these products have been fairly high, with industry losses of over $34 million last year. The reality is that it is expensive and time-consuming to assess borrower quality in the optimal way – using character-based lending and other tools besides just formulaic risk scoring models. Bringing borrowers and lenders (investors) together can work very well in an organization like On the Road Lending. Ironically, in peer-to-peer lending, the distance between the two gets fairly large.