Together with innovations in payments, the fastest growing application in fintech today is online lending increasingly attractive alternatives to services that underpin our everyday lives. They address consumer demands for faster, userfriendly services with reduced intermediaries.
”Innovation in finance is deliberate and predictable; incumbent players are most likely to be attacked where the greatest sources of customer friction meet the largest profit pools”
[World Economic Forum The Future of Financial Services]
At its heart, online lending bridges capital requirement gaps. Whether its business requiring funds to operate, or individuals seeking loans, the business opportunity is real and often unmet. It represents one of the biggest disruptive threats to existing financial organisations today.
Fintech innovation in online lending between people (P2P or crowdlending) or between people and business (P2B) was borne from the tightening of banks’ lending practices since the financial crisis of the last decade.
Today, online lending offers a myriad of options to access capital. And the services aren’t being used only by individuals who have struggled to obtain loans from banks. Those with the highest credit grades are also turning to online marketplaces both as borrowers and investors (or lenders). In the US for example, a significant proportion of the loans are being written by institutions, as they seize the opportunity to transact more efficiently using technology. The global landscape of online lending shows the increasing prevalence.
A compelling evolution to traditional lending
Online lending is built on simple and accessible processes, including mobile applications. It reduces friction, enhances customer experience, and facilitates more efficient capital flow. Borrower applications take minutes to complete, a decision is possible within hours, with funds available in days. Where loans are for business, the drawbacks of the traditional lenders’ approach can be costly to business on both sides. Compared to traditional routes which can take several visits to the bank and involve manual checks over many days, the difference is clear and increasingly understood by today’s customers.
For investors (or lenders), it is also an attractive proposition. Yields paid to lenders are often more competitive than regular savings or deposit rates available in banks. Rather than denying riskier borrowers, online lending instead sets higher interest rates commensurate with the risk of default.
Let’s not forget advantages for the institutions operating the platforms. Process efficiency, greater objectivity, scale and speed in assessing risk make operating online lending profitable from a process point of view. Ultimately however, the bottom line depends on the ability to correctly match risk and yield and acquisition costs such as marketing and sales. It is important to understand different models will work better in different markets with different borrowers and lenders.
At Lending Club and Prosper, leading US online lenders, loans with the highest rating can generate between 5 and 9% returns. The interest rate of riskier loans can exceed 12%. Lenders may mitigate risk by carefully screening borrowers and diversifying loan portfolios. The following chart shows the estimated returns, with the mid level grades of risk achieving above 10%.
Grow Advisors, a leading enabler of online marketplaces including p2p, believes the online lending market offers a compelling and natural evolution for traditional lenders searching new opportunities in alternative finance. They are assisting institutions in making the transition to digital finance from North America to Europe and now Asia. Disruption in finance doesn’t exclude incumbents and there’s every reason why traditional lenders should be making plans to evolve part of their business online.
The most common applications and approaches
Raising capital online can take many multiple forms. Since the credit crisis of 2007 and the global financial crisis that ensued, access to capital has led to slowing business and economic growth the world over. With the rise of peer to peer lending (P2P), individual borrowers connect with unrelated individual investors. Peer to Business Lending (P2B) is growing to offer funding to small businesses and start ups.
Common models for online P2P lending include algorithm based auctions, reverse auctions and fixed rates, the latter two models most widely adopted. In the reverse auction model, lenders bid for the lowest interest rate that matches the borrowers desire for yield. And, as the name suggests, fix rate models offer fixed rates based on the lender’s assessment of a borrower’s credit. In P2B lending, businesses with higher default possibilities usually pay higher interest rates.
Underpinning all models, access to consumer credit worthiness data or data related to a business’ ability to pay is key to matching risk with appropriate interest rate levels.
An expanding global footprint
According to official bank loan data in the US, in the last quarter of 2014, the outstanding portfolio balance of traditional banks’ declined 3.1% while online alternative lending grew 175%. While today the base is relatively insignificant, the trend is significant and offers valuable insight into tomorrow’s competitive landscape.
Looking further, the p2p lending market is growing around the world. Across Europe, online loan options available to consumers and business owners outside those offered through banks and capital markets grew 144% in 2014 to almost €3bn and is estimated to reach €7bn in 2015.
Online lenders in the UK issued $2.3 billion in loans on P2P platforms in 2014, making it the largest P2P lending market on a per capita basis. Major P2P lenders in the UK include Funding Circle, Zopa and RateSetter.
The rise of consumer and small business loan segments in Asian markets is fuelling a demand for P2P lending. In China, with limited investment opportunities and volatile stock markets, ordinary Chinese investors find the new lending channel appealing. It is creating a challenging competitive environment for traditional banks and denting profit margins. According to Wangdaizhijia, a data provider, with an estimated 1,575 platforms (up from just 50 three years ago), China’s P2P lending market was US$16.72 billion, roughly doubling the US. Though unregulated, Chinese regulators are now paying attention to the growth and have forced many operators to close.
Other markets in Asia aiming to replicate China’s experience include Malaysia. Recent reviews and initial consultations with regulators has led to six platforms being authorized to conduct lending online. Despite the big differences in maturity and regulatory approaches across Asia, approaches to P2P lending and regulations share a common thread and evolutionary path, and represents a wakeup call to traditional lenders. In the last 3 months alone, Grow Advisors has held discussions with organisations looking to initiate online lending marketplaces in Singapore, Philippines, Malaysia, Vietnam and Indonesia. South East Asia, which is already leading economic growth in Asia is likely to experience a surge in online lending in the coming years.
The global economy is still based around businesses where the vast majority of the transactions take place offline. While financial services are still dominated by banks legacy systems and physical branches, fintech is taking the battle for customers online and lending could well become the first traditional business segment to experience significant transformation.
A Grow Advisors article originally produced for Finance MONTHLY
Grace "Shuli" Chen, Grow Advisors
International marketing strategist and Project Management Professional (PMP) with focus on business development and investor relations in commercial real estate investment. She has managed cross-functional projects for Fortune 500 companies and startups in both United States and China.
Denisa Mäki, Grow Advisors
Political advisory, strategic communication and policy analysis. Subject matter expert in EU affairs, legal research and analysis of EU and International law. Use this link to contact Denisa.
Grow Advisors is proud to support the growth of FinTech around the world. We offer consulting and professional services on crowdfunding, crowd investing and p2p finance globally. Our advisors develop platforms that connect startup ecosystems, setup marketplaces and coinvestment models, structured investment instruments, and find innovative ways to create finance solutions globally.