from the Richmond Fed
— this post authored by Tim Sablik
True to its name, Prosper reported a good year in 2015. It originated $3.7 billion in consumer loans, more than half its total since it began operations in 2006. Prosper isn’t a bank, though. It’s one of a growing number of new alternative lenders that are part of the broader “fintech” movement bringing a Silicon Valley startup spirit to the world of consumer and small-business finance.
Like most of its peers, Prosper boasts sleek web and mobile platforms and promises to connect borrowers quickly with the funds they need at a competitive and transparent price. And judging by the growth in this sector over the last two years, consumers have been increasingly taking these lenders up on that offer. According to an April study by the University of Cambridge’s Centre for Alternative Finance and the University of Chicago’s Polsky Center for Entrepreneurship and Innovation, online lenders more than tripled their lending volume between 2014 and 2015, from $11.7 billion to $36.5 billion. The bulk of this lending has been to consumers. (See chart below).
This growth has been driven by both supply and demand factors. On the demand side, consumers and small-business owners are attracted to the ease of use and variety of options offered by alternative lenders. On the supply side, these firms claim to gain a cost and speed advantage over traditional lenders by forgoing physical branches and using advanced algorithms to instantly analyze huge swaths of new consumer data. Additionally, alternative lenders present a new opportunity for investors hoping for higher returns in a low interest rate environment.
But with expansion has come questions. Do these firms enjoy an advantage over traditional firms because of new methods and technology or because they have avoided costly financial regulations and oversight? As this sector has grown and evolved, financial regulators like the Office of the Comptroller of the Currency (OCC), the Treasury Department, the Federal Deposit Insurance Corporation (FDIC), and the Fed have begun asking in earnest: What opportunities and risks do these firms present for consumers, traditional lenders, and the financial system as a whole?
A Marketplace for Loans
Alternative lenders began with a simple, and old, idea: connect savers with borrowers. The challenge lies in convincing savers to lend money to strangers when the latter know more about their likelihood of repaying than the former. Traditionally, banks have served as middlemen for these transactions. Savers make deposits that become the bank’s liabilities. The deposits are federally insured, alleviating the need to worry about repayment. Banks use those deposits to fund loans, taking on the burden of assessing borrowers’ risk so that savers don’t have to. Banks then earn a profit on the spread between the interest they charge borrowers and the risk-free interest they pay depositors.
Many of the new online lenders connect savers and borrowers in a more direct way. Borrowers that come to Prosper or rivals like Lending Club are offered loan terms based on their credit history and other factors. Once approved to appear on the platform, these loans are listed on the site and investors can choose to invest in portions of any number of loans. Those savers earn a return based on the performance and riskiness of the loan, while the lending firm earns a fee from matching the two parties and facilitating the transaction. This peer-to-peer or marketplace lending draws on the power of the crowd, similar to funding websites like Kickstarter that pool hundreds of individual small-dollar donors to fund a big project.
Not all alternative lenders follow the same model, though. “Balance sheet” lenders like OnDeck, a leading alternative lender to small businesses, are much closer to traditional banks. They hold a significant portion of their loans on their own balance sheet and earn revenue from the performance of those loans. Investors hold stock in OnDeck rather than investing in individual loans.
While they have been billed as disruptors to banks, the similarities of some of these online platforms to traditional players somewhat belies that image. In fact, many alternative lenders depend on traditional institutions to originate their loans. Borrowers that apply for a loan from Lending Club, for example, actually receive a loan from a brick and mortar bank (WebBank in Salt Lake City, Utah, which partners with several online lenders). By having a bank originate the loan, marketplace lenders can piggyback on its charter without obtaining one of their own. The bank then sells the loan to the alternative lender after a few days, which in turn securitizes the loan for sale to its investors.
Still, online lenders have innovated on the traditional underwriting model by looking at more than just credit scores. Alternative lenders say they analyze borrowers’ social media accounts, educational histories, and online commerce sales at Amazon or eBay to glean more information not captured by traditional metrics. In theory, this information leads to a more accurate risk assessment of borrowers, allowing alternative lenders to price riskier loans more profitably and lower-risk loans more competitively than traditional lenders. Additionally, since individual investors rather than the firm bear the risk of the loans, marketplace lenders can hold less capital against their loans compared to traditional banks, further reducing their operating costs and passing those savings on to borrowers.
