Lending Club: Can technology fundamentally disrupt how we invest and borrow?
Banking has been around for 700+ years, and is the third most profitable sector in the economy. Financial intermediaries usually rely heavily on physical assesses and people. Is there a leaner way to do this? Lending Club says yes. The market's view is mixed. Read ahead to explore this topic.
Lending is an old, established, and successful industry. Historians traced evidence of grain loans as far back as the ancient world, and dated the birth of banks at around the 14th century [1]. Lending is also profitable: Finance is the third most profitable sector in the economy, with a 17.14% net margin [2].
One potential explanation for the industry’s longevity and success is the timeless and complex nature of the problem it solves. Many lenders want to invest excess funds for a profit, while many borrowers need money to finance their projects, such as buying houses, paying for education, etc. Although lending is mutually beneficial, parties have historically been unable to match without banks as intermediaries.
How lending traditionally works
Traditional financial intermediaries collect funds from individual and institutions, against a promise to pay them back with interest. Intermediaries pool these funds, search for suitable borrowers with the right risk profiles, and lend them money at higher interest rates. Intermediaries profit by 1) lending at higher interest rates than what they pay to investors and 2) minimizing defaults through risk assessment and collections management.
To implement this business model, lenders have traditionally needed large organizations and infrastructure. Physical branches and call centers service customers. Marketing teams increase sales. Trading desks invest temporary capital holdings. Risk teams ensure loans perform as expected. And the list goes on. For example, Wells Fargo, a commercial bank with a market capitalization of US$ 260bn [3] and US$ 1.9 trillion in outstanding assets, employs 268,000 people in 8,600 locations [4].
But wait, this is 2016. Can digital marketplaces cut intermediaries out?
Enter digital marketplaces: Lending Club
Lending Club is an internet marketplace that connects investors and borrowers directly, with limited intermediation. Founded in 2006, Lending Club is seen as the “flagship company” of the young peer-to-peer lending industry [5,6].
Beyond spearheading digitization in the lending industry, Lending Club has also created a significant financial impact. To date, it has facilitated US$ 22.7bn in loans. Furthermore, Lending Club’s model has been competitive by offering cheaper rates for borrowers and higher risk-adjusted returns for investors [6,9]. This enabled Lending Club’s IPO in 2014, attaining a peak market capitalization of US $10bn [10].
How is this different from traditional lending?
Lending Club’s business model is fundamentally different. Instead of lending their own funds, Lending Club provides a marketplace where borrowers and investors make their own transactions. Borrowers publish loans, and investors handpick individual loans to invest in. In return, Lending Club charges a small service fee to both parties [11, 12]. As a result, credit risk is transferred from institutions to investors, who now bear the full potential gains and losses from their investment decisions.
Also, Lending Club’s operating model is much leaner than traditional institutions:
- Fully automated loan approval. Borrowers fill an online form with personal and third party data, such as FICO scores. Lending Club then runs proprietary risk assessment and fraud detection algorithms to automatically approve the loan and set the appropriate interest rate given the loan’s risk.
- No physical branches, as all operations can be done via the website.
- Less employees, with only 1,400 employees reported as of December 2015. [12]
Recent trouble
Although Lending Club’s model seem to make sense, trouble has hit the young company. Its stock price has steadily declined since the IPO, and currently trades 74% below its peak in 2014.
Cited reasons include slight increases in default rates, which scared some investors away and pushed interest rates up, which in turn scared some borrowers away. With a fee-based model, Lending Club requires steady inflows of investors and borrowers to keep revenues up.
Other cited reasons are on legal, compliance, and regulation. Some investors that lost money are suing through class actions. Scandals have arisen from claims that its founder used the platform for personal gain. Regulators are still scrambling to refine the right legal framework for these marketplaces. In summary, there is a lot of uncertainty ahead. [13]
Looking ahead
In my opinion, Lending Club needs to strengthen its economics and reputation. For economics, Lending Club should continue perfecting its algorithms, to reduce defaults. It should also cross-sell highly-scalable financial services, such as insurance and automatic debt consolidation advice.
I would also encourage Lending Club to fully disclose sources and uses of capital, to shatter any doub of shady deals. I would also increase social networks presence with educative videos on the risks of investing in loans, and how they can be managed but not eliminated.
Regardless, the peer-to-peer lending industry is an exciting space likely to grow fast in the US and abroad. Its powerful value proposition and efficient operations are threatening to disrupt finance. However, will it have sufficient thrust to break into one of the most established and powerful industries in history? Only time will tell.
(800 words)
References:
[1] Banking through the ages by Hoggson, Noble Foster, b. 1865, https://archive.org/details/bankingthroughag00hogg
[2] “The most profitable industries in 2016”, www.forbes.com, http://www.forbes.com/sites/liyanchen/2015/12/21/the-most-profitable-industries-in-2016/#73cae7317a8b
[3] Yahoo Finance, consulted on November 16, 2016
[4] Wells Fargo Factsheet, 2nd Quarter 2016 https://www08.wellsfargomedia.com/assets/pdf/about/corporate/wells-fargo-today.pdf
[5] “The Stunning Fall of LendingClub’s Founder”, Bloomberg, https://www.bloomberg.com/news/articles/2016-05-09/lendingclub-founder-goes-from-wall-street-darling-to-unemployed
[6] “Banking without banks”, The Economist, http://www.economist.com/news/finance-and-economics/21597932-offering-both-borrowers-and-lenders-better-deal-websites-put-two
[7] Latest Company Stats, Lending Club, consulted on November 17, 2016, https://www.lendingclub.com/public/about-us.action
[8] United States Population Statistics, Census Bureau, consulted on November 17, 2016, https://www.census.gov/popclock/
[9] “Lending Club Can Be a Better Bank Than the Banks”, Bloomberg, https://www.bloomberg.com/view/articles/2014-08-27/lending-club-can-be-a-better-bank-than-the-banks
[10] http://www.bloomberg.com/news/articles/2015-06-29/lendingclub-falls-below-ipo-price-after-49-plunge-in-six-months
[11] “Frequently Asked Questions for Investors”, Lending Club, consulted on November 17, 2016, https://www.lendingclub.com/public/investing-faq.action
[12] Annual Report 2015, Lending Club, http://ir.lendingclub.com/file.aspx?iid=4213397&fid=1001209585
[13] “Lending Club: Membership Revoked”, The Economist, http://www.economist.com/news/finance-and-economics/21698698-sacking-ceo-leading-peer-peer-lender-jolts
Great post and good job laying out the difficulties with this model. I have a hard time believing this business model will make it through an entire economic cycle. I think any institutional investor will have access to bigger, stronger investments with more security and legitimate guarantees. That leaves smaller, one off investors who don’t have access to debt funds and MBS vehicles facilitated by premier originators. These players typically don’t have the underwriting capabilities to fully understand the risk associated with one off, personal loans. In a down-turn, a lot of people are going to lose money regardless of how strong this model is, which will lead to higher regulations. I suspect, the first business model to bite the dust will be the new one that is subject to class-action law suits.
Interesting article, thank you for writing!
As a former lender on Lending Club I found the discussion of the company’s recent troubles fascinating. I originally got into Lending Club to find higher interest rates for my money than those I could get from CDs or other stable investments at a bank. I made an account, logged in, and immediately sent small loans ($5 each) to more than a hundred different borrowers (diversification is magic, amirite). I had chosen a balance of borrowers with different risk profile, all paying different interest rates. All was going well for a year or two, while I was earning roughly 7% on my money, and had no defaults. Then, in 2014 I had my first borrower default (he still owed me like $4.50!!!) and then another and another. In all, though historical rates of default were cited to be below 1% on Lending Club, about 6% of my portfolio ending up defaulting. When it was all said and done, after 3 years I had earned an effective interest rate of about 0.5%–roughly in line with what I probably could have gotten from a savings account. Oh well, I guess there really is no free lunch.
As La Pistola said above, I agree that Lending Club will likely struggle to remain afloat during an economic downturn. Investors will likely look for products that have a long track record of low risks, and will pull their money out of Lending Club, causing dramatic decreases in fees coming into the company. Coupled with their ongoing regulatory and legal troubles, it seems like the future of Lending Club may not be secure. I think disintermediating banks is a good idea, but perhaps the next player will create a more sustainable business model.
Thanks Mike for sharing your story above about investing in Lending Club.
Companies like Lending Club are natural displays of how digital approaches can challenge antiquated business models. I think Lending Club’s troubles are not dissimilar from other underlying challenges of the financial industry: 1) overeager investors create a bubble and inflated expectations, which lead to disappointing results (again, thanks Mike for confirming), 2) conflicts between management’s and the firm’s incentives (in this case, the CEO did not disclose his interest in a fund that purchased Lending Club products, a clear discretion), and 3) lack of strong regulations and controls. These are some examples of challenges that can impact all financial institutions, and Lending Club is no exception.
Online consumer / P2P lending is potentially contributing to yet another risky asset bubble. However P2P market was only around $100 billion last year, a small percentage compared to the entire credit market, so it remains to be seen how the larger institutional investors and banks react to this product.
A really interesting article, Janice. It does make one think that the methodology and working of the banking sector hasn’t really changed much since its inception. The modality remains the same, and the way of operation relies mostly on a physical base. With the advent of technology and internet which has revolutionized banking so much, the core concept of banking, i.e. lending is still done through inter-personal methods, primarily at branches. This part of banking has begged for a paradigm shift for a long time. Cutting out the intermediary (banks and financial institutions) would seem to be the right way to go. The idea that Lending Club and various other players in this market space has is good, but it has a long way to go. In an era where digitization is occurring everywhere even this deeply-entrenched sector will have to follow suit. It is just a matter of time. I completely agree that till the time that this direct online financing industry gets traction, it will be a pawn to economic movement, with default rates being directly affected, but once issues of fraud are dealt with using more sophisticated algorithm and testing parameters, regulations are put into place protecting the rights of all parties, and the user base increases, this could be the next staple in the financial lending sector.