As strong advocates of peer-to-peer lending, we were excited to hear about LendIt. But the conference on alternative finance turned out to be a sobering experience.
Having written about the potential of information technology to make banking obsolete, it was a no-brainer for me (the Investment Banker co-author) to visit the LendIt conference. I wanted to see first-hand how far the marketplace lending industry has progressed to replace banking and to pave the path towards a brighter financial future. At this conference, the industry demonstrated that it has developed almost all the tools that are required to make banking obsolete. This is the good news. The bad news is that this potential is not used to end banking: It is used to reinvent (shadow) banking.
The encouraging developments
An encouraging area of development is small business lending. Many marketplace lenders (like Biz2Credit or Kabbage) have found ways to exclusively rely on data analytics and scoring methods to monitor borrowers in the small business sector. As we predicted in our book, the relationship lending model of banks is no longer needed to supply small businesses with credit. Small businesses have been among the main victims of the credit crunch that followed the financial crisis of 2007-08 and it is good to see that marketplace lending fills the void the banking industry has left.
Furthermore, countless companies such as LendingRobot or Orchard have established themselves around helping investors to select and invest into marketplace loans. They have developed algorithms that automate the investment process. Today, many investors rely on their services and the investment process has already become very similar to the one we described in Part III of The End of Banking. Furthermore, senior executives of these companies confirmed that they are highly interested in establishing secondary markets for these loans.
Technologies that are required to remove the need for banking are being improved at a staggering pace. The only element still missing are liquid secondary markets. The current environment in which investors are scrambling for fixed income assets that generate returns seems a main reason for me that a liquid secondary market has not yet emerged; investor demand far outpaces the supply of loans, and investors hold tightly on the loans they got allocated.
The concerning developments
It is for a good reason that the industry changed its label from peer-to-peer lending to marketplace lending: Peer-to-peer lending is dead. Institutional investors have taken over the entire investor side of marketplace lending. The initial idea of connecting borrowers and lenders directly has been abandoned. Now, hedge-funds, asset managers and banks are using marketplace lending as a supplier of loans in their chase for yield.
And with this development, marketplace lending becomes more and more integrated into banking. Companies such as Lending Club and Prosper have redefined themselves into loan originators and underwriters for traditional banks. One marketplace lending CEO I talked to explained that his company is a „raw material“ producer for the institutional investors. The times when the industry wanted to disintermediate the financial system are long gone.
Marketplace lending also connects with shadow banking. Asset managers have started to securitize marketplace loans into asset-backed securities, and hedge-funds use large amounts of borrowed money to leverage their investments. Some investors are already talking about the need to create credit default swaps for marketplace loans. Overall, the parallels between these developments in marketplace lending and the shadow banking that led to the financial crisis of 2007-08 become undeniable.
Where will it go?
Unfortunately, our predictions were right. Marketplace lending transforms into banking at a high speed. At the moment, the loans marketplace lending originates might still add value to a segment that has been ignored by the banking industry in the aftermath of the financial crisis. But abundant Federal Reserve liquidity and government guaranteed funding will eventually push monitoring standards down.
What shocked me the most were discussions around the growth of securitization. The industry recreates the same chain of financial commitments that led to a shadow banking panic in 2007-08. The resulting financial crisis has become a distant memory from the past. The big question really is how much marketplace lending can grow until the next financial crisis hits: will they succeed to become systemically relevant or will their investors lose out in the next credit crunch?
The LendIt conference affirmed my belief that we have to end banking with a systemic solvency rule to restore a functioning financial system. Otherwise, banking finds its way into every financial innovation, and transforms it into a device to circumvent regulations and increase risk taking. Marketplace lending is just one example in a long line of innovations.