“THE SILICON VALLEY IS COMING”

…JPMorgan Chase CEO James Dimon ominously warned shareholders in 2015. Following the financial crisis in 2008, Fintech startups gained a lot of prominence globally as consumers started to look for alternatives to traditional banking methods. These startups have penetrated every service area of consumer retail banking with the goal of dis-intermediating banks and becoming the new leaders of the financial services industry. They have been particularly disruptive in the lending space, tapping into an entirely new market of consumers whose credit histories were previously not sufficient to qualify them for loans.

These startups provide loans “eBay” style – acting as intermediaries to match lenders to investors. Investors provide funds based on pre-set factors and risk tolerances, while customers apply for loans online. Using proprietary algorithms, significantly more sophisticated than the traditional FICO score, these startups match investors to customers in a few seconds – an infinitely smaller time period than the weeks many are used to waiting for a response on their loan (paper!) application. These investors can be individuals or institutions that provide either massive funding upfront to the Fintech company or purchase loans in bulk from the startups, the latter accounting for approximately half the financing of these loans.

This combination of technological innovation, a streamlined business model and slow regulatory response have allowed these startups to provide banking services for significantly lower fees.

As a result, the media was abuzz with ‘David and Goliath’ headlines, predicting the fall of larger bank institutions. Not so fast. Despite their high level of growth, the honeymoon is over for marketplace lenders as they are starting to get challenged on both sides of their business model. Increasing delinquency rates and a high dependence on non-depository funding to finance loans are causing marketplace lenders to lose profits and loan origination volume. Compounding the problem, these lending startups lack the scale of existing consumer banks due to a lack of both a major brand and a large loyal customer base. Fintech companies do not threaten to disintermediate banks in the lending space, but rather provide a blueprint on how to innovate and keep up with the changing consumer mindset.

A DROP IN THE BUCKET

First of all, marketplace lenders do not have the necessary scale to disintermediate banks and are not expected to do so anytime soon. Although this now called marketplace lending is expected to grow at a high rate, it currently accounts for a miniscule amount of total US loan originations. According to PwC, fintech lending accounted for $15 B of US loan originations in 2015, and is projected to account for $150 B of US loans by 2025.

Even at this astronomical growth rate, marketplace lenders will not account for a significant enough portion of loans to disintermediate banks. Although this growth rate is quite impressive, $150 billion is still less than 3%, a fraction of the total $6.1 trillion of projected US non-mortgage loan originations by 2025.

Fintech startups’ biggest challenge to achieving scale in the US market are the entrenched incumbent consumer banks. Unlike China, where a humongous e-commerce system coupled with sluggish banks being far too slow to innovate led to the emergence of fintech titans, US banks have been quick to notice the threat fintech startups pose. In addition, US banks have a significantly more developed banking industry, with a massive and loyal customer base, vs. China’s, where the unbanked constitute 1/3 of the adult population. This forces US marketplace lenders to focus on a new market of underbanked consumers and millennials.

THE WELL DRIES UP

Despite the buzz in the headlines, fintech firms still depend too much on the same incumbent firms that they are trying to displace. The leading fintech startups in the industry rose to the top by either receiving massive funding from the major banks and venture capital firms, or by selling large quantities of loans to banks, both of which greatly increase a startups’ loan origination volume. This has been a gradual development as lending startups have recently began shifting away from the traditional P2P business model. For example, in 2010, 100% of Lending Club’s loans were financed by self-managed individual investors compared to only 20% in 2015. In 2015, on the other hand, 54% of the loan originations were sold in whole loan transactions comprised of institutional investors.

The key problem with this business model is its sustainability. Marketplace lenders face a major dilemma: their cost of capital is significantly higher than that of banks, forcing them to rely on non-deposit funding to finance loans. Fintech lenders have hardly any reserve capital to originate loans and face a massive problem if the market for purchasing or investing in their loans cools down. In fact, this is exactly what has happened throughout 2016 and it is beginning to take its toll on marketplace lenders. Until recently, these startups were viewed as revolutionary institutions and consumers had a lot of faith in their algorithms. However, recent events are changing the public’s view of these firms. In the midst of this shift in public perception, Lending Club CEO Reneaud Laplanche was outed after altering the application date of some loans and not disclosing his personal interest in funds he invested in. Following this news, Lending Club’s stock prices crashed and many of its investors decided to cut off funding and purchasing of new loans.

However, Lending Club is not the only marketplace lender to lose profits this year. Goldman Sachs, Jefferies, and Citi all took a step back with regards to buying loans affecting firms such as SoFi, Prosper, OnDeck and many more. OnDeck suffered $13 million in losses during the first quarter this year, an increase of $8 million from the same period in 2015. In addition, the percentage of loans sold to institutional investors during the first quarter is down to 26% from 40% in Q1 2015.

This drop in demand for purchasing loans has affected growth marketplace lenders so much that several players are taking rather drastic steps. For example, SoFi has taken a radical approach to solving the issue: starting a hedge fund to buy its own loans. SoFi aims to have this hedge fund grow to the point of being able to purchase other fintech firms’ loans too, but this venture should be viewed with caution.

Every fintech lender is in a race to achieve scale in the market, but providing more loans comes with a price: assuming more risk.

In order to maintain their vast origination growth, SoFi has started to provide risky loans, straining its previously almost untarnished delinquency record. If increasing numbers of loans continue to provide lower returns or higher default rates, SoFi’s hedge fund will not be able to continue purchasing them. However, there is a conflict of interest as without the necessary funds, SoFi will not be able to grow at their desired rate. This could turn into a vicious cycle that will ultimately impact SoFi’s profitability.

THE FUTURE OF MARKETPLACE LENDING

Incumbent banks have been smart to take a back seat and invest in marketplace lenders as cash providers. It has allowed them to see these startups rise and fall, waiting for the perfect moment to jump in – and it seems that the moment is now. Currently, 2 big players have provided a blueprint for how incumbent banks will play a new role.

JP Morgan has recently partnered with online small business lender OnDeck, yet not in the traditional relationship as an investor to OnDeck’s loans. Instead, JP Morgan is utilizing OnDeck’s technology to sell Chase-branded loans to their customer base. One of banks’ biggest fears with fintech startups is the possibility of losing valuable client relationships and customer data. JP Morgan has found a solution to this problem through this partnership as they retain the central brand and customer relationship while still providing loans in a user-friendly and cost-efficient manner.

Goldman Sachs, on the other hand, has recently launched a low-cost online-only banking service, GS Bank, providing customers savings and checking accounts with no minimum balance and certificates of deposit, both of which have high interest rates. With already over $114 billion in deposits after just a few months, this bank is the first step in Goldman Sachs’ plan to fund their online lending platform, Mosaic, set to launch in the second half of 2016. Not only does Goldman have the prominent brand, existing customer base and means to achieve massive scale, they have a sustainable business model as they are the first online lending platform to rely on deposit-based funds. Additionally, Goldman Sachs does not have the costs associated with traditional brick and mortar banks and can offer their services for lower fees and higher interest rates, making them equally competitive in the market fintech startups originally tapped into.

Both JP Morgan and Goldman Sachs provide a blueprint for other major banks to enter the online lending space.

Rather than be disrupted by these smaller startups, they are leveraging their key strengths, brand recognition and scale, to turn their key weaknesses, innovation and, arguably, client experience, against the startups that seek to disrupt them.

This phenomenon exposes the problem with fintech lending startups: their business model is too easy to replicate. The online-lending platform can easily be replicated by incumbent banks, who can more easily implement it and achieve scale. In the coming years, more banks will follow JP Morgan or Goldman Sachs’ examples and start to offer these digital-only services in order to compete with the once threatening fintech startups.

Marketplace lenders were once viewed as an incredibly disruptive force, ready to change financial services as we know it today. And with hundreds of such companies emerging in the US market, the fintech boom was undeniably threatening to banks. However, recent events have made clear that the emergence of fintech lenders benefitted from the perfect environment: record low interest rates, reduced unemployment, and a market beneficial for investments. The roles are now reversing, and the inherent flaws in the marketplace lending business model have set the stage for banks to dominate this industry. Beware Silicon Valley – banks are coming.