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A version of this article originally appeared in the Sept./Oct. 2014 issue of Private Lender, the e-zine of the American Association of Private Lenders.
The recent financial crisis found many banks over-leveraged and many potential borrowers suddenly rebuffed by their traditional sources of capital. Alternative lending – really, lending by anything other than a bank – has picked up steam to take the place of these more traditional institutions. This “private debt” – like private “equity” – has flourished in underserved niche markets, such as with the real estate-backed loans offered by sites such as RealtyMogul.com.
In most countries, only banks can hold deposits guaranteed by the state, and only banks have a standing offer of credit from the central bank. With these privileges, though, come lots of rules and restrictions, because banks are particularly vulnerable to “runs” – panicky withdrawals of deposits that can become self-fulfilling paths to a bank’s ruin.
New rules developed in the wake of the Great Recession have, among other things, forced banks to hold more capital relative to their loans, in order to help absorb losses if another crisis strikes. This can be accomplished in a number of ways; some banks have focused on raising more capital, but many banks have also cut back on their lending and investment. This retrenchment of banks, which in some sectors has been significant, has subsequently led to “alternative lending” to fill the void.
Money can be moved from savers to borrowers in many ways that do not involve banks. People and companies can make loans to one another directly or enter into any number of other arrangements, such as when pension funds put money into an investment fund that lends to mid-sized businesses. These arrangements can sometimes seem to a borrower slightly more expensive or less flexible than borrowing from a bank, but oftentimes they end up costing that borrower less in time spent on financing efforts. The increase in available financing options also allows borrowers to plan more dependably.
Such less-regulated credit has historically come from institutional investors and pension funds. The low returns currently offered by the bond market, however, have increasingly led to more of this credit coming from individual investors. The rise of the peer-to-peer (P2P) consumer credit companies, led by LendingClub and Prosper, is a striking example of “individualized” credit stepping into a market that banks were not serving very efficiently.
From a regulatory standpoint, these alternative arrangements are in many ways preferable, because investors not only receive loan proceeds directly, they also straightforwardly bear the risk -- any losses must fall squarely on their shoulders. Banks, by comparison, must enter into separate transactions with both savers and borrowers, with the associated risks. These alternative lenders are not, then, banks by another name, trying to cut regulatory corners – rather, they are genuinely different creatures, able to better absorb losses than banks. They are a buttress rather than a threat to financial stability.
The scale of the P2P lending platforms is thus far modest; LendingClub and Prosper have lent only $5 billion between them, a minute share of America’s personal-loan market of $1.8 trillion. Their rate of growth, however, is staggering; at Prosper, for example, the value of new loans originated in March 2014 was more than four times that of a year earlier.
Banks argue that P2P lenders’ underwriting standards will likely fall as volume grows, and that their appeal can be partly explained by the world’s current low interest rate environment. Proponents of P2P firms, however, respond that their newer technology lets them operate with far lower costs than banks, and that the industry’s underwriting standards are just as good or better than banks’ thanks to their nimbler systems and more creative use of data. Some of these firms, for example, have created enhanced risk assessment matrices for investors to utilize in making their own credit and risk evaluations.
A similar trend is occurring in certain areas of the real estate market. Home renovators, for example, have long had difficulties with conventional lenders who shied away from properties with a missing hot water heater or a partially ruined roof. Real estate “crowdlenders” like RealtyMogul.com, however, might be quick to jump on those opportunities if the renovator is experienced and the property’s loan-to-value ratio and other criteria are otherwise acceptable. Such crowdlenders can have technology systems that slot the property into well-established underwriting algorithms, so that proposed rates and loan amounts can be quickly delivered to a borrower applicant. Their much larger capital base than smaller shop “hard money” lenders also brings consistency to those quotes.
For the moment, P2P and similar crowdfunded loans have a long way to grow before they get anywhere near the scale of even some other non-bank alternatives. Their small scale, however, suggests enormous room for growth. The increased options these models provide both borrowers and investors argue for the traditional banking model to be slowly eaten up, bit by bit, by different competitors.