Composite Lending: Why a Hybrid of Balance Sheet and Marketplace Lending Makes The Most Sense

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A few years ago, marketplace lending platforms quickly gained steam and emerged as Wall Street darlings, promising to bring greater access, speed and efficiencies to all parties involved in the borrowing process – borrowers (small businesses and consumers), the marketplace lenders themselves,  and secondary investors. In recent weeks, however, a series of high profile incidents and disappointing earnings statements have called into question the transparency, stability and viability of the marketplace lending business model. Apparently, the headlines read, it is not time to ring the death knell for traditional banks just yet.

But it is not all bad news for the online lending sector, and not all online lending platforms are the same “under the hood.” Composite lending - a hybrid approach which delivers scalability and efficiency of marketplace lending, combined with the truer transparency, stability and viability of balance sheet lending - is likely the best suited to survive and thrive.

Transparency

Marketplace lending platforms work by connecting borrowers with investors seeking higher rates of return (interest) than that being offered by traditional banks. Once a marketplace lender approves an applicant for a loan, they must get the loan off their own books and fulfill the loan request – in order to protect their own profitability, as well as their reputation. Many marketplace lenders spend millions of advertising dollars showcasing how easy and dependable it is to secure loans through them – putting their brand at stake if they fail to deliver.

For these reasons, it can be difficult for marketplace lenders to not have conflicts of interest right from the start, as they offer loans to investors. These lenders provide background on loans and risk assessments, but they are susceptible to delivering only part of available information, or exclusively the details they want to share - because they need to get the loans off their books. They also package loans into groups to ensure that all the inventory will be sold, not only some portion of it. In contrast, balanced sheet lenders don’t face the same pressures. They are often more diversified financial service institutions, offering life insurance, savings and loan products, for example. They are used to keeping debt on their financial statements and aren’t so reliant on selling loans to investors as the only funding source. Since balanced sheet lenders can accept that some loans will be kept on their own balance, there is less reason to provide overly “polished” data or force investors to buy what they don’t want to buy.

Today, new fintech platforms have emerged that are similar to marketplaces in that they are online, but very different in that they serve to connect balance sheet lenders with investors, quickly and efficiently. Partnering with such platforms enables balance sheet lenders to scale their capital and operations in segments that are proven and established. These new platforms also feature advanced technologies and machine-learning algorithms that assess risk on loans being offered to investors and extract all the raw data needed to provide comprehensive analysis and due diligence. This adds further the higher degree of transparency that balance sheet lenders can deliver.  

Stability

For many marketplace lenders, their sole business is connecting borrowers with investors who want to buy loans. One key challenge is that many of these borrowers are sub-prime or representing new customer segments and geographies - which can increase the likelihood of these loans going bad. Additionally, research has shown that borrowers are often marketplace lenders’ biggest problem – they use their loans to pay off debt, and then accrue more debt. Faced with this increased risk, marketplace lenders will often attempt to boost loan volume by dropping lending standards or entering new, unproven markets, which can lead to more defaults and delinquencies. This has made Wall Street skittish, as well as investors – after all, if a loan portfolio performs unpredictably an investors could lose their money. Nobody wants to purchase untested loans from new segments and locations which have no substantial track record within particular originators’ operations.  

On the other hand, because many balanced sheet lenders are banks or other sustainable players with established history, they are inherently better positioned to successfully maintain and grow a healthy capital pipeline. Their business grows available funds by attracting debt, which can be used as a leverage on their own capital. More available and sustainable capital to enter new segments means increased loan volume and diversity, which translates to consistent ongoing asset generation for the balance sheet lender.  Increased loan volume also means less risk for investors, both in terms of the loans themselves and the originator’s viability. Finally, such flexibility to launch new products and target new customer segments allows balance sheet lenders to grow their business, create value for shareholders and present new asset classes to the market while using marketplace tools.

Ongoing Viability

This brings us to our final point, which is viability. Financial analysts have often wondered, what will happen to marketplace lenders if and when a recession hits and free-flow of capital grinds to a halt? Less loan generation will quickly lead to less asset generation. While marketplaces believe that servicing fees on their existing portfolios would cover operational expenses in the event of a downturn, the decrease in loan originations will still stress their future revenues and viability. Ultimately, this will lead to marketplace lenders circling the proverbial drain.

Decreases in loan origination will affect balance sheet lenders in the same way, but balance sheet lenders often have a much more stable source of funding from their existing debt and shareholders’ sources. So even with fewer new loans and capital being generated, balance sheet lenders still have the resources to fund new loan requests that do come their way. This makes balance sheet lenders inherently better positioned to survive a temporary recession. They have experienced higher loan volume and greater generation of capital over the years, giving them a strong head start over marketplace lenders. This, combined with more diversity (in terms of both overall lines of business as well as loans within their lending operations) will give balance sheet lenders easier access to capital needed to “keep the lights on” and temporarily “plug holes” to stay in business.

Conclusion

No one can deny the benefits that marketplace lending brings. Many consumers and small businesses can thank these ventures for simplifying loan applications, speeding decisions and providing much needed credit. And in spite of the fact that these ventures are vocal about disrupting traditional banks and other balance sheet lenders, the banks have made it clear that they plan to get into the fintech game themselves. Goldman Sachs, for example, is planning to roll out a consumer lending platform this fall. The firm is keeping mum on details like rates and terms until the service debuts, but company leaders expect it will be a “durable business” for the company. In addition, other established lenders are planning to launch “fast decision” portals for entrepreneurs, as well as integrations with online lending purposes to handle processes like credit-checking.

Clearly, in spite of the recent troubles, strong interest remains and industry leaders continue to see vast potential in online lending. We believe that by bringing advantages of the marketplace lending concept into the bigger and mature balance sheet lending industry, it’s possible to create win-win opportunities for all involved: lenders, investors and borrowers seeking quick, convenient access to needed capital.  A composite lending model combines benefits of the both worlds, and in contrast to pure marketplace lending, is the type of online lending best positioned to grow and thrive. Professional mediators can help both balance sheet lenders and investors to implement marketplace approaches void of conflicts of interest, while giving investors access to a new diverse asset set. Marketplace lending is best viewed as a tool for balance sheet lenders and investors, as opposed to a “silver bullet” upon which pure marketplace lending businesses should be built.

When it comes to predicting the future of lending – online lending platforms, or a return to traditional banks – the answer does not need to be an all or nothing scenario. Composite lending, which entails an online marketplace of balanced sheet lenders selling loans to investors, combines the efficiencies and convenience of marketplace lending with the transparency, stability and viability of traditional banks. It is a way to find new opportunities for all market participants and learn from previous experience for the best interest of the industry.