Alternative lending is one of the fastest-growing areas of FinTech, but its potential remains largely untapped by traditional industry players. For mainstream lenders and investors looking to take part, they will need to identify potential products to offer (personal lending, small business lending, auto loans, student loans or mortgage) and build strategic partnerships with alternative lenders that stand out from the pack.
A market for growth
With an estimated $29.1 billion (1) in online loans originated in the US market by alternative lenders in 2015 alone, marketplace lending has emerged as one of the fastest-growing areas of the credit universe. Online lenders understand that an increasing number of consumers are underserved by traditional lending channels. By using that insight, they have been able to grow marketplace lending each year for the past five years. To do this, alternative lenders reached out to four key groups:
- Consumers seeking to consolidate debt
- Small and mid-size enterprises (SMEs) whose business size and loan amounts are considered too low to be profitable for banks
- Mispriced students with low probabilities of default
- Risk-adjusted consumers and SMEs
Each of these groups has unique needs that often box them out of traditional underwriting requirements, even if they have a low probability of default. By working with non-traditional borrowers, marketplace lenders have been able to build a robust loan book that has performed well for investors. But growth alone is no longer enough. As demand brings more players into the market, lenders must find ways to differentiate themselves either through product, platform, channel, client experience, or servicing.
Strategic partnerships: the new proprietary deal flow
New financial technologies have given online lenders the ability to set up shop relatively quickly. Many of them offer leading-edge web design and mobile applications powered by finely tuned underwriting algorithms to enable users to apply for a loan and receive a decision in minutes – not weeks as with traditional banks. The FinTechs have been a step ahead with underwriting processes as they take in traditional inputs (financial and employment information) as well as the whole set of non-traditional inputs (social media input) to formulate a complete picture of a client’s risk profile. But as the industry matures, marketplace lenders will need to create strategic partnerships with mainstream lenders and investors in order to position themselves for long-term growth. To attract these important business partners, marketplace lenders will have to continue to refine their platforms for better performance. There are four critical areas for improvement:
- They must continue to simplify the experience by making it faster and easier for borrowers to access capital. The digital infrastructure that enables online lending for consumers and SMEs can fix critical pain points in the lending process for other types of loans, such as mortgages or vehicle loans, which are typically a little more cumbersome.
- They must qualify more underserved individuals and businesses applying big data and analytics technologies to prospects as they apply online. Marketplace lenders have been successful in targeting some of the largest groups of underserved borrowers, but there are others. Online lenders, like traditional banks, have developed underwriting standards that typically require at least a nominal credit and employment history, but this can leave young people or recent immigrants without access to financing. Platform providers that are able to develop models for dealing with new and unconventional borrowers will be able to add differentiated business lines and new customer segments to their loan book.
- They must offer competitive pricing while remaining profitable by lowering funding costs. Marketplace lenders in the consumer space have effectively reduced operating ratios to 2%, compared with the 5 to 7% (2) of a traditional lender. This enables alternative lenders to offer competitive rates; however, the nature of marketplace lending makes it impossible for these firms to access cheap deposit funds since they are not banks. Marketplace lenders should look to expand their sources of funding to include wirehouses and banking institutions in order to decrease funding costs and improve margins.
- They must gain access to larger groups of clients by building new partnerships. Marketplace lenders often have traditional banks and institutions as investors. But as these institutions become more interested in alternative lending, opportunities to expand these relationships will emerge. Savvy alternative lenders will use these new relationships to craft a more comprehensive suite of services and bring in new borrowers.
Many of the changes mentioned above will require marketplace lenders to make their day-to-day operations more efficient and profitable. Alongside these improvements, lenders will also need to work on developing strategic partnerships that can become referral networks of future borrowers. Alternative lenders can benefit tremendously from the credibility of the traditional financial institutions when it comes to expanding the pool of potential borrowers. Despite all of the technological innovation powering the sector, lending remains fundamentally a "people" business. Combining the strong data expertise of alternatives with the people skills of traditionals can help pinpoint the right borrowers, which supports long-term loan performance and strong investor interest.
By building stronger relationships, both alternative and traditional lenders can align interests in new and profitable ways. Studies (3) have shown that a co-branded outreach effort from an alternative lender and a bank targeting a prospective customer is three times more effective than a standalone outreach campaign from the same alternative lender, as one example. The bump in interest from consumers is not just good for the lenders; banks also become more relevant by being seen as providing access to new technology and borrowing channels that meets consumer demand.
Moving forward, it will be imperative for alternative lenders and banks to work together to support the fast-growing cohorts of underserved borrowers. Strategic partnerships can build bridges between FinTech and traditional financial markets participants, giving both a stronger foothold in the future of lending.
1 Ernst & Young, LLP whitepaper, Alternative Lending Whitepaper 2 Ernst & Young, LLP whitepaper, Alternative Lending Whitepaper 3 Ernst & Young, LLP whitepaper, Alternative Lending Whitepaper