Earlier this month, J.P. Morgan announced a strategic partnership with OnDeck Capital to originate, underwrite, and distribute loans targeted specifically at small businesses.
As evidenced by a 28% single-day spike in OnDeck’s share price, this announcement clearly is a big deal to one of the leading FinTech companies today, and has major implications for the future of alternative lending.
But before scrutinizing this specific agreement, it’s worth revisiting a passage from Jamie Dimon’s annual letter to J.P. Morgan shareholders in 2014:
There are hundreds of startups with a lot of brains and money working on various alternatives to traditional banking. The ones you read about most are in the lending business, whereby the firms can lend to individuals and small businesses very quickly and — these entities believe — effectively by using Big Data to enhance credit underwriting. They are very good at reducing the “pain points” in that they can make loans in minutes, which might take banks weeks. We are going to work hard to make our services as seamless and competitive as theirs. And we also are completely comfortable with partnering where it makes sense.
The last sentence is key, and is one that I brushed aside until spoke with a small business banker this past summer.
During the conversation, I asked the banker — the head of small business lending at a major US retail bank— whether he saw the emergence of technology-enabled alternative lenders as a threat to his business unit. And while he admitted that this could well be the case in the long run, he mentioned that “at least today, we [the traditional banks] have all the leverage”.
To those coming from the “Tech” side of FinTech, that statement may come across as arrogant. That said, I think he has point, and that eschewing partnerships altogether may turn out to be overly naive. Consider the following (note that these points are specific to small business lending):
- Product Construct. Alternative lenders are hesitant to compete head-on with larger retail banks when it comes to providing traditional credit products (i.e. term loans and lines of credit) at extended terms. For example, OnDeck and Kabbage loans are capped at 3 years and 6 months, respectively, while Bank of America term loans can go on for 5 years before reaching maturity. It’s also worth noting that several major banks (e.g., Wells Fargo) have started to roll out evergreen lines of credit; these are credit products that have no maturity date. By focusing on what I call “reactive” credit — short-term credit usually pursued by borrowers out of desperation — alternative lenders are left to compete in a small subset of a much larger market
- Pricing.OnDeck APRs for small, 3-month term loans are at the 70 to 80 percent range, while those for long-term loans (maxing out at 36-months) range between 30 and 40 percent. To put that into perspective, one of Bank of America’s basic small business credit cards (MasterCard Cash Rewards) has an APR range between 11 and 21 percent— not for a term loan or line of credit, but for a credit card. Alternatives can claim to underwrite credit quicker and more efficiently than their incumbent counterparts, but there’s a ceiling to the addressable market opportunity if this spread persists
- Borrower Risk Profile. In its latest 10-Q, OnDeck reported a weighted average default rate of 6.4 percent. Some are arguing that this is approaching subprime territory, as it’s not uncommon to see small business default rates for incumbent banks at under 1%. Anecdotally, I’ve regularly heard stories of small business owners going the alternative lending route only after having their loan applications rejected by major retail banks. This suggests that in many cases, alternative lenders are stuck with the “Cream of the Crap”
- Macro Sensitivity. An impending rate hike can have a crippling effect on alternative lenders. P2P lenders are under the most risk, as the lion’s share of their capital base comes from institutional investors — notorious for readily rotating out of existing asset classes to those offering the highest yield. Online balance sheet players are also under threat, as (1) they don’t have existing capital buffers often required of large financial institutions, and (2) will have a much harder time tapping into the capital markets, assuming that they’re public entities (most aren’t)
While the points above may appear as issues that need to be addressed separately, they’re ultimately driven by the fact that incumbent banks own data of economic value, while alternative lenders don’t.
Because the J.P. Morgans and Bank of Americas of the world are sitting on troves of account (i.e. balances, inflows / outflows), spending (i.e. transaction-level purchases), and risk (i.e. delinquency, write-off) data, they’re able to underwrite credit with more predictive certainty and confidence. Not only that, but because these institutions tend to be highly diversified, they’re theoretically able to assess a single borrower’s creditworthiness based on metrics captured from a variety of bank-offered products.
With greater confidence around future outcomes, banks can afford to offer loans and lines with longer maturities, price products a lot more competitively (i.e. avoid having to tack on an excessive “uncertainty premium”), and better forecast capital buffers required to hedge against future losses. And because these advantages ultimately lead to better unit economics to borrowers, banks can afford to cherry-pick the most creditworthy borrowers within each risk band. So for the incumbents, the issue is more about integrating disparate sources of data and systematizing the risk assessment and underwriting processes as much as possible. Difficult, but certainly doable.
Alternative lenders, on the other hand, have to work with rudimentary datasets that are (1) not comprehensive and (2) non-proprietary.
Unless the OnDecks and Lending Clubs of the world start offering direct deposit accounts to capture meaningful cash flow metrics, they’ll struggle to out-underwrite traditional banks at their own game merely with readily available FICO and TransUnion scores.
And for the alternatives that claim to be able to assess risk based on non-traditional (namely social) data, the issue is that these types of data tend to be publicly available — thus failing add much to sustaining competitive advantage in the long run. It’s also difficult to get excited about a company that relies too heavily on its ability to run advanced analytics on commodity metrics, as history suggests that companies betting on technology as the sole competitive differentiator tend not to succeed over time.
With this in mind, it makes sense that incumbent banks have the leverage today, and that alternative lenders are actually the ones relying on partnerships for survival. In addition, if you factor in the public backlash major banks could face for charging exorbitant interest rates, you can see why OnDeck shares exploded — it’s incredibly difficult to convince banks to embrace a business model that has yet to be proven in the long run.
However, this isn’t to say that the big banks are always going to win. My prediction is that once the alternative lending market reaches some sort steady state, which could involve a few more blockbuster partnerships and non-competitive lenders exiting the market, three things will happen:
- FinTech will move up the application layer. As the alternative lending infrastructure becomes more established and consumer / small business credit trends toward commoditization, attention is going to shift to platform plays. More specifically, price comparison services such as Fundera will play a bigger role in the FinTech ecosystem
- Non-bank data owners will enter the market. Consistent with my belief that data ownership is the most sustainable driver of competitive advantage, non-banks that have traditionally captured massive amounts of data will attempt to compete with traditional lenders. Large technology companies built around capturing and ingesting proprietary data seem to have the best shot of winning. Examples include Google (Search), Amazon (Commerce), and Facebook (Social)— companies that even now are starting to build out their financial services infrastructure, primarily through payments products
- Alternative lenders that build full-service solutions will survive. I’m especially bullish about lenders that are looking to position themselves as a “one-stop shop” for all banking needs. By offering a range of products and services comparable to traditional banks, while at the same time avoiding excessive overhead costs (e.g., an outdated network of branches) and maintaining operational efficiency (e.g., quick turnaround times for credit decisioning), there’s a chance that these lenders could one day displace some of the more established institutions. SoFi appears to be executing on this strategy nicely