BANKING is undergoing a major transition. No longer the only choice for consumers, banks are facing a tsunami of competition from non-traditional competitors.
There are online, non-bank financial services for everything a consumer needs, from loans, to investments, to money transfers, and more. The field is filling quickly with born-in-the-cloud “fintech” companies, leveraging the most advanced technologies and data analytics to serve up a host of alternatives to the public.
While analysts and media often pronounce these trends as threats to banking globally, the reality is far more nuanced and the outlook more positive, in my view.
Banking may be facing its greatest challenges, but at the same time as being presented with its greatest opportunities.
By the people, for the people?
Peer-to-peer (P2P) lending began with an objective to democratise financial services by using technology to match borrowers and lenders.
Viewed favourably by many governments because of its positive role in widening access to finance for small businesses, P2P lending has seen a meteoric rise since 2007.
However, it is important to note that P2P still remains a tiny part of overall lending. Also, in most instances, P2P lending companies provide the technology, but aren’t the actual lenders. They don’t take any credit risk, don’t hold loans on their balance sheet and still use a bank in the middle to write loans and sell them to investors.
The majority of P2P lenders’ income is derived from upfront fees deducted from new loans. This front-loading of their revenues and the fact that they have no skin in the game, make P2P lending platforms very risky for investors who are looking for long-term returns.
While investors may be attracted by the prospect of higher returns, P2P investments are not guaranteed or insured by governments or other sources, which means that investors could lose their capital in case of credit defaults. In addition, the fixed-rate nature of P2P loans exposes investors to market risks.
China is currently the largest P2P lending market in the world, with CreditEase leading the charge. Estimates suggest that there are more than 1,500 active platforms in China alone.
As the P2P lending industry has grown, it has become a magnet for institutional investors such as hedge funds. In fact, the majority of P2P lenders are no longer “peers”, but institutional investors. P2P companies have morphed into marketplace lending platforms that are sporting eye-popping public and private market valuations.
This dependency on wholesale funding is a fundamental flaw. History has taught us several lessons about finance companies that get all of their funding from the capital markets. The model works well in good times, but can quickly hit the wall when institutional funding is tight or prohibitively expensive.
As competition builds up and interest rates normalise, many P2P lending companies will face liquidity pressures, declining spreads and increasing temptation towards adverse credit selection to maintain top-line growth.
The changing credit and liquidity conditions in China in recent months have resulted in the failure of several hundred P2P lending companies. Big professional companies are likely to survive and thrive, but we should expect several more failures and significant consolidation as P2P lending weathers its first full economic cycle. With the meteoric growth of P2P lending will also come increased regulatory attention and scrutiny.
The US Treasury has initiated a study of the benefits and risks associated with these platforms, while the China Banking Regulatory Commission is expected to issue guidelines to the P2P lending industry that has grown rapidly in a lightly controlled environment.
The role of regulation
Consumer education and regulation have a role to play to protect retail investors. While the investment risk disclosures are reasonably comprehensive in countries such as the US, it’s not clear how many retail investors read or understand these. In countries such as China, the disclosures can be vague and there is limited transparency on the end-use of investments.
While some economies have chosen to ban P2P lending, others such as Singapore and Hong Kong are opting for a cautious approach to protect retail investors via greater licensing requirements or restricted participation.
Regulators around the world are reflecting on appropriate regulations for fintech companies conducting banking business, as they try to balance financial stability and consumer protection with economic growth.
It is not inconceivable that, in the future, regulators will regulate financial activities, rather than licensed institutions, meaning that P2P lenders may face tougher restrictions.
Despite these issues, any forward-looking bank will recognise the potential of P2P lending platforms and the greater ecosystem of fintech start-ups. The role played by P2P lending in providing small businesses with hard-to-come-by finance, and wider benefits to economic growth, is important.
Marriage of convenience?
P2P lending offers opportunities for international banks on multiple fronts. The US and China may provide sufficient scale for these companies to thrive, but most emerging markets are fragmented and have varying credit infrastructure and regulatory complexities, making partnerships with established banks a necessity.
Emerging-market banks with large customer bases and deep understanding of the credit and regulatory environment need to take an active role in shaping the future of P2P lending, by supporting the growth of new entrants and forming win-win relationships.
Perhaps marriages of convenience with P2P lending platforms can help banks attract new clients and stimulate much-needed innovation.
While a profound transformation of banking is inevitable, for the foreseeable future at least incumbent banks and technology disruptors are destined to be in a symbiotic relationship where each benefits from the other, enhancing the overall value proposition for clients.
Author: Anju Patwardhan – Group Chief Innovation Officer @ Standard Chartered.