This is a guest post from Jonathan McMillan, who has published The End of Banking: Money, Credit and the Digital Revolution. The book explains why a financial system without banking is both possible and desirable in the digital age. The views expressed in this article are the author’s own and do not necessarily reflect the views of Lend Academy.]
Ten years ago, marketplace lending did not even exist. Today, the industry features a publicly traded company and has underwritten a loan volume of more than $10 billion. The low returns for investors and high rates for borrowers in traditional lending channels suggest that marketplace lending has not even started to tap on its full potential.
The growing loan volumes and attractive return prospects increasingly attract major financial intermediaries to invest in marketplace loans. This direction is not what Lending Club CEO Renaud Laplanche envisioned in an interview in January 2011, where he described his business model as “the shortest possible path between the source of capital, individual investors, and the use of capital to individual people and small businesses.”
The recent success in attracting funds from traditional financial institutions has pushed the vision of disintermediating the financial system to the background. Instead of understanding itself as the disruptive force of finance, marketplace lenders now see themselves as a complementary part of the existing financial system. Today, they mainly focus on being more cost-efficient and providing a better customer experience than banking.
But being better is not enough for marketplace lending to succeed, and losing sight of the greater picture will turn out to be a fatal mistake.
It’s the Regulation Stupid!
Marketplace lending is set for a competition it cannot win. Taking on the big banks is like trying to win in boxing when the opponent gets a baseball bat in the decisive round. If you cannot change the rules of the fight before the final round, you will get beaten up hard, no matter how good you are.
If incumbent big banks can be defeated with better quality or cost-efficiency, they would have ceased to exist a long time ago. The financial industry is not comparable to other industries that have been disrupted by technology. The reason being is simple: In no other industry regulation plays such a crucial role for survival. As long as regulations in finance work against you, having superior service quality or cost leadership will not be enough to succeed.
Marketplace lenders in the U.S. got a first impression what impact regulations can have when the Securities Exchange Commission (SEC) clamped down on marketplace lenders and forced them to file prospectuses and register their loans as notes. Compliance with these regulations is expensive, but do not create added value for marketplace investors.
No doubt, banking institutions struggle with costly and often useless regulatory requirements, too. Potentially, they even bear higher relative costs to comply with regulations than marketplace lenders today. But banking institutions have two regulatory devices in place that give them the decisive edge over marketplace lending: access to government guarantees and Federal Reserve liquidity.
In the current market environment with high risk appetite, this does not really matter. But it will turn out as the game changer in the next financial crisis. Credit default losses on both marketplace and banking loans will pick up, but only investors in marketplace lending will actually suffer losses. Investors in banking debt can count on the fact that big banks are still too-big-to-fail.
Even having tighter lending standards than banks is not sufficient to compete against the full faith and credit of the United States government. Voices who predict the demise of marketplace lending in the next financial crisis will declare that this outcome was unavoidable. They will blame marketplace lending operators as reckless because they did not have any of their own skin in the game. Investor sentiment, public opinion, and regulators could then quickly turn against marketplace lending.
Change the rules of the game
Marketplace lenders must transform the regulatory environment to ensure their longer term survival and to successfully disrupt the financial system for the better. They have to educate the minds of the public about the asymmetry of financial regulation, and win over the hearts of the American people with a vision of a better financial system for the 21st century.
Together with other financial innovators, marketplace lending can sketch a powerful vision where households and businesses no longer need banking or other intermediaries for their financial needs. Already today, marketplace lending successfully channels loans without intermediation. Online matching allows Borrowers to pool large amounts from various investors, while investors can diversify even small savings across many borrowers.
With growing volumes, liquidity on secondary markets for marketplace loans will eventually increase. This will motivate other financial technology companies to develop trading algorithms that support these secondary markets. Trading algorithms can make buying or selling of marketplace loans as simple as withdrawing or depositing cash on a bank account.
A liquid and convenient secondary market for loans would eventually allow marketplace lending to serve all the needs for which banks are still used today. Homeowners and small businesses do no longer need banks to get loans. People from all income classes can invest sizeable portions of their savings into a diversified loan portfolio that fit their risk profile; if unexpected liquidity needs arise, they will be able to sell those loans on secondary markets just as they are able today to withdraw money from their bank accounts. And innovative payment providers could replace the archaic payment system of the banking industry that still operates on paper checks!
A financial system without banking would have two tremendous advantages. First, the banking induced illnesses would fall away. Without banking (and shadow banking), there can no longer be any bank runs that threaten the economy as a whole. We would no longer have to bail out banking institutions with taxpayers’ money, and could cut the costly and dense regulatory framework we need today to counter systemic risks.
The second advantage is that a disintermediated financial system can make the world a better place. The power people have today as consumers would be expanded to the realm of finance. For individuals, risk and returns are not the only factors that count when lending money. They also want to support their local communities and favorite companies that act in line with their own values. The responsible consumer would gain a powerful ally to influence the behavior of companies: the caring investor.
When you play the game of digital finance, you win or you die.
Marketplace lending has a strategic choice to make. It can either play nice with the incumbent banking industry and try to compete within the existing regulatory framework. Or it can choose confrontation and demand a fundamental overhaul of the financial system.
Giving in to the siren songs of the banking industry and trying to co-exist might attract more investments in the short run, but it will likely push marketplace lending out of business in the next financial crisis. The asymmetric regulatory environment makes co-existence a non-viable option. Only the bold will survive in the game of digital finance.
Consequently, marketplace lending should choose the path of confrontation. It should envision a modern financial system for the digital age which ends the privileged position of banking, and builds on the principles of liberty, innovation, and entrepreneurship. A disruptive marketplace lending industry can win over an American public that believes in these values and has lost the trust in the banking system. Once the public has removed the privileges for banking, being better will finally be the key to success not only in the real economy, but also in the financial industry.
This article is part of a two-part series. The next article will explain what changes in financial regulation will even the environment and provide the fundament for a digital financial system without banking to flourish.