Jack Hubbard comment
I’ve had the privilege of knowing Charles Wendel for more than two decades. I find his articles and his conference presentations to be straightforward and through provoking. Charles is President of FIC Advisors, Inc., a management consulting firm that for over 20 years has focused on providing an independent perspective and practical recommendations to financial services companies. In the alternative finance space, FIC’s works with banks evaluating whether and how to partner with alt fin providers as well as the actions required to make those partnerships work post-agreement.
Before founding FIC, Wendel was a bank lender and a consultant with McKinsey & Co. Wendel can be reached at 917-744-6600 or cwendel@ficinc.com.
JP Morgan recently announced a pilot project with OnDeck, one of the largest alternative lenders and one of the first, having started operations in 2007. This is only the most notable example of banks or credit unions entering “partnerships” with alternative lending companies (AFCs).
Over 200 small business platforms exist in the small business space and at least 100 in consumer-related areas. While some will disappear due to low origination, poor risk decisions, or other factors, AFCs are now part of the permanent lending space. For example, in a recent research report Morgan Stanley estimated that AFCs would generate more than eight percent of total consumer unsecured lending and 16 percent of small business lending within five years. More dramatically, Larry Summers, the former Secretary of Treasury and a Lending Club and Square Board member, said that he would “not be surprised“ if within ten years AFCs generate 75% of “non-subsidized” small business loans and 30-40% of direct consumer lending.
Banks of all size are waking up to this new potential partnership and determining whether and how they should participate. What began as turndown-lending opportunities (whereby the AFC gave a second look to a loan application that did not meet a bank’s criteria) has morphed to multiple ways to work together, including full integration of some lending areas. We will outline the areas for cooperation below, but please note that more areas are still emerging as AFCs “pivot” to exploit market opportunities.
Addressing the Skeptics. Before reviewing the various paths for potential cooperation, it is important to consider some of the objections that banks raise related to AFCs.
AFCs are the competition. In fact, AFCs want to do loans, not steal bank relationships. They view banks and credit unions as origination sources that can provide them with low cost leads. They do not want to take deposits or other ancillary business. When AFCs do work directly with small businesses it usually involves companies that do not meet bank credit screens or are willing to pay higher interest for faster decisions.
AFCs will blow up during the next downturn. Yes, some AFCs will have risk issues if there is an economic downturn; that is inevitable. But, the AFCs I know are rigorous about risk management and review more performance characteristics than most banks. Many are also direct lenders that risk their own capital. The most mature AFCs have hired strong risk professionals who not only develop strong decision models but also have the practical experience to review risk. This may be hard for banks to admit but some of them can learn from the risk management approaches followed by AFCs.
What about compliance? It can take up to a year or more for a bank to sign a deal with an AFC. The AFC has to meet multiple hurdles, not the smallest of which is compliance related. While there are 200 small business platforms, probably no more 10 of them have developed strong approaches to loan compliance. AFCs that want to work with banks ands credit unions know that meeting compliance requirements are part of their cost of admission and have worked or are working to meet those challenges.
AFCs hurt small businesses because of their high rates and repayment policies. AFCs exist because banks created a market opportunity for them. While some “bad players” exist among the hundreds of AFCs, most emphasize transparency and actually want to help their borrowers. And, while rates remain higher than bank rates, in many cases they have begun to decrease in response to competitive pressures.
Choices for Working Together Continue to Grow. The options for how a bank or credit union and AFC can work together have increased significantly and will continue to expand as creative minds continue to focus here. Some but not all of the approaches range on a spectrum from a “light touch” to heavy linkages between AFC and FI.
Loan/Turndown Referrals. Most AFCs first approached banks to review and fund their turndowns. Banks usually approve no more than 20-25% of loan applications, potentially generating significant leads for AFCs that can provide loans. However, in most cases both FIs and AFCs were frustrated by this relationship. Banks did not generate significant quality referrals and relatively few turndowns were funded by the AFCs. Neither banks nor AFCs generated significant revenue from these transactions, and in some cases banks abandoned these types of referral relationships.
Comment: This is likely a low priority opportunity for most banks.
Segment Expansion. Using the strong proprietary analytics that some AFCs have developed, they can analyze a bank’s current business portfolio and targets to uncover loan opportunities overlooked by traditional lenders. Typically, the AFC will fund the loan, providing the originating FI with a fee and additional cross-sell opportunities.
Comment: This can be an attractive opportunity for traditional lenders wishing to grow in the small business space. Banks can usually buy back loans that meet their requirements for their own portfolios.
Digital Banking as a Service. Most FIs need to provide their customers with digital capabilities, even if they do not want to enter a lending partnership with an AFC. Working with companies like LendKey on the consumer side or Mirador in small business, they can “rent” these digital platforms, improving their competitive position while minimizing the time and capital expenses required to do so. The risk parameters applied in this digital environment can come from the bank or credit union and third party lending may or may not be part of this technology offer.
Comment: This type of partnership can save a bank 12-18 months in development time and ensure the banks continued relevance to customers, in particular, Millennials.
Lending as a Service. Lending-focused AFCs want to pursue full digital integration with a bank, whereby, they handle all the lending up to a certain dollar amount. Applying the bank’s risk criteria, if a loan meets that threshold, the bank can purchase the loan for its portfolio. Loans that fail to meet the bank’s requirements can be funded by the AFC, either directly or through a marketplace. (Many AFCs now do both direct and marketplace lending.) In at least one case we know, the AFC does not charge for the digital platform it provides. However, the bank must generate a certain minimum loan volume to avoid paying a fee.
Comment: This approach provides both a digital platform and potential loan growth. But, banks need to gear up and refocus internally to make this effort successful.
Portfolio Purchases. Institutional investors and some banks are now purchasing loan portfolios from AFCs. Investors want the yields and the banks want both yield and the opportunity to put their excess deposits to work.
Comments: Many smaller banks are purchasing loans in order to put their excess deposits to work. However, this approach provides no franchise value to a bank and may not be a sustainable strategy. In a sense it shows an admission of a bank’s inability to generate organic growth.
Competition. Rather than cooperating with AFCs, several banks are developing approaches that compete directly with AFCs. For one, Eastern Labs, part of Massachusetts’ Eastern Bank, has created a venture headed by lenders experienced in this space. Other bank-owners players are in various stages of market development. We expect that only a small handful of banks will go this route and make it work.
Comment: This is an approach appropriate for very few.
Determining whether and how to cooperate. Up to now, even with the recent JPMorgan/OnDeck deal, only about six or seven significant lending-oriented bank/AFC deals have been completed in the small business space. Many more exist on the consumer side. Many of these relationships are still developing, and their success remains unknown. In several cases banks have picked their partner based not upon a rigorous analysis of the bank’s needs and goals but due to personal relationships or having worked with that AFC previously.
Understandable, but that approach can lead banks down the wrong path versus developing their developing RFP or other approach that forces a bank to make concrete statements about what its goals (and concerns) are. Banks need to know what they are trying to accomplish in working with an AFC and use those goals as their screening criteria for selecting a partner.
