Alternative Lenders Have a Ways to Go to Ensure 'Revolution'

Alternative online lenders have been thrust into the limelight with the recent initial public offerings of Lending Club and OnDeck. Industry leaders are confident about their ability to change the way that people borrow money. "There is an opportunity for the online marketplace model to transform the traditional banking system," Lending Club's prospectus states. The company's chief executive Renaud Laplanche writes, "Technology has successfully disrupted many industries to the benefit of society at large, and I believe banking is next." The financial industry is increasingly aware of alternative lenders' disruptive potential; online marketplace lending was even deemed the innovation of the year by American Banker.

This is far from the first time that entrepreneurs have married technology and lending. But history shows that some innovations in this sphere have proved unsustainable. Recall the fate of former online lenders like NextCard, Providian and E-Loan, which stumbled over fraud, compliance, credit and profitability challenges. Or consider how the global financial crash of 2008 was triggered in part by high-tech credit modeling gone haywire.

Technology allows companies to do more lending faster, with less human oversight. But if you move fast, you need to pay close attention to potential stumbling blocks. Four key challenges could stymie the growth of alternative online lenders in times to come.

Overlaying high-tech underwriting with human judgment. Online marketplaces have devoted significant resources to their credit decision-making process, using borrowers' FICO scores, debt-to-income ratios, credit history, bank statements, government filings and tax and census data. Their processes also include manual review of certain transactions and verification of borrower identity, income, and employment. But banks do all this too.

The problem is that all credit models, no matter how technologically sophisticated, are backward-looking. Models typically focus on micro attributes, such as loan and customer data, rather than forward-looking macro conditions such as economic growth or interest rates. Even worse, they rarely take into account the risk of credit saturation. After all, when credit comes easy, borrowers can pay off one loan by taking out another. This keeps companies' loss rates low. But when credit dries up, borrower default rates soar. This happened most recently during the crash of 2007-2008, when subprime loss rates shot up by multiple standard deviations in a dreaded "black swan" event. This happened despite the billions of dollars the financial industry had spent on computing power and modeling talent.

After some period of fast growth, alternative lenders will have to make a call about credit saturation—and do this before their models necessarily offer any indication. Otherwise, they risk experiencing a smaller version of a black swan event in their consumer and small business lending niches.

Building distribution. At present, online marketplaces are growing rapidly and acquiring customers through social media, search engine marketing, community bank partnerships, television and radio advertising, sales calls, small loan brokers and financial advisors. They've distinguished themselves with simple online applications, fast turnaround and good service. But their customers pay high rates. OnDeck's small business loans last year had an average annual percentage rate of 54%, according to one report. Lending Club's consumer interest rates range from 6% to 26%. Traditional banks typically offer much lower rates.

It remains to be seen if online marketplaces can develop enduring brand equity while peddling high-priced products. This has historically been a tough prospect for financial companies if their products aren't significantly differentiated. Without exceptional brand power, online marketplaces will end up fighting tooth and nail for incremental customers—just like everyone else.

Sustaining funding in choppy markets. Whether a company funds loans on its balance sheet or sells the loans to investors, its business model is vulnerable to market conditions. This is true for any financial company that does not take customer deposits. When economic or credit trends deteriorate, lenders and investors sometimes get cold feet. In such environments, online marketplaces would need to find new sources of financing, manage repurchasing and servicing obligations and possibly downsize their infrastructure.

Navigating financial regulation. This is one area in which the online marketplaces will fail to achieve much transformation. Just like banks, they need to pay close attention to disclosures, customer privacy, credit bureau reporting, discrimination, loan servicing, debt collection and treatment of borrowers. Compliance missteps would not only expose online lenders to sanctions and bad press, they could also cause regulators to scrutinize their relationships with issuing banks. Without the intermediation of those banks, online lenders become subject to state law—including usury rules that cap interest rates.

Technology is rapidly transforming our world. But in the financial sector, sustained success requires companies to have multiple strengths—of which technology is only one. That's why traditional banks are still with us, no matter how old-fashioned they sometimes seem.

Kenneth A. Posner is chief of strategic planning and investor relations at Capital Bank Financial Corp. A former analyst, Posner is also the author of Stalking the Black Swan: Investment Research and Decision-Making in a World of Extreme Volatility. Follow him on Twitter at @PosnerKenneth.