New lending platforms are transforming credit evaluation and loan origination as well as opening up consumer lending to non-traditional sources of capital

Since the financial crisis, trust in retail banks has declined, regulations on loans have increased and the banks themselves have shown a consistently low appetite for risk.

This combination of factors led to shrinkage of loan markets, particularly for high-risk borrowers, and a paucity of options for risk-seeking savers.

The resulting lending gap means conditions have been fertile for alternative lending models, such as online and peer-to-peer (P2P) platforms, to emerge and grow.

There is no doubt that these alternative platforms will shake-up the market and could pose a significant threat to traditional lenders.

But it isn’t clear whether they will move upstream to directly intermediate some loans, come to exist in a niche alongside established players or inspire older institutions to evolve by adopting their key features.

A faster, more flexible future

New platforms such as Lending Club in the US and Zopa in the UK offer fast and flexible services to customers at low cost.

They are particularly likely to prosper if they meet the growing demand for greater transparency, efficiency and control than traditional financial institutions have offered.

Future lending processes will be streamlined with greater emphasis on meeting funding requests in a timely manner – customers may expect approvals in three or four days, rather than as many weeks.

The key characteristics of alternative lending platforms are:

• P2P – online platforms and legal contracts are leveraged to directly match funds between savers and borrowers with no need to hold reserves and costs kept to a minimum by acting as an online marketplace
• Alternative adjudication – borrowers are assessed on criteria beyond traditional credit scores, such as social data, and risk engines are reviewed more often to incorporate recent feedback
• Lean automated processes – assessment of borrowers is at least partly automated against pre-defined rules via platforms that are free of legacy processes and technology

The future market will offer more accurate underwriting, more lending options for a broader spectrum of borrowers, greater transparency and quicker, customer-friendly processes.

Lending decisions will be less prone to human bias and guided more by algorithms. This could benefit people with low levels of capital, who may previously have been immediately rebuffed as high risk.

Will traditional lenders be knocked off balance?

Customers are likely to turn to new lending platforms for alternative short and medium-term investments and this will hit traditional deposits and investment products.

The resulting negative impact on financial institutions’ balance sheets would raise questions about how they would continue to meet lending requirements.

Traditional lenders may also face issues in consistently measuring creditworthiness if customers have their savings and credit portfolios spread across a range of new platforms with different reporting standards.

Consumer-friendly alternatives could eventually move upstream to replace traditional institutions as intermediaries of prime, low-risk loans.

The increased competition would pressurize the spread earned between interests paid to savers and earned from borrowers, putting pressure on margins.

Established lenders, weighed down by legacy processes and high capital requirements, would lose market share.

A second possibility is that the new entrants cater to different classes of investors and borrowers, comfortably co-existing alongside traditional institutions.

Risk-tolerant savers and high-risk borrowers would switch to alternative lenders and the profiles of customers served by traditional institutions would become increasingly homogenized.

Under a third scenario, financial institutions could adopt features of the alternative lending business model, such as alternative adjudication, and come to serve both prime and subprime borrowers with a wider range of savings and lending products.

Paving the way for partnerships or acquisitions

Despite their innovation, uncertainty remains about the ability of new entrants to deal with periods of increased volatility and higher interest rates.

Older institutions could learn important lessons from alternative players, form integrated partnerships with them or eventually acquire and absorb them.

Questions remain about whether alternative platforms should face the same regulatory rules as traditional players and how their customers can best be protected in an economic downturn.

However, the market dynamics created by the varying possibilities should result in improved customer experience and availability of loans whatever else comes to pass.

Implications for financial institutions

Erosion of deposits

Erosion of deposits and investment products:

As customers leverage alternative lending platforms for alternative short and medium-term investment vehicles, traditional deposits and investment products offered by traditional institutions will erode, ultimately leading to reduced balance sheet for retail financial institutions.

Distributed credit:

Customers’ savings and credit portfolio will be distributed over a large number of alternative platforms with varying reporting standards, making it difficult for financial institutions to measure each customer’s creditworthiness on a consistent basis.

Key Questions:

How will retail banks continue to maintain their ability to serve lending needs of customers as the erosion of deposits to alternative lending platforms leads to reduced balance sheet? How will retail banks continue to accurately and consistently assess creditworthiness of customers as customers’ loan portfolios become distributed and the measurement of creditworthiness becomes increasingly diversified?