As Gun-Shy Investors Turn Away from Traditional Markets, Banks Face Newest Threat

Earlier today, Bank of America and Citi Group posted huge losses, then stood in line with a tin cup held out for more government loans via TARP (16 January 2009, Washington Post, “Bank of America, Citigroup Post Major Losses”).   It’s clear that, despite an injection of $350 billion, the U.S. banking industry is still reeling nearly four months into the credit crisis that has brought down some of the World’s largest banks and investment houses, leaving carnage in its wake.

Yet, at the same time these titans deal with “toxic” loans and absorbing the remains of their recently departed siblings, another threat grows beneath their giant footsteps and between their toes – Peer-to-Peer Lending.  Fueled by the sour credit market, distrust in traditional banks and fear of continued losses in the stock or bond market, once-wary investors are taking their dollars to upstarts prosper.com, lendingclub.com and even virginmoney.com where they can earn superior returns, diversify their investments and know specifically where their money is going.  Though resources in traditional banks are best directed toward immediate financial crises and folding in the business of recently acquired competitors, it’s time for traditional banks to start planning for the coming onslaught from peer-to-peer.

In only a few years, peer-to-peer lending has sprouted from the more-proven micro-lending practiced in developing countries and pioneered by Dr. Muhammed Yunus and Grameen Bank in 1983 (16 January 2009, http://en.wikipedia.org/wiki/Muhammed_Yunus).  Realizing that the loans needed by low-income individuals were far too small, uncollateralized and therefore “too risky” for traditional banks, he began making many small loans via Grameen to under-privileged entrepreneurs, who took the meager sums and made sizable profits, yielding healthy returns for Grameen.  Not specifically interested in making money, Yunus saw how the concept of pooling small sums of money from borrowers to make larger loans or taking larger sums to make many smaller loans had an enormous positive impact on the poor.  This became his business model for Grameen and other micro-lenders like it.

Operated much like the micro-lending Grameen, peer-to-peer lenders match lenders with borrowers on a relatively small scale – often no more than $25,000 for an entire loan and typically in the $5,000-$15,000 range.  Borrowers meet minimum standards for credit-worthiness and credibility, then they post information about their requested loan on line, stating how the money will be used and how much they need.  For most peer-to-peer sites, borrowers approve each lender’s loan offer and terms until the target loan amount is met.

For their part, lenders can lend out as little as $25 to a specific borrower and spread their money around as they deem fit, minimizing the risk that a single lender’s default will cause a huge personal financial loss.  Most often, payments are received on a monthly basis and doled our proportionately to each of the lenders until the fund are repaid.

Peer-to-peer lending sites like LendingClub.com and Prosper.com make their money in a few ways, though the process isn’t entirely consistent between them:  Peer-to-peer lending sites collect a 1-to-3 point service fee on the loan, much like the spread between the amount banks charge their borrowers and the Federal Funds rate at which they borrow.  They may also collect an on-going loan maintenance fee, late payment fees and collection fees if the borrower defaults.  In return, the peer-to-peer brokers screen the borrowers, process the loan, capture legal signatures and may even assist with collections if the borrowers default.

None of this sounds very threatening to traditional banks as of 2009.  The current market for peer-to-peer lending is about $100 billion (www.business-standard.com) and is dwarfed by the total U.S. market of $2.56 trillion (Federal Reserve, http://www.federalreserve.gov/releases/g19/Current/).  But, consider how the credit crisis has created a fertile environment for peer-to-peer lending:

(1)    The spread on a secured consumer loan for a car is 6.88% (7.13% as listed on Bankrate.com – 0.25% Federal Funds rate), far more than the 1 to 3% charged at peer-to-peer lenders. Though rates a higher of unsecured loans in both environments, the difference in spreads is even more dramatic.  (www.bankrate.com and http://www.federalreserve.gov.)
(2)    The yield on a 5-year government bond is 1.47% while the yield on a loan with a similar commitment, an auto loan, can yield 6-9% for the lender – a 4-to-7 point difference (http://www.bloomberg.com/markets/rates/index.html).  Certainly, risk is a partial factor in the large spread, but the other factor is likely the profit margins of banks.
(3)    Traditional lenders are turning away borrowers on all types of loans at record rates in efforts to shore up their portfolios and reduce risk.  Consumer credit dropped in December 2008 for a third straight month and automakers are citing the credit crunch as a reason car sales were off  by one-third between ’07 and ’08 (http://online.wsj.com/mdc/public/page/2_3022-autosales.html).

Traditional banks have some time to respond to the threat posed by peer-to-peer lending sites, but it can be measured in months and not decades.  They are unlikely to be able to compete with them via traditional methods, because the cost of staff, buildings and infrastructure in the brick-and-mortar is simply too high.  But it is viable

(1)    Ignore peer-to-peer lending and hope it fades away – a dangerous way to deal with a tech-savvy threat.
(2)    Acquire a peer-to-peer lending site once the process is refined and market penetration still low, reaping the largest gains by increasing market penetration.  This can be dicey, especially if the market potential is recognized early, driving up the price.
(3)    Develop their own peer-to-per lending capabilities to compete with the upstarts, keeping one of the smaller players from becoming the next “MySpace” or “YouTube” that fetches an exorbitant price on the open market.

Regardless of the path chosen by traditional banks, their spreads are likely to drop, forcing their business practices to change, as well.  A few will under-assess the threat and act too late, bringing them down in the process.  This does not bode well for the people who work for the titans of banking’ they are likely to see another assault on their jobs, just after the “credit crisis” has already dramatically cut their ranks.