Alternative finance lending market booming on the back of low rates

12 September 2016 Consultancy.uk

The alternative finance market for SMEs and personal loans, through marketplace lenders, has in the space of just five years, grown from almost nothing to £2.7 billion. The rapid rise of the phenomenon may mean that banks need to take care or lose out to a new, more attractive, model. New analysis, however, suggests that it is mainly the current credit environment that makes MPL propositions more attractive than those of banks – an environment that is likely to face change.

The disruption of traditional business models, through new technologies and digital business models, has the potential to see incumbents rapidly lose market share. One recent area that has garnered attention from analysts is the phenomenon of marketplace lenders (MPLs) providing an easy means for peer-to-peer lending across a range of segments – resulting in a boom in the alternative finance market in recent years.

While large, corporate players, tend to be able to access debt through capital markets, smaller companies and consumers have traditionally needed to rely on backs to access credit. Banks, are relatively more expensive and risk adverse than the capital markets, which has resulted in more expensive loans for small businesses and consumers.

In recent years, the development of digital technologies has allowed lenders and borrowers to more easily find one another through MPL services. The MPL services connect lenders with borrowers without themselves, outside of fees and commissions, being responsible for the loans closed between the respective parties.

US MPL annual loan volumes

Rise of MPLs
In recent years, the phenomenon of MPLs has grown rapidly – jumping from $473 million in such loans across the US in 2011, to almost $22 billion in such loans in 2015. The CAGR within the industry suggests that a disruptive phenomenon may be unfolding, as total CAGR for the period hit 163.3%. In a new report from Deloitte, titled ‘A temporary phenomenon? Marketplace lending’, the professional services firm considers whether the peer-to-peer lending market through MPLs is likely to become a disruptive force to the banking industry within the SME and consumer lending segments.

UK MPL annual loan volume

As it stands, the UK has, much like the US, seen comparatively rapid expansion within the sector over recent years. In 2011 the sector leant £91 million, largely to the consumer market. Since then, however, the sector has grown at CAGR 171.6%, with the SME market last year worth £1.6 billion and the consumer lending market worth £1.1 billion. The UK market, relative to the wider EU market, is considerably more developed – in total across the continent €669 million in peer-to-peer loans have been leveraged.

The report notes, however, that, as a % of total loans, MPL lending remains relatively low in the UK, accounting for slightly less than 1% of consumer loans in 2015 and just over 0.5% of SME lending.

Driver behind usage of MPLs to borrow money

Drivers behind MPLs
The report also sought to identify what the main drivers for the use of MPLs are for borrowing money among consumers. Ease and quick turnaround are the most cited reasons by respondents, 81% say that one of the main drivers is an easy/quick application process, with 72% saying that it is the fast decision-making that makes the use of MPLs attractive. Additionally, MPL services offer competitive rates, and repayment flexibility – attracting a wide range of price conscious customers.

Cost economics of banks vs MPL

The consultancy firm further explores whether the MPL business model is really of sufficient improvement on that of the traditional banking proposition, to give rise to a ‘disruptive’ shakeup of the SME and consumer lending market. As it stands – within the current banking environment – the cost of an unsecured personal loan comes in at around 815 bps at banks, while at MPLs total costs stand at around 800 bps. For retail buy-to-let mortgages the bps for loans comes in at 460 for MPL and 500 for banks, while for SME loans, MPL can offer solutions at around 720 bps while banks offer loans at around 715 bps.

The relatively close cost profiles of banks and MPLs, as well as some of the benefits related to the use of MPLs, means that the service has had the opportunity to grow in recent years.

Cost of funding an unsecured personal loan

Niche market
The current market conditions are, in many ways, abnormal. Interest rates remain at historic lows, while QE and other measures continue to operate across Europe. The researchers consider whether the current financial environment, rather than a disruptive new business model, is the main driver for the rise of MPL.

As part of the research the Big Four firm considers the total cost of attracting the required funds for the respective loans. For banks, a large portion of the loan is not sensitive to changes in rates, at around 270 bps, while for MPLs around 90 bps is not sensitive to changes in rates. This means that, as a proportion of the total bps of the loan, the credit environment disproportionately affects MPL loans – mainly in terms of return to lenders whose money is on the line. When, and if, the UK, European and US rates again begin to see relatively significant increases, the higher proportion of interest sensitive loan costs will disproportionately affect MPLs, seeing an unsecured loan increase from 470 bps to 530 bps for banks, while for MPLs the increase is from 635 bps to 795 bps.

Neil Tomlinson, Deloitte UK head of banking, says that MPLs are unlikely to become a disruptive force in the long-term, "More broadly, our research shows that total funding costs for banks are lower than for MPLs, and the interest rate-sensitive component of an MPL’s funding profile is higher than that of banks. On that basis, MPLs’ costs could rise by more than banks as the credit environment normalises and interest rates increase. Despite the challenges, MPLs do have an opportunity to carve out a niche market and can do so by exploiting their market-leading user experience and boosting word-of-mouth recommendations. These benefits could decrease customer acquisition costs, making MPLs a more viable option. As more MPLs become fully authorised by the FCA, issues surrounding trust and security could lessen. In turn, we may well see banks become more open to partnering with them to enhance their overall customer proposition.”

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The business and operating models of digital-only banks

04 April 2019 Consultancy.uk

In recent years, several digital-only banks have successfully managed to nestle themselves in the banking landscape, with their popularity continuing to increase. Looking at it from the customer’s point-of-view, there is little difference between these FinTech unicorns; looking at the bigger picture, however, reveals significant variation in their business models. Matyas Fekete, a consultant at KAE, explores some of the main similarities and differences in digi-bank business and operating models. 

What about the profit?

Unlike in the UK, in most of continental Europe, bank accounts and corresponding banking services are historically paid-for services. The fact that digital banks offer most of their services free of charge has undoubtedly helped them build a large customer base. On the other hand, despite comparatively low set-up and minimised operational costs compared to that of traditional banks, and given the lack of revenue stemming from the typically no-fee model, profitability has proved difficult to achieve. Monzo, for instance, recorded a net loss of £30+ per customer in its most recent financial year. 

In the start-up world, it is customary to focus on expansion rather than profit – see the case of Uber, for instance. Still, while profitability might not be their number one priority in their early stages of development, it must be a long-term goal of any business. With their ever-growing customer base, digital banks are increasingly under pressure to turn their business from loss- to profit-making. 

Credit where credit is due

Digital banks pride themselves on their fair (often meaning “free”) proposition and have so far stayed clear of offering loans (including credit cards & overdrafts), traditionally amongst the most lucrative products for traditional providers. Though somewhat reluctantly, newcomers are also realising that offering lending products is one of the most straightforward ways to offset losses made on their free, often high-cost services (e.g. overseas ATM withdrawals). Monzo, N26 and Starling have recently started offering credit products to their customers, with their loan offering expected to be extended to a wide range of services, from mortgages to overdrafts. Correspondingly, creating a lending portfolio can also pave the way for launching an interest-paying savings offering – a proposition seen as a basic banking product that is yet to feature in most digital banks’ portfolios. 

The business and operating models of digital-only banks

The premium customer

While most digital banks offer most of their products for free, some have extended their offering by paid-for premium services in order to create a revenue stream. As these premium features – including different types of insurance, unlimited free transfers/withdrawals, faster payment settlement or concierge services – are often offered in a subscription format, customers are typically prompted to pay for the full package rather than just the desired service(s), providing a significant revenue stream for the bank. Revolut, for instance, was amongst the first digital banks in Europe to break even earlier this year, a feat largely due to revenue from its premium subscription.

SMEs like digital too

Traditional banks typically service small and medium sized businesses under their retail rather than corporate banking arm. Having their product offering tested with consumers, and consequently gaining a reasonable customer base, digital banks have also identified SMEs as an ideal segment to extend their target audience to. The five FinTechs profiled have already gone, or plan to go, down this path by following up their consumer solution with a business account. While both propositions are typically built on similar features, some providers charge businesses a monthly subscription (e.g. Revolut), while others apply additional fees to specific services (e.g. TransferWise), banking on the expectation that businesses are more likely to be willing to pay for banking – something they are already used to doing. 

The marketplace model

While most digital banks offer a wide range of banking services, some of these tend to come from partnering with third-party providers. For instance, Starling Bank’s only proprietary product is its current account, which serves as a basis for the provision of ancillary services, ranging from loans to insurance, to investment opportunities. Instead of developing these services in-house, Starling enables a select group of partnering financial service providers access to its platform in exchange for a fee. In effect, Starling is using its customer base to create a market for its partners, charging a commission for each acquired customer. 

In such cases of digital banks applying this marketplace model, the majority of their income often comes from partners rather than customers. Naturally, only banks with a large enough customer base can be successful in this set-up, underlining the current intensity of competition amongst digital banks.

Banking as a Service

While customer-centricity is heralded amongst the main USPs of digital banks, some are looking beyond offering consumer-facing services to diversify their revenue streams. Starling, which is among the few digital banks built on its own proprietary platform, has recently leapt into the Banking as a Service (BaaS) industry, making its technology available to other start-ups looking to launch a digital bank. Naturally, this raises the question whether the two offerings could threaten each other’s success. Generally, as long as such partners operate in different markets, the two business lines should be able to thrive alongside each other. Further along the line, however, such partners could easily end up expanding their banking solution into the same market(s) as they aim for global success, and by doing so, becoming direct competitors. 

Different approach, same result?

It is fair to say that consumers in Europe looking to bank with a digital-only provider would have a difficult time finding relative advantages/disadvantages amongst the leading players in the industry. Still, despite the limited surface-level variety, exploring the business models of leading digital banks reveals different approaches to the challenge of making money. Alongside the more straightforward method of offering paid-for premium features/subscriptions, some are banking on the value that access to their customer base offers to third-parties, while others outsource their technology to neobanks wanting to focus on the Fin rather than the Tech. With competition amongst digital banks heating up, it will be interesting to see which business model(s) prove to be the winning formula in the long term.