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bai bankingsresponsetoalternativefinance

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Banking’s Response to Alternative Finance Given that alternative finance companies are likely here to stay, banks would be better off viewing them as potential partners rather than as competitors. BY CHARLES WENDEL May 22, 2015 | 0 Comments At the recent Lendit conference focused on “alternative lending,” keynote speaker Larry Summers, the former Secretary of Treasury, said that he would not be surprised if within ten years alternative finance companies (AFCs) generated 75% of “nonsubsidized” (nonSmall Business Administration) small business loans and 30% to 40% of direct consumer lending. Today, the small business percentage generated by AFCs does not exceed 2% and the consumer percentage may be in the 5% to 10% range. Banks cannot afford to ignore this gamechanging possibility. Rather than view AFCs as just another set of competitors, banks have the opportunity to work with them to increase revenues, expand their market focus and leverage already welldeveloped processing and risk management platforms to improve productivity and performance. Digitallyenhanced Lending What is an alternative finance company? Described by one AFC CEO as emphasizing “digitally enhanced lending,” these entities do not take deposits and are usually owned by private equity firms, which see a substantial growth opportunity lending to companies to which banks either cannot or will not lend. AFCs imbed the effective use of information technology throughout their business systems (including origination, underwriting and monitoring) to streamline processes. In their view, this provides a quality of risk management that allows them to lend to companies considered unbankable. Here are some factors fueling the growth of AFCs: Banks define their “credit box” narrowly, creating a lending opportunity for AFCs, particularly with businesses. While banks want to lend, many have also increased the hurdles that businesses must meet to borrow. We estimate that banks overall consider only about 10% of all business loan prospects as bankable, leaving in excess of $1 trillion in loan opportunities for others. Banks have created the growth opportunity that AFCs are enjoying. AFCs provide greater speed in decisionmaking and funding. A 2014 Federal Reserve study estimates that small business owners spend 24 hours researching and applying for a loan, contrasting sharply with the 24 to 48hour turnaround that some AFCs can provide. During a due diligence project for a client, we found that a significant number of bankable credits had decided to work with AFCs for their speed and responsive customer service, despite higher cost.

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BAI BankingsResponseToAlternativeFinance

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  • 5/22/2015 BankingsResponsetoAlternativeFinance|BAI|BankingStrategies|Strategy|ManagementIssues

    https://www.bai.org/bankingstrategies/print.aspx?id=6abcf971c60a4cc9844d54a8d450f3f8 1/3

    BankingsResponsetoAlternativeFinanceGiventhatalternativefinancecompaniesarelikelyheretostay,bankswouldbebetteroffviewingthemaspotentialpartnersratherthanascompetitors.BY CHARLESWENDELMay22,2015|0Comments

    AttherecentLenditconferencefocusedonalternativelending,keynotespeakerLarrySummers,theformerSecretaryofTreasury,saidthathewouldnotbesurprisedifwithintenyearsalternativefinancecompanies(AFCs)generated75%ofnonsubsidized(nonSmallBusinessAdministration)smallbusinessloansand30%to40%ofdirectconsumerlending.Today,thesmallbusinesspercentagegeneratedbyAFCsdoesnotexceed2%andtheconsumerpercentagemaybeinthe5%to10%range.

    Bankscannotaffordtoignorethisgamechangingpossibility.RatherthanviewAFCsasjustanothersetofcompetitors,bankshavetheopportunitytoworkwiththemtoincreaserevenues,expandtheirmarketfocusandleveragealreadywelldevelopedprocessingandriskmanagementplatformstoimproveproductivityandperformance.

    DigitallyenhancedLending

    Whatisanalternativefinancecompany?DescribedbyoneAFCCEOasemphasizingdigitallyenhancedlending,theseentitiesdonottakedepositsandareusuallyownedbyprivateequityfirms,whichseeasubstantialgrowthopportunitylendingtocompaniestowhichbankseithercannotorwillnotlend.AFCsimbedtheeffectiveuseofinformationtechnologythroughouttheirbusinesssystems(includingorigination,underwritingandmonitoring)tostreamlineprocesses.Intheirview,thisprovidesaqualityofriskmanagementthatallowsthemtolendtocompaniesconsideredunbankable.

    HerearesomefactorsfuelingthegrowthofAFCs:

    Banksdefinetheircreditboxnarrowly,creatingalendingopportunityforAFCs,particularlywithbusinesses.Whilebankswanttolend,manyhavealsoincreasedthehurdlesthatbusinessesmustmeettoborrow.Weestimatethatbanksoverallconsideronlyabout10%ofallbusinessloanprospectsasbankable,leavinginexcessof$1trillioninloanopportunitiesforothers.BankshavecreatedthegrowthopportunitythatAFCsareenjoying.

    AFCsprovidegreaterspeedindecisionmakingandfunding.A2014FederalReservestudyestimatesthatsmallbusinessownersspend24hoursresearchingandapplyingforaloan,contrastingsharplywiththe24to48hourturnaroundthatsomeAFCscanprovide.Duringaduediligenceprojectforaclient,wefoundthatasignificantnumberofbankablecreditshaddecidedtoworkwithAFCsfortheirspeedandresponsivecustomerservice,despitehighercost.

  • 5/22/2015 BankingsResponsetoAlternativeFinance|BAI|BankingStrategies|Strategy|ManagementIssues

    https://www.bai.org/bankingstrategies/print.aspx?id=6abcf971c60a4cc9844d54a8d450f3f8 2/3

    FundingisplentifulforAFlendersandtheirborrowers.Privateequity,securitizations,bankloansandIPOsareallavailabletoAFCsandsupporttheirgrowth.SomecompaniessuchasLendingCluboperateasmarketplacesinwhichtheyact,ineffect,asintermediariesbetweenborrowersandlenders(ofteninstitutions,includingbanks).Marketplacelendersfurtherexpandthedollarsavailabletofundloans.Aneconomicdownturnwilllikelyreducefundingtomarginalplayersbutmoreestablishedlendersshouldcontinuetoattractbackers.

    AFCsoperatewithstrongriskmanagement.SomebankersIspeakwithviewAFCsasthesecondcomingofsubprimelendingandexpectthesamebadendasthatbusinesssufferedduetopoorlendingpractices.However,inmanycases,thequalityofriskmanagementprocessesfollowedbyAFCsmayexceedthatofbanksinbothdepthandquality.Nonbankshavedevelopedanalysesthatoftenincorporatetraditionalbankingdata,credithistorydata,cashflowinformation,variouspublicrecordsandevensocialmediadata.Riskalsoinvolvesanareaofcontinuedinvestmentandfocusforthesefirms,astheypushthemselvestobuildstrongerunderwritingprocesses.

    AFCsarebenefitingfromanimprovedreputationandenhancedPR.Aboutfiveyearsago,alternativelenderssufferedfrompoorpublicityandanimagethatoftenportrayedthemasthesmallbusinessequivalentofpaydaylenders.However,astheindustryhasmatured(and,insomeinstances,astheirlendingrateshavedeclined),theirimageimproved.MuchofthemedianowportraysAFCsasareasonablealternativetobanks,withstoriesoftenstressinghowtheycametotherescueofasmallcompanyandapprovedaloanrequestthatabankhadpreviouslydenied.

    AlternativeFinanceisheretostay.Onebankerrecentlycommentedtomethathehadseenthisrodeobefore,suggestingthatAFCsrepresentedalendingbubbleratherthanpermanentdisruption.Certainly,somelenderswillblowupoverthenextfewyears,whetherfromfraud,badlendingpracticesorunforeseencircumstances.Butmanywillcontinuetosucceedandexpandbyvirtueofcustomerneed,innovation,effectivemarketing,continuedaccesstofundsandlackofresponsefromtraditionallenders.Alternativefinancehasbecomeagamechangeritisnotgoingaway.

    So,whatshouldbetheproperstanceofbanksinregardstothisphenomenon?

    AFCsunderstandandrespecttheprivilegedpositionandpositivereputationthatbankscontinuetohavewithmostcustomers.Theyalsorealizethatbankscanprovideaccesstoalargecustomerbaseatareducedcostoforigination.FormanyAFCs,cooperationwithbanksmakesalotmoresensethancompetition.Fortheirpart,bankscanleveragetheAFCsinvestmentinprocessandriskrelatedtechnologytoreducecostsand/orexpandrevenueopportunities.

    Cooperationislikelytoinvolveoneormoreofthefollowingoptions:

    Referrals.ThisinvolvesAFCsobtainingreferralsfrombanksforloansnotacceptabletobankcriteria(turndowns).Thebankreceivesareferralfeeandretainsallthecustomersotherbusiness.However,thisactivityraisescomplianceandprivacyconcernsatmanybanksandmayalsonotprovidesignificantrevenuestobemeaningfultoeitherthebankortheAFC.

  • 5/22/2015 BankingsResponsetoAlternativeFinance|BAI|BankingStrategies|Strategy|ManagementIssues

    https://www.bai.org/bankingstrategies/print.aspx?id=6abcf971c60a4cc9844d54a8d450f3f8 3/3

    Businessexpansion.AFCscanworkwithbanksproactivelytoassesstheircurrentcustomerbaseandidentifynewloanopportunities.ThebankcanfundthosethatmeetitscriteriawhiletheAFCwillprovideloanstononbankabletargets,eitheronaprivatelabelorcobrandedbasis.ThishasbecomeanincreasingfocusofsomeAFCsandmayrepresentanattractivegrowthareaforbanksthatwanttoincreaseloanstosmallbusinesses.

    Integration.AhandfulofAFCscurrentlyoffertheirorigination,servicingandriskmanagementplatformsasaservicetobanks,allowingthemtostreamlinethelendingprocess,lowertheircostsandimprovethecustomerexperience.Mostbankslosemoneyonloanslessthan$100,000thisapproachcanreduceoperatingexpensesandallowthebanktofocusonoriginationratherthanbackofficeactivities.Byintegratingwiththebank,theAFCcanbecomethebankssmallbusinesslenderforallloansunderthe$50,000to$100,000range.

    Investmentsandfunding.SomelargerbanksandinstitutionalinvestorsarecurrentlypurchasingwholeloansorloanportfoliosoriginatedbyAFCs,allowingbankstotakeadvantageoftheirownlowcostfundingandaccesstodeposits.Thisactivitydemandsstrong,independentriskanalysis.BanksareoneofthemainfundersofAFCs,participatinginasecondarywayinthehighrateloansthatAFCsgenerate.

    Atthispointwealsoknowofthreebanks,onetoptenandtwosmallerinstitutions,thataretryingtoemulatetheAFCslendingapproachbyapplyingtheanalyticsthatAFCshavespearheadedtotheirownbankportfolios.Morebanksarelikelytodothesame,althoughtheextentofabankswillingnesstoalteritstraditionalapproachtoriskmanagementandpricingremainsaquestionmark.

    IfabankdecidestoworkswithAFCs,utilizingoneoftheaboveoptions,howshouldtheythenselectapartner?

    HundredsofAFcompaniesnowoperateandtheLenditconferencedemonstratedthatnewplayersareenteringthemarketeveryweek,tryingtodifferentiatethemselvesbaseduponfactorsincludinglendingfocusandindustryorloanproductexpertise.AbanksinternalchecklistneedstoincludehoweffectivelytheAFChasanticipatedandaddressedthebankingindustrysregulatoryandcomplianceissueswhetherthesolutionthatanAFCoffersisturnkey,therebylimitingthetimeandresourcesrequiredbythebankand,thewillingnessoftheAFCtocustomizeitsapproachtotheneedsandpreferencesofthebank.EventhisbriefchecklistwilleliminatemostAFCsascandidatesandallowbankmanagementtofocusonhighpriorityprospects.

    Mr.WendelispresidentofNewYorkCitybasedFinancialInstitutionsConsulting,[email protected].

    2015BAI.AllRightsReserved.


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