Those of you who know me well know that I have a history of challenging the norm. I’ve found myself called into many a boss’s office over things I did that didn’t conform to the rules. When faced with a problem or a challenge, I’ve always started by finding a solution that assumed away all constraints first. Only after I had an “ideal solution” in mind would I layer the constraints back on to see where compromise was necessary. And if I’m honest, more often than not I would ignore or challenge the constraints in pursuit of the best answer possible.
I bring this up because the current debate about the operating models that the non-Bank Specialty Originators have put in place is giving me flashbacks. Traditional Bankers are saying “you should have known better” and claim that the models were bankrupt from the start. If you ask the simple question “why”, the answers all feel like a variation on the theme of “you can’t run a lending business without access to deposits”. And when you ask the follow-up question “how else can you fund a lending business”, these same pundits don’t want to engage in a meaningful conversation. Instead they say “you should have known better” and claim that the operating model was destined to fail from the start.
But what’s interesting is that if you ask even the most conservative Banker “did this modern breed of Originator do anything right” you’ll get positive responses from almost all of them (at least those that know what the heck these models are all about). Even though to them the model doesn’t hold together they’re willing to admit that pieces and parts actually worked.
So what have they done right? What can be learned from the Innovators?
- Consumers are interested in an amortizing personal loan product. The Banks shut down their personal loan businesses during the last financial crisis and haven’t brought it back in any meaningful way (i.e. – The Hourglass Effect). In essence, the Banks haven’t been listening to and serving their customers’ needs because consumers like the product structure and when it went away it created a void. Over $20B of amortizing unsecured personal loans have been made by a small handful of players and if not for the current funding situation this number most likely would have doubled in the next year alone.
- Customers are willing to accept lending products from non-Banks. The brand and stability of a Bank doesn’t matter much when you’re giving out money to consumers (i.e. – loans). The situation might be very different if a consumer needs to give you their money (i.e. – deposits), but even this may be changing. The general insight is that if a consumer can easily understand the terms and conditions of a loan then they don’t care much about who they’re getting the loan from.
- Companies can create nearly frictionless loan application processes. With the right focus on tech and user experience, a loan application process can be created that allows applicants to use the device of their choice to quickly and easily navigate what has historically been a complex and drawn out process. The current leaders in the space have reduced the entire process to a single point of friction (verification) and even this point of friction is being attacked and improved upon. Instant approval is the new norm and loan proceeds can be made available as quickly as the verification process can be completed.
- Platforms can be created that allow lenders to invest in fractional loans/buy whole loans at the individual customer level. This might not sound like a big deal, but it is. “Assemble your own loan book” has never been done before and it’s a powerful idea. Approved loan applicants are systematically matched with buyers based on established criteria or put on a platform for “first come first serve” sale. This process is serving deep pools of existing capital but also has opened up new investor pools to the asset class, some of which never had the ability or desire to participate in large securitization programs (i.e. – retail investors).
- Scale matters. The infrastructure investment needed to put all the pieces in place is many multiples of what Entrepreneurs and Investors originally anticipated. Now that the model has matured it’s very clear that the capabilities needed to run a non-Bank loan originations platform aren’t trivial to assemble and manage. But, this can be seen as a double-edged sword because once the capabilities have been built, a real barrier to entry exists that won’t be easy for new start-ups to replicate.
- Funding is fickle. Without direct control of the inflow and outflow of funding capital, a loan originations platform has to find some way to attract capital that’s interested in its production. Many sources of capital look at the cash flows being thrown off by loans as a “trade” which means it has to stand up on both an absolute and a relative basis. If better risk/return options emerge in the market, the platforms have to figure out how to quickly improve the investor return profile or risk losing access to capital. This means that if a platform isn’t nimble and over-capacitized in terms of capital sources, its ability to originate new loans is always at risk.
If we tally the scorecard, it would look something like this:
- The first four learnings squarely favor the non-Bank Originators
- The fifth learning helps the at-scale players and hurts the smaller players
- The final learning is a big black-eye for the non-Bank Originators
Is the final learning a sign that an extinction event is on the horizon? You can judge for yourself but I can say with confidence that I’m not in that camp. There’s no need to believe in historical constraints and traditional viewpoints when by disbelieving them real solutions might (will) arise. Whether the solution ends up as an alignment with more permanent sources of capital or some other creative solution that has yet to show itself, I personally believe solutions exist. The next few weeks/months will likely write the story but to me it just feels like another trip to the boss’s office.