Competition Between Banks And Alternative Lenders: The Public Wins

It seems at times that modern media cover everything as if it were a sporting event, or perhaps it is a melodrama. On one side stands the team/characters everyone likes. On the other side, the “bad guys” gang together. Consideration of who will win either gives cause for despair or jubilation.  In the competition between the banks and alternative lenders, which not too long ago stories ominously called the “shadow banking system,” this typical treatment has missed the point entirely. What is happening is that competition (of the capitalist not the sporting kind) promises to improve the ability of both players to serve the public and has begun to create a kind of cooperation.

The competition between banks and fintech alternatives gained its greatest momentum right after the 2008-09 financial crisis. The economic hard times had made small business in particular and many consumers desperate for funds. At the same time, it greatly constrained their usual borrowing sources, community banks. On one side, bank managers, stung by an overhang of bad loans from the crisis and acutely aware of the growing number of bank failures and near failures, avoided all but the highest quality loans secured by the best collateral. Further killing banks’ appetite for risk, the Federal Reserve’s (Fed) decision at the time to drive short-term interest rates toward zero made deposits cheap and so allowed them to turn a profit simply by buying Treasury bonds.  After 2010, the Dodd-Frank financial reform legislation slowed lending still more by penalizing risk and burdening banks with new mountains of compliance paperwork.

While community banks stepped back and many failed, fintech alternatives stepped into the breach. There use of algorithms and data manipulation had already begun to offer banks competition by streamlining the loan approval process from weeks or longer at traditional institutions to days at most. Alternative lenders could approve riskier loans because fintech systems gave them more flexibility than the banks to adjust rates and covenants on the deals, including an ability to accept non-conventional sources of collateral, such as real estate and outstanding invoices. By meeting the demands of so many then neglected by the banks, these alternative arrangements rapidly made inroads into the market for small business loans and especially startups. In just a few short years, this shadow banking competition took one-third of the new small business loan market from banks. And because large banks coped better with Dodd-Frank’s burdens, most of the loss occurred among community banks. Many closed their doors. As a group, they saw their share of small business lending drop from 77% of the market to about 40% and their share of lending to startups drop from 82% to less than 30%. 

But as always with markets, the wheel continues to spin. Fintech and the alternatives have become victims of their own success. Demands from their services have left many desperate for the loanable funds and capital needed for expansion. This will become an increasing challenge as rising interest rates prompt a return of investors to more conventional outlets, including banks. This building need for capital and loanable funds has increasingly driven many alternative players to the very banks they had beat out for market share. For all the wonders of technology, it still seems that the collection and management of deposits presents an unrivaled method of securing loanable funds.

At the same time, the banks, large and small, have changed their approach to small business and even consumer lending. They appreciate that with the Fed raising rates, the cost of deposits will rise and they will have to take more risk to maintain profit margins. Recent alterations in Dodd-Frank have simultaneously freed community banks to move more aggressively than in the recent past. Fading memories of the carnage in 2008-09 have helped increase the appetite for risk taking as well. Most significant or all is how the past success of alternative lenders has converted the banks into fintech enthusiasts. Institutions as large as JP Morgan Chase and Goldman Sachs have carved out special divisions to approach lending in the ways that the alternatives have pioneered. Community banks have expressed their enthusiasm in a variety of ways.

Rather than build their own technology, as the bank might have in the past, they have leased it from developers or simply partnered with them. Some use fintech partners to enhance and streamline their loan approval processes. Some alternative lenders have developed networks of community banks to place borrowers they have already screened with the bank lender most likely to make the sort of loan involved. Some banks have developed networks of alternative lenders to whom they will channel borrowers that they cannot serve, sometimes even financing the loan through the alternative lender’s credit. Of course, there are fees and revenue sharing arrangements surrounding these structures at each stage.

This latest turn in the nature of the market seems well positioned to serve the future economy. Because the banks now clearly buy instead of build and so can shift quickly among fintech firms, these new developments promise to spur still more intense competition and innovation. These combinations also seem ideally suited to meet the growing market power of millennials, half of whom polls show intend to start their own business and will accordingly need a growing source of tailored loans even if many of their dreams never see the light of day. Nor is it just the preferences of millennials. Whatever the evolving inclinations of these young people, the economy’s increasingly innovative, knowledge-based character will heighten the rate of new business development, something that will surely demand more lending and more flexible ways of doing it.