Who is the biggest threat to banking as we know it?

There’s a headline in yesterday’s Financial Times: PayPal poses bigger threat to UK lenders than ‘challenger’ banks.

The article covers research published by lawfirm Pinsent Masons who used YouGov to survey 2,000 consumers on their views about banking and providers.  Headlines from the survey include:

• Online payment providers - such as PayPal and WePay - are more likely to disrupt the banking market than challenger banks such as Metrobank or Virgin Money.
• A quarter of respondents (24%) said they would be 'likely' to be banking with an alternative payment provider, such as PayPal, within two years. 
• Less than a fifth (19%) of respondents said they would bank with a company best known for non-banking products or services
• Only 13% said they would consider banking with a new banks - such as Metrobank.
• Less than 5% of respondents considered it likely that they would be banking with tech companies such as Google or Facebook.
• Just 10% envisage themselves using a bank branch or telephone banking.
• Only 12% of people see themselves using mobile devices to make payments.
• 65% of respondents cited security of payments made using new technologies - such as contactless cards or mobile phone apps - as their main concern in adopting new technologies.

Now there’s a problem with these surveys, as you can get whatever statistic you want if you frame the question the right way, as demonstrated by Sir Humphrey in the classic old comedy Yes Minister …

In fact, I would imagine that the survey above talked about PayPal and said would you feel better banking with PayPal or Metro Bank, with most of the consumers having never heard of the latter.  If they had said would you feel better banking with WePay or Metro Bank? the answer would probably be the latter, rather than the former.  Hence, we can turn this around quite easily.

My real problem with this survey is that the competition that’s rising is not really coming from payments providers or challenger banks.  Payments providers will stick to their knitting whilst challenger banks have a slow burn to get critical mass.  Metro Bank are doing great things, as are other start-ups, but all of these started with zero customers and it takes a long time to gain traction and significance.  Equally, they are not really challenging the traditional bank model but replicating it and trying to innovate around the edges, e.g. by extending opening hours and offering dog biscuits.  Tesco Bank is doing interesting things, but again replicating the products of incumbents.

Payments providers could move into more mainstream bank services, but they’re happy creaming off the cake rather than baking a new cake.  A few are doing interesting things, like Holvi a ipagoo, where they can offer what appears to be full deposit style banking services by leveraging a payments licence, but again these are slow burn players rather than mainstream.

So don’t take this survey at its face value, but look underneath the covers.  Which players are most likely to replace banks, rather than add on to the bank services?

I answered this a while ago, and pointed to the P2P players.

That’s P2P lending, P2P payments, P2P insurance, P2P finance.

That’s crowdfunding, cryptocurrencies, mobile inclusion and mobile wallets.

It’s all the fintech innovations we are seeing that is trying to squeeze banks out of the picture and replace them with processors.

That’s where the real threat to traditional banks is occurring, not the payments processors, especially now that P2P companies are starting to behave more like banks.

From Bloomberg, October 2014:

Peer-to-peer lenders turning to Asset-Backed Securities (ABS) market by Joy Wiltermuth

Online loan markets in the rapidly growing peer-to-peer lending sector are starting to attract more attention as a potential source of securitisation trades.

Peer-to-peer lenders SoFi and OnDeck have already tapped the Asset-Backed Securities (ABS) market, while CircleBack Lending recently lined up Jefferies to securitize a US$500m batch of consumer loans.

With some companies in the sector seeing up to a 40-fold increase in business, many see the push towards ABS as a natural next step in diversifying.

“We are right at the beginning,” said Dan Ciporin, a partner at venture capital firm Canaan Partners, which provided seed money to two P2P loan platforms, Lending Club and Orchard Platform.

“To use a sports analogy, we are probably 30 seconds into the first quarter.”

Peer-to-peer has evolved quickly over the past few years, stepping into niches in the consumer loan space that traditional banks have steered clear of since the crash.

Growth has been fuelled by big institutional spenders, which have been attracted by the sector’s estimated US$3trn lending opportunity.

“Peer-to-peer brings to mind images of retail investors buying these loans on their home computers,” said a hedge fund investor in the space who asked not to be named.

“But a big chunk are actually institutional investors.”

Orchard Platform, for example, allows hedge funds and institutional investors to buy tailor-made pools of P2P consumer loans from originators based on risk and return preferences.

It offers daily loan-level reports and analytics that help investors manage their risks but which could also ease the way for a securitizer working through the process of getting credit ratings assigned to a pool of loans.

“It could be an alternative to securitization or it could also be a precursor,” Orchard co-founder David Snitkof told IFR.

HIGH VOLUMES

Peer-to-peer lending started out as just that - matching borrowers to loans financed by their peers - but the surge in P2P platforms has steadily won a broader market.

Lending Club and Prosper, two of the largest names in the business, have grown their combined loan volumes roughly 40 times since 2009 from US$60.7m to US$2.36bn already this year, according to data from both companies.

But it is not just those lenders benefiting from borrowers looking for alternative means of credit.

“There is a lot of opportunity,” said Ryan Randall, the CFO at Upstart, which focuses on recent college graduates who have not yet built up significant credit track records.

Upstart uses non-traditional metrics - grade point averages in school, for example, or even which university they attended - to evaluate loan applicants.

While rates to borrowers range from 7%-25%, returns to investors in these loans are targeted at roughly 10%.

“As the pool of assets are increasing,” Randall said. “Many early purchasers will use securitization as a way to diversify their holdings and also provide a way for different buyers to acquire these assets.”

GETTING IT RIGHT

While peer-to-peer lending has focused on shorter-term consumer loans, other areas including small business loans and student debt and credit card refinancings are gaining ground.

And down the road, the ABS market should see a surge of activity from the P2P sector.

“Securitization ultimately will be a way that a lot of this is financed,” the hedge fund investor said.

But for now, at least, peer-to-peer is still tiny when measured against the US$190bn expected to be issued from the traditional consumer ABS market this year.

To get it right going forward, said Ciporin from Canaan Partners, participants will have to make sure they work within the regulatory framework set up after the financial crisis.

“Traditionally, where people run into problems in building great companies in the fin-tech world is (that) they focus on technology, but have a lack of focus on the regulatory side,” he said. “Now people understand that.”