Competition between banks and alternative lenders: the public wins
It sometimes seems like the modern media covers everything as if it is a sporting event, or maybe it’s a melodrama. On one side is the team / characters that everyone loves. On the other side, the “bad guys” are regrouping. Considering who will win is a source of despair or jubilation. In the competition between banks and alternative lenders, which not so long ago, the stories ominously called the “shadow banking system,” this typical treatment has completely missed the point. What is happening is that the competition (of the capitalist and non-sporting type) promises to improve the ability of both players to serve the public and has started to create a kind of cooperation.
Competition between banks and fintech alternatives took off just after the 2008-09 financial crisis. Tough economic times had made small businesses in particular and many consumers desperate for funds. At the same time, this severely constrained their usual sources of borrowing, the community banks. On the one hand, bank managers, stung by the glut of bad debts caused by the crisis and well aware of the growing number of bank failures and near bankruptcies, have avoided everything but the highest quality loans guaranteed by bankruptcies. best guarantees. Killing banks’ appetite for risk even more, the then Federal Reserve’s (Fed) decision to reduce short-term interest rates to zero made deposits cheap and thus allowed them to realize profits simply by buying treasury bills. After 2010, the Dodd-Frank financial reform legislation further slowed lending by penalizing risk and forcing banks on new mountains of compliance documents.
As community banks retreated and many fail, fintech alternatives have crept into the breach. The use of algorithms and manipulation of data had already started to offer competition to banks by streamlining the process of approving loans from weeks or more in traditional institutions to days at most. Alternative lenders could approve riskier loans, as fintech systems gave them more flexibility than banks to adjust transaction rates and covenants, including the ability to accept unconventional sources of collateral, such as as real estate and unpaid bills. By responding to the demands of so many people then neglected by the banks, these alternative devices quickly established themselves in the market for loans to small businesses and in particular to startups. In just a few short years, this parallel banking competition has taken over a third of the new market for small business loans from banks. And because the big banks handled Dodd-Frank’s burdens better, most of the losses occurred among the community banks. Many have closed their doors. As a group, they have seen their share of small business loans drop from 77% of the market to around 40% and their share of startup loans drop from 82% to less than 30%.
But as always with the markets, the wheel continues to turn. Fintech and alternatives have become victims of their own success. Demands for their services have left many people desperate for loanable funds and capital for expansion. This will become a growing challenge as rising interest rates push investors back to more conventional outlets, including banks. This growing need for capital and loanable funds has increasingly pushed many alternative players to the very banks they had beaten for market share. Despite all the wonders of technology, it still seems that collecting and managing deposits presents an unmatched method of securing loanable funds.
At the same time, banks, large and small, have changed their approach to lending to small businesses and even to consumers. They understand that with the Fed’s rate hike, the cost of deposits will rise and that they will have to take more risks to maintain their profit margins. The recent Dodd-Frank modifications have simultaneously allowed community banks to move more aggressively than in the recent past. The erasure of memories of the 2008-09 carnage also helped increase appetite for risk-taking. Most or most important is how the past success of alternative lenders has turned banks into fintech enthusiasts. Institutions as important as JP Morgan Chase and Goldman Sachs have created special divisions to approach lending the way the alternatives came first. Community banks have expressed their enthusiasm in various ways.
Rather than creating their own technology, as the bank may have done in the past, they rented it out to developers or just partnered with them. Some use fintech partners to improve and streamline their loan approval processes. Some alternative lenders have developed networks of community banks to place borrowers they have already selected with the bank lender most likely to grant the type of loan concerned. Some banks have developed networks of alternative lenders to which they will channel borrowers they cannot serve, sometimes even funding the loan through the credit of the alternative lender. Of course, fees and revenue sharing arrangements surround these structures at every stage.
This latest turning point in the nature of the market seems well positioned to serve the future economy. As banks are now clearly buying instead of building and can therefore quickly switch fintech companies, these new developments promise to spur even more competition and innovation. These combinations also appear to be ideally suited to meet the growing market power of millennials, half of the polls showing they intend to start their own businesses and will therefore need a growing source of tailor-made loans, though. many of their dreams never see the light of day. It’s not just the preferences of millennials. Whatever the changing trends of these young people, the increasingly innovative and knowledge-based nature of the economy will accelerate the development of new businesses, which will surely require more loans and more flexible ways of doing it.