Marketplace Lenders Aren’t Banks, Banks Have it Easier

Marketplace lenders (MPL) are compared to banks cause they issue and service loans like banks do. Some in and out of banking refer to our sector as 'Shadow Banking', a term I hate cause it implies there's something shady, not fully legal or compliant or just not right about what our sector does when none of those things are true.

Not only are peer lenders not shadow bankers, they are far more transparent with their practices and data than any bank I have ever seen anywhere.

The bankers who don't want to partner with marketplaces to fund loans like to piss on our sector and say we are not subject to their audit/regulatory environment making it easier for MPL's to issue and service loans.

Well marketplace lenders are not banks. Here are two important differences showing why MPLs aren't banks cause banks have it far easier to operate and make money than our MPLs do.

Regulation/Legislation

You know that banks are heavily regulated and that's true.

Did you also know that bankers write most of the legislation that gets passed? Yep, they do and they are pretty smart about doing it and how they do it.

What banks are really doing is they are creating barriers to entry and growth for the smaller and mid-size banks in their markets. How?

e.g. Regulation 666 passes and now some new compliance is required by all banks. What does Bank of America or Wells do? They just hire someone for their already fully staffed Compliance departments at their headquarters to monitor this new regulation.

What does little 2 branch small town main street community bank do? You know that little local bank you like cause they know your name. They probably even know how you like your coffee and you know you aren't just a number to them instead of at a big behemoth bank. What do they do with this new regulation?

It's not in their budget to hire someone for this new compliance.

Their existing guys and gals that do Compliance have to handle it and if they can't, well tough for them. It's a hindrance on their growth. And then maybe they have to sell to the big evil conglomerate bank that's also in their market......

This kind of legislation that benefits larger banks is so commonplace that it has become a contributing factor to why the big banks have only gotten bigger. There was even a major party candidate running on 'breaking up the big banks'. It's also so common that relationships with banks (and which ones) are openly discussed before nominations and appointments to places like the SEC, Dept of Treasury and the Federal Reserve.

MPLs don't have to go through the banking regulatory environment for now yet all of them have to go through the Securities regulatory environment whether that's the Regulation D or 506 type that platforms for accredited investors requires or Reg A+ or S-1 or S-3 that platforms like Groundfloor, Lending Club and Prosper have gone through to let retail investors like you and me invest in peer loans.

It's easier to navigate through the regulatory environment when you help to create it like banks do.

Score: Banks 1, MPLs 0

Cost of Funds

MPLs have a business model that requires they make most of their money on the origination (issuing) of the loan and on the servicing of it each month. There's a reason for this: Cost of Funds.

Cost of funds is a common financial term that means how much did your money cost you that you are now lending out. For MPLs this cost is high and for banks it's absurdly low.

You may have guessed by now that MPLs cost of funds are our lender interest rates. In other words, I lend my money on a MPL cause I want to make 10% then that 10% I am earning in interest is the MPL's cost of funds for the loan I bought.

So MPLs cost of funds are high cause we who lend on the platform want to make money on our investment. MPLs will always have a high cost of funds cause we lenders want to make money.

How about for a bank?

Banks cost of funds come from 2 places: Federal Reserve and Deposits.

You know that interest rates on your deposits at your banks are paltry but lets say you are earning 1% per year. The Fed Funds Rate is the rate that banks lend overnight (usually but not always) to each other. That rate today is 0.50%.

But let's say that all of a bank's funds are coming from deposits. We know they aren't so the costs are even lower. So for this example, a bank's cost of funds is 1%.

Does it make sense for a bank to hold a loan on it's books when its costs are 1% and they lend the money out at 8%? You bet it does. That 7%, or 700 basis points as its called in the industry, is called Net Interest Margin.

If you ever want to know how much money your bank is making, then this is the figure you want to go to. And its in the Audited Financials of a publicly traded bank like Wells or B of A. Net Interest Margin is the difference between Interest they charge on loans (8%) and Interest they pay to the Fed and to its depositors (1%). That spread is Operating Income over time for the bank.

Thanks to my experience in equipment finance and having a company I worked for get acquired by a bank, I know this Cost of Funds and Net Interest Margin stuff is vitally important. Their Credit Officers told me so and I believe them.

You can imagine how profitable the biggest banks are with their Net Interest Margin being earned on billions and billions of dollars lent. That is unless they are poorly managed or make stupid decisions in their investment and trading divisions.

Score: Banks 2, MPLs 0

Conclusion

In just 2 areas where we compare marketplace lenders to banks, it's very clear that making money from lending money is far easier for a bank than it is for a marketplace lender. The low cost of funds, higher Net Interest Margin and their ability to strongly impact their regulatory environment all favor banks. So next time you hear a banker complain about marketplace lenders taking business from them, you can ask them if their cost of funds is so low, why don't they just make these loans themselves? After all, if they did, there would be no need for a marketplace lending industry in the first place.

 

 

About the author

Stu Stu Lustman, the author of this post, is a Credit Analyst by trade trying to bring Commercial Credit Analysis techniques to the world of Peer to Peer Lending. Check me out on Twitter, LinkedIn and Google+

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