Running a bank might pay well but it comes with its fair share of headaches. There’s the constant speculation about a housing bubble. Growth in the economy is lacklustre at best. And higher capital requirements have taken a bite out of Aussie banks’ world beating return on equity.
There’s also the constant need for funding to worry about. Local depositors — mums and dads — make up a large chunk of Australian banks’ funding. Despite this, there will always be the need to source the remainder elsewhere, usually offshore.
That raises another headache. Any tightening of international credit markets will bump up the cost of borrowing, flowing through to mortgage rates as banks attempt to pass on the cost to borrowers.
These are just a few of the issues that are part and parcel of running a financial institution. While they are not always easily managed, they are something banks are familiar with and should be able to quantify.
Something all CEOs fear, though — including those running our largest banks — is something unforeseen taking a big chunk out of their business. Like a new style of lending that could cut out the middleman. Or, in other words, take the banks out of the loop.
You’ll often hear the word ‘disruptor’ used to describe a new entrant turning an existing industry completely on its head. In business terms, it refers to something that completely upheaves an existing model, replacing it with something new. Think Uber and its impact on the taxi industry.
In finance, one of these disruptors is ‘peer to peer’ (P2P) lending. Peer to peer lending is an online service that matches borrowers and lenders directly, without the need to go through a bank. For matching these two together and carrying out a credit check, the P2P provider earns a fee.
By only operating online, the P2P business should run at a lower cost than the banks. Investors — those that do the actual lending to the borrowers — should earn higher returns as there is no intermediary taking in a margin. And borrowers should also benefit as they take up loans with lower interest rates than those offered by the banks.
Banks have been hugely profitable over the last couple of decades. But there’s still plenty wrong with them. Many are encumbered by expensive and dated technology. They have huge overheads, with large numbers of employees and expensive CBD buildings to run. Plus a range of branches spread across the country.
Banks have also benefitted from operating in high margin, low competition industries. Like foreign exchange, for example.
That was until a disruptor like OZ Forex came along and took a big part of their business away. What was OZ Forex’s new business model? Offering a competitive product. They cut the fat margins out of foreign exchange transactions…and clients rushed in.
Banks still enjoy exorbitant margins on things like credit cards. A ‘low rate’ card offered by one of the big four still runs with an interest rate of 13.5%. What’s more, any card with an attached rewards program is likely to charge 20%-plus, even when the official cash rate is just 2%!
However, one part of their business that is very competitive is mortgage lending. Go online or ask a mortgage broker how many products there are — you’ll find the number runs into the hundreds. While a borrower will focus mainly on the rate, the lender has much more to worry about.
There’s the risk of default with the borrower losing their job or falling behind on their repayments. Plus the risk that the value of the property could fall below the loan amount. To adequately cover these risks, the lender needs two attributes that an investor (lender) in a P2P is going to lack — size and scale.
Size gives the lender the ability to better absorb potential losses. With scale, it gives them the means to diversify their risk away from a small concentration of loans. If you think of the number of home loans held by a bank, how would an investor in a P2P achieve the same kind of diversity?
Another big part of a bank’s business is commercial lending. It’s something that requires a particular level of skill. And a lot of it is based on personal relationships, which is difficult to replicate with an online-only model.
If you were investing in a P2P, how would you assess the risk of lending to a company to buy a truck? What about buying a pub, or starting up a shop? Credit scores are one thing, but there’s more to lending than that.
That’s why peer to peer lending will become an ‘evolution’, not a disruptor. In the end, someone, or some institution, has to take on the risks associated with lending money — the very real risk that a borrower fails to repay their loan.
In good economic times, there’s less chance of borrowers falling over. And, in the P2P model, less chance of investors getting hurt.
However, it’s when the cycle turns down that you need the weight of something substantial like a bank. I’m not too sure how many individual investors will be lining up to lend if the economy takes a tumble.
Banks are already involved in P2P. But it’s not just because they fear this new model will take over. Rather, it’s another distribution point for them to lend their funds. That’s why banks are already acting as the investors (lenders) in some of the P2P start-ups. It’s another avenue to earn a margin on the funds they hold from their depositors.
If the peer to peer concept really does take off, as those in this industry firmly believe, the money will be made from those that set up P2Ps and later offload them through IPOs. And who do you think will be the buyer? The banks, of course, as they take control of yet another channel of distribution.
For The Daily Reckoning