How regulation led to disruptive innovation in retail banking

Since the outset of the global financial crisis, the banking industry has been subject to dramatic regulatory policy change designed to restore stability and remove volatility and systemic risk from the financial sector. This new regulation has addressed capital adequacy, liquidity, organizational structure and corporate governance. In response, traditional banks have implemented changes in their structure, strategy and business models, made significant investments in technologies and systems and fundamentally changed their governance, compliance and risk management frameworks.

It is therefore plain to see that traditional banks have been on the defensive to satisfy risk-averse regulators and have committed an enormous amount of additional resources to managing this regulatory paradigm change whilst at the same time furtively trying to optimize their balance sheets and maximize returns. And at some level it must be accepted that this new regulation has impeded innovation and growth in traditional financial services.

Clayton Christensen, a Harvard Business School professor, coined the term “disruptive innovation” in his 1997 book, The Innovator’s Dilemma, to describe innovation that disrupts an established market and displaces established market leaders. Instances of market disruption are evident in a number of industries around the globe and particularly in industries in which the incumbents are complacent and inefficient and operate using outdated processes and technologies. Netflix, Airbnb and Uber are all examples of market disrupters.

The banking industry in its present state exhibits all the hallmarks of an industry susceptible to disruption yet has been one of the business sectors most resistant to it. This is because banks remain uniquely and systematically important to the economy; they are highly regulated institutions; they largely hold a monopoly on credit issuance; they are the major repository for deposits; and they continue to control the largest payment systems. In many ways, PayPal is the exception that proves the rule: it is difficult to disrupt banks.

However, with traditional banks squarely, and some may say solely, focused on regulatory compliance, opportunities for disruption have become rife and the status quo has finally changed. In recent years a vast number of financial technology companies have started bringing much needed innovation to the market. In a letter to shareholders, JPMorgan Chase CEO Jamie Dimon has previously said, “Silicon Valley is coming. There are hundreds of start-ups with a lot of brains and money working on various alternatives to traditional banking.” Globally, more than US$25 billion of venture capital has been invested in financial technology companies over the last 5 years alone.

A new alternative to retail banking

In particular, the nascent peer-to-peer lending industry and its myriad of start-ups are now starting to disrupt the traditional consumer credit sector at its very core. This year, global peer-to-peer lending is expected to exceed US$60 billion, of which US$35 billion will take place in the United States and US$10 billion will take place in the United Kingdom. PwC has predicted global peer-to-peer lending will exceed US$1 trillion by 2025. All at the expense of traditional retail banks.

Peer-to-peer lending (sometimes referred to as “P2P” lending) is a form of unsecured consumer credit provided by unrelated individuals, or “peers,” without going through a traditional financial intermediary such as a bank or other established financial institution because borrowers are matched directly with lenders. This lending takes places online, on a P2P platform provided by a third party.

Importantly, the P2P provider doesn’t lend its own funds but it does perform valuable services to both borrowers and lenders. It sets the minimum standards that borrowers must satisfy to qualify for a loan, assesses the credit risk and sets the interest rate payable by the borrower. It then provides this information to investors (without disclosing the identity of the borrower) so that they can evaluate the risks and returns of a loan. The P2P provider also administers the loan. Revenue is generated from arranging or servicing fees but not from the spread between lending and deposit rates in a classic intermediation scenario. Those who champion P2P lending compare it to Airbnb and Uber as examples of the new “sharing economy” or “peer-to-peer marketplaces” where the intermediary is displaced and two parties deal with each other directly – in the case of P2P lending, those who want to borrow money and those who want to lend money.

The use of online platforms reduces costs by eliminating many operational expenses associated with traditional consumer bank loans, such as the cost of maintaining and staffing physical branches. These cost savings are passed along to borrowers through lower interest rates than those offered by traditional banks. Furthermore, in the current low interest rate environment, P2P lending provides investors with an alternative investment opportunity where investment returns may be significantly higher than would otherwise be available from traditional fixed income asset classes.

A key marker of success for these P2P platforms has been the innovative use of big data and advanced data analytics in credit modelling and the assessment of credit risk. This kind of data-driven lending, incorporating a wide range of behavioral data, transactional data and educational and employment information to supplement traditional credit scores has demonstrated its superiority over credit assessments based solely on credit scores and has facilitated the extension of smartly priced credit to a broader spectrum of customer than would otherwise be provided credit by traditional retail banks. Furthermore, the delivery of a customized service through a simple interface and a streamlined customer experience has won the hearts and minds of a millennial customer base whose mindset around money, banks and technology differs greatly from the previous generation.

Those championing the democratization of finance have been disappointed by one notable development in the P2P lending space: institutionalization. As much as 75 percent of the money no longer comes from the general public, but from institutional investors such as hedge funds and pension funds, particularly on the larger platforms in the United States – like Lending Club and Prosper. In response, many peer-to-peer lenders have now started to describe themselves as marketplace lenders instead and many of the original P2P investors – individuals – have found themselves marginalized. Lending Club and Prosper have each stated they are trying to balance their lender mix among individuals, institutions and fund managers. However, the P2P business model relies on scale and the fastest, and some say only way for the P2P platforms to significantly increase scale is to turn to institutions for support.

Indeed, some marketplace lenders have already partnered with banks and institutional investors to fund the loans they offer – the Santander Group now has an agreement to fund up to 25 per cent of Lending Club’s loans and JPMorgan Chase has a similar arrangement with smaller rival OnDeck. Proponents of this institutional shift argue that it is good for the industry because it means more capital for borrowers than would otherwise be available solely from individual lenders. Although this argument has some merit, opponents argue that by eliminating peer lenders the disruptive force of the platforms may only be partially realized.

p2pThe future of retail banking

As the peer-to-peer industry continues to experience strong growth and the likes of Lending Club, Prosper and the multitude of imitators that have launched in their wake continue to steal market share from the traditional retail banks, it becomes inevitable that the banks will shift from a collaborative approach to a competitive one and either build or buy their own P2P platform. Indeed, Goldman Sachs has announced plans to launch its own P2P platform sometime in 2016. If one considers the consumer credit market is worth approximately US$3 trillion in the United States alone, the competition can be expected to be fierce.

If traditional retail banks can create P2P platforms that possess the same core capabilities as the existing P2P platforms and at the same time leverage their existing expertise in loan origination, credit underwriting and loan servicing, they may be able to slow the loss of revenue and market share – albeit at lower margins.

Traditional retail banks may also have an unexpected ally in this fight: regulators. There is currently no comprehensive regulatory framework in place governing the P2P industry in either the United States or the United Kingdom where P2P lending is most concentrated. As the industry continues to experience growth, it is inevitable that there will be greater regulation from the likes of the Securities and Exchange Commission and the Financial Services Authority.

The future regulation of P2P will likely, at a minimum, require a substantially more robust compliance and risk management framework and additional compliance processes and infrastructure to be implemented by all P2P platforms. The additional operational costs driven by this regulatory change can be expected to be significant. But for traditional retail banks, this expense will be significantly less because they can once again leverage their existing expertise in regulatory compliance and draw upon their vast regulatory compliance infrastructure already in place. This may see a further erosion of the cost and competitive advantages currently enjoyed by the existing P2P platforms.

The real challenge for regulators will be to impose the appropriate controls without impeding the spectacular innovation and growth that the marketplace lending industry is experiencing. This may prove to be no easy task but if it can be achieved, consumers will ultimately benefit from more competition, more innovation, more choice of products and services, lower costs and improved customer service, and the retail banking industry will have profoundly changed.

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