Deloitte just trashed the hype around a $180 billion fintech market

By Oscar William Grut for Business Insider

Deloitte just trashed the hype around the online lending industry.

The accountancy and consultancy practice has done a deep dive on the online lending industry, and its conclusions should make for devastating reading for anyone connected to the sector.

Deloitte concludes that marketplace lenders, more commonly called peer-to-peer lenders in the UK, “are unlikely to pose a threat to banks in the mass market,” according to Neil Tomlinson, Deloitte’s head of UK banking. The report concludes that the platforms “will not be significant players in terms of overall volume or share.”

This is a pretty devastating brush-off. Marketplace lenders have big ambitions — Funding Circle CEO Samir Desai told us that his company wanted to be lending $100 billion a year over its platform one day.

But the 44-page Deloitte report proceeds to ruthlessly set out why marketplace lenders hadn’t reinvented the wheel when it comes to lending, why they will struggle to grow, and why banks not only have a pricing advantage over them but could copy what they’re doing pretty quickly if they chose to.

The most basic summary of the report is that marketplace lenders can enjoy a profitable if modest existence targeting specialist, niche segments of the market where their knowledge can be a competitive advantage. But if they target more mass-market offerings, their destiny is not in their own hands. The success or failure of these platforms will be due to interest rates and banks.

A $180 billion industry

For those not up to speed, marketplace lending is where online platforms connect people who want to borrow money with people who want to lend cash at an attractive rate. Normally a bank would sit in between these two parties, taking the risk but also the bulk of the return.

Deloitte has this helpful graphic explaining how it all works:Deloitte

These types of platforms, or some variation of them, have become hugely popular in the US and Europe since the financial crisis, with big players including Prosper, Funding Circle, and Zopa. They offer great returns to investors when interest rates are at rock-bottom levels. For borrowers, like small businesses and consumers, they offered credit when other lines were drying up.

Cormac Leech, an analyst at the boutique investment bank Liberum who looks at the space, estimates that the market is worth $180 billion globally. Marketplace lending represented 0.96% of the UK consumer-lending market last year and 0.51% of business-lending market, according to Deloitte.

The conventional wisdom is that these platforms are profiting from the misfortune of banks. Hamstrung by new regulation since the financial crisis, banks are having to beef up capital requirements and as a result cut back on lending. Marketplace lending platforms are stepping in to mop up.

The marketplace model offers great returns to lenders at a time when interest rates are at historic lows and the UK stock market has been volatile or insipid. The below Deloitte graph shows that returns in the sector average about 7%.Deloitte

Marketplace lending platforms also like to shout about low default rates, innovative approaches to risk scoring, and lower operating costs compared with banks, which means a better deal for borrowers and lenders alike.

Marketplace lenders ‘do not have a sufficiently material source of competitive advantage’

Deloitte agrees that, yes, banks are having a tough time and marketplace lenders are taking advantage. Interest rates are also key to their success.

But marketplace lenders have not reinvented the wheel when it comes to costs, risk, and speed, Deloitte says. They are profiting from a macroeconomic fluke that most likely won’t last.

The report says these new platforms “do not have a sufficiently material source of competitive advantage to threaten banks’ mainstream retail and commercial lending and deposit-gathering businesses.”

Let’s look at the marketplace lenders’ apparent advantages in turn:

1. Cost: Marketplace lenders today have low operating costs and relatively low customer-acquisition costs because of the low-interest-rate environment. But Deloitte predicts that this will quickly be eroded once interest rates normalize. The report predicts an advertising “arms race” similar to what we’ve seen in the price-comparison-website industry. At the same time, banks will continue to enjoy cheap capital — they get their funds through deposits. As for operating costs, while they are low now, Deloitte thinks that when marketplace lenders’ “loan portfolios are likely to more closely resemble those of the market as a whole, MPLs will have no material source of cost advantage over banks relating to collections and recoveries.”
2. Risk: Deloitte says its research “gives us limited grounds to believe that MPLs will systematically price risk better in areas where banks have an appetite to play.” While novel new approaches to data have been taken by many platforms, such as using social-media data for small businesses to measure customer engagement, “the consensus was that this was unlikely to be the result of a systematic advantage of the MPL model; rather, it would be a specific, model-agnostic, innovation. In other words, banks could exploit the same algorithmic innovations. While default and loss rates are low in the industry, Deloitte says “the majority of UK MPLs are yet to go through a credit cycle, and it therefore remains to be seen if there will be an increase in default rates in the event of an economic downturn.”
3. Speed: Deloitte says: “Although borrowers currently value the benefits of speed and convenience offered by MPLs, these are likely to prove temporary as banks replicate successful innovation in this area. In addition, Deloitte believes that borrowers who are willing to pay a material premium to access loans quickly are in the minority.”

In short, when it comes to the mass market, marketplace lenders aren’t doing anything that the banks can’t do better. That’s not to say Deloitte doesn’t think these platforms have their strengths. The consultancy predicts that marketplace lenders will do best by servicing profitable, specialised niches. By building up specific expertise in areas like, say, asset finance or invoice financing, they can develop an advantage over the banks.

Tomlinson of Deloitte says: “In the medium term, however, MPLs are likely to find a series of profitable niches to exploit, such as borrowing which falls outside banks’ risk appetite and segments that value speed and convenience enough to pay a premium (for example SMEs, particularly in invoice financing, or high-risk retail borrowers).”

By their nature, however, niches are small. They are unlikely to sustain the rate of phenomenal growth the marketplace lending sector has seen.

Deloitte thinks the growth of the marketplace lending sector will ultimately rely on factors beyond the control of the companies: whether banks decide to compete with them and whether interest rates rise. This fairly crushing graph shows just how big an impact Deloitte thinks both of those factors will have:Deloitte

If interest rates remain at record lows and banks continue to do nothing, marketplace lenders could have 6% of the UK lending market by 2020. Deloitte forecasts a market share of less than 1%, however, if interest rates rise and banks compete. That’s pretty stark.

‘Not significant players in terms of overall volume or share’

As a result of all of the above, Deloitte concludes:

We believe that MPLs will not be significant players in terms of overall volume or share. We do not believe that marketplace lending will fundamentally disrupt or displace banks’ core function as lenders in the mass market. That is not to belittle MPLs’ undoubted achievements or the innovation they have brought to the market. But we see them as a sustaining innovation, likely to be limited to serving profitable, underserved segments that are currently overlooked by incumbent banks.

This conclusion is of course assuming interest rates do return to normal. There’s some debate as to whether low interest rates are in fact the new normal. And it also assumes at least some degree of competition from the banks, something that until now has been relatively pegged back because they have been focused on sorting out regulation and profitability. (Deloitte recommends that banks partner with online lenders in some way to take advantage of their various specialisms.)

But even still, the conclusion is a pretty sobering one if you’re in marketplace lending. Almost all of these businesses are backed by venture capitalists who invested on the assumption of growth rates continuing unfettered. These investors dream of 10 times returns, not gradual growth in niche markets.

A representative for the P2PFA, the UK industry body for marketplace lending, responded to the report in an emailed statement to Business Insider:

The growth of peer-to-peer lending in the UK has been consistently impressive, with more than £5 billion lent since 2010. This has been driven by the competitive prospectus for investors and borrowers offered by peer-to-peer lending platforms unencumbered by the legacy systems and costly infrastructure of banks, combined with excellent levels of customer service.

Many of the conclusions in the Deloitte report depend on assumptions which do not reflect the development of peer-to-peer lending to date. Peer-to-peer lending platforms have already established a permanent presence in the mainstream financial services’ sector, and the experience of the last economic downturn was favourable: not a single investor lost their capital, and platform performance was positive compared with the operation of the banking sector.

Online lenders have had a tough time since the start of the year. Lord Adair Turner, the banking regulator from 2008 to 2013, said in February that “the losses which will emerge from peer-to-peer lending over the next five to 10 years will make the bankers look like lending geniuses.”

More recently, the poster child of online lending in the US, LendingClub,has been engulfed in a scandal over disclosure and minor doctoring of loans that has led to the ousting of its CEO and founder.

First appeared at Business Insider