The Death of Banking is Overrated
“Lending is a feature. It’s no longer a product.”
A coworker of mine said the above several days ago in response to the launch of PayPal’s P2P lending platform. That comment really stuck with me and shortly afterwards, I read an article that referenced the relative cost of customer acquisition between banks and alternative lending platforms. As I thought about both the article and the remark, I began to solidify an opinion I’ve been mulling over for a while—that, despite high levels excitement around fintech, and the trendy idea that the death of banking is coming soon, it’s not going to happen. That’s because banks’ most important products aren’t loans—their real products are cash and cash flow management.
Banks’ Real Products are Cash—and Cash Flow Management
We tend to think of banks in terms of the money management tools they offer: savings accounts, checking accounts, CDs, mortgage loans, credit cards and so on. Their real products, however, are cash and cash flow management. The primary offerings that banks make available to customers exist to help us manage and optimize both our day-to-day and long-term cash flows.
Cash storage products (money market, savings, and checking accounts) and cash advances (mortgage, unsecured, or business loans) are key features of any online product suite that banks offer, and in order to manage our cash (relative to our desire for other goods and services), we can pick and choose from the relative fiscal menagerie our particular institution offers, whichever option best suits us. If we want a house today but don’t have enough cash to pay for it, we get a mortgage, and we commit to forego future income in the form of interest in order to be able to purchase that house immediately. In other words, banking simplified is just cash management. A step above stuffing your money in a mattress, but essentially the same ideal.
There are many other examples of companies that provide a slew of benefits to their users to elevate their base purpose and make it seem more lofty than just a cushy bottom line. By figuring out their underlying motive, you can better understand their endgame and how they intend to get there. When Amazon launched, many people assumed it was just a more convenient way to shop, although that is helpful. You can order something random like a hard drive off of Amazon in the morning and have it show up at your door later that afternoon. I’ve done it and it’s awesome. However, the true factor behind Amazon’s success was developing the infrastructure that allows them to quickly move goods around the world and then deliver them, which has changed accessibility and international availability forever.
As a result, in 2014 Amazon purchased a 25% stake in the French parcel delivery business Colis Privé and is now buying the rest of the company. In 2014 Amazon also bought a 4.2% stake in Yodel, a UK shipping service. Why did they do that? Because Amazon isn’t really about selling books, it’s about buying access to clients, logistics and infrastructure.
Everyone knows Amazon, but they may not know Mary’s Pret-a-Porter Dress Boutique in Topeka. It doesn’t matter. Mary’s business can get access to clients by selling on Amazon. She doesn’t have to spend a lot of cash marketing to a broad range of clients, setting up an online store, or even determining the cheapest, fastest way to get products to the buyer. Amazon handles that. Amazon has taken the expanse between online retailer and purchaser and shortened it to a single ‘buy it with one click’ button.
Likewise, Netflix isn’t really about making it easier to rent movies online. It’s really a new cable channel, with proprietary shows and movies delivered in a unique way to customers; anticipating and then dominating the shift of viewers from TVs to computers by capturing the best content already available and moving quickly to make as much of their own as possible. Similarly, Facebook pretends to be about “connecting people,” but their main business is selling access to you and your data to advertisers. If you don't have to pay for it, you are the product being sold.
Back to Fintech
There’s been a lot of airspace given to peer-to-peer or marketplace lenders such as LendingTree, LendingClub, and OnDeck, with some speculation about them taking over and replacing banks. But if you think about the relative size of J.P. Morgan’s balance sheet compared to those of all peer-to-peer lenders, you’ll realize that peer-to-peer lending amounts to a cup of water being thrown into the ocean. When these types of lenders get big enough to become competitive, a bank will just them and plug it into their already existing suite of products and tools for their customers.
That’s exactly what happened on the wealth management front. Companies like Betterment and Wealthfront touted their innovative algorithms for investment, and then Morgan Stanley decided to get into the game. They had longtime staff and experienced brokers, they could afford to charge lower fees, and people were already familiar with the brand and confident in their ability to recover if something went wrong. They’re not some new internet startup that could disappear—along with investors’ money—with no recourse. Even though Betterment and Wealthfront may have had a head start on wealth management innovation, they were running on foot while Morgan Stanley was driving.
In addition, marketplace lenders may have lower expenses, but those savings mostly come from loan processing and servicing. A bank could easily buy a marketplace lender and apply its technology to their process and shrink, if not eliminate, the cost advantage marketplace lenders have, as a result of either of big bankings’ two big advantages: the lower cost to acquire new borrowers and a lower cost of capital. Because banks provide a plethora of cash management services already used by borrowers and other potential clients, for them a loan is a cross-sale, not a new sale.
Banks Hold the Customer Acquisition Advantage
It’s important to remember that a company’s ability to find a client, keep that client, and keep making money off of that client over time is an expensive endeavor, especially as the company scales. It’s easy to catch a small, underserved niche market, such as how LendingClub was able to zero in on people with great credit scores who were being charged 15% and should be charged 6-9%, but that’s an extremely limited subset. You can only grow so big if you lend to those people before suddenly, you’re competing with banks for the same clients.
The graph below shows how peer-to-peer lenders spend more money to acquire their clients, winning them over with innovative tech and the promise of fundamentally different approaches to wealth management. However, all banks have to do is play the waiting game. The new players’ technology is often cutting-edge, so banks will wait for these startups to prove the functionality of their products, then acquire a company and integrate the technology—and suddenly, loan servicing and processing costs will be cheaper for the established bank. This will bring the bank’s operating expenses well below that of your average fintech company because maintenance is always cheaper than invention. Also, that way, the bank avoids getting screwed by investing early in unproven technology that doesn’t end up working (it’s easy to sue a big bank).
In addition, a bank’s cost of capital is lower than that of most marketplace lenders. A recent example from OnDeck showed the relative cost of capital: Banks’ funding is 3%, and a company like OnDeck might be at 6% if they get it through a structured security, double what the big bank is being charged. It’s always better to be a bank, which is why we’ve begun to see marketplace lenders starting to apply for bank charters rather than banks eagerly moving towards alternative banking concepts.
For example, SoFi applied for a banking charter in 2016 but withdrew the application in October 2017, as a result of controversy surrounding their CEO. In the fall of 2017, Square Capital applied for a bank charter, which would allow companies to deposit funds into Square’s bank and enable Square to make loans using cash from those deposits. Square’s loan offers were based on their clients’ transaction volume data, and its new partnerships were designed to allow the company to continue using specific financial data to inform its underwriting decisions as well as keep customer acquisition costs down (On a random note, apparently a lot of underwriters are using people’s astrological signs in underwriting, as it’s part of TransUnion’s TLO data. Who knew?).
On January 8, IEG Holdings announced a tender offer for about 4.99% of LendingClub’s stock, noting the flaws in LendingClub’s business model and explaining that it would remedy them by becoming a balance sheet lender. They argued that if LendingClub stopped originating loans, the majority of its income would dry up immediately. In addition, LendingClub doesn't hold individual state lending licenses and instead utilizes the services of a Utah-based bank, inviting regulatory scrutiny which can cut into profit. How can we worry that banking as we know it will die when they very institutions we fear will kill it off rely on them for their survival? It’s like trying to invent an electric car but insisting it still must require gasoline to run.
Sure, we can hold onto lofty and idealized hopes that its better to be a company that starts from scratch in terms of technology, integrates everything, and then applies for a banking license, but the bank is not dead, and most of these companies won’t execute like SoFi is doing (and let’s hope none of them copy SoFi’s scandal-ridden management team’s behavior, or they’ll get sued out of existence). There’s just not enough innovation; just copying and specializing.
For the average user, lending is only a small piece of the puzzle in cash management. Until marketplace lenders can offer a full suite of cash management solutions (features) and truly lure customers away from their banks with well-known brands, banks are likely to maintain their cost advantage in customer acquisition and retention. Those banks that adopt operational procedures that lower processing servicing and collections costs will survive and continue to thrive, even with the looming threat of marketplace lenders. Think of marketplace lenders less like the invention of the car replacing the horse and more like the kindle living alongside, and within, the publishing industry.