The Great Depression, which started in 1929, was a major cataclysmic event. While there are different theories as to what actually caused it, one key reason was a surplus of banks giving out too many loans during the “Roaring Twenties.” Flash forward to 2008, the largest economic crisis since the Great Depression. Once again, the culprit was loose credit leading to over-indebtedness, which proved catastrophic when the house pricing bubble burst at the same time that interest rates re-set for millions of subprime mortgage borrowers.
As a society, we have an innate tendency to always want more. Consumers get caught up in the good times and often borrow beyond the point of practicality, until the bubble inevitably bursts. This is the ebbing and flowing of the global economy. Legendary basketball coach Rick Pitino said it best: “Successful people lose their way at times. They often embrace and overindulge from the fruits of success. Humility halts this arrogance and self-indulging trap.”
Apparently, we have yet to take this lesson to heart. The late 2000’s saw a rapid rise of a new group of stars – the “peer to peer,” or marketplace lending platforms. The timing of this rise was serendipitous, growing out of frustration with a banking system that had led to a global credit crisis. As traditional banks tightened credit, borrowers sought alternatives, and the marketplace lenders were able to tap into this latent demand. In spite of the “Great Recession,” the appetite for loans among consumers and small businesses was stronger than ever.
The marketplace lenders soon became the darlings of Wall Street with huge valuations – it was as if nothing could stop them; some even IPO’d. However, starting earlier this year, these lenders hit turbulence, and market enthusiasm has started to wane. The LendingClub scandals, followed by a series of disappointing earnings and dramatic reductions in force across numerous other platforms, has led many to question the transparency and viability of the marketplace lending model. Unlike traditional banks, most of these organizations have no other source of revenue generation besides originating loans. “If investments falter, how will these organizations sustain themselves?” was the question many began asking.
In recent months, market favour seems to have swung back in favour of the traditional banks, and regulators have begun to swirl around the marketplace lenders. For some entrepreneurs, this is like showing garlic to a vampire – regulation is at complete odds with convenient, speedy access to capital, the marketplace lenders’ mantra. But as history has shown, regulation and intervention can be a necessary evil, protecting borrowers from their own worst enemies – themselves, and in many cases reckless financial services institutions.
For example, the Panic of 1907 led to massive bank runs across the country, which likely would have plunged the country into a depression had it not been for the intervention of J.P. Morgan, who temporarily restricted bank withdrawals. It is this intervention that is credited for avoiding a depression and ultimately leading to the creation of a market interventionist, the Fed Reserve. In fact, many believe that the lack of such an intervention was the main difference between the Panic and the Great Depression 20 years later. In 2008, government intervention in the form of bailouts was the only thing saving those banks that were “too big to fail.”
Whether we like it or not, regulations, oversights and interventional instruments are in place for a reason. In fact, we view regulation as an absolutely essential element of the marketplace lending industry’s maturation. There are certain regulations that we see as obvious:
Allow loan originators to serve only as originators – Originators should not be allowed to be originators, brokers and/or ratings companies all rolled into one, as they have been in the current marketplace lending business set-up. Combining these disciplines is a perfect recipe for a lack of transparency. Here’s why: as noted above, most marketplace lenders have no other source of revenue besides originating and selling loans. They are entirely dependent on this top-line growth, which means they have a vested interest in selling every single loan they originate on their books. They have tools to analyze and convey the risk levels of these loans, but they don’t necessarily have to disclose all the information. Marketplace lenders have an inherent conflict of interest, right from the start. In other more mature markets, like the traditional stock market, these roles are broken out.
Only licensed brokers should be able to execute trades, and only with sophisticated investors and credit-worthy borrowers. Think about it – in the traditional stock exchange model, prospective brokers need to go through an extensive, rigorous process to secure their licenses. Many begin by pursuing finance-related educations, and after that they must pass a challenging series of tests. In the United States, brokers are required to obtain several licenses, such as Series 7 and 63, before they are allowed to transact business with clients. Brokers must also satisfy Continuing Education requirements in order to demonstrate an ongoing awareness of compliance.
In the current marketplace lending model, essentially anyone working there can issue a loan to anyone. While the idea of making credit available to the underserved is noble, this “eBay for money” type of approach can quickly lead to disaster unless there are strict criteria governing the rules of engagement.
Finally, there needs to be an independent external rating system for loans and groups of loans. These organizations would be similar to the roles of Fitch, Moody’s and S&P in the traditional stock market. The ratings published by these credit rating agencies are used by investment professionals to assess the likelihood that debts will be repaid. Marketplace lending needs similar centers of expertise, offering independent views on loan quality, loan performance and individual marketplace lenders’ performance.
Marketplace lenders are taking steps on their own to improve the integrity of their business model and operations. For example, one marketplace lending platform recently set up its own hedge fund, with the express purpose of purchasing loans it originates. This kind of foresight can serve to buffer marketplace lenders in times of tight liquidity. Furthermore, while the United States Treasury currently has no direct regulatory oversight over the marketplace lenders, it recently outlined several recommendations to facilitate the safe growth of marketplace lending, including the creation of an independent private sector industry for tracking and reporting on the performance of loans and marketplace lenders overall.
The call for greater oversight and regulation may fly in the face of the entrepreneurial spirit and a current-day society that seems to value speed and convenience above all else. But regulation does not need to be a dirty word; if history shows us anything, it’s that it’s very much needed. Even with tighter controls in place, the marketplace lenders are still poised for a bright future. They have shown us that greater speed and convenience are in fact possible in the world of financial services; and in fact, the large established banks are actually incorporating these same attributes into their own business models. We believe out of the ashes marketplace lending leaders will arise, particularly when it comes to collaborating with banks to serve rapidly growing markets, like SMB lending.
Common sense oversights and regulations are, and must be, a necessary part of this equation. In the future, the most successful financial services firms are apt to be those that can apply controls while upholding the virtues of speed and convenience that current marketplace lenders have demonstrated can exist.