Fintech consumer lenders will be forced to become banks

By David Stevenson on Thursday 28 September 2017

OpinionAlternative LendingDigital Banking

Just a few short years ago, a glorious vision descended on the frequently fevered world of finance and investment. It was best expressed by a slide at an early AltFi conference, entitled "Banks. RIP?"

As financial disruption coursed its way through the system after the global financial crisis, banks were seen as Public Enemy Number 1. Megabank CEOs must have felt like they were marked men (for they usually are... men... sadly) with the regulators toughening up on everything and upstart tech outfits eating into their profitable sidelines such as FX and payments.

As is always the case with these bold narratives, there was, of course, a huge amount of boasting and hype in this argument. From the very beginning, for instance, alternative finance platforms have been perfectly happy to work with banks where appropriate. Deals between the likes of Santander and Funding Circle or Metro Bank and Zopa (for lending) suggested a more nuanced, symbiotic model where banks would happily use rival platforms if they felt they could improve returns or offer customers an alternative product. But in recent years this line between Incumbents and Upstarts has blurred even further with fintech firms taking the leap and turning into banks in all but name.

My colleague Ryan Weeks over at, for instance, has written at length on Zopa's move into banking and the similar move by continental player Younited Credit.

You can see the Zopa article here.

The article on Younited Credit is here.

Crucially these are from isolated examples of a turn towards banking. I know anecdotally of at least half a dozen fintech movers and shakers exploring a banking license. I also wouldn't be remotely surprised if digital payment outfits such as Revolut turn into a bank in the not too distant near future.

So, given this new rapprochement, does this mean the Banking RIP thesis is dead? I would tentatively suggest it is. Banks aren't going anywhere very soon - and I think most sensible altfi businesses now need to give serious consideration to becoming a bank.

Why the sudden turn-around in fortunes for banks as a business form?

In part it's a story of regulatory success. The central banks have in fact done a fair job of tightening up the rules and they have also become much more pro-active in anticipating future risks. They've made banks a bit more boring but also more reliable. If ordinary customers seriously felt like bolting into the arms of a new financial proposition they'd have done most of the fleeing after the GFC. By and large, they didn't because banks now seem much safer. 

This has helped underline another central insight. Banks are still trusted as the primary aggregators of financial and investment products. For every 1 customer - like me - who raves about the idea of having best of breed suppliers for each of their key financial services, there's another 9 who will just pick the boring incumbent (the bank). They know the banks sell them crap, but they simply can't be bothered to properly search the market - they are just too busy on social media or watching Netflix box sets. They'll take slightly more expensive incumbency any day. 

This, in turn, allows the banks a fantastic cross-selling platform to peddle rubbish - and the occasional excellent product. This cross-selling opportunity is crucial for any fintech business largely their core product is likely to be low margin, whereas every cross-sell is incredibly lucrative in margin terms.

But I would also argue that the real driver towards adopting a banking model is much baser, and simpler understand. 

Cost of capital 

In simple terms, if you're a bank you can access a huge universe of SAVINGS capital which is off limits to more INVESTMENT proposition based fintech platforms. One hugely important example of this is the thriving trade in cash protection arbitrage. Imagine you are a wealthy depositor with hundreds of thousands of pounds in cash deposits. The existing FSCS protection only applies up to £85,000 - above that.

Imagine you are a wealthy depositor with hundreds of thousands of pounds in cash deposits which you want to keep absolutely safe. The existing FSCS protection only applies up to £85,000 - above that level, you're on the hook! But if you salt away lots of individual £85k deposits, between lots of different banks, you keep that protection. This means that even the smallest banks are destined to pick up a steady trickle of cash from larger depositors - and if they raise rates to the absolute maximum, that trickle could turn into a deluge.

In reality, precisely because banks have entrenched legal protections - and FSCS guarantees - they can get away with paying a maximum of 2% for deposits. 

By contrast, investment based propositions, where there is platform risk, struggle to get away with a cost of capital of between 3.5% to 4%. That 2% or more difference is absolutely crucial, especially as the big high street banks are driving down the cost of unsecured consumer credit (helped along in turn by wholesale funding from the Bank of England, a crucial source of capital for many lenders). Given how low margin many altfi platforms are, that 2%, in fact, might be the difference between profit and loss.

Consumers are also happy to work with this difference in margins. Bank deposits are regarded as savings products - protected. P2P platforms, by contrast, are regarded as riskier investments. Thus the 2% plus difference is in effect a mirror of the equity risk premium in stock markets. Government-backed, safe bonds (the equivalent of cash deposits) rarely ever pay out more than 2% per annum in returns. Risky equities, over the long term, by contrast, are more likely to return around 5% per annum (in real terms). That difference - the 5% less the 2% - is what's called equity risk premium i.e roughly 3% per annum. The "Alternative finance risk premium" is also probably close to 2-3% per annum, which in turn suggests that investors are relatively sanguine about the real long-term risk of volatility for lending capital.

By turning into a bank that risk premium starts to fade away. But it's also important to understand that not every alternative finance platform needs to become a bank.

This risk premium is not entirely relevant if you can, for instance, sustain a higher cost of capital - by lending to small businesses. If those borrowers can afford to pay 8 to 12% per annum, as a platform you can probably sustain an investment return of between 6 and 8% per annum. The "alternative finance risk premium" thus becomes 4 to 6% per annum. At these levels, investors are happy to take default risk because over the long term (ten years or more) they'll reap a large reward for investment volatility.

The bottom line? Any altfi or fintech platform engaged in consumer lending will, by my estimation, probably be forced to turn into a bank at some stage in the not too distant future. In my view, the risk premium argument and accompanying cost of capital will force the conversion.

And if one accepts that argument, then we might also start to believe that we're maybe at the dawn of a glorious New Age of (Digital) Banking. A financial renaissance beckons!

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Companies in this Article:

Funding Circle
Zopa Bank
Younited Credit
Bank of England

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