Market credibility and an emphasis on better transparency will be two key factors for marketplace lending in 2017.
2017 will be a pivotal year for the marketplace lending (MPL) space as the market will seek stabilization in both confidence and venture funding, following a challenging 2016, but also as leading companies look to establish themselves as mainstay providers of consumer credit. According to PricewaterhouseCoopers’ DeNovo team, the main issues facing the MPL industry in 2017 include:
- ) an emphasis on improved transparency;
- ) next steps following regulatory changes;
- ) expansion to ancillary asset classes; and
- ) the potential impact from tax policy changes.
Ultimately, 2017 may prove to be the year which decides whether the MPL space is sustainable in its current form, or whether companies will need to alter their respective business models.
Transparency initiatives should accelerate in an effort to repair market confidence.
Transparency remains the single largest input affecting the overall health and sustainability of marketplace lenders. Additional loan disclosure and an improved process and/or economics on loan collection would likely provide stability and reinvigorate investor confidence in the marketplace lending space. There are many methods these platforms could employ, such as industry standardization and further diversification of funding sources. However, if platforms could initiate the process with 1) a full, transparent due-diligence process on every loan, which will indicate the ability to pay, and 2) have an enhanced process for loan collection, which is a response to the willingness to pay, they may be better able to retain and attract a larger investor base. Other loan level disclosure including appropriate verification steps and predictable defaults can also help enhance trust in the market.
The industry is still recovering from several notable 2016 events that have placed doubt on transparency and control; and eroded confidence in the market. In addition to the well-publicized events at Lending Club, select other MPL-bank partnerships have been terminated or strained; some directly tied to an incomplete picture of loan-level disclosure and hence the securitizations subsequently sold to investors. The general perception that disclosures were lacking across the industry became more of a concern when default rates started to increase in late 2015 / early 2106. The combined result has been a lack of market confidence and thus funding for lenders due to the incomplete risk/reward profile.
Signs of market stabilization are evident with several recent wholesale bond sales and new credit facilities. Although originations have declined for three consecutive quarters, year-to-date (through September 2016) originations of $7.8 billion are nearly equivalent to the $8.2 billion for the first nine months of 2015, according to Orchard Platform. Further encouraging data is the growth in securitizations, with year-to-date issuance of $5.4 billion up from $3.0 billion for the equivalent period in 2015.
Companies such as the Blackmoon Financial, Global Debt Registry, and Orchard Platform are working to alleviate the lack of transparency in the space. These services aim to provide loan level data and real-time data exchange between prospective investors and lenders, primarily through analytical tools that help investors make better decisions with more information on marketplace lending portfolio investments.
Next steps rest with the industry as the regulatory picture comes together.
The two key takeaways from recent global regulatory announcements are 1) the lending industry has changed with validation of the MPL model; and 2) the uncertain regulatory path for MPLs is over. The onus is now on marketplace lenders to take the next steps which could play a critical role in becoming a mainstay provider of credit.
Regulators in the United States including the Consumer Financial Protection Bureau (CFPB), the Federal Trade Commission (FTC), Office of the Comptroller of the Currency (OCC), and the United States Department of Treasury (Treasury); and the Federal Conduct Authority (FCA) in the United Kingdom have increasingly provided guidance to non-bank FinTechs. Because regulation is often reactive, the fact that these organizations are now involved is a clear signal that the lending industry has changed—and validation of the marketplace model should be the takeaway.
Marketplace lenders arguably have the greatest potential to impact the incumbent financial services industry; but could also see the largest impact from a higher level of regulatory scrutiny. The finalization of a framework for regulating FinTech and marketplace lending in the United States will occur in 2017, although actual policy enforcement may occur in 2018 or beyond. After years of ambiguity surrounding how MPLs might be regulated, 2017 should usher in granular detail on the newfound scrutiny.
The proposed rule outlines will likely be released around the official establishment of the OCC’s Office of Innovation, which is expected to be fully operational by the end of the first quarter of 2017. The approach will most likely involve a regulatory mandate to provide MPLs and other non-bank market participants the option to pursue a special purpose national charter. This would provide enforceable capital requirements (likely based on a risk-based capital approach), an outline of actionable enforcement items regulators could pursue with a focus on existing consumer protection laws, the requirement for strategic planning in tandem with appropriate regulatory entities, and a clear path to receivership should a non-bank, special purpose entity fail. This regulatory framework has the potential to validate the MPL model and further restore confidence (both on the institutional and consumer side) in the space.
In addition to non-bank optionality in pursuing special purpose charters, 2017 could mark the transition of a major marketplace lender to a traditional banking structure. The benefits of lower cost deposit funding and the potential need to increase balance sheet lending options could entice an established MPL to pursue a traditional bank structure. Given the increasing regulatory scrutiny for the space in aggregate, the incremental compliance to take on deposit activities will not be as large a gap.
Expansion into ancillary secured asset classes and refinancing.
A majority of marketplace, peer-to-peer and non-bank lenders have focused on unsecured credit. There was a need for this type of credit given the pullback by traditional lenders from unsecured consumer lending following the financial crisis. And the opportunity is immense with total outstanding consumer credit in the U.S. of $3.7 trillion as of September 2016, according to the Board of Governors of the Federal Reserve System.
Expansion by MPLs to ancillary asset classes has seen several recent false starts with the retreat mostly tied to the overall market disruption. Select companies, such as LendingClub and Avant, have reinitiated the efforts into areas such as auto loan refinancing, which allows customers to seek better rates on existing liens from other institutions. According to Lending Club, approximately 80% of the $1 trillion auto loan market which originates from dealer showrooms, and is likely have a dealer markup of between 1-3%, provides an immediately addressable market of roughly $280 billion.
The attractiveness of secured lending relative to the unsecured consumer-focused model marketplace lenders have pursued so far is clear. Both LendingClub and Prosper have disclosed they have previously sold charge-offs for 0 to 1 cent on the dollar. These rates can increase with servicing improvements however, recovery rates remain well below those possible on secured loan types such as mortgage and auto.
The success of marketplace lenders and their ability to successfully refinance and/or underwrite auto loans and other secured asset classes that have seen high levels of competition in recent years remains unclear. However, the refinance market does posit a niche approach that differentiates it from banks and could improve consumer experiences in the space.
The impact of potential tax reform could further entice investors.
An item that DeNovo views as more of a wildcard given the still uncertain outcome is the potential lower tax rate applied to investment income; which could be a potential catalyst for investor demand.
Congress may pursue Speaker Ryan’s “Better Way” plan as an initial framework for tax reform which would drastically reduce the maximum investment income tax to 16.5% from 43.4% (investment income is currently taxed at a minimum of 10% and a maximum of 39.6% with a 3.8% surcharge imposed on individuals that exceed certain income thresholds.)
This could significantly improve net yields to investors, improving the risk/reward profile of loan pools given the higher levels of defaults that the industry has experienced. Although it remains unclear what a draft tax reform bill would look like in its final form and its ability to pass, it is likely an area to watch when considering investor appetite in the coming year.
Thomas LeTrent is the banking industry specialist for DeNovo, a next-generation research platform focused on fintech innovation. DeNovo is published by PwC under Strategy&, the strategy consulting business at PwC.
Aaron Schwartz is the head of research for DeNovo. He is a director with PwC US. He was previously an equity research analyst covering technology at Macquarie, Jefferies, and JP Morgan. Aaron has authored multiple widely followed thematic publications and has appeared on CNBC.
DeNovo is a platform to aid in understanding how disruption affects business strategy and what actions to take