American Banker recently held their second annual Marketplace Lending and Investing Conference at the midtown Hilton in New York City. According to the event organizers, attendance was double from last year. The explosive growth in this sector along with heavily publicized IPOs in this space invited the inevitable question of regulation. Up to this point, marketplace lenders have been fairly unfettered by the restrictive lending constraints placed on traditional banks in the United States.
Basel and Dodd-Frank regulations have placed heavy underwriting and capitalization requirements on U.S. financial institutions, and for good reason. If nothing else, the financial crisis offered a significant wake-up call to the industry and the general public, to say the least. Marketplace lenders rushed to fill the gaps in consumer and business lending. Several of the early adopters in this arena have experienced enormous success, leaving many to ponder when (not if) regulations will follow.
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How Did We Get Here
When the financial markets collapsed in 2008 and 2009 the U.S. government responded by pushing a historic level of liquidity through the system. Several measures were employed to stave off a global economic meltdown. The Troubled Asset Relief Fund (TARP) was a coordinated effort to assist the largest financial institutions work a massive amount of toxic liabilities off their balance sheets. The American Recovery and Reinvestment Act of 2009 (better known as the Stimulus) was designed to inject nearly $800 billion into the struggling economy, most of it in short-term consumer assistance, such as extended unemployment, as well as funding to various states in budgetary crisis. The Stimulus also engineered longer-term infrastructure spending into projects the government deemed “shovel-ready.”
The effects and efficacy of these liquidity measures will likely be debated for years to come, though most economists appear to agree that without these emergency measures, the crisis could have been demonstrably worse.
Simultaneously, the Federal Reserve had a few tricks of its own. On the liquidity front, the Fed—under then-Chairman Ben Bernanke—established a program termed “Quantitative Easing.” In banking parlance this essentially meant printing money. This was done in a coordinated rate-suppression effort to encourage large-scale investment on the part of financial institutions and corporate America. The government’s strategy was to ensure that the investment banks were encouraged to put cheap capital to work.
One positive outcome was that many of the larger at-risk institutions were able to do just that, though it’s also debatable how far down the economic chain these benefits reached. By accessing federal funds at nearly no cost, banks were able to participate in a riskless arbitrage of sorts, whereby funds borrowed from the government at almost no cost could be invested into government-backed securities at a small, but guaranteed profit. This not only gave the banks the liquidity to maneuver through the crisis, it gave them the time they needed to purge non-performing investments from their balance sheets.
Main Street: Forgotten
While the above measures were no doubt favorable to the banking and investment community, one significant piece of the American puzzle remained stubbornly empty. Because of the capitalization, stress-testing and underwriting requirements, banks were forced to pull back on small business lending. Underwriting small businesses might seem like a fairly routine measure, but in the midst of a financial crisis, things got a little, well, messy. Personal credit scores plunged, lines of credit disappeared and credit card balances increased. So not only were businesses suffering, but the people behind them were suffering as well. Suddenly, the economic engine of the country seized, and “Main Street” was in a heap of trouble.This is where our story truly begins.
Since the collapse, large institutions weren’t the only ones deleveraging and working out their debt issues. Small business owners throughout the nation went through the painful process of downsizing, cutting deals and selling assets. They did so with more grit and fortitude than financial institutions, and, as a result, the businesses that made it through are perhaps in better shape than they were before the crisis.
Across the country, small business owners are battle-tested, and chomping at the bit to grow once again. The problem they face is that their battle scars are black marks to traditional lenders, who are perfectly willing but unable to loan money to less-than-perfect applicants. This disconnect is exactly what created the void—or opportunity—that is now inhabited by marketplace lenders.
Today, small business owners have the ability to apply for a loan in an instant. Marketplace lending took advantage of available technology to create clear, simple, and effective lending platforms that connect businesses to capital. The phenomenon is referred to as “FinTech” in financial circles, and it is real. From peer-to-peer platforms such as Prosper and Lending Club to direct lenders like OnDeck and CAN Capital, marketplace lending has exploded.
Because loan defaults are the lowest they have been in a decade, these lenders have enjoyed significant growth and success. And nothing invites government scrutiny like success. This is why regulation was on nearly everyone’s mind at the American Banker conference, and why borrowers and investors alike should be aware of developing trends.
Good News / Bad News
Let’s start with the bad news. The bad news is that currently, there isn’t much regulation in this environment.“What!?” you ask. “How could that be bad?”
That all depends on whom you talk to. You might think that marketplace lenders, the early adopters in this space, would largely be in favor of low-to-no regulation. What is surprising is that many express the opposite. This is an industry that is straddling a fine line between obscurity and scrutiny. Because it represents such a small percentage of the economy, most of the innovators in this space are writing the rules as they go. The surprising thing is that the rules are strikingly similar to existing rules.
Why? Because the rules simply make sense. There are several entrants into the market offering punishing terms that ultimately impact borrowers in a negative light. The bigger players are already on record demonstrating that they do not want this trend to continue. If success attracts scrutiny, then extortion invites it in, gives it a drink and rents it a room.
The larger innovators—Fundera, Prosper, OnDeck, Lending Club, and several others—are coalescing to help define acceptable standards and practices and ensure a higher degree of transparency. This is a positive and enlightening development, to say the least. Moreover, there is a general recognition that competition will ultimately cause rate compression, which will also benefit the borrowers in the long run.
One thing to recognize is that traditional banks, while not involved to the extent they once were, are participating, to a degree. A handful of enterprising institutions have even partnered with the larger providers to invest in loan portfolios and provide liquidity in this space, because the track record thus far has been impressive and transparent enough to placate regulators and underwriters alike.The real takeaway from the conference, however, has more to do with the need marketplace lenders are filling.
There is an awareness in Congress and the White House that Main Street got the proverbial short end of the stick during and after the financial crisis. Many of the good intentions to protect small businesses and the consumer actually became hurdles to getting the real economy back on track. Because marketplace lenders are not depository institutions potentially putting the public’s money at risk, there is no regulatory mechanism in place to govern the activity in this space. The activity is pure risk between a savvy investor and an individual borrower—or, in the case of peer-to-peer lending, between informed investors and individual borrowers.
That’s not to say marketplace lending is a free-for-all. It’s not. Individual states have usury laws to protect consumers, and public lenders are governed by the U.S. Securities and Exchange Commission. There is scrutiny where the largest players are concerned; what remains to be seen is what enforcement will look like.
Because marketplace lenders are scratching the itch in the American economy and it’s having a positive effect, the government is taking a wait-and-wait-some-more attitude toward regulation. And because no mechanism exists to govern this space, it would take years to invent appropriate regulatory practices.
In the meantime, expect marketplace lending to continue growing exponentially, and hopefully, Main Street along with it.