Chris Skinner: Beware the mice of fintech

I’m often asked whether banks should be afraid of the threat of fintech. My answer is that most fintech is enhancing what banks do, rather than threatening their core business. I sum this up as “wrappers, replacers and reformers.”

I believe that the only fintech firms banks should really fear are those that replace core bank services, such as saving, investing, and borrowing. These are the fintech start-ups offering robo-advice and peer-to-peer lending.

Now, already I can see some banks enjoying some schadenfreude as they see Lending Club trip up and Prosper stumble. But there is more to the picture than recent events. Let’s recap what’s been going on and assess where things could go.

LendingClub’s fall from rock star status

Not long ago LendingClub was the brightest star in the rapidly-growing world of online lending. Now it’s embroiled in turmoil that is shaking confidence in the emerging industry.

A few details: Shares of LendingClub plunged after it disclosed a grand jury subpoena from the U.S. Department of Justice. The company said it has also proactively contacted the Securities and Exchange Commission. The disclosures come just days after LendingClub announced a bombshell: founder and CEO Renaud Laplanche was being forced out amid a series of governance failures, including not disclosing a personal investment.

Prosper Marketplace to cut jobs and shuffle executives

Prosper Marketplace Inc., one of the biggest upstart online consumer lenders, is cutting about 28% of its staff and shuffling executives as it aims to cope with a decline in loan volume. The San Francisco company plans to close a Utah office dedicated to making loans for medical procedures, and it is eliminating 171 jobs overall, including about 14% of its combined San Francisco and Phoenix-based workforce, said Aaron Vermut, chief executive.

Vermut said in an email that “with the recent tightening of the capital markets, we are refocusing on our core consumer loans business.” The CEO will forgo a salary this year, the company said.

The moves mark a retrenchment for a company that had been rapidly expanding as recently as last year. Prosper’s staff nearly tripled to 619 employees in 2015, and the company spent around $40 million to acquire medical-loan provider American Healthcare Lending LLC and personal-finance startup Billguard Inc.

But Prosper, like its peers which also make money by finding borrowers online and selling the loans to investors, has dialed back its ambitions in response to softening investor sentiment. Loan buyers are concerned about falling returns on online consumer debt, while they have been tempted by higher returns on other forms of credit, such as corporate junk bonds …

The pressure of declining investor demand for loans has been felt throughout the nascent online lending industry, which reached $21 billion last year, and had been expected to nearly double this year, according to Autonomous Research. Prosper’s loan volume shrunk to $973 million for the first quarter of 2016, down 12% from $1.1 billion in the last quarter of 2015, the company said. Prosper had been expecting loan volume to double this year from 2015, but now management says that it won’t meet that target.

In addition, online business lender OnDeck Capital Inc. reported a drop-off in investor demand and lower projections for loan growth this year, causing its shares to plunge by nearly a third in value afterward. The company still grew its lending by 37%, but used its own capital to buy more loans.

Since these developments, it’s pretty much been more of the same.

What robo advisers miss for investors

Is this the end of  a budding lending industry?  Similarly we are starting to see a blip in robo-advisors as the incumbents fight back.

Robo-advisers as a trend may be peaking: The pace of new asset in-flows has remained relatively flat at start-ups Betterment and Wealthfront since the end of 2014.

Based on the latest Form ADV disclosures these firms file with regulators, the pace of asset growth at Betterment is about $150 million a month, flat versus a year ago, and growth at Wealthfront is down to $60 million a month over the last six months … and robo-advisers may need $50 billion to $80 billion in assets under management to survive.

The slowing growth implies that Betterment and Wealthfront may not even reach $10 billion in assets by 2020.

So is this an opportunity to sit back and smile complacently?  I think not.

A lesson from the elephant and the mouse

If anything, it’s more a moment where the elephant faces the mouse. Now we all know that elephants are supposed to be afraid of mice, but why? 

Maybe the old Malaysian story of the mouse and the elephant has something to tell us.

In the Malay Archipelago, one of the fables of “Sang Kancil” tells of a meeting among all animals to choose a king from among them.

The elephant, deer, tiger, and mouse offered themselves to be elected and it was decided that they should have a series of contests between them to decide the matter.

After the deer and tiger are eliminated, the mouse and the elephant compete in a duel. The mouse tried to beat and bite at the elephant but the elephant’s hide was thick. Because the elephant thought he was strong, he just laughed at the mouse.

The mouse grew angry and finally climbed into the elephant’s ear. The elephant, becoming afraid, stomped his feet. The mouse then became afraid and bit the elephant’s eardrum as hard as he could. The elephant was in great pain and ran around and hit all the tree trunks.

Finally, the elephant admitted defeat and the mouse was declared king.

In other words, banks should be wary of fintech. I don’t think it’s being afraid, but it’s being aware. That is the key. The nascent industries of replacement services for wealth management and lending are the new mice of finance, and they definitely want to attack core bank services.

“We wanted to take the technology institutions are using and make that available to retail investors,” Jon Stein, co-founder and CEO of Betterment, has been quoted as saying. “We think it’s harder for retail investors to compete in the market—if you’re a retail investor the game is rigged against you.” 

Robinhood, an app for stock trading without commissions, is also about taking down the big brokers, having grown out of the discontent for the financial services industry in general, as characterized by the Occupy Wall Street demographic. 

What does future look like?

The thing is that, for all their hype, can such organizations really achieve these ambitions?

While the rise of fintech firms highlights the shift to digital in financial services, banks will retain a place at the center of the industry and continue to work both alongside and in competition with new entrants, said Moody’s Investors Service.

Estimates for the number of fintech-related startups range as high as 4,000 companies, globally, with total estimated venture capital investment rising from about $2.4 billion in 2011 to more than $19 billion in 2015. Along with the high growth rate of investment, the sector has shown signs of maturation—with later stage investments accounting for a rising share of the total and the number of “exits” via acquisitions and (a still small number of) IPOs also increasing.

In a new report, Moody’s said it anticipates an evolutionary path for banks, as the traditional players take advantage of new technologies and approaches to improve the consumer experience in order to maintain competitiveness.

While the millennial cohort—who are typically more open to, and often expect, technology-enabled services and interfaces—are behind much of the impetus for fintech’s rise, Moody’s analysts said it will likely be a few years before this large group predominates in terms of consumption of financial services.

“Millennials lag prior generations along a number of indicators important to financial services firms, including lower household formation and home buying rates, higher student loan burdens, lower earnings, and higher debt-to-income ratios,” said Robard Williams, senior vice-president at Moody’s. “Banks will certainly need to transform to appeal to this generation and counter fintechs’ rise, but many incumbents have made significant steps towards implementing their own digital strategies and they have some time before the full transformation is complete.”

The ratings agency noted in its report that much of the focus of fintechs has been on retail banking services, largely lending and financing along with payments-related products and services. While the new entrants have shown growth in these areas—in some cases filling space vacated by the banks due to post-crisis regulation—Moody’s said banks have a number of competitive advantages that place them in good stead as the industry evolves, including large customer bases, deep client relationships, long lending histories, and experience navigating regulatory bodies.

“For banks, being traditional players in the space remains a significant competitive advantage, but it also means they have the resources to build internally or acquire to establish a presence on new platforms,” said Williams.

Though a major competitive reversal for banks is unlikely, Moody’s noted that several forces could shift the scales or accelerate the transformation of the industry. These include greater movement toward open data; a more defined regulatory stance that would crystalize, and perhaps change, the rules of engagement; the introduction of a “killer app”; or the entrance of one or more bigger technology companies into the fintech space.

This guest blog originally appeared on Chris Skinner’s own blog, The Finanser.

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Read a recent Banking Exchange magazine interview with Skinner: “Chris Skinner: Provocative without the rant”