The linked dangers of an inverted yield curve and a slowing economy have hammered banks stocks in recent months, and profit margins are already compressing. But the banks' worries pale in comparison to challenges confronting the peer-to-peer or "marketplace" lenders — the start-ups that have set out, over the past decade or so, to upturn the banking industry.
A few years ago, start-up lenders on both sides of the Atlantic looked set to reveal that banks were little more than commodity businesses with high fixed costs.
Money is money, after all, and the peer-to-peer platforms intended to provide it at a better price by becoming an internet middleman between borrower and lender — ditching all that expensive physical and human infrastructure in the process.
But the reality has proven more complicated. One can see this by looking at the profit and loss statements of even the more-established digital lenders.
The US's Lending Club, perhaps the strongest player in the industry, originated US$3.1 billion ($4.8b) in loans in its last quarter — and yet still delivered a small net loss.
The UK's Funding Circle is considerably smaller, and the ink is redder. It gave an indication of what a slower economy might do to the industry when it cut its 2019 revenue growth forecast in half, to 20 per cent. Its shares have lost half their value since June.
These are not birth pangs. Lending Club and Funding Circle were founded 13 and nine years ago, respectively. Others, such as Prosper and Sofi, are also getting on in years, too.
A slick digital platform, as it turns out, is not enough. Lenders and borrowers need to be found — and finding them is difficult.
On the lending side, there were not enough individuals out there willing to put their money at risk in someone else's small business or credit card consolidation loan.
The industry solved this by going wholesale, selling the loans they originate to banks and asset managers, or bundling them up to be consumed by capital markets.
Year to date, US$9b in marketplace loans have been securitised and sold into markets, according to Finsight.
Hence "peer-to-peer lending" became "marketplace lending". One of the "peers" was cut largely out of the picture.
But the problem of finding borrowers remains, a difficulty reflected in high marketing costs. They eat up more than a third of revenue at Lending Club and more than 40 per cent at Funding Circle. Much of this goes to internet advertising, and, industry insiders say, to advertising on just two venues: Credit Karma and Lending Tree, where customers can compare and shop for various loan products (Lending Tree is a public company and, unlike so many marketplace lenders, it is profitable).
The core problem is that lending is a spread business. It is about maximising the difference between the cost of capital and the return on it.
Banks are likely to maintain a permanent edge in the former, given that they can take government-guaranteed deposits. And because their balance sheets are leveraged, they can accept reasonably low returns on their loans (4 per cent, say) and still make money.
Yes, banks' legacy infrastructure drags down their returns. And there are some classes of borrowers — small businesses, or individuals with spotty credit — that banks are not nimble enough to serve well.
But banks' structural advantages remain a massive barrier for the upstarts.
And the challenges will be even greater in a recession, as investors naturally shy away from riskier loans and towards the safety of insured deposits.
However, there may be a bright spot for the loan marketplaces. Those that manage to survive the next downturn, whenever it comes, may be able to consolidate the market, gaining scale and spreading their marketing costs across a larger revenue base.
And if they can prove that they can lend profitably through a recession, they should come out the other side with more investor confidence and, as such, a lower cost of capital.
And who is likely to whether a storm?
Rhydian Lewis, chief executive of the UK based platform RateSetter, believes it will be those that follow the "tortoise" model.
That means working with investors with a low cost of capital (RateSetter, unusually, have stuck with retail investors looking for an alternative to bank deposits), and avoiding yield-hungry hedge funds.
It means not reaching too hard for high returns, which will become high losses in a recession. It means sticking to niches with good borrowers, who are too hard for big banks to serve. Finally, it means not spending excessively on marketing.
All this, of course, implies slow growth: hence the tortoise. But the hares are set for a very nasty couple of years.
Written by: Robert Armstrong
© Financial Times