Notes from the Vault
W. Scott Frame
Marketplace lending, which matches borrowers and lenders using online platforms, is a recent financial innovation that has been expanding around the world. In the United States, intermediaries such as Lending Club and Prosper act as a financing alternative to depository institutions and finance companies for consumer loans.
This Notes from the Vault describes U.S. marketplace lending and then compares it to incumbent approaches to unsecured consumer lending. Along the way, I identify some potential legal and economic issues that this emerging industry may confront in the coming years.
Marketplace lending arrangements generally work in the following way. First, borrowers apply on the platform and are subject to automated underwriting based on standard criteria (such as credit score and debt-to-income ratio) and assigned a proprietary risk rating. Second, investors elect whether to fund individual loans based on these risk ratings as well as specific borrower and loan information available to them on the platform. Marketplace lender websites provide historical performance information for loans by risk rating.
Once a match occurs between a borrower and investor(s), the loan is actually originated onto the balance sheet of a partner bank. (Both Lending Club and Prosper use WebBank, a Utah-chartered industrial bank.) The partner bank holds loans for a few days before selling them to the marketplace lender, which in turn sells them to investors. Having a partner bank allows the marketplace lender to: (1) purchase the loans without needing to obtain individual state banking/lending licenses; and (2) charge interest rates that are legal in the partner bank's state but may not be in the borrowers’ state. Notably, this second benefit of the partner bank model seems to be legally unsettled following a recent U.S. Appellate Court opinion.
After loan origination, marketplace lenders are responsible for servicing, which primarily involves maintaining accounts, processing borrower payments, and distributing funds to investors. Payments and distributions are transmitted electronically via the Automated Clearing House (ACH), with the marketplace lender maintaining segregated accounts at a depository institution. For past due loans, marketplace lenders maintain an in-house collection team for new delinquencies and contract with debt collection agencies for recovery of amounts more than 30 days past due.
Standard marketplace loans are freely prepayable three-year or five-year unsecured personal loans for amounts ranging from $1,000 to $35,000 offered to borrowers with a minimum FICO score of 640–660 who meet other credit criteria. These loans are most often used for debt refinancing and/or consolidation. More recently, online platforms have been offering small business loans, education loans, and health care finance loans with different terms and conditions.
Investment in marketplace loans generally occurs through either notes/certificates or whole-loan sales. Notes/certificates may be directly issued by the marketplace itself or through a bankruptcy-remote trust holding loans whose (postservicing) cash flows are owned by note/certificate holders. Although marketplace lending originally involved raising funds from individual investors (and hence the platforms were often referred to as being "peer-to-peer"), the bulk of financing today is provided by institutional investors. The online marketplaces themselves generally have no direct exposure to the credit risk of the loans through their platforms, as they do not typically hold the loans or otherwise retain an interest in them or guarantee their performance.
Marketplace lenders principally generate revenue from loan origination and servicing fees. Loan origination fees vary by loan risk (for example, Prosper’s origination fees range from 1 percent to 5 percent of the requested loan amount). These fees are charged by the partner bank and then transferred to the marketplace lender at the time of sale as compensation for its loan origination activities. Servicing fees vary based on investment channel: note/certificate investors pay 1 percent of each monthly payment amount received, while whole-loan purchasers pay a monthly servicing fee of around 1 percent per annum on the outstanding month-end principal balance of loans serviced.
Comparison to standard consumer lending
Much of what constitutes marketplace lending is actually not new. For many years, larger banks and finance companies have used credit registry data, credit scores, and borrower income information as inputs into credit scoring systems to estimate risk and price consumer loans. Importantly, the information technology underlying such an automated approach to underwriting is subject to significant scale economies (large fixed costs and very low marginal costs), which provides strong incentives to grow large quickly.
Marketplace lending is growing rapidly, but it remains a relatively small part of the $3.3 trillion U.S. consumer lending market. Lending Club, by far the largest marketplace lender, increased its loans outstanding from $1.8 billion to $2.8 billion during 2014. But during the same period, the online platform posted a $32 million loss. Given the very low loan volumes and lack of profitability at most marketplace lenders, it would not be surprising to see some consolidation (either among themselves or with traditional lenders) and market exit.
The original innovation with marketplace lending is the ability of liability holders to invest directly in specific assets. This was the heart of the original peer-to-peer model envisioned a decade ago. However, as institutional investors have become the dominant liability holders, marketplace lending has become much more passive and allows for the financing of large portfolios of consumer loans. In this way, online platforms have become networks that allow potential investors the ability to lend to consumers without having to incur the fixed costs associated with the origination platform.
Marketplace lender websites offer a variety of statistics about their loan performance, historical ranges of interest rates paid by borrowers, and net yields received by investors by risk class. Cleveland Fed Senior Research Economist Yuliya Demyanyk and Research Analyst Daniel Kolliner provided time-series evidence that, on average, marketplace loans perform similarly—but carry lower interest rates—than credit cards. It would be interesting to learn more about why this occurs outside of any cost differences between offering credit cards (lines of credit) versus closed-end loans. Are marketplace lenders underpricing in an effort to gain market share and achieve minimum efficient scale, or do they maintain a potentially sustainable advantage in terms of more accurate credit-scoring models, more efficient information technology systems, or more pronounced network benefits? Do the online platforms benefit from lower overhead costs by not maintaining physical bank branch networks and avoiding certain regulatory burdens (at least compared to depository institutions)? Or are marketplace lenders simply eroding excess profits earned by incumbent consumer lenders? Of course, these potential explanations are not mutually exclusive. The U.S. Treasury recently issued a Request for Information seeking a better understanding of the potential social benefits and costs of marketplace lending.
Marketplace lending represents an interesting example of how advances in information technology can potentially improve the efficiency of financial intermediation. However, the cost structure of these online platforms, coupled with their lack of profitability, suggests that some industry consolidation could occur. Moreover, as marketplace lenders become more successful, they are likely to find themselves facing increased competition from incumbent consumer lenders. We will be following developments in this area with considerable interest.
W. Scott Frame is a financial economist and senior policy adviser at the Atlanta Fed. The author thanks Larry Wall for helpful comments on the paper. The views expressed here are the author's and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. If you wish to comment on this post, please e-mail email@example.com.