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Online lenders put small banks in a bind

It’s cost them business but could also help them compete with bigger rivals

Want to keep up with the future investors of America? Get out your calculators. (Shutterstock)
Want to keep up with the future investors of America? Get out your calculators. (Shutterstock)

The boom in internet lending is taking a toll on traditional commercial banks, especially smaller ones, suggesting that they’re going to have to find ways to adjust to the changes wrought by financial technology.

New academic research says more than a quarter of the “peer-to-peer” dollars loaned over the internet today would’ve traditionally been handled by small commercial banks before the advent of online lenders.

The figures come from a paper presented at Federal Reserve Bank of New York’s fintech conference in March, which found 27 percent of peer-to-peer lending dollars had displaced traditional bank lending.

But there’s plenty of evidence that online lenders also help small banks, or at least have the potential to provide them tools to better compete with their larger rivals.

Peer-to-peer lenders, sometimes referred to as “P2P” or “social lending,” match people who want a steady income through lending to those who want to borrow online. They have sprung up as the internet has matured, with some companies now lending for more than a decade. San Francisco-based Lending Club, for example, said it provided $10.9 billion in loans last year, and its loan applications were up 35 percent over the year before.

The loss of lending volume to fintechs may be driving smaller banks — those with assets under $300 million — to make riskier loans more prone to delinquency and default, according to the study, which was conducted by finance professors with the University of Buffalo, Pennsylvania State University and Saginaw Valley State University.

“Lenders may lower credit standards to maintain loan volume,” the authors wrote in their nearly 70-page study. “We find evidence that personal loan quality also deteriorates among small banks with increasing peer-to-peer pressure.”

The loss of brick-and-mortar local bank branches in rural areas could prove “absolutely devastating” to some communities, said Christopher Cole, executive vice president and senior regulatory counsel at the Independent Community Bankers of America, a Washington-based industry group. He said local bankers have a superior knowledge of local economic and market conditions and can better serve the type of complex business and agricultural loans in which rural banks specialize.

Cole said the small personal consumer loans that are the focus of the study may be handled by internet-based and web app peer-to-peer lenders, but when it comes to originating and servicing relatively complicated small business and farm lending, “there is no substitute for local community bankers.”

In presenting their paper to the New York Fed fintech conference, the authors said there was an emerging tension between supporting the growth of new banking technology and maintaining access to existing banks.

“Banks with branches in counties with sparse branch density might be more distant from consumers and thus more likely to have customers poached by peer-to-peer lenders,” they said. Other research, they said, indicates the most “profitable borrowers” are the likely targets.

But research like this misses the point that fintech companies and smaller regional and community banks are “natural allies,” says Nat Hoopes, executive director of the Marketplace Lending Association, an industry group.

He said small banks are building partnerships with the online lenders that strengthen both. These agreements expand access to credit and allow customers to get their money faster without the red tape of a traditional loan. By partnering with the community bank, the customer retains a certain loyalty to the brand and will continue to do business there.

Lending Club, for example, has a partnership with BancAlliance, a network of community banks, that allows those customers access to loans that are “co-branded” with Lending Club.

The online lender said that by collaborating, smaller banks can thrive and compete with their larger rivals.

The authors of the paper, titled “Crowding Out Banks: Credit Substitution by Peer-to-Peer Lending,” noted the upside of peer-to-peer lending — the expansion of credit to those who previously might have been turned away from traditional commercial banks.

The internet provides access for those who may otherwise be isolated by geography, said professors Brian Wolfe of Buffalo University, Jess Cornaggia of Penn State, and Woongsun Yoo of Saginaw Valley State.

If small banks don’t seek out these opportunities, however, younger clientele will abandon them for services that are more nimble, Hoopes said.

Regulators are keenly aware of the challenge facing small lenders. Jelena McWilliams, who chairs the Federal Deposit Insurance Corporation, said late last year that one of the agency’s missions was to promote technological development at community banks that have limited research and development funding to support their independent efforts.

The situation is at the forefront for the Independent Community Bankers of America, which advocates on behalf of small banks.

“Today, fintech is at a tipping point,” the organization said last year in an assessment of the impact on its industry. “Companies are not simply focused on enhancing customer experiences — they want to radically change and improve the way banking services are offered in the digital economy. Community banks that wisely engage with fintech will have an opportunity to do just that.”

In the meantime, there could be emerging risks.

Small banks risk not only losing personal loan volume, but they may hold loans that are more likely to default as a result of the peer-to-peer competition. These banks substitute “stolen borrowers with lower quality borrowers,” the study’s authors said.

In addition to the New York Fed, they gave the study to the FDIC, the Securities and Exchange Commission, and the North American Securities Administrators Association, an organization of state securities regulators.

Moving forward, the peer-to-peer model is popular enough that larger banks are getting into the act. The authors note that big commercial banks have started to enter the business previously occupied by LendingClub and another large peer-to-peer lender named Prosper.

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