Also posted on LinkedIn: https://www.linkedin.com/pulse/future-lending-disrupted-become-disruptors-david-snitkof/

It is no exaggeration to say that online lenders have revolutionized lending. They achieved this by providing a better customer experience than retail banks, at lower interest rates than credit cards, at a time when credit was hard to come by for many consumers. Now that a few well-capitalized banks such as Goldman Sachs have finally started getting into the game with their own online personal loan offerings, the competition is heating up. Touting the same technology-driven customer experience introduced by online lenders but with loans funded by low-cost, federally insured deposits, these formerly ‘traditional’ lenders are taking a page straight out of the disruptors’ playbook. Using the advantage that access to low-cost capital provides, they have targeted a primary revenue source of most non-bank, online lending models, namely fees, for their own brand of disruption. How might this affect a borrower’s choice of lender in the future? Will the disrupted become the disruptors?

How Do Borrowers Choose a Lender?

The matrix above provides a useful framework for visualizing the factors that weigh in a borrower’s choice of lender. By comparing various lenders on these dimensions, it is possible to make predictions on their relative advantages and disadvantages with regards to attracting and retaining high-quality customers. On the vertical axis, we plot the value dimension, classifying factors into economic or emotional. While pricing is obviously of crucial importance to would-be customers, qualitative aspects also bear on any decision. On the horizontal axis, we plot the temporal dimension, classifying factors into short-term and long-term. For example, a customer’s business relationship with a lender can last many years, and borrowers will want to weigh factors that may impact them from the time of application to loan maturity.

Emotional Factors

In addition to purely economic interests, a borrower’s choice of lender takes into account various experiential and emotional components. At the outset of a relationship, borrowers will certainly prefer a lender who offers an efficient, pleasant, and intuitive customer experience during the loan application and origination process. For example, most small business owners would greatly prefer filling out OnDeck’s online application—connecting their accounting software to provide financial data and receiving a decision in minutes—to the process of walking into a bank branch, filling out forms, faxing hundreds of pages of financial statements, and receiving a decision in weeks. A better user experience has fueled the rapid growth of innovative online lenders over the past several years.

In addition to ease of use, customers also place importance on the overall reputation and trust level of a financial brand. People and businesses want to know that the data they provide to a lender will be well cared for, and many want to trust that the company they are conducting business with has their best interests at heart. In this regard, the comparison of newer online lenders with more-established banks is less straightforward. Banks’ reputations are still hurting from the aftermath of the Great Recession and suffer from a general perception of unpopularity with the general public. Large institutions are still working to regain their customers’ trust. In particular, customers who are digital-natives may be more likely to place their trust in a technology-focused company with a customer-friendly persona. At the same time, some customers may worry about the corporate longevity of the more recently launched online lenders and may take comfort in established banks with a long operating history and clear regulatory oversight.

Economic Factors

In a lending business, there are essentially two types of revenue for lenders: fee revenue and spread revenue. Commonly, fee revenue refers to amounts paid from borrower to lender corresponding to various situations. Across credit products, there exist front-end fees, such as application fees, origination fees, or membership fees, and there are back-end fees, such as late payment fees or over-limit fees. In practice, the manner in which lenders apply these fees varies between lenders and product types. The table below lists some typical examples, though it is by no means exhaustive. A massive variety of products exists in the wild.

There are many fees across a variety of loan products, and even within the online lending space, there is significant variation.

Spread revenue is another key mechanism by which lenders make money. This refers to the difference (“spread”) between their cost of capital and the net interest yield from borrowers. While this is a core component of traditional lending businesses, a “pure marketplace” lender who never holds assets on balance sheet and sells all loans at par would not have this revenue line. Instead of earning interest, the interest payments flow through to investors, and the originator generally takes a servicing fee. For example, LendingClub’s 2015 annual report shows net interest income as less than 1% of total net revenue for 2015, while fees represent 97% of revenue. By contrast, net interest revenue accounted for over 46% of J.P. Morgan Chase’s 2015 net revenue.

Goldman Sachs’ new foray into online, small-dollar consumer loans is funded in a highly traditional way, using low-cost, federally insured bank deposits. GS Bank, acquired from GE Capital earlier this year, offers savers interest rates from 1.05% to 1.85%, resulting in significant capital Goldman can use to lend to consumers. Given the opportunity to earn such significant spread revenue, Goldman has opted not to charge origination fees and has emphasized this in its competitive positioning.

What’s Next?

With Goldman Sachs having recently launched its long-awaited online consumer lending platform and other large banks likely to follow suit, it will be interesting to observe the interplay between these institutions and their fintech counterparts. While some imagine banking’s entrance into the space will be a sputtering failure, and others are fearful that the disrupted will become the disruptors and well-capitalized banks will put today’s online lenders out of business, the truth is likely somewhere between these two extremes.

Competition will be fierce, and there will be winners and losers, but a future where lenders are focused on building trusted brands and improving the customer experience will only benefit borrowers in the long-run. Borrowers have come to expect that the processes of applying for a loan will be conducted online regardless of whether or not they are applying at a bank or one of the new non-bank, online lenders. Taking a step back to consider the economic and emotional motivations behind why borrowers tend to choose a given lender will help organizations position themselves for success in the future.