Bypassing the Bankers

How peer-to-peer lending is changing the way consumers get loans

Matt Chase

One of the more hopeful consequences of the 2008 financial crisis has been the growth of a group of small companies dedicated to upending the status quo on Wall Street. Bearing cute, Silicon Valley–esque names such as Kabbage, Zopa, Kiva, and Prosper, these precocious upstarts are tiny by banking standards, and pose no near-term threat to behemoths like Goldman Sachs, Morgan Stanley, JPMorgan Chase, Bank of America, or Citigroup—banks that between them control much of the world’s capital flow. But there is no question that these young companies have smartly exploited the too-big-to-fail banks’ failure to cater to the credit needs of consumers and small businesses, and will likely do so more noticeably in the years ahead.

At the forefront of the group is Lending Club, a San Francisco–based company founded in 2007 by Renaud Laplanche, a serial entrepreneur and former Wall Street attorney. Laplanche, 43, grew up in a small town in France and, as a teenager, worked every day for three hours before school in his father’s grocery store. He also won two national sailing championships in France, in 1988 and 1990. Now an American citizen, he created Lending Club after being astonished at the high cost of consumer credit in the United States. Lending Club uses the Internet to match investors with individual borrowers, most of whom are looking to refinance their credit-card debt or other personal loans. The result is a sort of eHarmony for borrowers and lenders. Lending Club has facilitated more than $4 billion in loans and is the largest company performing this sort of service, by a factor of four.

The matching of individual lenders with borrowers on Lending Club’s Web site takes place anonymously (lenders can see would-be borrowers’ relevant characteristics, just not their name), but each party gets what it wants. Many borrowers can shave a few percentage points off the interest rate on the debt they refinance, and lock in the lower rate for three to five years. But that interest rate is still more than the lenders could earn on a three-year Treasury security (about 1 percent), or a typical “high yield” or “junk” bond (averaging about 5 percent). Lending Club claims that its loans have so far yielded an annual net return to lenders of about 8 percent, after fees and accounting for losses. It’s worth noting, however, that what lenders gain in yield, they lose in safety: the loans are unsecured, so if a borrower does not pay his debts—and each year, between 3 and 4 percent of Lending Club borrowers do not—the lender can do little about it except absorb the loss and move on. The average consumer loan on Lending Club is about $14,000; many lenders make several loans at once to hedge against the risk of any single loan going bad.

Lending Club’s astute initial investors, including the venture-capital firms Norwest Venture Partners, Canaan Partners, and Foundation Capital, also get what they want: no liability for the loans being made, no oversight from persnickety bank regulators (Lending Club is regulated by the Securities and Exchange Commission), none of the costs associated with the typical bank-branch network, and, best of all, a plethora of fees, collected from both the borrower and the lender, totaling about 5 percent of the loan amount, on average.

Compared with Wall Street firms, Lending Club is a flea on an elephant’s tail. In the first quarter of 2014, it helped arrange 56,557 loans totaling $791 million; JPMorgan Chase made $47 billion in what it classifies as consumer loans during the same period. But the company is growing quickly. In 2013, its revenue—the fees it charges for the loans it helps arrange—tripled, to $98 million. There is talk of an IPO later this year. In April, the company was valued at $3.75 billion—38 times its 2013 revenue and more than 520,000 times its net income—when it raised $65 million in additional equity from a new group of high-powered institutional investors, including BlackRock and T. Rowe Price. Lending Club used the cash to help it acquire Springstone Financial, which provides financing for school loans and some elective medical procedures.

The big banks charge just about all credit-card borrowers similarly usurious rates.

In other words, Lending Club is backed by quite a few smart-money players, eager to buy its equity at nosebleed valuations in return for the chance to get in on the micro-loan market—and perhaps to change the way consumers and small businesses get credit. “It’s a value proposition that really comes from the fact that we operate at a lower cost, and then pass on the cost savings to both borrowers and investors,” Laplanche told me. “We give each side a better deal than they could get elsewhere.” That’s certainly true: Lending Club doesn’t have physical branches, or several other layers of costs that weigh down traditional banks. But Lending Club also seems to exploit a market inefficiency that is really quite shocking, given the supposed sophistication of the big Wall Street firms. When it comes to interest rates, the major credit-card issuers—among them JPMorgan Chase and Citigroup—do not differentiate greatly among the many people who borrow money on their credit cards. They charge just about all of them similarly usurious rates. While a dizzying array of credit cards offer a plethora of introductory interest rates and benefits—cash back, for instance—regular interest rates on cards issued by the big players to consumers with average credit scores typically range between 13 and 23 percent. Lending Club’s business strategy, in part, is simply to differentiate more finely among borrowers, particularly those with good credit histories.

Lending Club screens loan applicants—only 10 to 20 percent of people seeking loans get approved to use the marketplace. The company then places each approved borrower into one of 35 credit categories, using many factors, including Fico score. Those with the highest credit ranking can borrow money at about 7 percent interest. As of the first quarter of 2014, the largest category of Lending Club loans charged borrowers an interest rate of about 13 percent, well below the rate charged by the typical credit-card company, which in early June was almost 16 percent.

It’s quite possible, of course, that Lending Club is merely mispricing the credit risk posed by these small borrowers. After all, Lending Club isn’t making the loans; it bears no liability if, say, default rates rise when another recession hits. So far, however, Lending Club’s loan-default rates appear no worse than the industry average.

Another possibility is that the six largest credit-card issuers in the United States—Chase, Bank of America, American Express, Citigroup, CapitalOne, and Discover—which together control about two-thirds of the domestic consumer-credit-card market, have been acting like a cartel, keeping lending rates higher than they would be in a truly competitive market, and reaping huge profits. In the first quarter of 2014, Chase’s credit-card business—which also includes auto loans and merchant services—had a net income of $1.1 billion and a profit margin of nearly 25 percent. Few businesses on Wall Street provide the same level of consistent profitability as does the consumer-credit-card business. If a few crumbs fall off the table to the likes of Lending Club or Prosper, so be it.

Renaud Laplanche is a firm believer in transparency, and Lending Club’s Web site and public filings are filled with statistics about borrowers. In contrast to the practice of the big banks, the company makes details about each loan available publicly. It recently announced a partnership with San Francisco–based Union Bank, which has $107 billion in assets, to offer the bank’s customers access to its borrowing marketplace.

At a conference in May in San Francisco, where more than 900 peer-to-peer-banking enthusiasts gathered to hear about the latest trends in the industry, Charles Moldow, a general partner at Foundation Capital—one of Lending Club’s largest investors—reportedly created a stir when he discussed a white paper titled “A Trillion Dollar Market by the People, for the People.” In his talk, Moldow spoke about how marketplace lending would change banking in much the same way Amazon has changed retail. He went on to cite Bill Gates’s observation two decades ago that banking is necessary, but bricks-and-mortar banks are not. “Marketplace lending is now poised to demonstrate how accurate that observation was,” Moldow concluded.

That’s probably too exuberant. Whether or not bank branches themselves are necessary, applying for individual peer-to-peer loans will always be more of a hassle than swiping a piece of plastic: inertia is a powerful force. And as his company’s alliance with Union Bank demonstrates, Laplanche is not hell-bent on blowing up the old banking model: he wants to work with established banks. To that end, he has invited onto Lending Club’s board of directors John Mack, the former CEO of Morgan Stanley and a stalwart of the Wall Street status quo. Larry Summers, the former Treasury secretary, is also on the board. “In order to transform the banking system, it’s useful to have people on board who have participated in building it,” Laplanche explained. “We essentially combine that experience and brainpower with more of a Silicon Valley mind-set of using technology to shake things up for the benefit of the consumer.”

One can only hope that it works out that way. For all of Big Finance’s innovation in recent decades, ordinary people haven’t seen much obvious benefit. Perhaps if Lending Club continues to win away some of the credit-card business’s best customers—those with persistent balances but solid credit ratings, for whom it is worth the effort to refinance their personal debt through the marketplace—the big banks might begin to treat borrowers more subtly and equitably. If that were to happen—and I wouldn’t hold my breath—then the cost of credit could be lowered for more people, and Wall Street could take a step toward meeting whatever obligation it feels it may have to repair its tattered relationship with Main Street.