One of the less predictable consequences of the financial crisis has been the growth of alternative finance providers, particularly online platforms. These services have become more popular in part because of the regulatory constraints imposed upon mainstream financial providers in the aftermath of the crash, but also as a result of a perfect storm of low interest rates and technological and social change.
Before 2008, the term ‘alternative finance’ usually referred to one of two things: in developing countries as an alternative to existing financial systems that were not functioning properly; or, mostly in Europe and the US (although emerging economies have seen enormous growth), it referred to shadow banking – lending by, for example, insurance companies or investment funds to corporate entities.
However, new online platforms – crowdfunding, peer-to-peer lending and invoice trading (where businesses sell their accounts receivable invoices at a discount to individual or institutional investors) – have transformed the definition of alternative finance, and the sector has prospered in developed countries in recent years, outside mainstream banking and capital markets. And, far from being a passing trend associated with favourable but temporary conditions, it now seems more and more likely that alternative finance will go on to alter the shape of the global financial sector and the business world.
That can only mean good news for SMEs, since arguably the most significant role played by alternative finance is as a supplier of working capital to small businesses.
New sources of finance for SMEs
The best online alternative finance platforms have access to new technology and to multiple data sources that enable them to operate more efficiently than most incumbent banks in some respects, such as assessing and underwriting loans to SMEs. For the borrower, this translates into a much faster application process and quicker access to capital than is usually associated with a conventional bank loan.
“The overriding advantage is speed,” says Natasha Jones, a spokesperson for Funding Circle, established five years ago and now one of the largest alternative finance platforms. “Businesses can make an application online in under ten minutes. Half of applications happen outside working hours – compare that to booking a meeting with the bank manager. They then get a decision in two days and may have the funds in a week.”
Funding Circle is a marketplace-lending platform where businesses can source funds from 40,000 peer-to-peer lenders – or from other sources, including the UK government, via the British Business Bank. Other investors include the University of Huddersfield (which puts any interest it earns from loans into its Entrepreneurship Scholarship programme) and 12 local councils, some using treasury funds to lend to any business, while others use economic development pots to support local companies. More than £650m has been lent through the site, with some 8,000 businesses taking out around 10,000 loans.
But a growing number of companies and institutions from the mainstream financial sector are now lending or investing via the platform, and Funding Circle anticipates pension funds doing so in future. The more that happens, the more the distinction between alternative and mainstream finance will blur.
The benefits of data
“We believe there is a structural change underway, driven by technology,” says Robert Wardrop, Executive Director of the Cambridge Centre for Alternative Finance (CCAF). “Ultimately these technologies enable disintermediation, but it’s not as simple as new players having lower barriers to entry.”
He believes profound change is being driven by social media, advances in analytics and the fact that at least part of so many of our social lives is now conducted online. “The first outcome of this shift is huge amounts of data being produced,” he explains. “The analytic capabilities are able to connect the dots in respect of the data that one individual is producing, in social media and online decision-making.” This is why alternative finance platforms can model credit risks and underwrite loans far more swiftly and efficiently than can most banks, which are restricted both by regulatory controls and by the limitations of legacy technology.
The other side of the story is the growing popularity of alternative finance as a vehicle for investment. “Alternative finance models, such as peer-to-peer lending, are popular because of their relatively low risk profile, and they can offer steady returns akin to a fixed income asset class,” says Bryan Zhang, Director of Operations and Policy at the CCAF.
Although low interest rates may have helped make these investments look more attractive, the efficiency of alternative financing processes is also playing an important role, he asserts. “Savers are chasing the yield, but if you think about why these platforms are competitive, it is because of their underlying cost structure and innovations in credit risk modeling and customer services. They don’t have physical branches and many platforms have better, more efficient technology to evaluate credit-worthiness and control risk. Even with moderate increases in interest rates, borrowers and lenders can still be better off in the peer-to-peer lending marketplace with attractive rates, more flexible terms and speedy services.”
A growing market
In February the CCAF, along with professional services organisation EY, published a benchmarking study of the sector in Europe called Moving Mainstream, which showed that alternative finance in Europe grew by 144 per cent in 2013/2014 (from €1.2bn to €2.9bn). The report revealed that the UK has the largest alternative finance sector in Europe at present, worth €2.3bn (£1.8bn) by the end of 2014, compared to €154m in France and €140m in Germany. By the end of 2015, if current growth rates continue, the collective European market should grow beyond €7bn.
But why is alternative finance developing differently across countries? Cultural differences may be a factor, suggests Raghavendra Rau, Sir Evelyn de Rothschild Professor of Finance. “The UK and the US lie in the forefront of shareholder-dominated societies,” he says. “In Germany and France, the equity culture is just not there. If you take any investment risk, it’s likely to be in the form of bonds or debt, which are lower risk.”
Local regulatory conditions also have an impact: in France every loan contract has to be written on paper; while in Germany peer to peer lenders have to have a banking license. In the US there is a need for peer-to-peer lenders to seek approval state by state.
In the UK, Funding Circle’s Natasha Jones says her company anticipates increased regulation – but it has already worked closely with the government and regulator the Financial Conduct Authority (FCA) to help shape existing regulation applying to alternative finance, “to boost our credibility”.
Zhang points out that the FCA has just completed a review of current UK regulation of this sector. “So far regulation has been largely perceived as proportionate by the industry,” he says. “The general sentiment is that the new regulatory regime has been designed to strike a balance between investor protections while encouraging sector growth.”
The financial empires strike back
However, the landscape of alternative finance may be altered by increasing involvement from mainstream financial companies and institutions. “Institutional investors, including the banks, are entering this space by lending or investing through the platforms or by taking a stake in platforms themselves,” says Zhang. “With an influx of institutional capital, the upside is more liquidity for origination and deal flow. The concern, however, is whether or not institutional finance will crowd out or disadvantage smaller investors by gaining privileged access or suppressing yields.”
Meanwhile, working partnerships between alternative and mainstream financial players are also being established. UK challenger bank Metro Bank now lends to some customers via Zopa. Both Santander and Royal Bank of Scotland have agreed partnerships with Funding Circle whereby the banks will refer some SME borrowers that do not meet their lending criteria to Funding Circle instead.
Even if mainstream financial companies do find a way to profit from these new forms of financial provision, they are still threatened by them to some extent. Research from Goldman Sachs suggests that more than seven per cent of US banking profits (about $11bn out of $150bn) may leave the banking sector within the next five years as a direct result of disintermediation from the alternative finance sector, including shadow banking.
“There’s going to be a battle for intermediation between banks, the stronger and larger platforms and large institutional investors,” says Wardrop. “Ultimately, finance will be provisioned in a different way. Some banks will transition well to the digitisation of finance. Some will not.”
But a more competitive market providing finance to business should be good news for many small businesses. “Competition was desperately needed,” says Jones. “We’re trying to build an infrastructure where any investor can lend to small businesses. We now have tens of thousands of lenders and that will protect SMEs against the next shock.”