There was a time when community banks were friendly places.
Bank employees and managers worked hard to build trust with people in the area, trying to attract depositors, as well as potential lending clients. But that was, to quote Star Wars… long ago, in a galaxy far, far away.
Today, deposits are not hard to come by. Cash seems to be everywhere. The problem is… what to do with it?
Over the last decade small banks have been phasing out small personal loans, which left them over-weighted in business loans as well as asset-backed loans. When there weren’t enough people in their area applying, and qualifying, for such loans, the banks would buy bonds.
This situation leaves small banks in a predicament. If they don’t earn solid returns on their lending and investing, then they have to make up the shortfall by paying less interest to depositors, charging higher fees on services, or a combination of the two. Neither of these approaches endears local banks in their communities, so they’ve looked far afield for a better way.
They’ve found one, but it involves taking opportunities away from retail investors.
As small banks shifted their focus away from small, uncollateralized personal loans, they also allowed their underwriting skills in this area to diminish. When other lending opportunities dried up, the banks could not, or did not want to, restart this type of lending in-house.
Looking at trends in the industry, banks found what could be a great fit — Lending Club.
I’ve written about Lending Club before. It’s a peer-to-peer (P2P) lending organization that matches those with money to lend with those who are seeking a loan.
Potential lenders sign up with the service and deposit money into their accounts. Potential borrowers fill out applications that, upon approval, earn the borrowers a spot on the Lending Club website where lenders can review the borrowing requests.
Many metrics about the borrowers are included in the descriptions, like borrowing and repayment history, credit score, etc., and there’s even a ranking from Lending Club itself. All of this gives the lenders more information to use when determining where to lend their funds.
Lenders can spread their funds around in small increments, putting as little as $25 into each loan they fund. This means that lenders are spreading their risk of non-payment among many borrowers, and any single borrower can receive funds from many different lenders.
Since its inception in 2006, Lending Club has made more than $6 billion in loans. These loans typically have higher interest rates than mortgages or car loans but have lower rates than credit cards, which make the loans attractive to borrowers. The loans also tend to have interest rates higher than rates on bonds, which also makes lending money through the program attractive to investors.
That’s until the community banks get involved.
Recently, a group of 200 community banks announced they’ve created BancAlliance, which will funnel $5 billion to Lending Club to be used in funding loans. In the second quarter of 2014, Lending Club funded just under $1.2 billion in loans, which means that the new funds from BancAlliance represent more than a year’s worth of funding for Lending Club and could displace all of the current lenders in the program.
This is a smart move by the banks because they can rely on Lending Club’s proven process for vetting borrowers and assigning them different risk classifications. This allows the banks to put their excess funds to work making small personal loans without having to recreate lending expertise in this area.
Arguably borrowers who use the service will also benefit because more dollars will be chasing their loans, which should drive down the interest rates they must pay to borrow funds.
While that’s good for the banks and borrowers, it does mean that investors who use Lending Club to make loans will have to work a little harder, and probably settle for smaller returns. The members of BancAlliance will have parameters on what types of loans they will fund, and what types of borrowers will qualify.
Given the size of the funding involved, this will most likely shut individual lenders out of whatever categories fit the metrics approved by BancAlliance.
In the larger picture, this new arrangement highlights the difficulty that all fixed-income investors have when trying to put their funds to work. Yield is so hard to come by that investors are willing to consider investments today that they would have dismissed out of hand before the financial crisis.
Part of this has to do with the activities of central banks as mentioned above, but it also has to do with where we are in the economic cycle.
Almost every country in the developed world is struggling with weak economic growth while their populations age and seek out guaranteed income. These two trends favor fixed-income investing, which in turn drives down interest rates as more money chases cash flow investments.
As the boomers continue passing through the retirement door over the next several years, this trend will only get worse, and make yield even harder to find.
This is one of the most common questions we receive at Dent Research, and it’s why I wrote about the possibility of continued low interest rates in Boom & Bust this month, where Adam O’Dell highlighted a great opportunity for income investors.
P.S. Charles explores how to build a portfolio with a safe income in today’s Ahead of the Curve. Read up on his tips now.