Could online lending cause the next financial crisis? While the odds seem overwhelmingly against it, the recent turmoil at LendingClub — a leading online lender — makes it hard not to ask the question. There are some disquieting parallels with subprime mortgages, which seemed beneficial until sloppy and fraudulent lending practices triggered a wider collapse of confidence. Are we about to repeat the cycle?
In theory, online lending makes a lot of sense. Consumers and companies that want credit submit their applications electronically; their creditworthiness is evaluated electronically from data, including FICO scores and payment history, kept by credit bureaus or available from other sources. If prospective borrowers pass the tests, they get the loans. The process is straightforward and fast; the lack of bank branches cuts costs.
Business has boomed, in part because some traditional banks retreated from consumer and business lending after the financial crisis. By one study, online lending in the United States totaled $36 billion in 2015, triple the 2014 volume. The increases have continued. In the first three months of 2016, LendingClub’s new loans rose 68 percent to $2.75 billion from the same period in 2015. Online lending was emerging as an alternative to bank and credit card loans.
Much of the personal lending goes toward “refinancing existing debts, not receiving new credit,” concluded a new Treasury Department study of the industry. LendingClub says nearly 70 percent of its borrowers use loans this way. Small businesses, frustrated by long waits and tough lending guidelines at banks, are also turning to online lenders. A 2015 survey found that 22 percent of small firms (annual revenues: $100,000 to $1 million) applied for online loans, Treasury reports. Now comes the LendingClub surprise. In early May, its directors pushed out the company’s founder and chief executive, Renaud Laplanche. According to excellent reporting by the Wall Street Journal, the schism apparently reflected a loss of trust between the directors and Laplanche. He allegedly failed to provide the board with timely information on several issues. An investigation also found that the firm’s rapid growth had compromised some of its financial controls.
Normally, this would be a run-of-the-mill business dispute. What gives it added significance is that LendingClub, aside from being one of the largest online lenders, had a “sterling” reputation, says Ram Ahluwalia, chief executive of PeerIQ, a financial software firm. Its problems cast a cloud over the entire industry, which depends on enlisting outside investors — wealthy individuals, hedge funds, pensions — to finance new loans or buy them outright. “It will be harder to attract investors,” Ahluwalia says.
The larger question is whether online lending is viable in the long run. The crucial issue is whether lenders can predict repayment behavior accurately enough to avoid widespread defaults, which would inflict large losses on current investors and deter future investors. Can online lenders devise underwriting standards that identify good credit risks, reject the bad and ensure that the underlying data is reliable?
No one knows. The Treasury report warns that the new electronic “underwriting tools have been developed in a period of very low interest rates [and] declining unemployment” — a favorable climate discouraging defaults — and remain “untested through a complete credit cycle” of higher interest rates and joblessness.
This is the closest parallel with the subprime mortgage debacle, which embraced unrealistically lax underwriting standards and assumed unrealistically high house prices. There are comparable signs of wishful thinking today. Reports Treasury:
“Some online marketplace lenders are accepting applications without FICO scores or with short credit histories and making credit decisions based on the applicant’s college, school, and current income.”
Like the subprime debacle, the explosion of online lending leaves a lot to the imagination. Compared with banks, which undergo regular government examinations and regulatory supervision, online lending is relatively unregulated. Although many early borrowers had high credit ratings, as judged by FICO scores, it may be that as the number of borrowers rose, their creditworthiness has fallen.
Still, based on what we now know, it seems doubtful that online lending will soon precipitate a financial crisis. Although last year’s $36 billion of online loans is a lot, it represents only about 1 percent of the consumer lending market — excluding home mortgages — of $3.5 trillion, as estimated by the Federal Reserve. It’s also tiny compared with the volume of subprime mortgages, which exceeded $1 trillion by 2007. Plausible losses now seem orders of magnitude smaller.
What hangs in the balance is the financial system’s future. Will more-competitive lending serve consumer interests? Do the benefits of rapid response times outweigh the dangers of misleading data and cyberattacks? These are fundamental questions. Like it or not, the future is being redesigned before our eyes.
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