Credit cards are good business. Large banks' overall earnings may rise and fall, but as the Federal Reserve reports, there's one near-constant: credit cards are the most profitable major operation at large depository banks.
The sheer volume is impressive: JPMorgan Chase (JPM) has 119.4 million credit cards in circulation in the United States, Citibank (C) has 92 million, Bank of America (BAC) has 80.2 million, American Express (AXP) has 46.5 million, Capital One (COF) has 46.3 million. HSBC (HSBC), Discover (DFS) and Wells Fargo (WFC) round out the list of top credit card lenders, all with tens of millions in circulation.
Now, with the rise of peer-to-peer lending, there is an emerging competitor to credit cards.
Peer-to-peer lending platforms like Lending Club and Prosper allow individual (and increasingly institutional) investors to loan money to different classes of borrowers online.
Technology has transformed the music and publishing industries. Some, including Andy Haldane of the Bank of England, have speculated that peer-to-peer may have the potential to wreak similar havoc on lending.
Let's explore what kind of threat, if any, the rise of peer-to-peer lending poses to the earnings of large banks.
The Rise of P2P and Declining Interest Rates
There is an interesting correlation between the rise of peer-to-peer lending and declining interest rates among credit card lenders. Card interest rates hit their peak in the past decade at 15.2% in August 2007, after which began a steady downward trend which took us as low as 12.7% in May of this year before settling in at 13.1% this September.
It's hard to pinpoint what started this trend. But it might be worth noting that August 2007 happens to be the very same month that Lending Club, a leading peer-to-peer outfit, secured its series A funding round at $10.6 million.
While this is clearly a coincidence, it doesn't mean that Lending Club and fellow P2P heavy-hitter Prosper are not having an impact on the credit markets today. There is every reason to believe that this impact will only continue to grow as consumers (and small businesses) have an increasing number of credit and financing options. In fact, credit card and personal loan rates at banks have trended downward since 2009.
It's worth noting that total outstanding revolving consumer debt - mainly held on credit cards - has remained relatively flat since 2010 (see previous link) after falling substantially during the recession; it currently sits at just under $849 billion. At the same time, total nonrevolving consumer debt outstanding (including P2P loans) has increased between 2010 and 2013 by nearly $400 billion.
A Changing Landscape
As Haldane points out, there is a two-pronged revolution underway in the banking industry. The financial crisis is clearly driving up demand; on the supply side, technology is a game-changer as well.
Haldane makes a compelling case that peer-to-peer lending has the capability to rock the banking world, essentially becoming "a sort of eBay for credit." His analysis notes that banking is rooted in the core services of payments and lending, each of which is being radically altered by technology. Payments are going digital through the rise of PayPal and instant smartphone transactions, while peer-to-peer is reorienting the lending landscape.
As peer-to-peer guru Peter Renton shares, "We live in a highly sophisticated and interconnected world yet the banking system is still based on a centuries-old model. There is no need for borrowers to obtain loans from a bank anymore when they can turn to their peers, often with a lower interest rate. Borrowers can save money by taking out peer-to-peer loans and investors can earn great returns on their money."
According to Renton's analysis, as of October 2013, the two largest P2P lenders had originated a cumulative amount of more than $3.4 billion since 2006. In 2008, the platforms originated $79,566,325 in loans, by 2012, this number was $826,290,459.
A Matter of Trust
Noting that the lending industry relies heavily on the control and exchange of information, Haldane explains that "banking is a conjuring act and all conjurers rely on the trust of the public."
Who is going to trust some internet company to lend their money to a bunch of strangers? This must be an advantage for the large banks over Lending Club and Prosper, right?
Haldane astutely points to recent surveys indicating that large banks are among our least-trusted institutions while technology companies are garnering high credibility ratings among the public. This shifting pattern of trust is one indicator of the disruptive potential of peer-to-peer lending with respect to traditional banking and credit cards. Not to mention Google's (GOOG) $125 million deal it led this year to purchase a stake in Lending Club.
The Direct Mail Game
Direct mail has long been a major driver of the credit card business, with banks relying on perks and zero-interest transfers to solicit new customers.
Now, as Lending Club, Prosper and other direct lenders have scaled, they are muscling their way into the direct mail game as well, wooing borrowers with appealing balance transfer and loan consolidation offers at good rates for those with decent credit. APY for the best borrowers is less than 7%,
The above sounds great in theory, but the proof is in the pudding. We have outlined a lot of reasons why peer-to-peer could be, should be, a threat to large banks, but is peer-to-peer really catching on?
Absolutely. In October this year, Lending Club and Prosper issued more than $273 million in loans, representing a more than 174% increase over last year, according to industry analyst Lend Academy. Additionally, Lending Club reports that more than 82% of borrowers say they use the money to pay off credit cards and/or consolidate debt. Above all, that is the figure that should make banks sit up and take notice.
Chart from Nickel Steamroller, here
Of course, correlation does not prove causation. The fact that the rise of peer-to-peer lending coincided with the decline in credit card interest rates doesn't necessarily mean that peer-to-peer was a factor in 2007. However, there is more reason to believe that banks must be, or at least should be, taking note in 2013.
Online lenders are offering competitive rates and are marketing themselves (e.g., direct mail) the same way as credit cards, and obviously consumers are responding. Every time a quality borrower transfers a balance from a credit card into an amortizing three-year peer-to-peer loan, they are taking low-risk profit from a bank, which has significant implications for the high-margin credit card business.
Additional disclosure: I do not have any stock in LC or Prosper; however, I do own loans there personally, but not in my Fund.