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March 27, 2014

Hogging the Credit - Why Software Is Eating Banking

 

When this 10s decade is over, we will look back and be amazed that a mere ten years prior, a few, absolutely massive financial institutions controlled the global banking industry.  Software is eating the world, as Marc Andreessen famously observed, and an industry like financial services -- whose service offering is essentially all information-based -- is particularly susceptible to the disruptive force of technology.  That disruptive force is particularly acute in the credit markets.

Consumer credit has long been a pretty sleepy industry.  For years, the same 5-10 or so banks have been the main issuers of credit cards and the same 4 associations have been the main brands and platforms.  But when the credit crisis hit, everything changed.  Due to market forces and government regulations, banks abandoned the lower end of the consumer market.  20% of US households are now considered underbanked, representing a massive market opportunity.  A further window of opportunity is the fact that credit cards are still charging 20% APR, yet interest rates are effectively zero.

Stepping into the vaccuum are new providers of consumer credit and broader banking services that are 100% virtual.  ZestFinance (a Flybridge portfolio company) and Wonga are among those providing consumer credit in the form of installment loans, with ZestFinance leveraging the magic of big data to do more sophisticated underwriting.  Lending Club and Prosper are showing the promise of peer-to-peer lending, issuing $2.4 billion in credit last year, a 3x increase over 2012.  Institutions are taking notice - one investor that I spoke to in a peer to peer lender shared with me that hedge funds are now flocking to the platform in search of higher rates.  ING - soon to be renamed Voya Financial - demonstrated that a bank could be constructed that serviced consumers over the Internet without traditional branches.  

At the same time, the proliferation of smart phones is allowing consumers to access money and conduct financial transactions with extraordinary convenience.  Why would those services and capabilities be only provided by traditional banks?  China's Alipay reports that they processed $150 billion in mobile transactions in 2013 - nearly 6x the $27 billion PayPal reported (not including the Venmo acquisition, which is bound to accelerate growth in 2014).  This intersection of mobile, convenience and new lending brands is going to substantially erode existing banking franchises in the years to come.  

The business lending market is no different.  In fact, innovation in business credit may be outpacing consumer credit.  Startups such as OnDeck Capital, Kabbage and Capital Access Network have each raised tens of millions of capital and are building large brands and franchises in servicing small businesses.  With their bloated bureaucracies and overhead, banks are not architected to service this market effectively - particularly as more and more small businesses are reachable over the Internet.  OnDeck recently reported a $77 million growth round and that it has acheived nearly $1 billion in loan volume.  Kabbage is rumored to be on the verge of reporting a similar monster round.  And Credit Karma, a credit management service for consumers, just announced an $85 million growth round.

A few weeks ago, Brand Finance released their annual survey of the 20 most valuable banking brands in the US.  Atop the list were the usual suspects:  Wells Fargo, Bank of America, Citi and Chase.  The market capitalization of these four banks is currently around $800 billion.  Will these same brand franchises be unassailable by 2020, or will a new cohort of brands emerge from this soup of startups and innovators?  I know what venture capitalists and entrepreneurs are betting on.

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