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Global Credit Strategy - Fintech

31 August 2016

TABLE OF CONTENTS
Summary
MPLs Are Steadily Expanding Credit
for SMEs
Small Business MPLs Charge High
Interest Rates Partly Due to High
Customer Acquisition and Funding
Costs
Relationships with Banks and Other
Funding Organizations Can Reduce
Acquisition Costs and Funding Costs
While Banks Form Partnerships, They
Are also Exploring and Building Their
Own Technology Platforms
Small Business MPLs Will Continue
to Build Other Alliances to Lend to
Small businesses, Especially MicroBorrowers
Model Risk and Evolving Regulatory
Landscape Can Still Stymie These
Nascent Partnerships
Small Business MPLs That Go at
It Alone Face Adverse Selection
Challenge
Moody's Related Research

Online Marketplace Lending Partnerships

Can Benefit Lenders and Small Businesses;
Pitfalls Remain for A Nascent Industry
1
2

Summary
The number of Marketplace Lenders (MPLs) serving the small business community has
increased steadily in the US since the crisis, although is still a small share of overall lending
to small businesses. The high lending rates at small business MPLs reflect the high credit risk;
however, they also reflect high sales and marketing customer acquisition expenses and high
costs of funding. MPL partnerships with banks have potential to benefit lenders and small
businesses, although such partnerships involve regulatory and loan performance pitfalls.

We believe that the recent partnerships MPLs are forming with banks such as the
OnDeck-JP Morgan partnership could help lower MPL acquisition and funding
costs. Customer acquisition costs average about 25% of revenue at some of the largest
small business MPLs, and finding a reliable and low-cost source of funding has also been
a challenge for small business MPLs. Relationships with banks allow MPLs to leverage
existing relationships between banks and SMEs, such as existing retail lending or existing
retail or commercial deposit relationships, and allow small business MPLs to lower their
customer acquisitions costs. At the same time, the partnership loans are funded by the
bank, at the lower bank funding cost. Therefore, the MPL would benefit from higher
origination volumes, lower customer acquisition costs, and a more stable funding source.

Bank-MPL partnerships can also benefit small businesses and banks. On the
one hand, small business borrowers would benefit from the expediency of an MPLs
technology platform, along with lower rates than what would be stand-alone MPL rates.
On the other hand, banks would benefit from a faster loan review and approval process
and by keeping as well as expanding their existing relationships.

Nevertheless, MPL-bank partnerships could face several challenges going

forward, including model risk, regulatory and loan performance uncertainty, and
increasing competition from banks' indigenous platforms. Quantitative modelbased ability to accurately assess credit risk through a credit downturn is still unproven.
Currently small business lending is subject to less regulation compared to consumer
lending. However, there is a risk that lending to small businesses might be grouped under
consumer lending and become subject to greater regulatory scrutiny. For example, some
US states have already begun to take steps to regulate small business MPLs. Finally, MPL-

6
6

Analyst Contacts
Madhur Duggar
+1 212 553 4808
Vice President - Senior
Credit Officer
madhur.duggar@moodys.com
Praveen Varma
212-553-7763
Senior Vice President
praveen.varma@moodys.com
Warren Kornfeld
212-553-1932
Senior Vice President
warren.kornfeld@moodys.com
Robert Young
+1 212 553 4122
MD-Financial
Institutions
robert.young@moodys.com
Anne Van Praagh
212-553-3744
MD-Sovereign Risk
anne.vanpraagh@moodys.com

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bank partnerships could face competition from banks such as Wells Fargo developing in-house platforms.

MPLs Are Steadily Expanding Credit for SMEs

The number of MPLs serving the US small business community has increased steadily since the crisis. In a recent survey conducted by
the US Treasury,1 13 MPLs responded who were offering lending products to the small business community. Although online lenders
still provide a relatively small share of overall lending to SMEs, as Exhibit 1 shows they are a much more important source of funding for
small businesses compared to larger companies.
Exhibit 1

Online-Lending-Based Loan Applications Constitute a Larger Share of Applications Made By Small Businesses
Credit Sources Applied to by Revenue Size of Firm

Source: Moody's Investors Service(MIS) and 2015 Small Business Credit Survey - Report on Employer Firms, FRB, March 2016

Further, the 2015 Small Business Credit Survey, conducted by the Federal Reserve, revealed that most small businesses who borrow
from MPLs fall into two main categories:
1. Micro-businesses, which we define in this article as small businesses with less than $1 million in revenues, and
2. Established small businesses, which we define as small businesses with greater than $1 million in revenues.
Each of these borrower categories have slightly different borrowing needs that MPLs meet.
Micro-businesses are often constrained by the lack of credit history
Insufficient credit history is a leading impediment to obtaining funding for micro-businesses, and drives a larger proportion of such
borrowers to small business MPLs relative to larger firms. Exhibit 2 shows that roughly 47% of micro-businesses with less than $100K
in revenues and 29% of micro-businesses with $100K-$1 million in revenues cited insufficient credit history as the reason for why
they received less funding than requested. Insufficient collateral is the next leading cause. Unlike micro-businesses, insufficient credit
history is not a leading reason cited by firms with more than $1M in revenues, which are generally more mature and have had time to
establish a credit history.

This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page on
www.moodys.com for the most updated credit rating action information and rating history.

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Global Credit Strategy - Fintech: Online Marketplace Lending Partnerships Can Benefit Lenders and Small Businesses; Pitfalls Remain for A Nascent
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Exhibit 2

Insufficient Credit History is a Leading Impediment for Micro-Businesses to Obtain Funding

Financing Shortfalls for Small Business Applicants

Source: MIS and 2015 Small Business Credit Survey - Report on Employer Firms, FRB, March 2016

Difficulties in obtaining funding due to insufficient credit history or collateral is more often a constraint when borrowing from banks
who are often themselves constrained by internal policies that limit exposure to such borrowers. This would naturally lead to a higher
fraction of online loan applications made by small businesses, which is what we observe in Exhibit 1 - while bank loan applications
constitute the majority of loan applications across all small businesses, online-lending-based applications constitute a larger share of
the applications made by micro-businesses.
Established small businesses often approach MPLs to meet short-term liquidity needs
Established small businesses (which we defined as small businesses with greater than $1 million in revenues) more often have existing
banking relationships and approach MPLs either when their credit histories are deemed too weak for banks to lend to, or when they
have immediate liquidity needs and bank application and approval processes are not fast enough to address their immediate needs.
As we saw in Exhibit 2, unlike micro-businesses, insufficient credit history is not as big a concern for established small businesses.
Instead, weak business performance history was cited in over 36% of the survey responses as one of the leading reasons for why
established small businesses were unable to obtain funds from their lenders.
Established businesses, more so than micro-businesses, approach MPLs to meet their short-term liquidity needs. As Exhibit 3 shows,
established small businesses show a greater demand for lines of credit (LOCs) relative to micro businesses -- a loan product that is
primarily designed to meet short-term liquidity needs.
Exhibit 3

Established Small Businesses and Micro Businesses Approach MPLs For Different Reasons
Loan Application Types by Revenue Size of Firm

Source: MIS and 2015 Small Business Credit Survey - Report on Employer Firms, FRB, March 2016

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Global Credit Strategy - Fintech: Online Marketplace Lending Partnerships Can Benefit Lenders and Small Businesses; Pitfalls Remain for A Nascent
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Small Business MPLs Charge High Interest Rates Partly Due to High Customer Acquisition and Funding
Costs
Although small borrowers are able to secure funds from MPLs, they are often unhappy about the high borrowing rates. The US Treasury
survey showed that marketplace borrowers had the lowest lender satisfaction scores amongst MPLs, large and small banks, and credit
unions. A vast majority of dissatisfied borrowers, roughly 70%, cited the high interest rates at MPLs as the reason for dissatisfaction-compared with 15% and 18% at small and large banks respectively. As an example, OnDeck reported in its 10-K filing with the SEC that
its weighted average APR for term loans and lines of credit was roughly 41% in Q4 2015.
The high lending rates at small business MPLs reflect the high credit risk; however, high sales and marketing customer acquisition
expenses and high costs of funding are some of the non-credit reasons for why lending rates at small business MPLs are high.

Relationships with Banks and Other Funding Organizations Can Reduce Acquisition Costs and Funding
Costs
To attract a larger borrower base, MPLs have been looking at ways to improve the efficiency of their customer acquisition process, as
well as capital funding. One of the avenues MPLs are pursuing is establishing partnerships with banks: recent examples of relationships
between small business MPLs and banks include OnDeck and BBVA and OnDeck and JP Morgan.
Relationships with banks help reduce customer acquisition cost by rebalancing the channel mix
Customer acquisition costs are a major expense for small business MPLs, averaging roughly 25% of revenues at some of the largest
small business MPLs like OnDeck. Since customer acquisition costs vary by channel, with indirect channels (e.g., 3rd-party brokers)
generally costing more than direct channels (e.g., online advertising, mail, strategic partner referrals), lenders like OnDeck have focused
on increasing the share of direct channel customer acquisitions by building strategic relationships with banks. For example, OnDeck
stated in its annual reports that loan originations from direct channels, which include direct marketing and strategic partnerships,
increased to 79.5% from 54.4% of originations between 2013 and 2015. Loan originations from funding advisors, which include loan
brokers, decreased over the same period.
Relationships with banks allow MPLs to leverage existing relationships between banks and SMEs such as existing retail lending or
existing retail or commercial deposit relationships, and allow small business MPLs to lower their acquisitions costs.
Relationship with banks can reduce funding costs for small business borrowers as well as provide the MPL with a more
stable funding source
Finding a reliable and low-cost source of funding has also been a challenge for small business MPLs who have used a variety of
strategies to fund their loans. These include funding loans through fractional interests with retail investors, directly with institutional
investors accessing the securitization market as well as through their own access to funding.
The recently initiated OnDeck-JP Morgan partnership is an example of ways in which banks and small business MPLs can form
partnerships to lend to small businesses. Under the OnDeck-JP Morgan relationship, small businesses are first pre-approved as clients
to whom Chase is willing to lend to, even though specific loans have not been approved. Pre-approved borrowers can apply for loans of
up to $250,000 using the OnDeck technology platform, with approved borrowers funded by JP Morgan:

Small business borrowers benefit from the expediency of an MPLs technology platform, along with what we expect are lower rates
than offered by standalone MPLs (due to the lower acquisition costs as well as JP Morgan's low funding costs).

OnDeck benefits from higher origination volumes, lower customer acquisition costs, and a more stable funding source.

The bank benefits from a faster loan review and approval process and by keeping as well as expanding its existing relationships.

31 August 2016

Global Credit Strategy - Fintech: Online Marketplace Lending Partnerships Can Benefit Lenders and Small Businesses; Pitfalls Remain for A Nascent
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While Banks Form Partnerships, They Are also Exploring and Building Their Own Technology Platforms
Partnering with MPLs gives banks faster access to an online technology platform, access to the marketplace lenders proprietary credit
models and to its performance history. However, it also requires banks to share their small-business-client information with MPLs,
something which may not be appealing to all banks. This will likely give rise to some banks forming their own marketplace lending
technology platforms.
We are already beginning to see initial interest from banks in this space. Recently, Wells Fargo announced the launch of its own online
platform, FastFlexFM, to lend to small businesses. FastFlex Small Business loans will be available with one-year terms, at amounts
ranging from $10,000 to $35,000, with required payments made on a weekly basis automatically deducted from the customers
business-deposit account. It will be available to Wells Fargo business-deposit customers who have been a customer of the bank for at
least one year.
The creation of more online technology platforms by banks like Wells Fargo will also increase competition among MPLs and may
further lead to lower borrowing rates for established small businesses.

Small Business MPLs Will Continue to Build Other Alliances to Lend to Small businesses, Especially
Micro-Borrowers
Despite its potential benefits, the OnDeck-JP Morgan partnership likely does not address the lending needs of micro-borrowers, an
important borrowing group for MPLs. Micro-businesses, which lack the credit histories to obtain funding from banks, are largely unable
to benefit from such relationships.
We expect small business MPLs to continue to serve these businesses through other avenues, including forming alliances with nonbanks. We believe that regardless of the eventual outcome of the OnDeck-JP Morgan partnership, MPLs will continue to seek and build
other third-party partnerships in order to expand their funding and lend to micro-businesses, as well as reduce acquisitions costs and
increase origination volumes through referral agreements.
Exhibit 4 lists a few of the key partnerships formed over the last 5-years between some of the well-known small business MPLs and
third-parties. We note that in most of these partnerships, the third-party has largely played the role of referring clients as potential
borrowers to the MPLs, with MPLs responsible for obtaining funding for approved borrowers.
Exhibit 4

Past Small Business Partnerships Have Generally Required MPLs to Fund Loans for Borrowers
Key Partnerships Between Small Business MPLs and Third Parties

Source: MIS and Company News Reports

A concern that arises with respect to these partnerships is their ability to find stable funding during times of market volatility, when
investors are likely to pull back from investing in a non-core asset class. In this regard, Funding Circle in the UK represents an interesting
example: by accessing funding in public markets and committed lines of credit from the government, Funding Circle has been able to
reduce its dependency on uncommitted funding lines to lend to small businesses.

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Global Credit Strategy - Fintech: Online Marketplace Lending Partnerships Can Benefit Lenders and Small Businesses; Pitfalls Remain for A Nascent
Industry

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Model Risk and Evolving Regulatory Landscape Can Still Stymie These Nascent Partnerships
Despite the potential economic benefits, several challenges, especially regulatory and loan performance uncertainty, could stymie the
growth of bank and small business MPLs partnerships.
OnDecks quantitative model-based ability to accurately assess credit risk through a credit downturn is still unproven. The lender has
been in existence since before the crisis - the company was founded in 2006 and the first loans were issued in 2007. However, roughly
90% of its $4 billion of loans have been originated since 2013. Additionally, there is regulatory uncertainty that hangs over the small
business marketplace lending space, which could adversely affect such partnerships.
Small businesses lending is subject to less regulation compared to consumer lending; however, there is a risk that lending to small
businesses might be grouped under consumer lending and become subject to greater regulatory scrutiny. Certain states have already
begun to take steps to regulate small business MPLs. For example, state regulators in Illinois, New York and California have announced
that they are exploring ways to place greater restrictions on small business marketplace lending practices. These restrictions include
requiring greater transparency and disclosure around lending rates, prohibiting MPLs from using more than 50% of a borrowers net
cash revenues as a source of repayment, and making lenders liable for representations made by their brokers to borrowers. While such
efforts are still in their initial stages, we believe they speak to the likelihood of greater disclosure requirements and possible greater
regulatory scrutiny over the small business marketplace lending space.

Small Business MPLs That Go at It Alone Face Adverse Selection Challenge

As discussed above, established small businesses often have existing banking relationships and tend to approach MPLs either when their
business performance history is weak and reduces their access to bank funding, or when they are in need of immediate liquidity and
banks cannot approve their loan quickly.
Banks indigenous lending technology solutions are likely to cater to SMEs immediate liquidity needs, in addition to regular funding
needs. As a result, small businesses that approach MPLs outside of banking partnerships are likely to consist more and more of
borrowers with poor credit histories. This raises the risks of adverse selection for small business MPLs that lend outside of the
partnership model, particularly if this model is increasingly adopted.

Moody's Related Research

Credit Strategy Blockchain Technology: Robust, Cost-effective Applications Key to Unlocking Blockchain's Potential Credit
Benefits, July 2016

Insurance Global: Internet of Things Brings Short-Term Benefits, Long-Term Disruption, June 2016

Insurance Global: As Technology Transforms Landscape, Innovative Insurers Have Competitive Edge, June 2016

Insurance Global: With Big Data Come Big Advantages, June 2016

Financial Institutions - Global: Fintech Transforms Competitive Landscape, but Unlikely to Displace Banks' Central Role, May 2016

Asset Management Global: Digital Adaptation Shapes Tomorrow's Asset Managers, May 2016

Marketplace Lending - Consumer ABS: Underwriting of Marketplace Lending Platforms Poses Unique Credit Risks and Is Untested
Through Stressed Economic Cycle, March 2016

Marketplace Lending ABS Global: 2016 Outlook -Marketplace Lending Platforms Will Continue to Evolve, Expand Loan Types,
January 2016

US Consumer ABS: Understand the Risks of Marketplace Lending Securitizations, May 2015

Peer-to-Peer Lending: Prospects and Pitfalls, January 2015

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Endnotes
1 Public Input on Expanding Access to Credit for Online Marketplace Lending, Department of Treasury, 7 October 2015

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Global Credit Strategy - Fintech: Online Marketplace Lending Partnerships Can Benefit Lenders and Small Businesses; Pitfalls Remain for A Nascent
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