Marketplace lending platforms — Lending Club, OnDeck, Prosper and the like — have inarguably and fundamentally altered the geography of the lending landscape. In the last decade, they’ve gone from being a niche product to representing about a third of unsecured consumer loan volume in the United States as of 2016, according to a recent study by Harvard Business School Professor Boris Vallée and University of Washington Professor Yao Zeng.
The study concludes that their addition to the marketplace has mostly been a strong one.
Consumers receive better choice, better access and often better pricing for unsecured loans than they would generally be able to secure easily through the traditional bank-based system. Investors in the loans, on the other hand, get far more transparency in what they’re buying then they could ever have hoped for in the regular banking system.
“The lending model has fundamentally changed,” Vallée told Harvard Business School Weekly.
Back in the “old days,” he noted, those who bought loans from banks in the past — those investors didn’t have much transparency into the loans they bought. Moreover, he says, those investors were entirely dependent on the banks’ underwriting criteria — which he says are necessarily laden with subjective values.
“It’s the ‘he had a soft shake so I’m not going to lend to him,’ school of thought — and it is supremely outdated,” he noted. “Now decisions are increasingly based on hard information. As a sophisticated capital provider, you have 10 million data points that help you decide on how to optimally allocate your money, and everything is automated. That’s the future of banking.”
Which, Vallée and Zeng argue, is largely to the good for the entire ecosystem. Tedious, paper-based processes reliant on a lot of face-to-face consumer interactions with bankers that often ended in a denial were a problem. A streamlined, online only process where a customer can be evaluated, approved and posted on the marketplace within minutes — and where investors can pick and choose — is an improvement.
But, the study finds, it is an improvement that is now in need of an improvement of its own.
According to Vallée and Zeng, marketplace lending platforms as currently conceived have a design flaw — they are a little too transparent, and thus a little too likely to give ultra-savvy, technologically enhanced investors a massive advantage when it comes to buying loans from these platforms. And, according to the study, an noticeably uneven playing field in this regard will ultimately be very bad for business.
“If the sophisticated investor picks all the good fruit, the unsophisticated investor will do poorly and [potentially] leave the platform. Platforms need to be attentive about this potential problem when thinking about their design. They want as many investors as possible, both sophisticated and less so, [and] they want to make sure it’s a sufficiently fair game so everyone can participate.”
A Big Gap
The really savvy investors, the study noted, aren’t merely savvy because of the knowledge they possess — but because of the technology they leverage. One popular such technology is LendingRobot’s quantitative modeling that takes in the historical data provided by the platforms and uses it to create rules of purchase — and then allows its user set it to literally auto-invest whenever it encounters a loan that meets the rules’ criteria.
The upshot, according to the study, is that these high-tech investors can quickly evaluate loans and then skim the cream of the platform’s loan crop.
They say the proof is in the numbers.
Looking at a swath of loans executed by LendingRobot users between January 2014 and January 2017, with a particular focus on $120 million invested in LendingClub and Prosper during that time period, what they found is that those who used LendingRobot bought much better loans — the average default rate for LendingRobot purchases was 20 percent lower than the average default rate on the platform.
And that, according to the study, is a result that the platform shouldn’t want — because though savvy investors are an important part of the platform, often bringing large capital reserves with them, the platform needs a healthy mix of investors and a healthy mix of risk appetites.
Over time, they argue, the unleveled playing field drives off those lower-skilled investors who find themselves consistently buying lower quality, more likely to default loans.
Transparency isn’t a bad idea for lending platforms, Vallée noted, because it is important for the platform to draw high-line investors to the platform — and a generous offering of data is a very strong way to do it.
“As a marketplace, you get sophisticated investors interested in playing the game by giving them some information. They bring their capital, and you can even learn from them,” Vallée says.
It’s a sensible onboarding strategy for early days, but as the platform matures and has a better-established value proposition, the strategy should change because of the ways incredibly rich data sets tend to overly weight outcomes toward one class of investors.
Said simply, marketplace lenders need to start giving up less data to investors.
It’s a solution, they note, that has been tried — to visible effect. In 2014, LendingClub cut in half the number of information variables it has previously shared with investors — from 100 down to 50.
The outperformance rate of the technology-assisted savvy investors also fell by half.
That change is not risk free — savvy investors like data and will also flee the platform if they don’t have enough. No one wants a return to the black box days of bank-based underwriting as the only show in town. But it is a balance, Vallée and Zee noted, that marketplace lenders will need to find going forward if they want to thrive.
“In the long run, giving them all the information you have is too much,” Vallée said.