Upcoming Challenges for Retail Banks

There is a genuine sense that our high street big banks are about to enter a new era (unwittingly for some) where the old and tested retail banking model is due for a dramatic (and painful) shake-up. Sadly, this comes just as our banks are about to recover from the recent financial crisis, and many see traditional prudent retail banking as the way forward.

Peer-to-peer lending is coming. I came across this term recently and was shocked (in a good way) by this idea. It is very simple: peer-to-peer lending matches people with money to those who need it, bypassing the bank altogether. And because the bank is not involved, the rates for both the lender and the borrower can be better than they can get from the bank.

 

This is a brilliant idea, enabled by the Internet age. Only now can we seamlessly match lenders and borrowers in the masses efficiently, quickly and (safely?). And in case you haven't noticed, the idea is based on not having the banks involved.

A short definition of how banks make money from Investopedia:

Banks make money by lending at rates higher than the cost of the money they lend. More specifically, banks collect interest on loans and interest payments from the debt they issue out and pay interest on deposits and funds they borrow. The difference is known as the "spread" or the net interest income (net interest income is divided by the bank's earning assets, known as the net interest margin).

A quick comparison:

In the traditional model, the bank invites you to save your money with them (known as deposits) and pay you interest on that money. Then, the bank uses this money and earns more than it has to pay in interest. However, because these are people's "savings", strict financial rules guarantee the safety of these deposits, and the bank takes on ALL the risks in its operation.

In Peer-to-peer lending, the money is not called "savings"; lenders know that they are "lending" out the money in return for a % payback and agree to take on the associated risks. The risk can be minimized if the lender's capital is divided into small parts and lent to many borrowers; that way if one borrower defaults, most of the money is still safe for that individual lender.

Notice that the Peer-to-peer service provider takes on No risks at all. It is purely a match-making service, ensuring the borrowers are trustworthy and the lenders are not exposed to too much risk. It makes money by charging BOTH the lender and the borrower for the better rates they can get by using their service.

If your bank were to charge you for paying you interest, you would be outraged. And yet, a peer-to-peer lending service wants you to take the capital risks as well, and no one seems to mind as it makes intuitive sense because you are the one lending people money. This is how clever this idea is.

So, it's only a matter of time before people hear about this cheaper way to borrow money instead of going to the banks. And with the current low-interest rates, it is only a matter of time before savers and investors discover this convenient way to earn a reasonable return with their money. The big losers, of course- are the banks if they don't figure out how they can adapt to this change.

Conclusion:

Banks, just like other companies, need to be reminded that innovation is the key to survival. The world has changed (and is changing rapidly), and more innovative ideas will come along to challenge the status quo. Those who ignore the changes and do not adapt will have an increasingly smaller slice of the pie.

p.s. oh, and on top of everything, P2P lending is also perceived to be more "ethical". Looking rather formidable, I hope my banks are ready.

Recommended Book