Banking's double disruption

Digital wallets and P2P lending will do more than simply reduce banks' margins -- they'll completely break up the business of banking as we know it.

It’s taken a while, but banks have now been brought to the edge of the disruption abyss over which the media, mail and music businesses have been staring or toppling for 10 years.

The opening of Apple’s iTunes store in 2003 and the IPO of Google in 2004 were the events that transformed the advertising and music industries. Apple and Google are now the world’s first and third-largest companies, worth a combined $US1 trillion exactly.

Now it’s banking’s turn.

Apple’s launch last week of its new payments system and the planned IPO of Lending Club means the two core pillars of banking -- transactions and lending -- are being disrupted at the same time.

Google launched its digital wallet technology, Google Wallet, three years ago but it hasn’t taken off.

The reason Apple’s launch of its own version of this last week is being called another iPod and iTunes moment is because the company has managed to negotiate a deal with the 11 biggest US credit card issuers as well as a group of big retailers.

An Apple team led by its iTunes chief Eddy Cue negotiated in secret with retailers and banks for a year before last week’s launch, and managed to get a commission of 15 basis points (0.15 per cent) of all transactions -- something Google was not able to do.

There’s nothing very new in the technology, which uses 'near-field communication' to allow a customer to tap their phone next to a terminal to transfer money to a vendor. 

The difference with Apple’s system is that keeps the banks at the centre, paying Apple, as iTunes did with music companies. 

So banks are now hoping Apple wins the payments battle and are giving up revenue to help make that happen. That is, they are joining in a relatively benign disruption that reduces their margins in the hope that fends off one that destroys their margins completely.

The same can’t be said of peer-to-peer (P2P) lending, led by Lending Club.

The company’s planned $US500 million IPO this year is being likened to the IPO of Google in 2004 because of the way it could legitimise and strengthen the business case for the disruption it is championing.

Google’s listing 10 years ago was a seminal event for print media. Lending Club’s founder and chief executive Renaud Laplanche has similar ambitions for what his company will do to banking, as spelled out in the prospectus.

It will “transform the banking system”, the company says, by “making credit more affordable and investing more rewarding … by cutting out the middleman and lowering intermediation costs".

Lending Club lent $US2.1 billion in 2013 and is expected to lend $US4bn in 2014. It’s still a tiny fraction of the $US3.2 trillion in total consumer debt in the US, but it’s growing quickly.

McKinsey & Co estimates that Lending Club has a cost advantage over large-scale banks of around 400 basis points, which comes from having no branches, no capital and minimal compliance costs.

What’s more, most of its costs are variable. Sales and marketing currently consume 45 per cent of its costs, but that will reduce over time and further improve its cost advantage over banks.

Borrowers are mainly using it to pay off credit card debt and getting a 5-6 per cent rate advantage, depending on their credit standing. There are 35 different grades of credit ranging from G5 up to A1, and interest rates from 8-25 per cent.

Investors can lend either fractionally through a sort of book build process or take the whole loan, which typically range up to about $35,000. In general P2P lenders are reporting lower bad debt rates than traditional banks.

P2P lending has been slow to take off in Australia but is starting to gain traction. The leading player here, SocietyOne, is not disclosing the size of its book, but was reported to have lent $4m up to March. Apparently its default rate is 2.8 per cent.

While Google has bought 8 per cent of Lending Club, in Australia Westpac is one of the backers of SocietyOne, through its venture capital fund, Reinventure Group.

Banks are hoping that if they can stay in the payments game through Apple’s system, and not be cut out entirely, they can also remain in control of saving and lending because it’s more convenient to save and borrow with the institution that handles your transactions.

The problem is that, as with iTunes, it’s Apple that’s in control, not them. And as print media found with classified advertising, digital disruption doesn’t just involve margin compression, but also disaggregation.

Just as classified advertising and journalism have been separated from each other (with a dramatic impact on the margins of each) the advent of digital wallets and P2P lending is likely to break the business of banking into its parts, each with its own set of disruptors.