Digital lending as a financing source for Loan Originators:
a tool for diversification
One of the key profitability drivers for Loan Originators is to maximise their utilization of assets while keeping sufficient liquidity. A review of common and new financing instruments shows the potential of digital lending marketplaces. Is this the key to future success for Loan Originators?
Loan Origination is a business which is usually run by a high leverage. Loan Originators (for terminology in digital lending check out our blog post “MPL terminology: what you need to know”) have to try to find customers, which they can rate according to their credit risk model and price them accordingly.
Loan Originators face the challenge of having to constantly juggle the financial resources at their disposal and the demand of their customers. One of their key profitability drivers is maximising the utilisation of their assets, while having sufficient liquidity to service redemptions. The fact that these goals are very contradictory is best illustrated by the practical example of a bank run.
In recent years, banks have increasingly been withdrawing from numerous areas of lending. As a result, digital lenders have been entering this niche, hoping to fill the gap left by the banks while gaining a competitive advantage through digital processing. The disadvantage of these digital lenders is that they have no customer deposit available providing cash for their lending business.
The most obvious solution to circumvent said disadvantage is to reach out to traditional lenders or insurance companies to provide a loan or in best case a credit line. The disadvantage of this supply is that in most cases there is a cluster risk1, leaving digital lenders in a vulnerable position. Only one loan termination is enough to jeopardize the whole business. Moreover, a cluster risk is always a contributor to a reduced company value, making it particularly painful for shareholders looking for an exit.
Henceforth bigger loan originators started to issue bonds or look for alternative sources of funding. Thanks to the ongoing technological developments one such alternative source that is being used more and more are digital marketplaces. Known amongst retail investors as crowdfunding, or P2P online platforms, these new digital grounds offer access to a diverse and rich financing source. This means that depending on the set-up Loan Originators can finance parts of, or entire issued loans through this channel.
Investors from platforms buy loan assignments and are entitled to the future interest and principal of the underlying loan. This way Loan Originators can acquire capital for liquidity and growth purposes that previously was locked in their loan portfolio and at the same time not lose earning on their issued loans. Loan Originators can still keep the spread of income since the loans sold to the platform are with lower interest than originally generateds and the duration of the loan agreement and loan assignment usually match.
The disadvantage for Loan Originators is that they usually have to pay slightly higher interest and need to service the marketplace by providing all the information about each particular loan and its payment on a daily basis.
In contrast the advantages are obvious: loan originators can diversify their source of funding and actively optimize their capital cost. Only if refinancing is needed loan assignments are sold on the market place. Furthermore if marketplaces in Europe are growing it might strengthen the stability of digital lenders in the long term, which would positively affect the economy.
Key _Takeaways:
1. Financing diversification as protection measure is made possible with digital lending.
2. Optimisation of capital cost is possible through the utilisation of digital lenders.
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1 Reliance on one source of funding or funding which has different access channels but one source.