Alternative finance and traditional finance: the terminology itself evokes a perennial battle between the “revolutionary new” and the “tried and true.” But the financial world of 2016 is less a battlefield than a thriving marketplace with a growing supply of options. The democratizing power of the internet and a public wary of the banking industry has created a range of financing alternatives to bank financing. Recent legislation has only expanded the profile of these disruptive methods.
How is this multi-billion dollar alternative finance force changing the financial game? Can traditional finance prosper in the future? Can these divergent industries coexist?
“Traditional finance” refers mostly to the banks that have historically comprised most of the financial industry. Banks can help companies package and sell bonds, sell stock through an IPO or other offering, or give loans directly. Once upon a time, small businesses, real estate companies, and entrepreneurs could take out a bank loan relatively easily. During the peak of the U.S. Housing Bubble in the mid-2000s, subprime borrowers could access loans for major purchases in much the way sophisticated borrowers could, due to loosened underwriting standards. The 2007-08 collapse of the housing market and ensuing financial crisis altered the landscape, crippling the reputation of financial institutions worldwide. Taxpayers were rightfully aggrieved to witness their government bail out banks that were “too big to fail”, and to see small business owners drown in debt while subprime lenders were saved.
Now it’s more difficult than ever for some borrowers to secure a bank loan. Lending rules have become more stringent—traditional banks decline up to 80% of small business loan applications, only fund renovation projects on foreclosed or abandoned homes for primary residences, and must comply with Fannie Mae general requirements. (SBA) Global economic uncertainty in Europe, Asia, and the Middle-East have prompted tighter lending standards, which has led JP Morgan to increase its view of the probability of recession in the next twelve months from 21 percent to 32 percent in mid-January. (Reuters) Furthermore, since the Fed recently raised interest rates—and is contemplating further raises this year—banks have increased their lending rates. Hence many small businesses who already struggling to get off the ground are finding fewer and fewer options for raising capital.
Traditional finance also includes venture capital, private equity firms, and family offices. The century-old prestige and exclusivity of these types of traditional finance is becoming an increasing liability—these types of firms are as risk avert and sluggish as banks in supplying loans, if not more so. Modern companies and borrowers, however, want easier, faster, and more robust funding solutions.
Crowdfunding is the most high-profile form of alternative finance. True to its name, it raises all funding for a project from a crowd of lenders, greatly reducing (if not eliminating) the presence of banks in the process. Being unregulated by Fannie Mae or Freddie Mac, real estate crowdfunding platforms can unlock equity for projects in hours, whereas a bank takes weeks. Crowdfunding also minimizes the fees a borrower would have to pay their bank, while generating interest in a brand through the crowd network. Investors benefit from the ability to diversify their portfolio, choose how much to invest, and potentially earn high returns (see our previous posts on how crowdfunding works for investors and companies).
Crowdfunding is not just a disruptive force, however: platforms can also provide bridge loans for projects that banks won’t finance in their entirety—raising money through the crowd can supplement a bank loan. Moreover, crowdfunding is growing exponentially in popularity. Of the $870 million in capital raised through crowdfunding from Sept 2013 to Sept 2015, $208.3 million was raised via real estate crowdfunding (NuWire Investor). In 2014, real estate crowdfunding crossed the $1 billion mark worldwide, growing to $2.57 billion in 2015. Some predict growth as high as $90 billion by 2025. (TRN)
Like crowdfunding, peer lending democratizes the process of qualifying for and receiving loans. On a peer lending platform, people or businesses who want to borrow money write up proposals detailing how much they need and how they will use it. Potential lenders then read that information and decide whether or not to loan money and what rate to set. Loans can be obtained at lower rates, and the credit becomes available faster, than with bank loans.
Lending Club is perhaps the most visible peer lending platform, allowing persons to borrow up to $35,000 with a fixed interest rate and monthly principal and interest payments (business borrowers can have credit lines up to $300,000).
Like any industry, alternative finance has its dark segments. According to Federal Reserve chair Ben Bernanke, shadow banking “comprises a diverse set of institutions and markets that, collectively, carry out traditional banking functions—but do so outside, or in ways only loosely linked to, the traditional system of regulated depository institutions.” (FRB) Shadow banking is a $24 trillion industry accounting for at least a third of total systemic risk in the U.S. (CNBC) Shadow lenders absorbing risks that regulated institutions pass on could gain as much as $118 billion in commercial real-estate mortgages and development loans over the next several years. (Seattle Times)
Crowdfunding and peer lending are the most viable alternatives to shadow banking—they have equal funding capabilities, but without the level of risk and illegal activity.
With the internet as its bedrock, alternative finance has become an unprecedentedly accessible and democratically new way to raise capital, invest, and see projects through. Banks will persist, but as long as they continue restricting the borrowing agency of real estate firms and other businesses, the latter will look elsewhere for funding and discover the most innovative options on market.