Marketplace Lending, Financial Analysis, and the Future of Credit

IOANNIS AKKIZIDIS, MSc, PHD, is global product manager on financial risk management systems for Wolters Kluwer in Zurich, Switzerland. He has experience in designing and implementing advanced solutions in risk-management and profitability analysis fields for the financial industry all around the world. MANUEL STAGARS, CFA, CAIA, ERP, consults private clients on entrepreneurship, business models and financial strategy, and he is serial entrepreneur and founder of seven companies in Switzerland, the United States and Japan.

Preface xvii

Acknowledgments xix

About the Authors xxi

About the Website xxiii

Introduction 1

I.1 Who is this Book For? 2

I.2 What is Fintech? 2

I.2.1 Distinction between Financial Technology Innovation and Financial Innovation 3

I.3 Why Does this Book Focus on Online Lending? 4

I.4 The Hybrid Financial Sector: The Opportunity to Build a Healthier Financial System 5

PART ONE Fintech and Online Lending Landscape—Where Are We Now? 11

CHAPTER 1 Introduction to the Business Models in Financial Technology 15

1.1 Innovation Themes in Fintech 15

1.2 The Promises and Pitfalls of Fintech Business Models 20

1.3 The Pitfalls 22

1.4 Why is Financial Technology Innovation Important? 23

1.5 Challenges and Roadblocks for Fintech Companies 24

1.6 Fintech is a Long-Term Play 26

1.7 Concluding Remarks 27

CHAPTER 2 How Does Online Lending Work? An Overview with a Focus on Marketplace Lending 29

2.1 Reliance on Technology and Data 29

2.2 How Do Online Lenders Differ From Banks? 30

2.3 Types of Online Lenders 31

2.4 Some Background on Peer-to-Peer Networks 36

2.5 The Business Model of Marketplace Lending Platforms 40

2.6 Onboarding Process 41

2.7 Comparing Marketplace Loans with Bank Credit or Credit Card Debt 44

2.8 Who are the Alternative Borrowers? 47

2.9 Who Are Investors in Marketplace Loans? 48

2.10 Underwriting and Credit Scoring 48

2.11 Regulation 49

2.12 The Response of Banks to Online Lending 51

2.13 Concluding Remarks 52

CHAPTER 3 What Made the Rise of Online Lending Possible? 57

3.1 Technological Factors 57

3.2 Social Factors 62

3.3 Structural Factors 63

3.4 The Perfect Storm 65

3.5 A Divergence of Trends 66

3.6 Concluding Remarks 67

CHAPTER 4 Why Fintech Lives Outside of Banks 69

4.1 The Technology Mudslide Hypothesis: Sustaining Innovation vs. Disruptive Innovation 70

4.2 Will Banks Notice the Next Fintech Breakthrough? 73

4.3 Why Do Banks Have Difficulty in Innovating? 76

4.4 Developing Core Competence in Financial Technology Innovation 79

4.5 Concluding Remarks 81

PART TWO The Status Quo of Analytics in the Financial Industry—The Perspective of Banks 83

P2.1 Banking is Innovation 84

P2.2 Banking Goes Mobile 84

P2.3 Banks Are Far From Dead 85

P2.4 How to Read This Part of the Book 85

P2.5 What We Discuss in This Part 86

CHAPTER 5 Financial Contracts 89

5.1 Contract Elements 89

5.2 Time in Financial Contracts 90

5.3 Contract Mechanisms Producing Financial Events 92

5.4 Concluding Remarks 106

CHAPTER 6 Markets 107

6.1 Real-world and Risk-neutral Expectations of Markets 108

6.2 Economic Scenarios Based on Real-world Probabilities 109

6.3 The Risk-neutral Expectations 110

6.4 Beyond Market Risk-Free Rates 113

6.5 Discounting Cash Flows 116

6.6 Considering Market Elements in P2P Finance 117

6.7 Concluding Remarks 118

CHAPTER 7 Counterparties 121

7.1 Types and Roles of Counterparties 121

7.2 Descriptive Characteristics 123

7.3 Default Probability 124

7.4 Credit Ratings 129

7.5 Credit Spreads Based on Real-world Probabilities 130

7.6 Link of Counterparties via Markets 131

7.7 Concluding Remarks 137

CHAPTER 8 Behavior Risk 139

8.1 Prepayments 140

8.2 Draw-downs/Remaining Principle/Facilities and Credit Lines 141

8.3 Withdrawals 143

8.4 Selling 143

8.5 Default and Downgrading 144

8.6 Use at Default 145

8.7 Recoveries 146

8.8 Concluding Remarks 147

CHAPTER 9 Credit Exposures 151

9.1 Gross Exposure 151

9.2 Net Exposure 152

9.3 Evolution of the Gross and Net Exposures 152

9.4 Exposure Distribution 155

9.5 Credit Losses 156

9.6 Link of Counterparties via Credit Exposures 157

9.7 Concluding Remarks 158

CHAPTER 10 Credit Enhancements 161

10.1 What are Credit Enhancements? Types and Structure 162

10.2 Asset-based Credit Enhancements 162

10.3 Counterparty-based Credit Enhancements 165

10.4 Additional Elements Considered in Credit Enhancements 168

10.5 Extending Credit Enhancements in Marketplace Lending 170

10.6 Concluding Remarks 175

CHAPTER 11 Systemic and Concentration Risks 177

11.1 Credit Exposure Systemic Risk 177

11.2 Counterparty Systemic Risk 180

11.3 Systemic Risk Exposures and Losses 183

11.4 Credit Exposure Concentration Risk 184

11.5 Counterparty Concentration Risk 185

11.6 Systemic Risk and Portfolio Diversification 187

11.7 Concluding Remarks 187

CHAPTER 12 Liquidity, Value, Income, Risk and New Production 189

12.1 Liquidity 190

12.2 Value and Income 197

12.3 New Production 203

12.4 Treasury and Funds Transfer Pricing (FTP) 205

PART THREE Toward the Future of the Hybrid Financial Sector 215

P3.1 Dangers of a Big Bang Approach to Catch up with Technology Innovation 216

P3.2 The Need to Collaborate in a Hybrid Financial System 217

CHAPTER 13 Profitability and Risk of Marketplace Loans 219

13.1 Underlying Assumptions of the Analysis 220

13.2 Risk Factors 222

13.3 Portfolio Construction 224

13.4 Modeling Portfolio Performance 226

13.5 Risk Management 236

13.6 The Road Forward 246

13.7 Concluding Remarks 247

CHAPTER 14 Digital Competencies and Digital Dilemmas 251

14.1 Digital Competencies 252

14.2 Digital Dilemmas 255

14.3 Concluding Remarks 260

CHAPTER 15 Digital Strategy 263

15.1 Who Needs Digital Strategy? 263

15.2 Frameworks to Analyze the Impact of Innovation 264

15.3 Spotting Signs of Trouble on the Horizon 267

15.4 How Banks Can Overcome the Innovator’s Dilemma 269

15.5 From Producer to Supplier and Moving to a New Singularity 271

15.6 From Closed Innovation to Open Services Innovation 272

15.7 The Role of Leadership in Driving Emergent Strategy 273

15.8 Concluding Remarks 274

CHAPTER 16 The Hybrid Financial Sector 277

16.1 Forces of Competition in the Digital Age 277

16.2 The Dangers of Knife Fights 279

16.3 Good Ideas in Marketplace Lending That Might Be Here to Stay 280

16.4 The Alternative to the Hybrid Financial Sector: A Doomsday Scenario for Established Banks? 286

16.5 Concluding Remarks 286

CHAPTER 17 Unified Analytics 289

17.1 Why Do Marketplace Lending Platforms Need Unified Financial Analytics? 290

17.2 An Overview of a Unified Analytics Platform 296

17.3 Concluding Remarks 301

Bibliography 303