Alice in Wonderland’s first edition was going to press and Lincoln running for presidency when the UK’s youngest high street bank launched. For 185 years after that a select few financial edifices towered over the high street, single-handedly setting our expectations for banking services.
That was until 2010 when Metro Bank opened its doors in Holborn, London, in the wake of the financial crisis.
The Times sums up the atmosphere in the years preceding its launch with the headline: “Fear stalks the banks.” Major high street players were going cap in hand to the government. And we later found out that the Royal Bank of Scotland was just hours from running out of money.
So, why launch a new bank when the financial world was being rocked to its core?
Metro Bank was a 100-year outlier, but it wasn’t unique. The first so-called challenger bank, it was followed by a wave of new licensees including Atom Bank, Tandem and Monzo. These companies provide new options to consumers and began chipping away at high street banks' monopoly on small business finance.
Tech-enabled startups targeted particular elements of banks’ services too, in a process that’s sometimes called ‘unbundling’. Funding Circle and ThinCats created the first peer-to-peer business loans services in 2010. These online services match lenders and borrowers, allowing people to give money directly to businesses.
By 2016, peer-to-peer business lending had reached £1.2bn, 40% higher than the previous year and an almost seven-fold increase on just three years earlier.
TransferWise launched in 2011 to disrupt currency transfer and equity crowdfunding platform Crowdcube, a worldwide first, opened the same year.
Low-interest rates stimulate innovation
ThinCats genesis was during a lunchtime discussion between angel investors. The government had slashed interest rates to stimulate the economy, creating poor returns for savers.
The idea was to find businesses to loan their savings to. Someone mentioned Zopa’s model of connecting borrowers and lenders directly, cutting out financial institutions.
The financial crash also led to a huge retrenchment in bank lending to small businesses as they attempted to reduce risk.
ThinCats’ founders Kevin Caley and Peter Brown thought the model could be applied to companies, and wrote a business plan that afternoon.
Peer-to-peer business lending had reached £1.2bn by 2016, 40% higher than the previous year and an almost seven-fold increase on just three years earlier.
Low-interest rates played a role in the creation of equity crowdfunding too. Seedrs’ chief legal officer Karen Kerrigan helped shepherd the platform through regulation. Speaking to AccountingWEB for a recent profile, Kerrigan points to the poor returns offered to savers as a key part of their early success.
“I don't think it's quite as obvious as everyone hates the banks and so looks for somewhere else to put their money, which is the common refine,” she says. “I think it's about choice and transparency, and low-interest rates.”
Socio-economic factors to alternative finance
If interest rates were the spark, the growing numbers of business incorporations and lower bank lending were the kindling.
Redundancies caused by the crisis led an increasing number of people to think about starting their own business. A trend which only began to falter last year. The financial crash also led to a huge retrenchment in bank lending to small businesses as they attempted to reduce risk.
The founders of Crowdcube, Seedrs’ long-time rival, point to similar environmental factors. They set out to democratise access to finance, in part because banks had stopped lending.
“When you go through a period of instability and recession, that’s when a lot of great ideas start, people leave their jobs with a pot of redundancy money and go and set up the thing they’ve been dreaming of,” co-founder and CMO Luke Lang told the Evening Standard recently.
Crowdcube facilitated £87m of investment last year and were the largest seed-stage investor by deal numbers. The size of their offering is just one fact that underlines the impact of these new players.
More than £10bn of funding has been provided by alternative finance platforms since 2011. For business owners, the change has been particularly pronounced, with 17% of seed and venture funding, and 15% of small business loans now provided by alt-finance.
As Bryan Zhang, co-founder of the Cambridge Centre for Alternative Finance puts it: “They [alternative finance providers] are now one of the default fundraising and investments channels for businesses, retail investors and institutions.”
Consumers have felt the benefits too. Long ripped off by exorbitant exchange rates, newcomers like Transferwise have openly flouted their independent status - its 2015 advert titled The Party’s Over advert boasted savings of 89%.
Light touch or heavy hand?
The Financial Conduct Authority (FCA) played an important role in these innovative financial offerings. Supporting the nascent sector with world-leading regulation, it also gave it time to find its feet.
That said, the momentum alternative fianance platforms have achieved, and the potential risk that created, couldn’t stay unnoticed for long.
“It's like getting invited to the swimming pool by sharks that are telling you the water’s warm.”
The FCA’s involvement was a double-edged sword. On one hand, it reassures potential customers. On the other, regulation put an expensive burden on new platforms. Caley describes regulators becoming involved in peer-to-peer business lending as “like getting invited to the swimming pool by sharks that are telling you the water’s warm”.
The number of peer-to-peer licences fell by 38% from 91 to 56 during 2016, according to the FCA, and industry insiders estimate there were only 30 operational last year.
“You have to get to a significant volume of loans to cover costs,” Tim Slesinger, CEO of P2P investment aggregator LendingWell, explained to AccountingWEB’s sister publication BusinessZone last year. “In the interim, you can be quite lean, but there are more and more regulations and pressures, which is good, but with that comes a cost.”
The disruptive force of peer-to-peer has been absorbed by the system and turned into asset management.
This has led to consolidation. Funding Circle accounted for 41% of new business lending in Q4 2017, Zopa 30% and MarketInvoice 20% according to the Peer 2 Peer Finance association. The other platforms had less than 5% market share (download the data here).
How alternative is alternative finance?
It was interesting to talk to ThinCat’s Caley about the genesis of alternative finance when he’s preparing to retire. With ten years at the forefront of P2P lending, he’s helped shape the evolution of the sector. Today he believes P2P is “dead as we know it”.
“When we invented peer-to-peer lending the individual lender made the decision. They picked the person or business and the interest rate. It was disintermediation and that was very successful,” recounts Caley.
That changed with the involvement of institutional investors, beginning with the British Business Bank. These investors needed a simple way to assess loans. The need to automate this process led to a rating system and started a shift away from investing in individuals.
“The disruptive force of peer-to-peer has been absorbed by the system and turned into asset management,” Caley says.
That’s not to say the potential business benefit of peer-to-peer lending and crowdfunding is threatened.
Crowdfunding is experiencing a similar trend, although a few years later that peer-to-peer lending. Larger crowdfunding raises are more likely to succeed and offer bigger fees for platforms. These often involve institutional investors, whose share of the amount invested increased from 8% to 25% between 2015 and 2016 (see below data).
Proportion of Funding from Institutional Investors, 2015 vs 2016 (Cambridge Centre for Alternative Finance)
Alternative finance providers’ work with intermediaries means they have started to lose the hallmarks of disruption. In short, they’re less alternative and more mainstream.
That’s not to say the potential business benefit of peer-to-peer lending and crowdfunding is threatened. Regulation reassures consumers, making them more likely to invest, and increased institutional involvement has spurred growth.
Less than a decade on, challenger banks continue to build on their success too - Metro Bank now has nearly £12bn in assets - and they offer services that are incredibly convenient, pushing high street banks to innovate.