As Regulators Circle, Will LendingClub and On Deck Capital Be Able to Comply?

LendingClub (LC 1.36%), On Deck Capital (ONDK) and other online lending marketplaces will argue that their business models are superior to a traditional bank's because its more efficient, leaner, and nimbler. There are no branches to build, far fewer employees to pay, and a much greater reliance on technology to automate, speed up, and streamline the operation.

Many of these assertions are true, however, they also ignore other critical facts that paint a different picture. When it comes to managing the costs of regulation, efficiently building long-term customer relationships, and finding cheap, stable sources of funding, traditional banks still maintain a significant advantage.

In this segment from The Motley Fool's Industry Focus podcast, host Gaby Lapera and bank analyst Jay Jenkins dive into the real economics of peer-to-peer lenders, and how high-performing traditional banks like First Republic Bank (FRCB) and Wells Fargo (WFC -0.26%) are maintaining an edge despite the challenge from these new, online competitors. 

A transcript follows the video.

This podcast was recorded on May 16, 2016.

Gaby Lapera: You mentioned Dodd-Frank earlier, which is the regulation that surrounds how banks are capitalized and their liquidity ratios and all this stuff to make sure that banks don't fail.

Jay Jenkins: Right. It also gave rise to the Consumer Financial Protection Bureau.

Lapera: Right.

Jenkins: It's a behemoth these days. It's really making a lot of changes throughout the whole industry.

Lapera: They're having some problems of their own, which could also be another podcast episode, that bureau is. The banks, my point is, have a lot of regulation surrounding them. These online lenders have a lot less because D.C. is a slow-moving city. They just haven't quite caught up with the times yet.

Jenkins: Sure, sure. These lenders are subject to a lot of the same regulations. Truth in Lending, Know Your Customer. Even some of the securities laws. Blue Sky laws, the Securities Acts of 1933 and 1940. All these laws do apply and they are regulated, but it is kind of the Wild West. The CFPB has not yet truly turned their attention to Lending Club or On Deck or any of these other players, but I'll tell you all of the bad headlines, this event last week, On Deck Capital had a pretty bad quarter... All this stuff is drawing a lot of attention, and a lot of people in Washington are expecting the crosshairs to move in a little bit more quickly than will have otherwise. It's just yet another headwind that has to be overcome.

Lapera: One of the things that happened at the banks is when they instituted Dodd-Frank, a lot of smaller banks went out of business or were acquired by larger banks because they just couldn't keep up with the amount of money required to come up to par with federal regulation. Who knows what will happen to these online lenders, especially because their balance sheets are very interesting when you look at them.

Jenkins: Sure. If their whole argument is that they have better economics than a traditional bank, because they're online only, because there's fewer heads to pay salaries, no branches that you have to pay rent or keep the lights on. That really brings into question if those economics are really there when you layer on some of these additional operator costs from having to do the same regulatory work that a trillion dollar or hundred billion dollar bank has to do. It's a big question mark.

Then on the cost front, too -- I wanted to come back to marketing -- again, their argument is that their economics are better. They can make more money more efficiently because of this lower overhead. However, when you look at look at their numbers, their customer acquisition costs are extremely high. Routinely, 35% to 45% of their revenue goes to marketing. You might be thinking they're spending a lot of money on marketing because they're trying to brand and do all these things they have to do. But tracking it over time, their marketing expense has been moving up in lock step as their revenues have increased. They're really not achieving any scale with consumers. That's problematic for them because it's a transactional model. They don't really have any way to kind of go back to the well and get one customer; how can we expand that relationship?

Again, clearly you can tell I'm in favor of traditional banks at this point in time on this, because that's the biggest benefit of traditional banks, is that relationship. Wells Fargo was famous in '80s. Their slogan was, "Eight is great," meaning for every customer they wanted to sell eight products.

Lapera: Yeah. That's something that they've actually achieved, which is great.

Jenkins: It's amazing. The best banks in the U.S., that's what they do. First Republic, over seven accounts per new customer. You walk into the bank, most likely you're walking out with seven accounts or more. That's fantastic for profits. That's fantastic for long-term wealth building. It's something that at this point I don't see how Lending Club, or On Deck, or some of these others are going to replicate. It just seems so transactional.

Lapera: Right. When we say accounts, it's not just loans, right? We're talking credit cards, debit cards, savings accounts. All these types of things.

Jenkins: Wealth management. Checking accounts. Savings accounts.

Lapera: Exactly. These are all things that these online lenders just can't do, not unless they decide to become a bank and then they're no longer what they were.

Jenkins: That's right. That's what some of them are doing. Some of the smaller ones. They're actually going out and trying to buy community banks for that reason, and also another advantage traditional banks have is their cost of funding. I'm sure everyone listening and watching knows that if you go and open up a savings account today, the bank's really not going to pay any interest on it, maybe a few basis points. That money is free money for the bank to go out and make loans and drive their yields higher. But on the online lending marketplace, that money is either going directly to some other person in a peer-to-peer, at a really high yield, or it's going to some capital investor whose cost of funds might be 7%, 8%, 9% as opposed to 7, 8, 9 basis points. That's a huge advantage for traditional banks and it's going to be really challenging and it's going to be really interesting to see how these online lenders kind of overcome and try to manage that. I wouldn't be surprised if a lot of them end up with bank charters and accept deposits, just like some of the existing online-only banks.