Can Lending Club Save Community Banks?

A consortium of community banks believes it has found a way to compete with their larger peers in the market for consumer loans, a business that has come to be dominated by too-big-to-fail lenders like Bank of America, Wells Fargo, and JPMorgan Chase.

On Monday, BancAlliance, a network of nearly 200 community banks, announced that its members will use LendingClub (LC 2.40%), a newly public company that operates an online lending platform, to construct portfolios of consumer loans.

Here's how The Wall Street Journal, which broke the story at the beginning of this week, explains it:

Members of BancAlliance [...] will start using Lending Club, a website that facilitates loans to individuals, to build new portfolios of consumer loans. The banks will each commit to buy a certain amount of loans from Lending Club, which will vet borrowers for their ability to repay. The borrowers will come either from the bank's own customers, whom the bank will send to a Lending Club website, or other borrowers that come directly to Lending Club.

The banks are expected to buy unsecured loans of less than $35,000 without requiring collateral. Until now, small banks generally haven't been able to justify the cost of underwriting those loans because big banks can do so much more efficiently.

It's hard to deny that this is a smart way for community banks to level the playing field in an increasingly concentrated industry.

Since the mid-1990s, the country's smallest banks have been supplanted as the major source of consumer lending. This is the result of mergers and acquisitions that have created a top-heavy industry dominated by a handful of massive banks. And along with size, at least in theory, comes economies of scale, which make it nearly impossible for small banks to compete against a multitrillion-dollar giant like Bank of America.

Thus, by banding together to syndicate larger loans through Lending Club's credit platform, BancAlliance is addressing the issue head-on.

But it's important to note that this strategy doesn't come without risk. One of the lessons history teaches us about banking is that outsourcing credit decisions can lead to disaster. There are numerous examples of this, but two from the recent past stand out from the rest.

In the early 1980s, some of the nation's biggest banks outsourced the origination of oil and gas loans to Penn Square Bank, an Oklahoma City-based lender that specialized in the energy industry. It wasn't until after the syndicated loans began defaulting that the correspondent lenders, including Chicago's Continental Illinois Bank and Seattle's Seafirst Bank, learned they had been shoddily originated and lacked proper documentation. In the fallout, Continental Illinois, the nation's seventh biggest bank at the time, was seized by regulators while Seafirst had to be rescued by Bank of America.

Virtually the same thing happened in the financial crisis of 2008-2009. In that case, mortgage originators like Countrywide Financial and Ameriquest underwrote billions of dollars in toxic sub-prime home loans that were then sold to bigger banks as well as to Fannie Mae and Freddie Mac. It was largely these loans, in turn, that went on to cost many of the nation's biggest banks tens of billions of dollars in credit losses and elevated legal costs.

This is why JPMorgan CEO Jamie Dimon said that the decision to use mortgage brokers was the "biggest mistake of his career." It's why Bank of America has since shuttered its correspondent mortgage operations altogether. And it's the reason many other leading lenders -- including Citigroup, MetLife, and Ally Financial -- have all reduced their reliance on third-party loan originators.

What makes the present case even more suspect is Lending Club's, at least in my opinion, cavalier attitude toward credit risk. The company purports to offer borrowers a "convenient, simple, and fast online application that improves the often time-consuming and frustrating loan application process." But here's the thing: there's a reason the credit application process takes time. Determining a borrower's creditworthiness isn't only about running a sophisticated algorithm. It's also about assessing the character of perspective borrowers. And that takes time.

Along these same lines, here's how Lending Club pitches its services to potential credit providers: "We use proprietary credit decisioning and scoring models and extensive historical loan performance data to provide investors with tools to construct loan portfolios confidently and model targeted returns." While this too sounds great, it evidences a level of confidence that isn't warranted by Lending Club's experience.

For instance, consider these findings from the FDIC about the prevalence of failures in the 1980s and 1990s among the then-most recently chartered banks and thrifts:

• "Banks chartered in the 1980s and mutual institutions converting to the stock form of ownership failed with greater frequency than comparable banks."
• "Of all the institutions chartered in 1980-90, 16.2 percent failed through 1994, compared with a 7.6 percent failure rate for banks that were already in existence on December 31, 1979."
• "Although the data are dominated by the Texas experience, in most areas banks chartered in the 1980s generally had a higher failure rate than banks existing at the beginning of the 1980s."

It's worth noting as well that this isn't the first time we've heard predictions about the ability to reduce credit risk. Most recently, in the years before the crisis of 2008-2009, lenders thought that credit default swaps, financial derivatives developed by JPMorgan in the 1990s, had effectively freed banks from the centuries-old menace. But in reality, swaps had merely substituted counterparty risk in the place of credit risk. You'd be excused, in other words, for harboring suspicions about claims that someone can "construct loan portfolios confidently and model targeted returns" (emphasis mine).

The net result is that BancAlliance's strategy, while promising on its face, certainly isn't a guaranteed panacea. Its success depends on Lending Club's ability to consistently originate high-quality consumer loans through all stages of the credit cycle. Will the upstart lending platform be able to meet this challenge? That remains to be seen, but it should be watched closely in the meantime.