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The nature of social capital and trust in banking and financial services


I have enjoyed a re-read of Bowling Alone during a recent vacation.  Its a fascinating book written very academically, so not an easy read.  Tons of statistics.  However the concepts that it explores are relevant and interesting for Banks.  For me it helped to sort out differences between Banks and others, and the nature of trust.  It helped me better understand social capital.

What is especially interesting and relevant for our times is that it was written in 1999.  This book predated the dot com crash, and predated the rise of social networks, yet it nailed the much of the direction of internet that we have witnessed through the twentyfirst century to date.

It does that because it takes a sweeping century wide view of social progress, and lays out the possible reasons for the shifts in a quite objective and analytical manner.

The basic premise is that the fabric of US society has altered dramatically in the last 1/3 of the twentieth century, and people are significantly less civically engaged than in the first 2/3.

We care less <here> about civic engagement, but more about the underpinnings of that shift.  In the discussion Putman talks about social capital, and the shifts in that capital.

I see relevance here for Banks to understand their customers from a perspective that normal segmentation will not pick up.  First some definitions that the book uses, then discussion.  I am keeping this deliberately relatively brief, and if you want to delve deeper, then 540 pages await you!  Worth the read if you care about this stuff.

First some definitions, which you can skim, then the discussion.

Definitions [from “Bowling Alone]:

Social Capital:

“How does social capital work?
The term social capital emphasizes not just warm and cuddly feelings, but a wide variety of quite specific benefits that flow from the trust, reciprocity, information, and cooperation associated with social networks. Social capital creates value for the people who are connected and – at least sometimes – for bystanders as well.

Social capital works through multiple channels:
– Information flows (e.g. learning about jobs, learning about candidates running for office, exchanging ideas at college, etc.) depend on social capital.

Social networks are important in all our lives, often for finding jobs, more often for finding a helping hand, companionship, or a shoulder to cry on.  [Fischer]”

Bonding Capital:

… inward looking and tend to reinforce exclusive identities and homogeneous groups.  eg fraternal organisations, church based womens groups, fashionable country clubs, ethnic enclaves, start up financing groups, etc. [sociological superglue]

Bridging Capital:

Bridging networks, by contrast are better for linkage to external assets and for information diffusion.  .. when seeking jobs, political allies the weak ties that link me to distant acquaintances who move in different circles from mine, are actually more valuable than the strong ties that link me to relatives and intimate friends, whose sociological niche is very like my own.   [sociological WD-40]

Thick trust:

Social trust embedded in personal relations embedded in personal relations that are strong frequent and nested in wider networks.

Thin Trust

Social trust that exists beyond thick trust.  e.g. an acquaintance at the coffee shop, or at work.  Think trust rest implicitly on some background of shared social networks and expectations of reciprocity.  A standing decision to give most people – even those whom one does not know from direct experience – the benefit of the doubt.

the test: “Generally speaking, would you say that most people can be trusted, or that you can’t nbe to careful in dealing with other people” – this taps feelings about .. thin trust.

Discussion:

Putnam discusses throughout the continual balance between legal trust constituted by law and order and civil law versus the thin trust that exists around us all.  This goes to reputation of people, of groups of cities, and of countries.  Generally he concludes that thin trust is less now than 30 years ago, and there are many drivers attributed to that including television, lack of personal time, commuting separation of home location and work location etc etc.  In any event people feel less engaged and are less engaged.

However what he notes and is interesting is that people still respond to social capital despite the disincentives in our modern life.  He notes in particular the potential of internet and information technology to dramatically improve the opportunities for social capital.  [note book written in 1999].

Whether we look at social lending, or social networks like Facebook, there is much discussion and optimism on topics of ‘friends’, and levering social capital in simple and convenient ways.  It is interesting to look at those two examples plus traditional banking.

What struck me the most is that these examples are largely based today on different kinds of trust.  Facebook is all about thick trust for the most part.  Exceptions are those that choose to gather lots of friends, and in those cases I would argue not even thin trust exists, but it may be somewhat developable.

Social Lending has thin trust established between the lender and the social lending service.  There is also thin trust established between the borrower and the lending service.  These thin trusts are based on trading of confidential information, between the borrower or lender and the service.  By accepting that role as the trust broker, the social lending service is able to allow the creation of a new thin trust to exist between the lender and the borrower that could not have otherwise existed.

Its clear that all social lenders are not the same, and the securities regulatory environment hinders the development of a  broad development of thin trust by imposing other rules that obscure the underlying benefits, nonetheless this is the promise of social lending and social finance in general.

Traditional banks have no such level of social trust that can be created.  Each relationship is unique and between the customer and the bank as an organisation.  Particularly in lending, that is managed through brokers or different personal lenders each time, the relationship is defined by gathering and validation of information each time.  One of the complaints I frequently heard in my banking career was the lack of continuity in the branch, and the lack of long term relationships being built with the bankers.

Lastly looking at the bridging vs bonding, then similar patterns emerge.  FaceBook is about bonding capital, based on thick trust.

Banks have neither bonding nor bridging.  Social Lenders are to various degrees creating hybrid elements of bridging capital, and although the users are anonymous to each other, they get to know each other by user name identifiers.

Relevance to Bankwatch:

The book helped me at least to differentiate the fundamentals of the model between banks and social lenders, and between social lenders and FaceBook.  The difference is in the type of trust that forms the basis of them  FaceBook is thick trust, and I would argue a bad place to establish a business.  The old adage of doing business directly with friends (real friends) is a bad idea, prone to future disaster for the friendship.

Banks I would argue have neither thin nor think trust.  They are based on legal relationships.

Social lenders, at least, have the opportunity to lever trust, albeit thin trust that could not otherwise exist without the social lending service, and establish some bridging capital.  Bridging capital is the more powerful capital in terms of impacts on people and society.

Written by Colin Henderson

August 26, 2008 at 11:34

Posted in Social Lending

Platform vs market logic, applied to P2P Lending


Back from vacation, and thinking about all kinds of stuff.  Long post on Social Capital coming, but meantime, and kind of related <in my mind> Umair does a nice job of discussing the merits of platforms and markets.  It is an important distinction, and his final quote here explains what caught my eye.

What Apple Knows That Facebook Doesn’t – Umair Haque

This conclusion also helps us answer another critical question on the minds of today’s investors, entrepreneurs, and would-be revolutionaries: when will today’s crop of startups start making serious cash? The answer: when they shift from platform logic to market logic.

He finishes by asking which players are being held back by platform thinking?  I worry about P2P Lending being held back back by that thinking, but feel a little better after going through this exercise.  First the background:

Platform logic vs market logic

Platform thinking; is based on consistent sets of principles including these taken from the book Platform Leadership: How Intel, Microsoft, and Cisco Drive Industry Innovation (Hardcover) that “drive success”.

1. Determine the scope of the firm
2. Design product technology strategically
3. Shape relationships with external complementors
4. Optimize internal organizational structures

The book was written in 2002, and the examples are interesting in that context.

Platforms are all about creating a monolithic enterprise that determines its own fate by being consistent and strong to the outside world.  Platforms are about convenience, including external and internal relationships, and products designed to dominate the space.  Platforms are about scale.  Think Microsoft, IBM, Intel, and in banking, Bank of America, Barclays, or HSBC. 

It sounds and feels very insular and inwardly focussed.

Market thinking;  is all about customers and offering something of value, for value.  Its about oferring something for sale that people want.  Market thinking will, as Umair says, “alter the basis of competition”.  This requires a structural shift and is designed to catch the competition wrong footed, not as platforms would, merely look to dominate, using corporate shock and awe.

P2P Lending is generally following a market logic approach

P2P Lending is in its infancy, so its hard to consider any of the players are market dominating at this early stage.

The three market attributes that Umair discusses are interesting though, to explore which, if any of the current players are exemplifying those attributes.

Markets alter the basis of competition
P2P Lending could be said to alter the basis of competition.  The interest rates and the customer processes vary, but generally they do achieve that. 

Markets cause strategic domino effect
Is there a strategic domino effect?  This will be based on scale, and as yet we are not seeing a shift in banking as a result of P2P Lending.  Or are we?  Banks are seeking ways to enter the space and test the waters, by becoming lenders in some P2P Lending companies.  P2P Lenders are springing up around the world, with the latest count being over 30.

Yet, there is somthing holding back the ‘domino effect’.  That is regulation.  The one thing that prohibits the domino effect is regulation.  I am living that with CommunityLend, and Lending Club have filed their revised S-1 in the US.  Once we start to see regulataory approvals in place, how will the picture change?

However many are not considering, or dealing with the regulations.  Is that a good thing or a bad thing?  Regulation, and the ability to have P2P Lending be seen as a friend of safety and security will ultimately be a key factor.  Borrowing and investing are matters of finance that are all the more important to everyone concerned, following the major ball-drop by Banks’ lately.

Markets atomise the value chain
This is where existing players see their processes and products chopped into tiny pieces and taken over by new entrants who see better ways to manage things.  P2P Lenders are doing a good job at this aspect. 

 

So it seems that P2P Lenders are pretty good on 1. and 3. but not quite so much on 2. yet.  Umair uses FaceBook and Apple to compare the platform to market approach.  He speaks of FB signing deals with incumbents <Microsoft> and thus failing on 2. 

What of P2P Lenders allowing Banks to participate in their services?  On reflection I think this is not the same as selling out to incumbents.  Rather it is requiring incumbents to adapt to the new model if they wish to participate, and places them on the same playing field as the others in the P2P market. 

However the regulation impact is still troubling and whether enough P2P lenders will be able to see it through to establish the domino effect is key. 

Time will tell.

Written by Colin Henderson

August 23, 2008 at 03:00

LendingClub file revised S-1; suggests progress being made


LendingClub has filed a revised S-1 with the SEC. This suggests progress, and will be as a result of comments on the original S-1. Comments from the SEC are not public until final approvals.

I need to review the copy to figure out the changes and updates. More tomorrow.

www.sec.gov

As filed with the Securities and Exchange Commission on August 1, 2008

UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Amendment No. 1
to
Form S-1
REGISTRATION STATEMENT
UNDER
THE SECURITIES ACT OF 1933
LendingClub Corporation

Written by Colin Henderson

August 4, 2008 at 23:51

Posted in Social Lending

Tagged with

Zopa, CEO Douglas H. Dolton – SNW Interview


Interview with Doug Dolton, CEO of Zopa, the social lending company with offices in UK, US, Italy, and Japan. He has some interesting thoughts, and bullish views on the scale that social finance will achieve over time.

Social Networking Watch: Zopa, CEO Douglas H. Dolton – SNW Interview

What is your long term vision? Where could you see Zopa and the industry being in 10 years time?

I honesty think that the efficiency, convenience and trust that you get with dealing with an entity like Zopa will become more and more attractive to people. I can see this will be a multi-billion dollar business. 10 years from now or so, we’re going to have quite a bit of interactive social finance activities taking place with unsecured consumer loans and who knows beyond where that could go. Transactions involving currency exchange, transactions involved car insurance – that’s another thought, where a group of people will come together and pool their resources to provide the first tier of losses associated with car insurance and then they will buy a blanket coverage to provide a full coverage to everybody. As time goes on, we will see more and more of this democratization of finance taking place with transactions well beyond simply unsecured consumer loans.

Written by Colin Henderson

July 26, 2008 at 21:15

Posted in Social Lending

Global Financial Turmoil and the responsibility of social lending


Nice crisp explanation of the cause of the sub prime crisis by Governor Frederic S. Mishkin of the US Federal Reserve. In particular I liked this quote “a global margin call on virtually all leveraged positions”. Later on I offer an observation on how social lending has a responsibility, and a role to play in all this.

FRB: Speech–Mishkin, Global Financial Turmoil and the World Economy–July 2, 2008

The subprime crisis exposed problems with the securitization of mortgages. In particular, it became painfully clear how poor the underwriting and credit-risk analysis were for a wide range of products. Some appraisers, brokers, and investment banks were motivated by transaction fees and had little stake in the ultimate performance of the loans they helped to arrange. Many securitized products were complex, and the ownership structure of the underlying assets was opaque. Investors relied heavily on credit ratings instead of conducting due diligence themselves, and credit rating agencies failed to fulfill their raison d’etre. The result has been rising defaults, particularly in the subprime mortgage markets, with losses to both investors and financial institutions.

The ultimate losses from the recent residential mortgage-market meltdown have been estimated by Wall Street analysts at about $500 billion–less than 3 percent of the outstanding $22 trillion in U.S. equities.2 Why did a relatively small amount of losses on subprime mortgage loans lead to such broad-based financial disruption? After all, a 3 percent decline in stock market prices sometimes happens on a daily basis with hardly a ripple in the U.S. economy.

In part, the outsized impact of mortgage losses on broader financial markets probably stems from the fact that they exposed a more extensive set of problems in financial intermediation that were not limited to the original subprime loans. The liquidity shock that hit us in August has been described by one of my colleagues as a global margin call on virtually all leveraged positions.3 The liquidity shock quickly brought an end to the credit boom that preceded it, as a striking loss of confidence in credit ratings and an accompanying revaluation of risks led investors to pull back from a wide range of securities, especially structured credit products. Along the way, the inadequacies of the business models of many large financial institutions were exposed, and these models are now in the process of significant re-examination and rehabilitation.

However this statement, when the Governor spokeof the future, caught my eye. The agency problem he refers to, is the reliance on mortgage brokers, appraisers, and all catch points for mortgages. He explained earlier those agents had been motivated by mortgage volume, took their commissions, and ran. There was no incentive for those agents to offer quality, and in fact they were incented to offer volume, with poor or fictitious quality.

Although some of the most complex structured-finance products may be gone for good, securitization will only recover fully when new business models solve the agency problems that were inadequately dealt with in recent years

This highlights a market opportunity, where social lending can bring significant leverage to bear. In the speech, the Governor spoke of credit ratings failing, and he spoke there of the Moodys etc rating on the ABCP (Asset Backed Commercial Paper) market. There is another rating that becomes essential in all this, and that is the rating on the end borrower, the person who takes out the mortgage to purchase a home. The rating on that person must be complete, accurate, and transferrable. By transferrable, I mean it must be available for inspection, and due diligence up stream as the collaterisation process disseminates the mortgage into pieces that become CDO’s and other ABCP. Social Lending is not just about people lending to people. That is a great beginning, and offers the valuable inspection from the wisdom of crowds.

In the future the market may well see additional markets appear, and social lending must at a minimum outperform the old way of doing things.

Written by Colin Henderson

July 6, 2008 at 03:17

“The proceeds we receive from the sale of each series of Notes will be designated by the lender members who purchased the Notes of that series to fund an unsecured consumer loan” | Lending Club


With that lengthy statement, we now see how Lending Club intend to operate their business as defined in their SEC S-1 filing today.

Some more detail here.

sv1 Lending Club S-1 filing

The proceeds we receive from the sale of each series of Notes will be designated by the lender members who purchased the Notes of that series to fund an unsecured consumer loan originated through our platform to an individual consumer who is one of our borrower members.
… …

A series of Notes will be issued only if and when the corresponding member loan closes and is funded. A member loan will close and be funded if the borrower member loan request has received full funding commitments, or if the borrower member chooses to accept partial funding of the loan request after receiving funding commitments for the loan request.

And this taken from the description of the lending platform:

About the
Loan Platform

Through our online platform, we allow qualified borrower members
to obtain unsecured loans with lower interest rates than they
could through credit cards or traditional banks. We also provide
our lender members with the opportunity to indirectly fund
specific member loans with credit characteristics, interest
rates and other terms the lender members find attractive by
purchasing Notes that in turn are dependent for payment on the
payments we receive from those borrower member loans. As a part
of operating our lending platform, we verify the identity of
members, obtain borrower members’ credit profiles from
consumer reporting agencies such as TransUnion, Experian or
Equifax and screen borrower members for eligibility to
participate in the platform. We also service the member loans on
an ongoing basis. See “About the Loan Platform.”
The Notes. Our lender members will have the
opportunity to buy Notes issued by Lending Club. Lender members
will be able to designate the particular member loan that they
want the proceeds of each Note they purchase to be used to fund.
The holders of Notes of each series will have the right to
receive their pro rata portion of principal and interest
payments on their Note but only if, and to the extent, that we
receive loan payments on the corresponding member loan, net of
our service charge.
The Notes will be special, limited obligations of Lending Club
only and not obligations of any borrower member. The Notes are
unsecured and holders of the Notes do not have a security
interest in the corresponding member loans or the proceeds of
those corresponding member loans.
Lending Club is obligated to pay principal and interest on each
Note in a series only if and to the extent that Lending Club
receives payments from the borrower member on the corresponding
member loan funded by the proceeds of that series, and such
borrower member payments will be shared ratably among all Notes
of the series after deduction of Lending Club’s service
charge and any unsuccessful payment fees, collection fees or
payments due to Lending Club on account of the portion of the
corresponding member loan, if any, funded by Lending Club in its
capacity as a lender on the platform. If Lending Club were to
become subject to a bankruptcy or similar proceeding, the holder
of a Note may have a general unsecured claim against Lending
Club that is not limited in recovery to such borrower payments,
but, as described in more detail below, the matter is not free
from doubt. See “Risk Factors — If we were to
become subject to a bankruptcy or similar proceeding.”

In essence it appears that Lending Club make loans to borrowers. Lending Club then issues notes to investors, corresponding with the loans to borrowers. Seems simple enough. The rest of the prospectus details the risks as expected in any prospecus, and has a great amount of detail in words and tables on FICO scores, expected default rates, and other statistical data.

Written by Colin Henderson

June 20, 2008 at 20:41

Posted in Social Lending

Trust and verify | Tapscott offers radical solution for credit crisis


Don makes a terrific point here on the power of what he terms wikinomics, that comprises four principles:

  1. openness
  2. peering
  3. sharing
  4. act globally

CNW Group | DON TAPSCOTT | Troubled financial markets need to embrace Wikinomics-style transparency says Don Tapscott

“For example, investors should be able to “fly over” and “drill down” into a CDO’s underlying assets. With full data, they could readily graph the payment history, and correlate information such as employment histories, recent appreciation (or depreciation), location, neighborhood pricings, delinquency patterns, and recent neighborhood offer and sales activities. Now that AAA ratings have proved worthless, currently investors don’t have a glimmer of what they are being asked to buy. And they won’t start buying until they fully understand what they are purchasing, and that the price is fair.

There is little chance that the Banks would do this together, but what if one or two did it first. In the book, Don offers the example of Goldcorp who were having difficulty locating their next gold find, and CEO McEwan was frustrated by the ‘glacial’ progress from traditional geologists. So he took all their supporting geological data, and offierred it online, in the form of a contest.

Within weeks, they received 100’s of submissions but not jsut from geologists, but from students, mathematicians, military officers etc. The contestants identified 110 targets, 50% of which had not been previously identified. Over 80% of the targets yielded substantial gold reserves. McEwan estimates 2 – 3 years were shaved from the normal process.

The Banking system suffers the same problem as Goldcorp. Glacial movement in determining the true underlying value of ABCP supporting assets.

Tapscott offers that if the data were made available online, the data that supports the paper, then the internet community could solve the problem faster and more effectively by providing insights, solutions, early warnings, and no approaches that could never be developed by information protective bankers.

Written by Colin Henderson

June 11, 2008 at 10:59

Posted in Social Lending

Tagged with

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