As part of a project for the Equipment Finance and Leasing Foundation, we have been analyzing what is commonly termed alternative finance. Based on this group’s growth, increasing acceptance by end customers, and the potential value they can provide to banks, alternative lenders should not be ignored. Too many banks appear blissfully unaware of what alternative finance is or how it may impact their current business. That’s a mistake.

“Shadow banking” has been around for a long time. Basically, it involves non-bank lenders who often make loans that banks assess as too high in risk to be bankable. In our view alternative financing is a subset of this world and what makes alternative financing new and unique is its dependence on and integration with FinTech or financial technology. Without fully exploiting FinTech, alternative finance could not exist.

Alternative lending goes well beyond peer-to-peer loans. Initially, this segment largely consisted of “loans” or more likely dollar gifts to charities. Other websites allowed someone with spare cash to give dollars to fund a project such as a movie with the “interest” received by the lender often being no more than a thank you in the movie’s endnotes. Providing investors with a more traditional return, Lending Club built a huge business in providing the platform for an individual to assist a borrower to pay down a high-interest credit card. Institutional money has entered this and related businesses in a big way with private equity firms lending their own dollars and, increasingly, banks buying portfolios of loans packaged by the crowdfunding platforms, among others.

We have had the opportunity to work for several FinTech players and have evaluated dozens of others. Some common characteristics include:

* Focus where the banks will or cannot. Banks created the alternative financing business by ignoring (where justifiable or not) the majority of U.S. small businesses. Oxxford Information Technology, our partner in the data analytics area, estimates that banks focus on just 10% of potential small business borrowers with about 25% of the available lending dollars. That leaves over $1 Trillion of loan potential up for the alternative companies to grab.

While alternatives currently focus on small businesses and small loans, some indications exist that they are moving upscale, perhaps a greater threat to banks. A number of crowdfunding sites now focus on “qualified” lenders providing loans in excess of $1 million. Industry insiders say that moving upscale will be easier than making small business loans with their lack of information and small size.

* Technology at the core. Social media experts and technologists at most banks have a problem, as they seem to be treated as something of an afterthought at many banks. Top management knows they must pay attention to digitalization and omni-channel requirements, but they are also saddled with a high cost, low return branch system that every day become less important to a growing set of customers. Alternative finance players start with a clean slate and, instead of being encumbered by the past, they are free to explore new approaches without concerns about cannibalizing legacy approaches. Most emphasize the use of technology to originate a loan, underwrite it, and monitor it. Some “touch” does exist but high tech predominates.

* They start with one idea and then adapt. Targeting and segmentation are fundamental drivers of how these lenders pursue opportunities. For example:

• SmartBiz’s creators started with a way for banks to compete with payday lenders. As banks avoided this space, it moved more decisively into providing a low-cost platform for SBA lending.
• Lending Club provides the major peer-to-peer lending platform. However, they are quickly moving into the institutional space with individual lenders playing a smaller role. They have also moved into small business lending from peer-to-peer.
• Lending Club, OnDeck, and others are going beyond directly competing with banks to working with them to improve their efficiencies and the quality of their lending decisions, often allowing banks to expand their sales focus.

* Young, nontraditional leaders. Many of the creators of these companies have had success in areas outside banking; usually, they know how to use FinTech better than they know bank bureaucracies. Typically, they are also much younger than the Baby Boomers who still run many banks. Because they often come from outside the established banking industry, they address situations differently, looking to disrupt current businesses rather than preserve old ways.

* Partnership with banks. Many alternative players see banks as great partners for them in one or more ways:

• Fundera is a loan marketplace that provides borrowers with multiple non-bank choices, including On Deck, merchant advance companies, private equity lenders, SBA lenders, and others. They want to work with banks to screen their turndowns and providing multiple offers from alternative lenders. The banks keep relationship control and get referral fees.
• Individual alternative lenders are also pursuing bank partnerships for loan volume.
• As noted above, several FinTech players offer banks loan platforms to originate, underwrite, and monitor loans at a reduced cost and they believe with improved performance. This can turn some loans that today are unprofitable into profit makers.

Like banking, alternative lenders face challenges going forward. Currently, the largely stable economy increases the likelihood of their success. However, when a downturn occurs parts of the alternative business will quickly contract. Further, some companies within this industry seem to be operating largely under the radar of regulators, a situation that is likely to change. In addition, more competitors enter this business almost daily, lowering margins and in a few cases banks are looking at their own data to determine how they can compete in this space. Nonetheless, we believe many of these players will grow and thrive. Banks cannot afford to ignore them.

One alternative industry executive commented that in the near future alternative players will become the major lenders to small business. Given the limited number of companies banks focus on, that is not an unrealistic projection. Yet, what a mistake for banks to allow this to happen when they have the opportunity to team up to avoid losing a critical bank franchise.