The Small Firms Revolutionizing Banking

At the height of the recent financial crisis, consumers discovered that banks were in no mood to make any sort of loans. In response, they sought out a new kind of bank, known as a peer-to-peer lender.

Banks now likely rue the day they turned those consumers away. Peer-to-peer lending represented just $26 million worth of loans in 2009. Today, it's a $1.7 billion business and could be a $10 billion business within five years.

Peer-to-peer lending is just one of the radical changes taking place in the banking landscape. For example, banks issued 90% of all mortgages in 2009. Today, that figure has dropped to 58%. And small businesses, which are at the backbone of the U.S. economy, are now going out of their way to get loan quotes from alternative finance providers.

Gone are the days when local banks cultivated deep relationships with local businesses and citizens. Many of those banks have been gobbled up in an industrywide consolidation, and borrowers are quickly discovering new alternatives.

Frankly, it's easy to see why both consumers and businesses are flocking toward the upstarts. Not only do the "non-banks" offer slightly better loan rates, but they are also much more likely to approve a loan. According to Goldman Sachs, alternative lenders approved 62% of small business loan requests last year. The traditional big banks approved just 21%.

The Pullback

The big banks are being buffeted by a pair of factors that are leading them to reduce their exposure to lending.

First, they've been working hard to shore up their capital bases to meet new mandates. That means they've had little interest in making new loans that weigh down a balance sheet.

Second, the Dodd-Frank Act is boosting expenses for the major banks, as they comply with a slew of new regulations. Alternative lenders -- also known as "shadow bankers" -- aren't burdened by the regulations and costs and as a result, can offer better loan rates and still generate similar net interest margins.

To be sure, the big banks may soon conclude that their capital bases are sufficiently strong and they may start to boost their lending activity. And regulators may eventually force the alternative lenders to adhere to stricter regulation. But the longer it takes for such changes to take place, the deeper inroads the alternative lenders will have made.

The other major factor in this industry disruption is the traditional bank branch business model. The big banks still maintain thousands of local branches across the country. And every branch consumes hundreds of thousands of dollars in annual salary and general overhead. The alternative lenders simply use the internet to conduct most of their business.

The Peer-To-Peer Revolution

The peer-to-peer lending industry is growing very rapidly, and investors can invest in this niche in several ways. My colleague Jimmy Butts provided an in-depth pre-IPO profile of LendingClub Corp. (NYSE: LC ) . And roughly a month ago, I noted that George Soros' investment firm now owns more than four million shares .

LendingClub, along with privately-held, are currently the leading providers of loans to and from consumers. How big might the consumer end of peer-to-peer lending grow?

"Of the $843 billion of consumer loans outstanding, we see $209 billion 'at risk' to move to new players over the longer-term," predict analysts at Goldman Sachs.

To be sure, such a large total market opportunity will attract new entrants, making it crucial that LendingClub and Prosper grow as fast as they can in the near-term. (Prosper's venture capital backers may look to bring the company public later this year.)

In terms of small business lending, On Deck Capital, Inc. (Nasdaq: ONDK ) and privately-held Kabbage have the early lead. Notably, shares of both LendingClub and On Deck have traded off of their highs, following concerns that growth expectations may have been too aggressive. Still, each of these firms appear on pace to boost revenue at least 50% in 2015 and 2016. Investors interested in this niche should also research Steel Partners Holdings LP (NYSE: SPLP ), which owns WebBank, a provider of administrative and compliance services to a broad range of peer-to-peer lenders.

Business development companies (BDCs) have been making loans to mid-sized businesses for many years. They are more heavily regulated, though not to the extent that the major banks are. My colleagues Andy Obermueller and Nathan Slaughter have been writing about BDCs for a number of years, and I encourage you to read their newsletters ( Game-Changing Stocks and High-Yield Investing , respectively) to see why they hold BDCs in such high esteem.

Perhaps one of the largest niches of "shadow banking" will be in the area of student loans. There is now $1.2 trillion worth of student loan debt outstanding, up from $700 billion in 2008 and range of upstarts are angling to get a slice of that pie. Privately-held companies such as SoFi, CommonBond and Earnest are working to connect students with alumni and other potential lenders.

These firms also work with students that are well-suited to consolidate multiple student loans into one loan. A backdoor way to invest in this niche is through Nelnet, Inc. (Nasdaq: NNI ) , a traditional student loan issuer that has been making a series of investments in CommonBond.

Risks To Consider:Now that the big banks have strengthened their capital bases, they may start to re-take lost market share in various lending niches. So even as you track the peer-to-peer firms, it's wise to track the competitive response of the big bank as well.

Action To Take --> The traditional world of finance is being upended and billions in profits are at stake. This is a good time to start researching all of the leading industry upstarts, whether they are public or private. A few have already come public and trade nicely below their all-time highs. That doesn't make them bargains per se, but the early froth seems to be gone from these stocks.

Oftentimes the little ideas are the big game changers -- something like peer-to-peer lending. My colleague Andy Obermueller devotes his time to identifying game-changing trends and the companies that should benefit from this. This has led readers to investments that went on to gain triple-digits. More recently, Andy has been talking about the profit potential for Apple's newest technology Apple Pay -- and more importantly the company's key suppliers . If you haven't heard about this opportunity yet, then I urge you to check out his comprehensive report on how to profit from this technology, by clicking here .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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