UK P2P lending: over a quarter of a billion pound business

Giles Andrews, Chief Executive of Zopa, recently spoke at the Financial Services Club, London, and has kindly provided me with his script and slides to share with y'all so, here it is ...

Thanks very much to Chris and Andy for asking me back and to all of you for coming to listen.  I hope most of you know a little about what we do but, for those who don’t, here’s a slide that explains it pretty simply. 

By cutting out banks we provide better value to consumers who are sensible with their money – lower cost loans on one side, and better returns on their savings on the other.

Before I prepared something for tonight I had a look at what I have said here before, on the small chance that anyone would actually come and listen to me again.  So I’m not going to talk about the origins of the idea.  I’m obviously happy to do that over a glass of wine later.

Firstly, I’m going to give you an update on how we’re doing; secondly, I want to talk about innovation; and thirdly, and perhaps most controversially in this setting I’m afraid, I want to talk about culture and its impact on trust.  It may mean I’m not invited back, but I hope not, as it’s meant to stimulate thinking and discussion!

So now for that update.  Chris always wants to know how we’re growing and I want to make some announcements tonight the first of which is that we have lent over £250m now, or a quarter of a billion pounds as my PR people tell me to say. 

I’m jumping the gun slightly as we will actually hit the milestone on Friday, but I thought I could get away with it in this company.

So now we’ve got that out of the way I’m going to talk about innovation.  This has been an issue in financial services for a long time, well before the crisis.  

We all know the story about the ATM being the biggest financial innovation in recent times.

As Paul Volcker, former Chairman of the US Federal Reserve, said in the Wall Street Journal, 8th December 2009: “...the most important financial innovation that I have seen the past 20 years is the automatic teller machine...”

That's it?

One of my favourite stories comes from a different sector and this one is relevant to banks when we think about genuine consumer value focussed innovation.

Forty years ago, garage workshops were located (as they still are) in large, usually flashy “general” dealerships in inconvenient places.

The aftersales product sold (not the one customers thought they were buying) was labour, and all jobs had a labour component. 

These labour charges were high, allegedly to support the highly trained mechanics and to pay for the expensive facilities. 

I understand the top labour rates within the London area have now broken through £200 per hour, or about the same as you pay a junior city solicitor or accountant.

The easiest way to run these businesses was to organise a workflow from all the jobs of the day and, as customers couldn’t be trusted to bring their vehicles in, to organise that workflow once all the jobs were booked in. 

That meant all the customers dropping their cars off in the morning leading, of course, to queues at the counter.

Customers then had to somehow get to their place of work from the inconveniently located dealership, only to have to repeat that mission at the end of the day, and pay over the odds for often trivial work.

But someone thought of a better way to handle part (importantly not all) of this £8 billion UK aftersales market. 

In 1971 a young entrepreneur called Tom Farmer was on holiday in the USA, after selling his first business. 

He noticed the “muffler shops” there with interest. 

Some aftersales jobs didn’t need skilled mechanics or smart facilities.  Some of the parts to be supplied had terrifically high margins and could be fitted very fast. 

The KwikFit operation he started in the UK had a genuinely different business model. 

They didn’t seek to replace full service garages, but only to steal the bits of their business they could do better, offering more convenience and better value to their customers. 

Full service garages now don’t sell any tyres or exhausts. 

The whole business worth over £1 billion per year - or 15% of their business - has gone, never to be replaced. 

The customer gets to go to a convenient location on a High Street, at a time of his choosing, while paying less for the service. 

No wonder these businesses enjoyed stratospheric growth and Tom Farmer became a very wealthy man.

The parallel with Zopa is that we have developed a lower cost model for a small part of banking. 

Why is it a lower cost model? 

We offer unsecured personal loans and a simple savings or investment product. 

Because the loans are fixed length, we can easily match their maturities with the savings product, and provide our lenders with a decent and predictable return. But we couldn’t offer current accounts or credit cards, as we couldn’t pay our lenders a return on unused facilities without becoming a bank with a complex treasury function.  Because the loans are unsecured we don’t need lots of admin, and the resulting high overheads, to manage the security.

In terms of running the business, our job is to make sure that returns are safe and reliable by screening the applicants and spreading each lender’s risk across many different borrowers. 

We have therefore built most, but importantly not all, of the functions of a typical bank, including managing credit and risk.  And we have done that better than any other UK lender, with defaults below 0.8% of the quarter of a billion pounds we have lent to date.  And we have done it profitably since 2011, so are proud to be a self-sustaining business.

Now back to retail banking. 

I keep being struck by hearing bankers talking about the strengths of the branch model, and the importance of their customer “relationships”. 

I heard a presentation by a high profile new entrant talking about the strong economics of deposits taken by branches, as customers apparently value service and relationship above rate. 

So the question becomes: how does that compete with a model that provides both service and value? 

We are told of the “stickiness” of deposits taken at branches during the credit crisis versus internet deposits like at ING Direct. 

In other words, banks treat branch customers as either stupider or lazier than online banking customers, since they didn’t remove their funds to the same extent. 

So how about addressing the problem of making internet deposits sticky, as we have by matching the maturities of the savings and loan products, while saving the costs of the branch network? 

A recent survey by the American Bankers Association found that 57% of customers over the age of 55 prefer to do their banking online, yet banks continue to invest vastly more in developing their branch offerings than their internet and mobile channels, which are sub-standard in terms of service, perversely driving some consumers back to the branches and reinforcing the delusion that’s what customers want!

Our view is that most consumers want value above all else, and I think the winners will be those who focus on that and not a flawed “relationship”. 

And that brings me on to the subject of culture and its impact on trust.

We hear a lot about banks needing to restore trust and that’s pretty well it. We don’t hear about why they have lost it and what they propose to do about it.  It’s as if the words are enough.  It’s some kind of PR issue that they just need to work through.  Well, even if that were the case, what are the golden rules for dealing with PR crises?

1. admit the problem, in full, no weasel words;
2. say sorry, you understand how people feel;
3. say it may even get worse before it gets better so you look really honest;
4. say what you are going to do about it; and
5. say sorry again.

Compare that to what have we had here: “There has been a global financial crisis (it’s not our fault); we understand that has led to people not trusting us (nothing about what they have done to cause that); so we recognise we need to rebuild trust (nothing about how) … and then everything will be back to normal.

Let me be clear, this is not just a PR problem. It’s far more fundamental than that.  I think it’s a culture problem not a trust problem at its root, although the loss of trust is clearly a consequence.

Let me give you a few examples. 

I was kindly invited to dinner with some leading UK retail bankers.  I won’t name names but suffice it to say there were UK heads of most of them.  Our host asked what they thought had caused the loss of trust, and they answered:

1. the USA; and
2. investment banks flawed business models and misaligned bonus structures.

They were very clear it was nothing to do with UK retail banking. 

When I politely mentioned PPI, the biggest financial mis-selling scandal in UK history and entirely retail bank based, there was some nervous coughing and fidgeting.

Then would you believe the answer? 

It was the previous discredited and now-departed management at their banks what done it. 

The irony is “now-departed” in these cases actually often meant to another of the banks in the room, so in effect some of them were blaming other regimes in the room that were also passing the buck!  

You really couldn’t make it up. 

It was also the previous sales incentives, now changed of course, although they did admit the new ones were still commission or bonus based in large part.

I’m sure those incentive structures did play a major part, but those structures were driven by the culture of the organisation, and that culture somehow forgot the importance of the customer!

Throughout this period the FSA had a regulatory standard called “Treating Customers Fairly”, which was evidently about as much use as a chocolate teapot in the face of the overwhelming culture of profits at all cost.

Another retail (or at least not investment) banking example, and I’m sorry to name names here, is the “alleged” failure of HSBC to perform reasonable anti-money laundering checks in Mexico and, rather closer to home, the Channel Islands, resulting in it “allegedly” dealing with known criminals. 

Or from our very own Chris Skinner’s fine blog recently, their decision to exit the Money Services Business with only 30 days notice, not giving long standing customers the chance to find alternatives. 

Or ING pulling out of equipment leasing at a few days notice. 

At least that was to the benefit of one of my P2P colleagues Funding Circle, but again with no thought to customers.

Or to move to investment banking, perhaps the clearest example of forgetting the customer is the enormous conflict of interest caused by betting against your own customer in the derivatives markets, for which major banks have accepted fines if not blame.

Back to my PR crisis lesson, everyone really knows they did it.  And do I need to mention LIBOR?

So what to do?

Firstly, challenge the assumption of economies of scale. 

I commend to you an article in the Economist a couple of weeks ago challenging the assumption across many industries, with banking at the forefront. 

I would assert that the economy of scale “enjoyed” by the big banks was all to do with funding costs and look where that got us: cheap money looking for a home in ever bigger bets... 

The mistake is now being repeated by governments and, if you strip it out, I think you would find the big banks are less and not more efficient. 

If this simple business fact was transparent, the egregious “too big to fail” problem would go away of its own accord, stimulating more competition.

For consumers and tax payers, what’s not to like about that? 

Indeed Andy Haldane (he’s a fan of Zopa and P2P by the way, as mentioned in the invitation tonight) said recently he would set the cap at a surprisingly low level versus Barclays and RBS balance sheets of £1.5 trillion.

Secondly, challenge the assumption of cross border economies. 

With the exception of a handful of global equity and fixed income trading businesses, and some outliers like VISA, MasterCard and PayPal, I don’t think there’s much positive evidence for them. 

That removes the business case for most of the “bulge bracket” investment banks, again helping to solve the “too big to fail” problem. 

Maybe the old partnership model that was dispensed with in the pursuit of scale was simply better?

Thirdly, banks need to actually do something positive about addressing their culture.  My contention is that they haven’t to date. 

They could start by designing products and services that provide genuine value, put the customer and not their P&L first, that customers like and tell their friends about. 

I’m not advocating some kind of altruistic nirvana, as some of the most successful and profitable companies put customer enjoyment and experience first.  Apple and Zappos spring to mind. 

I’ll never forget a lesson from my first job, which was that the customer pays my wages.

I’m not going to get into the regulatory debate, there are others much better qualified; suffice it to say that I hope, perhaps unrealistically, that the banking review does lead to increased competition.  And I do expect P2P lending to be regulated one day. 

I’m happy to discuss that further in Q&A if anyone is interested.

So where does that leave Zopa and our growing P2P sector?

I hope I have made the case for increased efficiency through a narrow business model. 

I was at another dinner recently, this time hosted by Chris Skinner, where the most common question was “can it scale”? 

I believe that the efficiency of our business model will allow us and our competitors to scale in our particular sector more than the banks – now there’s a promise!  

Fortunately we aren’t the only people to believe it, so I’m delighted to make my second announcement of the night: now that we have proven all aspects of the model – it provides great value to our savers and borrowers, profitably for us - we have secured a new round of multi-million pound funding through equity investment in Zopa to help scale and critically to build awareness of our business. 

Thank you.

Comments

[Iang]

The partnership aspect is very important. If you look at the Scottish Free Banking period, and other similar periods, the ability of the owners to be directly involved, be responsible and rewarded both, was essential for safe banking. The owners knew the business, knew the customers, took the risks, and shared the rewards.

The alternative, known as Central Banking, works less well because there is no direct feedback loop to keep all these drivers aligned: there are no involved owners, no single party takes on the risks, nobody in banks is close to the customer and the rewards are spoil from the battleground.

It is perhaps poignant that even Zopa has the problem that in order to move forward, they must cut the very feedback loop that enabled their business.