Crowdfunding : a real threat to banks – with a little help

With small business lending by banks still weak, crowdfunding could assist broader based economic recovery. But the slow pace of regulatory reform is limiting its potential.

Banks still fail to view the sector as a strategic threat and regulation is painfully slow. With just a little more encouragement from politicians and regulators, crowdfunding could represent the first real competition for the high street banking model – a bigger threat than many of the new “challenger” banks.

Called peer-to-peer lending (P2P), crowdfunding is a rapidly growing source of finance for small and start-up businesses. In April, it passed a major milestone with the introduction of Financial Conduct Authority rules for the sector. More is still needed. The opportunity is too important for the official ambivalence it currently gets, but the crowdfunding sector also needs to raise its game and reduce risks.

P2P lenders facilitate the matching of individuals lending and companies seeking capital. Higher historic returns have attracted investors who are comfortable with the online format, and who feel they can judge company prospects for themselves. However, there have been failures, and P2P lending is still an infant industry despite its dramatic growth in the past five years.

Already, crowdfunding has seen its first big success in the US, with the $2 billion bid by Facebook for virtual-reality goggles maker, Oculus VR, partly financed on a P2P basis. There are estimates that the sector could reach $17 billion globally by 2015, with more than 1,000 funding organisations involved. Some of the finance provided is equity, whilst other platforms focus on loans, mimicking informal credit unions.

US policy is helpful, and the Securities and Exchange Commission has already moved to permit limited advertising to “accredited investors”. Later in 2014, the SEC is expected to finalise legislation which may allow smaller investors also to get involved

Crowdfunding happens online, but beyond that there is no single definition. The term is applied to seeking donations to charity or payment for goods or services. It is also used for lending to enterprises or investing in them by buying securities. A network of services is being built around the concept, with the latest being the potential for some insurance against default. These services need to grow.

The FCA rules, which came into force on April 1, apply only to the lending and investment aspects of crowdfunding, and require entities seeking loans or selling shares to have regulatory approval. Knowing there are rules in place should give consumer confidence in the sector a welcome boost but the FCA does not plan another review until 2016 and the delay could stifle innovation.

This is despite encouragement from the Bank of England’s executive director for financial stability, Andy Haldane. He has argued that banks exist as an information bridge, as a middleman between savers and borrowers. Social media may have a role to play in developing a market for credit.

Few in the financial sector doubt the revolution that social media has brought in other areas, and banks should take note of Haldane’s vision. He has also stated that a more diverse decentralised financial system could improve the financial resilience and productivity of the bank sector. Yet failure to set the right regulatory framework and encourage a working relationship with the traditional bank sector, could strangle crowdfunding at birth.

The potential benefit for early stage businesses is clear. But critical gaps remain. Regulators are reluctant to get more deeply involved, and need political encouragement to do so. And most crowdfunding platforms appear to have turned a blind eye to the potential for fraud. A young industry cannot afford a major scandal, and the mere possibility is holding back stronger political backing.

Some P2P platforms have recently added disclaimers, ducking responsibility for any of the information or promises that appear on their sites. But the industry will not develop if it is seen as the Wild West. The platforms need investors’ trust, and must make greater effort to cut the risk of fraud. Encouragingly, some are moving in this direction, but doing more would increase political and public acceptance.

The banking sector also has its part to play as it could work more closely with the P2P equity-raising business model. Some of this investment-based crowdfunding requires escrow accounts to hold investor money until targets are met, but banks have been reluctant to provide these. The accounts would return funds to investors if the investment target was not met. Banks are wary about liability if they become involved in this. Platforms need to work out a fee basis that meets banks’ needs, given all the paperwork involved.

The one group that appears to value a relationship with crowdfunding are venture capitalists and angel investors. Some venture capitalists are already co-operating in joint fundraisings. Given the tax breaks for early stage investment and private equity, the position of equity crowdfunding looks anomalous.

A recent paper from the European Commission, “Unleashing the potential of crowdfunding in the European Union”, recognised the potential of the sector to provide needed SME funding as bank lending to these companies declines. Unfortunately, the EC has recently stepped back from regulating the sector this year as originally planned. The EC will carry out a wider study this year and explore the potential of crowdfunding to support research and innovation. Tax incentives could be part of this. However, dealing with legal and structural obstacles might matter more.

Peer-to-peer lending has earned some official endorsement in the UK, but with a little more help could revolutionise lending. It may be young, but so once were Amazon and eBay. Consumers have benefited from that retail revolution. Now, SME and early stage businesses need a new source of finance to fill the void left by traditional banks that are short of capital. Politicians and regulators alike should push the sector up the agenda if they want to give traditional banks a real fright.

A version of this article was published as an Op-Ed in Financial News on May 26 2014.

Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. The information presented in this article has been obtained from sources believed to be reliable, however, I make no representation as to their accuracy or completeness and accepts no liability for loss arising from the use of the material. Articles and information do not represent investment advice. Equity investments I manage on clients’ behalf include RBS, UBI Banca, Intesa Sanpaolo and Swedish-listed P2P lender Trustbuddy International.

Image credit: http://openclipart.org/detail/101989/population-by-netalloy
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