Zopa’s strategy is to be immaterial to banks

Over at the Zopa blog, Martin says the following:

Could Zopa become the first real competitive pressure banks feel to put their customers more at the centre of what they do? I think so. And that would be good for all of us – even ultimately the banks themselves. Imagine a world in which people liked their bank…

But when I have suggested this to one or two bankers in charge of strategy for a couple of the big banks, they laugh – out loud.

They are amused because in their eyes, peer-to-peer finance is so small, they think it doesn't even warrant thinking about. When I made the point that P2P finance is growing fast and that every new phenomena had to start somewhere (iPods etc) there is a chilling response. In hushed, conspiratorial tones they say, "If Zopa ever gets big enough to matter, we will just undercut it on price for as long as it takes to kill it off, then get back to normal. Simple."

I don't question his statements here, and neither do I question the fact that some strategy people in banks may have made the remarks they're supposed to have made. Indeed, I suspect that the ordinary forces of competition would cause banks to behave in just the way described: the same way they do when anyone attempts to take share. Banking is a commodity business, and the chief battleground is price.

I am not trying to be arrogant here, but the simple fact is this: If Zopa were to have a material effect on bank lending, and its competitive differentiation is price, it will not win. It does not have pockets deep enough to win a price war with a major bank, let along the whole market. This much is simple market forces at play. The only reason this isn't happening now is that, as Martin says, Zopa is not having a material effect on the market at present.

But this, of course, reveals the long term flaw in Zopa strategy: entering an unwinnable battle which brings defeat just at the moment of success.

I have said for some time that Zopa needs to be lending where banks cannot compete in order to be successful. They need to be lending to niches where traditional banking operations prevent bankers from going. Now obviously that includes less prime customers, but really, it is any niche in which the social lending model provides an insight into riskiness that banks can't get themselves. But Zopa rely on credit scoring, just the same as banks do.

Zopa, if it is to be disruptive, needs to be creating lending to new customer segments either underserved or not served by traditional banks. From that bastion, it would have the opportunity to expand its product into more traditional lending and there would be very little banks could do about it. Bankers wouldn't have the infrastructures or the cost bases to compete in the Zopa niche, but Zopa would be able to use its infrastructures and cost base to compete in the banks mainline business.

This is the classic disruptive strategy that PayPal, iPod, and all those other things that people hold out as examples of new entrants upsetting existing ones have used.

However insensitive bank strategists might be about the prospects of a Zopa-Big Bank price war, they are probably calling it correctly. A material impact to mainline lending will be vigorously defended.

But perhaps the Zopa strategy isn't to be material? Maybe they know all the above, and have determined themselves that they'll get big enough to generate decent returns for themselves, but not so big they actually have an impact on the market?

If so, it would be a pity. I return to Martin's first paragraph, because quite clearly, none of the good he mentions will come to pass unless non-traditional lenders actually do become material to big banks.

Update: Chris Skinner posts a relatively scathing attack on this post in which he remarks variously that I am a tooth puller, a luddite, and decended from criminal transportees. It is humouros reading, and I suggest you read it in full. I intend to respond to Chris's substantive points tomorrow.

Comments

[Pragmatist]

James, I really enjoy reading your thoughts on Zopa, thank you. These get to the nub of how Zopa is distinctive from banks - and sustainably so.

You say that Zopa should be enabling "lending to niches where traditional banking operations prevent bankers from going". And I say that's exactly what Zopa is doing.

Zopa was launched in the belief that very creditworthy people looking for an unsecured loan are not well-served by banks, and people with surplus cash would do better than bank savings rates by lending to those creditworthy people. Over 4 years later, Zopa's growth testifies to the fact that these are indeed niches that banks can't get to.

I don't believe this is the result of the banks having somehow chosen not to serve these niches for a while, and they could turn on the charm at any moment - let alone when Zopa reaches what they consider to be some critical size that deserves competition. And a 'price war' amongst banks doesn't amount to a decent service that would win such people's loyalty - though it might win customers from other banks where they are equally poorly served.

In any event, even assuming banks could afford the odd marketing battle, I can't imagine the economics justify them engaging in a sustained war in the prime unsecured loan market, especially when there are so many other wars to fight. In 2004/5, Banks' early repayment penalties got cut to about 59 days interest (none, if you just pay your bank loan off without notice), whereas Zopa has never charged for early repayment. In 2008 banks effectively had to cease (mis-)selling payment protection insurance, which used to cross-subsidise massive marketing campaigns and loss-leading rates. Finally, banks' consumer loan books are now bleeding heavily from bad debt, and their recent provisions say this will get worse before it improves. So cross-selling loans to cardholders to soak up credit card debt won't be terribly palatable for a while (nor satisfy the fabled 'responsible lending' criteria).

But Zopa lenders aren't saddled with those impediments and continue to offer good rates to borrowers at decent returns. Zopa's job is simply to remain a lean and effective facilitator for both sets of people.

So, I'd say it's inevitable that Zopa will rank as a very substantial personal finance service, albeit in due course - Rome wasn't built in a day. ;-)

[Chris Skinner]

The whole premise here is that banks can kill something if it matters enough to be worth killing.

I've heard that view many times, and it is just not a premise that is sustainable.

For example, taking another industry, the Home Shopping Channel QVC was pitched as an idea to the major networks, but was seen as not being worthy of note until it gained critical mass.

What's critical mass, was the question posed.

When you get 2.5 million viewers, was the answer.

The trouble is that when you get critical mass, you won't be interested in being acquired and selling out, because that's when the business is working.

Taking this and then adding the network effect, means that when Zopa starts working - let's say, it gets 2.5% of net new lending in 2011 - a year later, it can double, quadruple or even take ten times that market share because, once it has reached critical mass, EVERYONE WILL KNOW WHAT IT IS, WHAT IT CAN DO AND WHY IT IS RELEVANT.

That means they will trust it.

So, Zopa get 2.5% of net new lending in 2011 ... 2012 - 10%? 20%? or more.

This is highly likely and reasonable.

Then the banks think, let's kill it ... by undermining it's pricing model? Zopa's pricing is razon thin, so I don't think so.

By buying it? Why would you want to sell-out when you've just snatched victory?

By copying it? Who has first mover advantage?

I think you're point is worthy James therefore ... but misguided, like the bankers that Martin references.

[Tim Gray]

I truly appreciate the use of the term "disruption" in its Claytonesque sense. Too often pundits slap the label "disruption" on something that's arguable disruptive only in the limited sense of causing chaos - when, in fact, the innovation is simply sustaining.

[James Gardner]

Chris:

If customers start flocking to Zopa, and therefore sales of traditional loans fall, banks will reduce their rates to get those customers back. They can afford to do so for sustained periods of time, even if their products are loss making. In fact, there are whole classes of products *now* where that is the case: the current account is the obvious case.

Banks aren't monolines. Products can cross-subsidise each other.

Zopa cannot afford its monoline to be loss making, and if that were continue once zopa has reasonable scale, it will certainly not be in business for very long.

[Chris Skinner]

James

There have been disruptions in banking, but only one or two and not very often. Case in point being PayPal. Comment on PayPal from bank: "we wish we'd bought them but we didn't realise how disruptive they would be when eBay spotted the vision".

Zopa on their own may not succeed, but there are plenty of other pretenders (Propser et al.) and the social model is going to change banking resulting in new models (Caja Navarro).

So I'm not in agreement with any of your view here. It's good timing though as, in my series for SIBOS, this is the debate I was going to get into tomorrow, so I'll pick up on this then.

Chris

[FredericBaud]

James, you seem to have skipped the final step in the disruption scenario as outlined by Christensen - when mainstream customers start to move to the disruptor's offer, there's nothing the incumbent can do any longer - it has lost on all the product's dimensions and the disruptor has a lower cost model. Do you think that GM lowering the price of their models could have saved them from being eaten out by Asian constructors?

Plus, studies have shown that price is not the main dimension that customers look into a bank, but trust. In fact, this is one of the reasons why banks have been able to maintain fat fees. If a customer starts considering leaving their bank, lowering fees won't have any impact: when a relationship is dead, it's dead.

[James Gardner]

Chris:

The PayPal argument does not fit here. It was disruptive because it served a new set of customers that had an unfilled need. Zopa goes after the *same* customers as banks.

My argument here is not that P2P can't be disruptive, only that the Zopa stratgy isn't disruptive. They could be, but they choose to do the same things banks do, but with a nice little social layer on top.

[James Gardner]

Frederick:

I think my point was that Zopa isn't disruptive in the first place. Therefore, the Christensen failure model doesn't apply.

[Chris Skinner]

I see your argument ... will respond tomorrow.

[FredericBaud]

Hi James,

Fair enough, missed your initial assumption.

Let's start from your premises then. I have bad news: fat cats never manage to kill lean and hungry cubs. They may possibly buy them, but at a significant premium that makes it painfull for the shareholders to realize they had shares in a fat cat. How do you recognize a fat cat? It's cat that's only interested in the food served on its plate and that always thinks he can outrun younger felins. To paraphrase Andy Grove, fat cats are not the paranoid lot, they always think they're safe on their cushion.

Now, how do you attack a fat cat when you're still a very young cub? You can attack on either ends: either the low-end (think of the hard discount model) or on the high-end (think Apple for the phone).

As an investor, I would highly recommend shaking thinks up if you hear employees saying they don't have to worry now because they will always be able to dive in their deeps pockets. It's actually your pockets that they will eventually deplete.

[Colin Henderson]

The self fulfilling prophecy here is that if Zopa becomes significant to banks', then it is too late, and the train has left the station.

But lets go back to your argument that Zopa is not transformational. I believe it is and here is whay. I won't pretend to speak for Zopa strategy, but p2p lending generally is not a price play imho. It is a productivity play, and that is why banks will fail.

To use that unnamed bankers notion that they would merely drop the price, merely suggests that the loss banks produce on unsecured consumer lending would increase. Take a look at Zopa loan apps .. many are for consolidation of credit card debts. Those are high rate loans, and are banks' going to drop credit card rates to zopa levels?

Zopa has the potential to go where banks' cannot compete and that is the arena of efficiency. In fact where I thought you were going at the beginning of the post is more accurate ... banks should participate in Zopa and lever the economic platform. They may have no choice based on this story....

Banks 'may need to close a third of branches'
http://www.ft.com/cms/s/0/80dcb84c-8ac4-11de-ad08-00144feabdc0.html

[Neil Robinson]

A thought provoking post - and some great responses, James.

Shades of Microsoft v Netscape, eh?

I see a number of flaws in your argument, though. Firstly, I feel you make the mistake of looking at this situation in isolation. So you think all the banks would work in concert to kill a newcomer like Zopa?

I think we call that a cartel. Think Virgin + BA.

Or that HSBC would simply stand and watch Barclays go into a market that threatened it?

Could the oil tanker banks turn in a swimming pool in time to converge on such a threat?

I don't think so.

They'd end up locked in a death spiral as margins vanished and risk became untenable.

But that could never happen in our banking system, now could it?

And would today's social networks not see such a trend emerging and generate such a bad vibe that the banks would be committing PR suicide to continue?

[Chris Skinner]

Lengthy response posted today:
http://thefinanser.co.uk/fsclub/2009/08/why-social-finance-and-particularly-zopa-matters.html

[Michael]

Hey James, thought provoking post, thanks, but in my view it misses the point on where the peer to peer model is the most disruptive. IMHO it's actually not on the borrower side, it's on the lender side.

The motivation of the borrower will always be on where to get the best rate. And, as you correctly point out, if the banks feel really threatened, they can just uneconomically lower their rates for a while to outlast competitors working on the same models.

Even in your scenario of P2P lenders being better borrower pickers by becoming a niche expert I would submit is just another version of price competition, just smarter price competition.

It's actually the lender part that is revolutionary. There are no banks today that offer their sources of capital (individual and institutional) the opportunity to directly participate in their core profit engines, consumer lending. Quite the opposite, in fact. These are the crown jewels for all of the banks and because of this it where the disruptive power of peer to peer lending resides.

Here's why. If, as you argue, this is all about price, then remember where pricing for capital comes from in P2P lending. It's not the p2p lending company - they are just a set fee transaction facilitator. It's actually from the lender. And what is "economical" for the lender in terms of pricing is how this investment compares in returns to its market alternative. Which, to illuminate the bank's catch 22, is their price of capital offer back to in their "lender".

To win a war against P2P lending, it will have to be fought on 2 fronts - both in lower rates to the bank's borrowers and in higher deposit rates (securitization rates) to their lenders. It's tough to see how they will be able to justify that strategy for any length of time to their shareholders.

My 2 cents.

- Michael

[James W]

I posted on Chris' post, but thought I may aswell add my 2c here too.

I think that Zopa has potential to do something really cool.

Small, reasonably priced loans to sectors of the market that are underserviced. And sectors that give the lender some satisfaction, too.

Think ipods for students with part time jobs. Or laptops, or books for university. In Australia (where I'm from) this sort of thing would go down pretty well.

On the subject of students, what about loans for formal attire (think job interviews) for graduates.

Or loans for flights to visit family inter-state?

Basically, small loans that would have a small repayment, making them affordable to your average (or even below average) Joe.

I'm sure some brain at Zopa could think up a hundred better ideas, my point is that they should really be thinking outside of the square, because James is right... as soon as they succeed their going to fail.

[Martin Campbell]

Hi James, Martin here.

Given the blue touch paper that you have clearly lit here, I find I can barely keep up with all the different shots that are being fired back and forward – fun reading though!

As the chap who started this game off with my original post on the Zopa blog, can I just interject to address a key mistake being made in some of the assertions…

I disagree with you (and possibly others) that one or more banks “could kill off Zopa with a price war because Zopa’s pockets aren’t deep enough”. WRONG! The depth of Zopa’s pockets are virtually irrelevant because Zopa is not a lender, it is a MARKETPLACE.

Zopa does NOT set the rates. Lenders choose their own rates, and if borrowers think they are good enough they will take them up. If they don’t, they won’t. Prices are NOT a function of the depth of Zopa’s pockets.

If banks wanted to destroy Zopa through a price war, they would have to undercut all the people lending on Zopa by offering rates MUCH lower than they are now. Or they would need to offer would-be lenders on Zopa hugely better rates on cash savings to remove the attraction of lending on Zopa.

Ironically, it’s the banks that cannot afford this price war:

Firstly, the price advantage for both borrowers and lenders at Zopa is very large, especially at the moment while banks are charging such huge spreads across loan and savings products to try to rebuild their shattered balance sheets.

Secondly, bank overheads are enormous and hard to shrink. In stark contrast, Zopa’s operating costs are wafer thin, and because of the way the model works, will only get proportionately smaller as the business continues to grow in size.

Thirdly, and perhaps the real ‘show-stopper’ for any bank trying to kill off Zopa with a price war is the bank’s inability to target the loss-making offers. There is no way to target Zopa members directly or even indirectly, so these undercutting price offers would have to be made to the entire country. That in itself would destroy the bank concerned long before it would shut down Zopa.

Finally, I think you need to think about what you are proposing banks could or even should kill off. It is real people trying to get a better deal by bypassing the banks and dealing with other real people instead. Given banks’ current popularity, most people would view cynical strategies like you suggest as a disgrace (and potentially illegal), especially if the banks concerned were majority-owned by the taxpayer.

Over to you guys...

MC

[borrower]

If Zopa is really a marketplace banks could undercut existing lenders. Easy to do if banks have lower cost funding and better treatment of bad debt than those who currently lend via Zopa. Or maybe Zopa isn't a real marketplace after all and would bar some potential market participants?

If Zopa doesn't bar those market participants how would it avoid providing them with a copy of their consumer credit agreements that give the name and address of the borrower so competitive pitches can be made?

We're in a world where banks will offer 0% interest with 3% initial fee for as long as 16 months to try to get borrowing business. Repackage that sort of credit card deal as a balance transfer from Zopa borrowers. Do it with an existing card product. Or promote life of balance transfers at 7% to those who have loans from Zopa lenders. That'll undercut just about every existing loan. Or offer 3% below an existing loan rate for a balance transfer.

Offer legal services to those who borrow via Zopa. Can borrowers settle early just one loan from one lender or are they required to do as Zopa says they must and split the payment between all of them instead of settling the expensive ones first? Does Zopa have to provide a meaningful appeal right for its automated market rejection or assignment decisions or can it continue to run the same rule on the same old data and ignore any new information provided as part of an appeal? Is it legal for Zopa to pay a referral fee without disclosing it to a borrower? It used to, but no longer. Perhaps it has to refund the fee to the borrower as an undisclosed commission?

Fairer treatment of applicants and better rates for borrowers seems like a good competitive pitch.