Analysis

Are Challenger Banks better positioned than marketplace lenders to disrupt?

Challenger banks have a cost of capital under 2% through Certificates of Deposits (CDs), a cost of underwriting similar to online lenders, and the regulator’s support, at least in the UK. They are also usually very well-capitalized due to bank regulatory requirements.

Serial entrepreneurs Rishi Khosla and Joel Perlman decided to launch OakNorth Bank Limited in 2013. Both the founders understand SME credit pain points as they themselves were denied a loan for their knowledge process outsourcing company, “Copal Amba” several years earlier.  Copal Amba, an outsource research business for investment banks, was launched in 2002 and required credit funding of £50,000 in 2004. Copal was however declined a credit line despite healthy cash flows because the partners were not able to provide property as collateral to secure the loan. Even the contingency funding was declined against the book debts. This led to a realization of how mid-sized growth businesses and entrepreneurs were underserved by the big banks. In mid-2008, Copal Amba was ranked the Number One Investment Research and Analytics KPO in Brown and Wilson Group’s annual ‘Black Book of Outsourcing 2008’. When the founders sold Copal Amba to Moody’s in 2014 it had $50mil in revenue and over 1,300 employees. With extensive experience in how to outsource research, or, in other words, underwriting, Rishi Khosla and Joel Perlman decided to start OakNorth bank, to marry very cost effective human underwriting for mid-sized growth businesses, with flexible and bespoke debt finance which does not require property as collateral..

OakNorth entered the big leagues in November 2015 when it raised £66 Million for a 40% stake from Indiabulls (India’s largest non-bank SME lender). This came on the heels of the 30% stake bought by Spanish Giant BBVA in UKs digital only lender- Atom bank. Leading UK challenger banks, like OneSavings or Metro Bank, are focused on mortgages to smaller landlords buying a few properties to let. OakNorth is focused on lending to the portion of the market that has been structurally underserved by the large banks for decades – mid-sized growth businesses and entrepreneurs..

How to build a bank

OakNorth began the application process for the banking license in December 2013 and obtained it by March 2015. The bank began lending and deposit taking six months later in September. The regulator requires a minimum capital of one million pounds but according to Rishi Khosla, £20 million is required as regulatory capital to make the operations feasible. The cost of the process was handled as efficiently as possible and the entrepreneurs did as much of the work as possible themselves.

The regulator has been supportive of new-age banks and has tried to create a regulatory environment conducive to alternative lending to SMEs. OakNorth has selected “Mambu” – the SaaS banking platform provider, to help ensure the company maintains a competitive advantage when it comes to its technology.

 Modus-Operandi

The founders’ business plan was to marry the flexibility of p2p lending, the focus of lending-funds and the consistent funding base from retail deposits.

The deposits handling of the company is completely automatic. However, the loan handling is nearly 100% human driven. All prospective borrowers are met face-to-face. The loan size normally varies in the range of £1 Million to £15 million. Because each business is different, has different needs, is in a different state, OakNorth believes that human interaction and human credit analysis becomes vital to understand the business and its credit standing. OakNorth can afford to do so by leveraging its previous experience with Copal Amba.

The bank focuses on a different segment of the market than p2p lenders: its competition is large banks who do not serve the requirements of the small borrowers adequately. The bank focuses on the requirements of the borrower, understanding the entrepreneur’s vision, its mode of business and the management of the borrowing unit. The bank’s lending capital comes exclusively from its depositor product One of its recent deals involved Thesqua.re, a London-based serviced apartments provider, which raised financing from OakNorth in early January, and then, two weeks later, secured additional financing from 15 high-profile retail investors via platform Crowd2Fund, raising $2m in total. Overall, the funding outlay is nearly 2/3rd to SMEs and the remaining 1/3rd to property financing.

Methodology of Fund Raising

The bank has a significant advantage versus the p2p lenders because of its status as a bank. As a bank, it can mobilize low-cost deposits (currently its average term deposits at a rate of 1.62%) whereas the p2p cost of capital starts with a minimum 5-8%. The bank borrows through Certificates of Deposits (CDs) for a tenure of 1 to 2 years. Rates of Interest move in tandem with the quantum of funds required by the bank in a particular week. Surprisingly, just a slight difference of 10 basis points in the CD interest rates drives significantly more deposits. The bank can, therefore, control their capital availability very reliably across orders of magnitude in size as needed.

The bank’s strategy is to raise deposits at competitive rates and get the qualitative credit rating outsourced to India. This translates to better margins even after lending at competitive rates. This saves 80% of the normal costs of credit analyzing. The cost of underwriting is less than 1%. The bank is able to capture 80% of the value from a 10,000 $ due diligence versus a full blown 500,000$ due diligence performed for PE funds.

US regulation on banks

To have a better understanding of the US bank regulatory regime let’s examine the Atherotech case where the bank holding the debt, called Regions’ bank, choose to foreclose on the loan despite having 100% chance of getting $0 in the bankruptcy. A more lenient approach would have probably yielded much better results for everybody included the bank. You can read the case details here.

Talking about the Atherotech bankruptcy a reader of the daily newsletter Term Sheet explains: ” [The bank named] Regions’ behavior in this case is basically a function of increased regulation through the years. Non-regulated lenders such as Madison Capital have the flexibility to double-down on a bad loan for the sake of providing necessary liquidity which could ultimately save the company. Regulated banks such as Regions can’t really do this. Regulators then hammer them for throwing good (depositor) money after bad. Since the late 80’s, it’s been pretty standard for [US] commercial banks to immediately liquidate bad assets under any circumstances, regardless of whether they believe a company can be saved, because regulators still tend to take a black-and-white view of everything, thus prohibiting such a subjective decision by the bank in a work-out. Similarly, banks won’t convert their debt to equity anymore, because equity is too risky. Regions could be found at fault for seeking liquidation when it wasn’t feasible (key asset licensed from University of Alabama). However, in today’s banking environment they didn’t really have another choice.”

Future Prospects

OakNorth Bank intends to focus its activities in the UK for the immediate future. However, it is considering potentially expanding its business to various locations in the USA, Europe, and emerging markets further down the line. According to Rishi, a lot of it will depend upon the outcome of the forthcoming US General Elections and the European Union Referendum.

An oak tree can live for 1,000 years & “North Star” serves as a guide to navigators. The name “OakNorth” thus symbolizes sustainable durability and a strong guiding power. OakNorth Bank is focusing on simple banking – accepting deposits and lending funds. The bank has a dual advantage of lower funding costs and human credit analysis at extremely competitive pricing. The credit crisis had led to a vacuum in the sub $20 million growth business and entrepreneur lending space and with the new funding and an impressive board; the bank looks to be living up to its name.

Authors: George Popescu and Heena Dhir

 

About the author

George Popescu

Serial entrepreneur.

George sold and exited his most successful company, Boston Technologies (BT) group, in 2014. BT was a technology, market maker, high-frequency trading and inter-broker broker-dealer in the FX Spot, precious metals and CFDs space company. George was the Founder and CEO and he boot-strapped from $0 to a $20+ million in revenue without any equity investment. BT has been #1 fastest growing company in Boston in 2011 according to the Boston Business Journal and the only company being in top 10 fastest in 2012-13 as it was #5 in 2012. BT has been on the Inc. 500/5000 list of fastest growing companies in the US for 4 years in a row ( #143, #373, #897 and #1270). After the company sale in July 2014 until February 2015 George was Head-of-Strategy for Currency Mountain ( www.currencymountain.com ), a USD 100 million+ holding company focused on retail and medium institutional currencies, precious metals, stocks, fixed income and commodities businesses.

• Over the last 10 years, George founded 10 companies in online lending, craft beer brewery, exotic sports car rental space, hedge funds, peer-reviewed scientific journal ( Journal of Cellular and Molecular medicine…) and more. George advised 30+ early stage start-ups in different fields. George was also a mentor at MIT’s Venture Mentoring Services and Techstar Fintech in NY.

• Previously George obtained 3 Master's Degrees: a Master's of Science from MIT working on 3D printing, a Master’s in Electrical Engineering and Computer Science from Supelec, France and a Master's in Nanosciences from Paris XI University. Previously he worked as a visiting scientist at MIT in Bio-engineering for 2 years. George had 3 undergrad majors: Maths, Physics and Chemistry. His scientific career led to about 10 publications and patents.

• On the business side, Boston Business Journal has named me in the top 40 under 40 in 2012 in recognition of his business achievements.

• George is originally from Romania and grew up in Paris, France.

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