Whitepaper - Alternative Finance in Europe

21-09-2015 1
Is Alternative Finance The future of Banking? Time For Banks to Innovate
Is Alternative Finance The Future of Banking?
Time for Banks to Innovate
The past decade has seen a revolution in the financing industry in Europe
with the increasing presence of ‘Alternative Finance’, in particular the
online crowd funding and Peer-to Peer lending. They have been
supplying funds to individuals and SMEs, providing capital to startups
and offering diverse and innovative ways for customer to borrow and
invest. Armed with latest technological platforms and innovative
business models these ‘disruptive’ players are taking advantage of the
changing customer preference towards affordability, flexibility,
convenience and accessibility.
Till very recently the incumbent mainstream financial institutions in
Europe saw no threat from these so called ‘small niche players’. But now
the banks can no longer ignore them, as their competitive advantage is
being eroded by technology and regulations. However many argue that
this is just another piece of innovation that will die as has various other
‘Napsters’ of the world. But then there are the ‘Squares’ of the world
which were ignored by competing payment systems only to realize the
threat very late. Banks are still very critical players in the market and
enjoy a major market share, but they need to be vigilant and keep a note
of the changing market trends. They need to redesign their processes
and products to meet the needs of the digital world and improve
customer experience. Identification of the pain areas of the customers
and innovating and designing the products to address these pain points
is the need of the hour. Use of advanced digital technology and
improved IT systems can support the banks in this endeavor.

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Alternative Finance- An overview
Although some of forms of alternative finance have long existed, it was the financial crisis followed by strict
intermediation of the traditional banks that led to the growth of alternative finance market. The traditional
banks still enjoy a major market share, but the stress of post-crisis regulation has started reducing their
margins and they are being forced to exit from many business lines. These opportunities have been seized
by Alternative Finance market and is fast filling the gaps in credit supply. They are using innovative
technologies that connect lenders and borrowers online- the ‘intermediary’ becoming only a platform for
interaction.
According to an estimate by Accenture these players can erode as much as one-third of the revenue of the
traditional banks by 20201. These banks face the risk of becoming like utilities wherein the relationship with
the customer will become only transactional.
Alternative Finance is basically an umbrella term which consists of different kinds of models ranging from
individuals lending money to each other or to businesses, to people donating to community projects and
businesses trading their invoices. Figure 1 summarizes the different types of the alternative finance models.
Figure1: Types of Alternative Finance Models
Source: The UK Alternative Finance Industry Report 2014, Nesta & University of Cambridge
One of the most popular forms of alternative finance operating on this concept is Peer-2-Peer Lending which
connects the lenders and borrowers directly while maintaining lower overhead cost. This allows the players
in this segment to offer cheap loans to borrowers and attractive rates to the lenders. Because of this P2P
has been witnessing the highest growth in UK reaching $ 2.01 Bn in 2014 which is almost 188% growth over
20132.
1
Accenture, Banking Customer 2020 Rising Expectations Point to the Everyday Bank, 2015
2
University of Cambridge & EY, Moving Upstream: The European Alternative Finance Benchmarking Report, 2015
•A group of individual lenders lent out money to individuals via a online
platform , usually unsecured personal loansP2P Consumer Lending
•A group of individual lenders lent out money to businesses/SMEs as a single
loanP2P Business Lending
•Non profit concept where individuals donate small amounts of money towards
a charitable projectDonation Based Crowdfunding
•Individuals donate towards a project with the expectation of receiving a
tangible (non-financial) reward or product in exchangeReward Based Crowdfunding
•Businesses sell their receivables at a discounted rate to access funds
immediately than waiting for invoices to be repaidInvoice Trading
•Number of investors invest in early-stage firms in return of a stake in the
businessEquity Based Crowdfunding
•The term community shares refers to withdraw able share capital; a form of
share capital unique to co-operative and community benefit society legislation.Community Shares
•Allows SME owners/directors to use their accumulated pension funds in order
to invest in their own businesses.Pension-led Funding
•Lenders receive a non–collateralized debt obligation typically paid back over an
extended period of time.Debt based Securities

21-09-2015 3
Customer behavior and expectations are dramatically changing, most of which is driven by technology. And
alternative finance is taking advantage of this change and offering customers affordability, flexibility,
convenience and accessibility. This is highly visible in the growth number in Europe where Alternative finance
saw a 3 digit growth (149%) in 2013 while total lending by traditional banks saw a 4.5% dip.
Growth of Alternative Finance
European alternative finance market saw a phenomenal 144% growth in 2014 from 1.33 Bn USD in 2013 to
3.25 Bn USD in 2014. This market is estimated to grow beyond $ 7.74 Bn by the end of 2015.
In 2013, the alternative finance market saw a growth of 149% while the total loans by monetary financial
institutions saw a dip of 4.5%.
UK leads in European region, accounting for 79% of the total Alternative Finance market ($ 2.58 Bn) followed
by France ($0.17 Bn), Germany ($ 0.15 Bn), Sweden ($118 Mn), Netherlands ($ 86.2 Mn) and Spain ($ 68
Mn)2
Source: Moving Upstream: The European Alternative Finance Benchmarking Report, 2015
In terms of the different forms of alternative finance models, Peer-to-Peer lending leads and is the largest
segment in Europe. In Europe (excluding UK) Peer-to-Peer Consumer lending has the largest market
amounting to $301 Mn followed by Reward Based Crowd funding ($133 Mn), Peer-to-Peer Business lending
($103 Mn) and Equity Based Crowd funding ($91.2 Mn).
Peer-to-Peer business lending is the largest alternative finance segment in UK (largest market in Europe).
Peer-to-Peer consumer lending is the second largest market followed by Invoice trading at the third spot.
2.58, 80%
0.17, 5%
0.15, 5% 0.34,
10%
Share of European Alternative
Finance Market( 2014- $ Bn)
UK France Germany Rest of Europe
44%
15%
20%
13%
8%
European (excluding UK) Market
Share 2014 ( $ Mn)
P2P Consumer
Lending
P2P Business Lending
Reward Based
Crowdfunding
Equity Based
Crowdfunding
Others

21-09-2015 4
However the scene is as not as grim as it seems. Banks have been in existence and have been the most
preferred financer for the borrowers & least risky
avenue for investors. Though the traditional banking
system witnessed its own share of ups and downs, the
fact is that the end customers still perceive traditional
banks as a safer option than the alternative finance
market. According to a survey by the University of
Cambridge, 60% of the end customers are ‘unlikely’ or
‘very unlikely’ to begin/continue using alternative
finance platforms3. The investors feel that there is
lack of information about the individuals and the
businesses they fund and hence there is a higher
degree of risk involved. Majority of the investors still
believe that their money would be much safer with
the traditional financial institutions than the
alternative finance providers.
Although the traditional banking system is currently facing the heat from the regulatory bodies, the fact that
these traditional banks are protected by the government in terms of having access to deposit insurance,
regulatory body liquidity and too big to fail guarantees gives an assurance to the end customer about the
safety of his deposits/investments. On the other hand the alternative finance market is more vulnerable to
risks as they are not covered by the safety net of the regulatory bodies.
There are numerous examples of disruptive innovation like ‘Alternative Finance’ across different geographies
and industries. While some of them survived and pushed the incumbents out of the playing field, there were
many that grew only to close down in the years to come. One such example is ‘NAPSTER’- an online sharing
system where fans could upload and share millions of music mp3 files totally free of cost. At the peak of its
growth the company had more than 80 million registered users but much to the dismay of the music industry
and the artists. This unique service made it easier for music enthusiasts to download copies of songs which
were otherwise difficult to obtain. But the success was short-lived because of copyright infringement and
walked in to legal lawsuits within 7 years of its inception. Finally in July 2001 the company shutdown.
One could draw analogies between Napster and Alternative Finance saying that both were fine examples of
disruptive innovation, which addressed the customer pain-points but were not regulated and were
susceptible to risks. Alternative finance could meet the same fate as that of Napster but then maybe it will
survive as has many other innovations in the world have.
One such example of an innovation is ‘SQUARE’ payment system which addressed the widespread need of
an effective business payment solution for small business owners. Before Square it was illegal for non-
registered merchants to accept credit card payments. For small business owners registering is a costly and a
difficult process. Once ‘Square’ was in the market it changed the landscape and gave a strong competition
to the incumbents.
3
Nesta, University of Cambridge, Understanding Alternative Finance, The UK Alternative Finance Industry Report 2014

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What is Alternative Finance doing right?
Though traditional banking systems have the undue advantage of attracting the low cost capital market
funding, the alternative finance providers are challenging this competitive advantage of the banks by using
technology to ’disintermediate’ banks on a much lower level of financing but on a far greater level of scale.
The main source of capital for the alternative finance companies are the individual investors who are looking
for higher returns on their money than what is offered by the traditional banks. By offering good rates the
alternative finance providers are able to attract the investors. This is not only affecting the bank borrowing
but also shrinking the bank deposits, a core source of funding on the liability side of the balance sheet.
Most of the Alternative Finance companies operate online via platforms. This enables them to have a greater
reach to the end customer. The entire customer acquisition process is online and doesn’t require any manual
intervention or paperwork. Not only does this adoption of technology improve the customer experience but
also reduces costs for the finance companies. On the other hand the traditional banking system in Europe is
struggling to control regulatory compliance cost, and are passing these costs on to the end customer.
The main pain-point that is being addressed by the Alternative finance providers is assessment of credit
worthiness of the borrower. This becomes more relevant in those cases where the party seeking the funding
is a start-up or a SME. SMEs which seek funding early-on have a risk associated with them because there is
no guarantee that the business would succeed and that’s why the traditional banks are reluctant to extend
credit. This was addressed by the alternative finance providers by building a new and more efficient &
balanced model of assessment for the end borrowers.
These alternative finance providers gather reams of data about the personal and business credit worthiness
of the borrower right from official credit scores to financial history to sales volumes on credit/debit cards.
They also look at government filings to get information about the tax and census data. The data analysis and
underwriting teams of the these alternative finance providers have immense computer processing
bandwidth, and proprietary advanced analytics algorithms which are able to sift through enormous amounts
of data to arrive at the most critical relationships between the data to determine the likelihood of the
timeliness and full repayment by the borrower. The use of such highly advanced analytics solutions has given
a competitive advantage to the alternative finance providers and reduced the probability of a good borrower
being rejected and a bad borrower being accepted.
These companies are also building on the relationship with their customers by providing more personalized
services- to both individuals and corporates. Large banks however are known to provide such services only
to their bigger esteemed corporate clients.
The most intelligent step taken by the alternative finance providers (such as P2P and crowd funding) was
identifying the changing customer preference and building its offerings around the same concept. The
modern customer now prefers accessibility, affordability and flexibility. Some of the examples of how
alternative finance providers addressed these changes are as follows:
1. Providing the customer an estimate of the funding (such as approved loan amount, interest rate
applicable etc.) by just visiting the website and entering the necessary details
2. Online uploads of the required documents, photos etc. which is as easy as attaching a photo to an
email
3. E-signatures for the contracts

21-09-2015 6
4. Seamless transfer of funds to the borrowers account, automatic debit for repayments
Clearly alternative finance is providing more choices to individual customers and SMEs, and is modernizing
Europe’s financial services.
Need for Reformation….Going beyond banks’ traditional competitive
advantages
Though the threat from the alternative finance market is not yet as big now, its exponential growth over the
last decade is an indicator of tectonic shifts in customer preferences and sufficiently massive for banks to
take notice of. While the banks are distracted from this threat by more pressing challenges of recent
financial crisis and tsunami of re-regulation, it’s about time that they keep sight of these changes in the
marketplace and take necessary steps to rethink their offerings to customers.
To start with, the banks can look at the fundamental competitive advantages that they enjoy and leverage
them. In the short term they should take advantage of the low-cost funding that they get from the central
bank and use it to generate profit. These profits can be used in strategic priorities, the top one being
analytics. Advanced analytical capabilities will enable banks to exploit their enormous amount of data and
address the various business needs. This intelligence will allow banks to gather insights about customer
behavior, identify potentially loans well in advance, and judge the effectiveness of marketing events, to
name a few. These analytics capabilities can be leveraged well in order to make much better informed
decisions in a timely fashion.
Source: Celent Accenture 2014 The Financial Brand
Apart from analytics the banks should also look at the existing IT systems being used. Banks have been using
systems which were designed to support processes that deliver products across multiple channels rather
than around customers. They need systems which serve customers and capture their experiences and
address the future expectations. However this is easier said than done. The IT spending of the banks is
running into millions. According to Deloitte, for a mid-sized retail and commercial bank the annual costs of
‘non-transformational’ change is likely to be in excess of $ 100 Mn , more than 50% of which can be
attributed to regulatory compliance. The solution to this is outsourcing the systems to third party vendors.
The outsourcing of the system to external third party vendors providing modern IT systems has proven to
improve the profitability. In a study done by Deloitte, it was found that over the past 5 years banks which

21-09-2015 7
were using third party IT banking systems saw a 19% higher return on assets, 8% higher return on capital
and a 6.5% lower cost to income ratio.
Source: Deloitte, Temenos: Restoring profitability in the digital age
Banks should now look at their business verticals and identify those aspects of their business model which
they can sustainably defend from these alternative finance providers and invest in them. Traditional banks,
especially the ones which were big in size mostly had transactional relationships with their borrowers. Banks
need to go beyond this to a much more personal relationship which will in turn increase the loyalty of the
end customer.
Many traditional banks have now started moving into the realm of alternative finance and venturing into
partnerships with the players. One of the biggest UK banks, Santander has partnered with FundingCircle, a
P2P alternative finance provider and will refer customers to it. In return the P2P lender has agreed to market
Santander’s services to their customer base. Royal Bank of Scotland is another ‘Big Bank’ in Europe which is
planning to enter the P2P lending market and aims to collaborate with an alternative finance player to service
more businesses and entrepreneurs.
The threat that the banks are facing is not that the alternative non-banks finance providers are replicating
the universal banking model but that they are continuously innovating around it which fundamentally
undermines the traditional banking business model. Banks need to reconsider their strategies which can
not only help them compete against these alternative finance players but also maintain their relevancy in
today’s digital world.
19%
28%
-6.50%
-10%
-5%
0%
5%
10%
15%
20%
25%
30%
Return on Assets Return on Capital Cost to Income ratio
Improvement in performance in banks using third party IT
applications over the past 5 years

21-09-2015 8
Arup Das
Lending Product Head (P&L Management), Nucleus Software
Arup is the Vice President and Lending Product Head (P&L
Management) at Nucleus Software where he is responsible to lead the
flagship product to the next level of global leadership. Before joining
Nucleus, he has played various roles in strategy and product
management with leading companies like CISCO, IPValue and Mphasis.
Author e-mail id: arup.das@nucleussoftware.com
Amrithaa Shankar
Lending Product Manager, Nucleus Software
Amrithaa is a Product Manager at Nucleus Software where she is
responsible for managing P&L for FinnOne Neo for Europe and India.
She has previously worked with Deloitte in new service development
and go-to-market activities for new businesses in the Enterprise Risk
domain.
Author e-mail id: amrithaa.shankar@nucleussoftware.com
Vidushi Yadav
Lending Product Analyst, Nucleus Software
Vidushi is a Product Analyst at Nucleus Software where she is
responsible for managing P&L for FinnOne Neo for Europe. She is a
PGDM (MBA) holder from Indian Institute of Management (IIM)
Udaipur, specializing in Marketing & Strategy. Previously, she has
interned at United Breweries Limited in the Strategy domain.
Author e-mail id: vidushi.yadav@nucleussoftware.com

Whitepaper - Alternative Finance in Europe

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