Alternative Financing: What It Is and Why Banks Fear It

As alternative financing continues to migrate from the fringes of the finance world to mainstream awareness, new opportunities emerge for those typically shunned by conventional institutions, as well as those seeking local and more progressive funding sources. Ever-growing in number, alternative financing models extend capital and cash to millions while inspiring fear among some in the traditional world of finance.

Alternative vs. Traditional Finance

The financial channels and instruments labeled “alternative finance” include investment, donation and reward crowdfunding, microlending, and marketplace peer-to-peer lending. These have emerged as alternatives to the traditional banking system, which includes regulated mainstream banks and capital markets. Examples of traditional financing include bank loans, payday loans, Small Business Administration loans, home equity loans, venture capital, credit cards, charitable grants and equipment leasing.
Mainstream banks use depositors’ money to fund investments at their discretion, with individuals having no control over, or even knowledge of, the investments. In contrast, alternative finance investors usually invest in a specific, chosen project. Alternative finance allows greater transparency into where people’s money is and what it is being used for.

Common Alternative Financing Examples

  • Crowdfunding: Crowdfunding, in which large numbers of people contribute small amounts of money toward a specific project, can be based on donations, equity or rewards. Reward-based crowdfunding, the second largest category of alternative financing, provides backers a nonfinancial reward in exchange for funds.
  • Peer-to-Peer Lending: Groups of individuals support a business venture by providing unsecured personal loans in exchange for a return on that investment over time. It’s the largest category of alternative financing.
  • Microfunding: Small amounts of money are loaned to small businesses or entrepreneurs, often in economically disadvantaged areas. These sums are significantly smaller than the minimum banks will fund.

Scope of Alternative Financing

As traditional banks increasingly favor established companies, customers with bigger bank accounts and loans of higher dollar amounts, alternative finance companies are filling the gaps. Though alternative finance isn’t exactly new – the first online peer-to-peer lender, Zopa, was founded in 2004 – its market volume has increased exponentially in the past few years, and this growth is expected to continue. According to research:
  • In 2015, the market volume in the Americas jumped from $11.4 billion to $36.49 billion, with $36.17 billion of that volume in the United States alone.
  • Use of alternative finance methods in North and South America increased from 2014 to 2015 by 212 percent.
  • In a two-year period, online alternative finance platforms provided more than $10.8 billion worth of capital to over 268,000 small businesses and startups in the United States.

Factors Influencing the Rise of Alternative Finance

Factors contributing to the rising use of alternative finance options include the economic crisis that occurred around 2008 and an ever-advancing level of technology. Specifically:

 

  • After the recession that followed the housing market meltdown, small business owners find obtaining credit or capital even more challenging, as banks apply more stringent criteria and favor large companies and large loans. Banks deny more than 80 percent of small business loan applications.
  • Technological advances extend to the finance world, too. Emerging technological innovations in the financial sector, dubbed “FinTech,” allow for online collection of information, near-instant analysis of lending criteria and extremely fast authorizations, credit checks and financing approval. FinTech also connects crowdfunding platforms to people across the world and expands the network of peer-to-peer financing sources, rapidly and easily connecting those in need of money with those wishing to invest.

Alternative finance companies threaten the traditional banks’ business models, as well as their market volume. As world technologies and consumer expectations continue to evolve, so must the banking industry.

 

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