Why Your Bank Is Terrified of Crowdfunding

As crowdfunding becomes more mainstream, more entrepreneurs see it as an alternative to bank loans. Banks are none too pleased.

In 2012, crowdfunding portals helped small business owners and individuals raise about $2.7 billion. By the end of this year, that figure could nearly double, according to Massolution, which tracks the market. 

I’ve written about crowdfunding extensively, mostly from the point of view of entrepreneurs, who view crowdfunding as a cheaper way to finance their business over traditional bank loans. But little has been written from the perspective of the banks, which are beginning to view crowdfunding’s rise as a potential threat to their core business.

Nathaniel Karp, the chief economist for BBVA Compass, a midsized bank headquartered in Alabama, issued a report last week that voiced some of those concerns–as well as potential solutions for banks.

“There is a real risk that banks stop being the primary source for personal andsmall businesses loans,” writes Karp in BBVA’s recently released economic outlook. “Therefore, it is important that commercial banks devote resources to understand and potentially benefit from this kind of disruptive technologies.”

What’s most interesting about Karp’s analysis is that he believes banks may be able to integrate crowdfunding into their lending repertoire. If that seems counterintuitive (and sounds like a potentially harrowing regulatory nightmare), Karp would likely agree. He writes

Crowdfunding platforms do not raise deposits and thus, they are not regulated by the FDIC or the Federal Reserve. Although the SEC is expected to regulate equity-based crowdfunding, it is still unclear who will regulate the entire industry. This sort of regulatory vacuum significantly reduces the cost of compliance and allows platforms to speed up processing times. The combination of no physical location and limited regulatory costs allows crowdfunding firms to keep operating costs low and offer better terms to their clients.

Ultimately, Karp likens the rise of crowdfunding as a classic innovator’s dilemma for banks: In the first stage, banks should be “introspective,” and figure out what they do best. Then, “banks should actually invest resources in the disruptive model and keep the new project isolated from the main business.”

It’s a pretty remarkable idea that banks could potentially build their own crowdfunding platform into their existing services. It’s also an idea that carries with it a level of risk that’s hard to determine.

This is challenging because banks, as is the case with many large firms in different industries, work with investors’ money. Thus, convincing investors to put money into ventures with low profitability in the short-run but with strong potential in the future is something that only few companies are able to do

To what extent crowdfunding platforms will displace commercial banks in the retail and small business segments remains to be seen. However, banks should be prepared for this trend and make it work to their advantage.
It’s certainly a laudable goal for banks to try to integrate a crowdfunding option into their core offering. But I think it’s unlikely to gain much traction. Why not? It’s simple: Crowdfunding isn’t just about the money.

Portals like Indiegogo and Kickstarter have created strong platforms for launching successful, meaningful projects, while sites like LendingClub have established a recognizable brand for peer-to-peer lending. One of the major attractions of using these crowdfunding portals in the first place is the promotional element: Create a buzzworthy campaign and you can reach your funding goal in a matter of days or weeks, not to mention garner a loyal base of fans. For that reason, entrepreneurs will stick with major crowdfunding “brands” they know.

Eric Markowitz reports on start-ups, entrepreneurs, and issues that affect small businesses. Previously, he worked at Vanity Fair. He lives in New York City. @EricMarkowitz

Source: Inc.