Crowdfunding and the financial industry: a review

Author: Iloka Benneth Chiemelie
Published: 27th April 2018

Introduction

Presently, the financial markets are passing through an era of digital and structural transformation which is aided by the internet and digitalization that is remodeling the attitudes of consumers towards conventional financial process. This rapid advancement of financial technology (Fintech) is reshaping the conventional bank services while ushering in new independent services providers in the financial industry. Fintech comers offer financial solutions that provide consumers and businesses with new, faster and efficient ways of undertaking their financial transactions. Crowdfunding is one these Fintech processes and this research will discuss its overall role, impact and barriers in the banking industry.

Present status of crowdfunding in the financial industry

EY (2016) conducted a global report which shows that 6 out of 10 consumers highlighted decrease in their level of dependence on banks as their primary financial service providers. It was noted in the research that this finding is an indication of the need for banks to improve the experience of their consumers by simplifying and innovating their products in line with the evolution of Fintech solutions (EY 2016, 10.).

Crowdfunding is one of such Fintech solutions. Crowfunding is the process of funding a venture of project by raising small amounts of money from large group of people (in the form of donation), normally through the internet. The funding process in this Fintech solution is facilitated through intermediaries, which unlike the conventional intermediaries, are not actually involved in the process of raising such funds.

Presently, crowdfunding is popular in enterprise financing. The annual growth rate has repeatedly exceeded 100% and more, with crowdfunding now establishing itself as a potential source of funding for SMEs and startups (Massolution, 2015). In any case, crowdfunding doesn’t yet threaten the conventional banking industry, but in line from the growth rate recorded for crowdfunding, the demand for alternative funding solutions is on the rise. In the financial industry, crowdfunding can offer new channels to banks to handle riskier enterprises, which are considered illegible for funding, and providing a way for both the banks and consumers to adopt to the era of digital funding.

Current market penetration / popularity of crowdfunding 

It is reported by European Expertise Centre on Alternative Finance and Community Finance (CrowdfundingHub 2016) that following years of cautious watch of crowdfunding, the banking industry is now slowly entering the crowdfunding industry either through their own platform of via existing ones. Banks are awakening to the reality that added to the business potential that crowdfunding brings, this emerging industry could pose significant risk to conventional financial services provided by the banks. However, the extent to which banks are integrating the crowdfunding solutions are based on the obtainable financial regulations in the banking industry, and this is slowly adjusting to changes in operations across different countries. In 2015, the size of the total crowdfunding industry was estimated to be in the region of $34 billion and lending-based crowdfunding is still significantly the largest form of crowdfunding with an estimated $10 billion as the funding volume in 2015 (Massolution 2015). Essentially, crowdfunding is very popular now and as the technology advances, its popularity will continue to increase, leading to an even greater level of adoption across the financial industry and beyond.

Influence of crowdfunding on the financial industry

In accordance with Salomon (2016), the main driver for entrepreneurs in search of funds for their projects is actually not the price of capital. This is based on a range of interview the researcher conducted with entrepreneurs and it lead to the fascinating conclusion that the main driver for entrepreneurs when choosing between banks and crowdfunding as a source of financing is actually not eligibility, instead, it is the slow and rigid process that banks employ (Salomon, 2016). Additionally, through crowdfunding, applicants can fill out loan applications 24/7, and unlike the bank applications that can take numerous weeks as a result of high bureaucracy, performing similar assessments in crowdfunding can be done under 48 hours (Salomon, 2016).

Green (2014) discovered similar barrier in the lending process of banks, which entails small business owners being mandated to make available numerous application forms, personal financial statements as well as other information. Once done, the documents are handled by two or more people, which can result to wastage of valuable time as well as misinformation (due to the physical approach of handling documents (Green, 2014). The researcher also noted that the tight regulations imposed on banks are the main reason for large quantity of information gathered as loan applications are assessed based on 5Cs: capital, capacity, credit, collateral, and competence. Thus, these rigid processes of application and assessment do deter some interested borrowers from applying for loan from the banks. As such, it makes crowdfunding the preferred option leading to increased adoption against loans from banks. Irrespective of these flaws in the banking systems, numerous banks are still yet to adopt new processes for handling loans, allowing crowdfunding to permeate the financial industry even further. Thus, crowdfunding is having huge influence on the financial industry because it is drawing their market shares on loan application significantly.

Barriers to adoption of crowdfunding 

One of the major barriers to adoption of crowdfunding is information asymmetric. It was noted by Agrawal et al. (2016) that is a major barrier to financing of new ventures because they have the potential of impeding the information of a fully functioning market. Investors’ decision making processes are hugely influenced by information asymmetry because they decided based on the information at their disposal. Thus, when choosing lending platform, consumers that are either unaware of crowdfunding or have preexisting negative information on the platform tend to abort it as a choice for funding source.

Another barrier is costs. Unlike loans through banks that only require collateral and no added costs, crowdfunding comes with costs. Moritz et al. (2014) noted that depending on the platform, the cost of using crowdfunding can range from relatively low to significantly high as some platforms will actually demand certain percentage of the total funds raised. The investors might eventually get more than the projected funds due to the costs that they will need to bear in the form of service charges, creating a barrier to adoption.

Besides the two barriers above, reputational risks also limits the intention of banks to adopt crowdfunding solutions as noted by Viitamo (2012). It kind of make them look incompetent in the eyes of the consumers, who question their reasons for stepping aside their functional roles into sourcing funds from them from other people (as if the bank is facing some kind of financial issues due to their inability to fund loans internally).

The future of crowdfunding 

Based on earlier discussions, it was made known that crowdfunding is an open call to the public, normally through the internet, for them to offer financial resources either in the form of donation or an exchange for the future products or some kind of rewards to support an initiative that is designed for certain purpose (Belleflamme et al., 2015). The internet has made it possible for funding to be democratized and socialized, eliminating the need for financial institutions such as banks to be involved in some cases. Considering that crowdfunding is usually through the internet, one could only expected that continued advanced and penetration of internet technologies will also created room for the crowdfunding process to reach new heights. Compared to traditional financial institutions, crowdfunding allows for finances to be gathered through the crowd where anyone can participate in line with their individual capabilities; also, crowdfunding considered to be more easy, transparent and democratic method of funding when compared to banks (Haas et al. 2015). This positive image will result to increased adoptions and eventually leading to potential displacing of the conventional loan system with crowdfunding (something e-mail has done to courier mail in recent years).

The underlying mechanism in internet economy has transformed crowdfunding to become a new form of financial intermediation. The sizes of users continue to grow, together with the overall value of the industry. Thus, as more people become aware, they will eventually see reasons to adopt crowdfunding, leading to an even greater market value and penetration of this Fintech solution.

Summary

From the onset, the purpose of this study was communicated as to analyze crowdfunding in relation to the financial sector. It was made known that it is an online based form of funding for projects and ventures, where funds are sources from crowds either in the form of donation or exchange for the future products. In the banking industry, crowdfunding was found to be having huge influence because customers choose it over loan due it ease of use and less bureaucracy. In any case, there are barriers in the form of information asymmetry, reputational issues and costs. However, since crowdfunding is internet based, it is expected that it will potentially displace the conventional loan processes because as internet technologies continue to advance, enhanced penetration of the internet will lead to resulting enhancement on the penetration of crowdfunding.  In conclusion, crowdfunding is a significant Fintech solution that has the potential of breaching gaps in the financial industry.

References

Agrawal, A., Catalini, C. & Goldfarb, A. (2016). Are Syndicates the Killer App of Equity Crowdfunding? California Management Review, 58(2), pp. 111-124.

Belleflamme, P., Omrani, N. & Peitz, M. (2015). The Economics of Crowdfunding Platforms. Information Economics and Policy, 33, pp. 11-28. Retrieved from http://ac.els-cdn.com/S0167624515000463/1-s2.0- S0167624515000463-main.pdf?_tid=3603db38-deeb-11e6-bffa00000aacb361&acdnat=1484901428_ac41fa131e3d95278e720ec60198f069

CrowdfundingHub (2016): Current State of Crowdfunding in Europe. An Overview of the Crowdfunding Industry in more than 25 Countries: Trends Volumes & Regulations. Retrieved from: http://www.crowdfundinghub.eu/the-current-state-of-crowdfunding-ineurope/

EY (2016). The Relevance Challenge: What Banks Need to Must Do to Remain in the Game. Retrieved from http://www.ey.com/Publication/vwLUAssets/ey-the-relevancechallenge/$FILE/ey-the-relevance-challenge-2016.pdf

Green, C. H. (2014). Banker's guide to new small business finance: Venture deals, crowdfunding, private equity, and technology. Hoboken, New Jersey: Wiley.

Haas, P., Blohm, I., Peters, C. & Leimeister, J. M. (2015). "Modularization of Crowdfunding Services – Designing Disruptive Innovations in the Banking Industry," in: 36th. International Conference on Information Systems (ICIS). Fort Worth, USA.

Massolution (2015). Crowdfunding Industry 2015 Report. Retrieved from http://reports.crowdsourcing.org/index.php?route=product/product&p roduct_id=54

Moritz, A., Block, J., & Lutz, E. (2014). Investor Communication in Crowdfunding: A Qualitative- Empirical Study (SSRN Working Paper No 2462282). Retrieved from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2462282*

Salomon, V. (2016). Emergent models of financial intermediation for innovative companies: from venture capital to crowdinvesting platforms in Switzerland, Venture Capital, 18:1, 21-41.

Viitamo, E. (2012). Productivity as a competitive edge of a service firm: Theoretical analysis and a case study of the Finnish banking industry. [Espoo]: Aalto University, School of Science.