P2P Lending: A Bank by the People, of the People, for the People
Peer to Peer (P2P) Lending is a type of service that allows individual lenders and borrowers to connect through online platforms. Many of the most common types of loans in the economy can be made via P2P lending platforms without much difficulty - although with some added risk, as we will discuss later.
The theoretical applications of P2P lending are many. For example, individual borrowers in need of student, auto, or debt consolidation loans are just a sample profile of P2P participants. Small businesses looking to launch, expand, or restructure will also find lots of opportunity in the P2P ecosystem. Finally, many property developers and landlords have made use of P2P to finance projects.
The embryo of P2P lending was the UK, where most of the major players are based. The first P2P lending company was Zopa, founded in Britain in 2004. Funding Circle and RateSetter, along with Zopa, make up the three biggest names in the UK P2P lending industry, and have lent over £4 billion combined. Since then, the industry has grown tremendously, led by China, who saw total P2P loans exceed $100b for the first time in 2015. The P2P lending space has also been a success story in the US, where two of the largest players, Lending Club and OnDeck, have gone public with multibillion dollar valuations.
How does it work?
Compared to traditional bank loans, P2P lending is defined by a few characteristics such as using technology as an enabler and lower barriers of entry for both borrowers and lenders.
A typical P2P lending model would work as such: lenders open an account on a lending website, where they can find out detailed information about potential borrowers. The website platform provides detailed credit report on the borrowers, lowering information asymmetry, although there are questions raised about these sites’ capacity to reliably assess creditworthiness. That said, most of the major P2P platforms have default rates below 1%.
Overall, P2P products have some striking similarities to those of traditional banking. These similarities include that both are generally fixed-rate products (as opposed to variable rate), are term based and are fully amortized at the end of the loan. Interest rates on P2P lending sites tend to be slightly lower than those offered by banks. This is because rates are usually determined via a reverse auction, wherein different lenders bid with rates they are willing to accept, and the lowest bid wins. Another major difference we have identified is that the P2P lenders charge an upfront fee, typically up to 5%, while banks do not.
The biggest difference between the traditional and new entrant (i.e P2P lending) models is the way the loan is issued and funded. For a personal loan made by a bank, the loan is funded with deposits, is held on the banks’ balance sheet and they maintain the credit risk. In contrast, P2P lenders connect investors (willing to take credit risk) to borrowers, largely without the conduit of a traditional financial institution, leaving the intermediary (the P2P platform) with no retained credit risk. While the process of connecting borrowers and lenders has been around for many years, the differentiating aspect of today’s P2P lenders is the use of technology, the internet, and social networks so that the process can be amortized and democratized. In other words, borrowers can borrow money from people they have never met and investors can lend money to a multitude of anonymous borrowers based on their credit information and statistics, which are available to all users, not just a single credit assessment institution like a bank.
Why does it work?
Capital arbitrage: P2P lenders generally don’t assume credit risk. This is possible because P2P lenders do not hold capital against the loans they originate as capital is sourced from third party investors. This allows P2P lenders to maintain a larger receivable portfolio relative to their equity base.
Lower credit risk: Unlike traditional lenders where rising credit costs may affect profitability, P2P lenders are able to stem profitability declines when credit costs rise.
Implications & Industry Reactions
The competitive landscape of lending would continue shifting over the next decade with new market entrants and certain ‘core’ banking activities today being phased out of the traditional banking system.
Regulatory upheaval and new technologies are transforming traditional banking activities. The growth of P2P lending will have an interesting interplay with monetary policy regimes around the world. Central banks are already having difficulty manipulating interest rates to stimulate the economy. The shift of lending activity from traditional institutions to individual users may only make things more difficult since P2P lending institutions do not hold money at central banks and rates are determined in a much more “free market”, equilibrium-seeking manner. Interestingly, this may be perfectly in line with the end goals of central banks, since P2P seems to result in better rates and more investment, ostensibly the final objective of central banks.
Institutional regulation will continue shifting its current focus from banks to non-banking entities. Laws such as stricter capital requirements are being passed while scrutiny for high yield loans are forcing banks restructure their business model. Shifts in the consumer market have also caused a re-pricing of the credit premium and P2P lenders, often backed by private equity firms, are now becoming lenders. The combination of technology and big data analytics has also opened the market to new entrants in the consumer lending space. Benefiting from lower cost bases than banks, P2P lenders are able to price loans at lower rates.
Reaction of the traditional industry has also been swift. Emergent P2P lenders has forced traditional lenders to change their competitive behaviour. Pricing has seen the greatest reactionary change, driving lower returns across the industry. In the United States, lobbying efforts for greater scrutiny and regulation of non-bank financial companies are making P2P lending companies uncomfortable.
Tough times ahead?
A host of scandals and bankruptcies at P2P lending companies across the US and UK have stoked investors concerns. A prominent US venture capital-backed firm closed down to great fanfare in June while employee layoffs and cost efficiency measures are being instituted across the board. Why and how is this happening to a business model and industry that was the darling of the FinTech industry?
P2P lending operates on a model where new customers make up the bulk of the revenue stream. Contrast this to retail banks who can make money from a diverse revenue stream such as current accounts, re-mortgages and credit card fees, P2P lenders find themselves in the unenviable position of being required to constantly source new borrowers to earn a ‘rip’ (commission in industry slang). The inherent problem with this model is that shareholders will eventually start to demand higher returns, possibly pushing P2P lenders to start approving loans for riskier borrowers to sustain growth.
What started out as a platform where institutions would play a smaller role that they would have at traditional banks, P2P is fast betraying its humble roots. From hedge funds to private equity firms, hordes of cash are being funneled into P2P lending companies, leading to P2P lenders increasingly looking more like I2P banks. Goldman Sachs’ private equity arm in the United States for example is a prominent financier of the P2P lending scene. This may be a problem when traditional credit providers end up picking only the best and safest borrowers, leaving individual lenders to pick up either: loans with lower yields or higher-risk borrowers. Institutionalisation of P2P lending is laying siege to the fundamental idea that P2P lenders were meant to introduce competition and efficiency into an otherwise cartel-like industry.
While P2P lending has made great strides, there are still many issues to consider. Technology and the ability to participate in the parts of the market that banks traditionally don’t participate will drive growth to alternative lenders. Many P2P lending platforms allow the consumer a greater array of choice, lower rates and access liquidity after being turned away from traditional financing avenues.
The disruption of the business models of many traditional incumbent loan facilitators has forced market incumbents to react. Goldman Sachs for example recently launched its retail banking arm, GS Bank, ostensibly to appeal more to main street customers.
For all its benefits however, investors and consumers should be not be too eager to jump onto the P2P lending bandwagon. Once heralded as the new force to be reckoned with, the P2P lending industry still has a long way to go before becoming a mainstay in the world of finance.
WRITTEN BY EVAN OLINER & FELIX LIM FOR BESA
PLEASE DIRECT ANY INQUIRY TO AS.BESA@UNIBOCCONI.IT