Samer Abou Saad

Peer-to-peer lending (P2P lending)

Money and Banking (FIN 305)
Summary: P2P lending is one of the fastest growing financial market in the UK as savers
and lenders rush towards secure better rates online. The problem is that as the growth of the
sector accelerates it is taking on more risks and since we are not operating in a normal world
of credit, demand from desperate investors scrabbling for returns is driving down the rates on
offer from all asset classes.
The biggest providers in the market are Zopa, Ratesetter, and Funding Circle. These websites
are allowing investors to earn typically between 5% and 6% while these funds are lent to
hundreds of people. The websites are mainly providing unsecured credit for car loans, home
improvements, and to pay off other credit card debts.
On the other side; Zopa which is the largest provider of loans to consumers has managed to
navigate the credit crunch with no losses to investors’ capital and only a small dip in returns
during 2008. And default rates remaining safely below 2%. Furthermore, the website created
something called the Zopa Safeguard Trust which was introduced in 2013 and currently
covers £344 million of the almost £500 million outstanding.
While investors are reducing risk whereby the funds they invest are spread over hundreds of
borrowers; the issue is when another downturn hits, borrowers with similar credit profiles
will tend to fall over at the same time.
The defense is that P2P platform have built records of thousands of lenders and when taking a
new business they use this experience when cross-checking application data against other
credit information to reach a decision.
In conclusion, the P2P industry is a good thing for the both the investors and the lenders.
However, they are not bank accounts and thus should not be compared to them but rather to
investment alternatives such as corporate bonds offering 4%-5% and shares offering 3%-6%
return.

Counter argument:
The evolution of “Fintech” in the last years was due to our transition to interact with money
digitally instead of physically which paved the way for a tech wave thus changing how
consumers perceive ease and convenience.
The biggest trend in Fintech is that alternative financial products that began to appear
following the financial crisis of 2008 and the consequent tightening of banks’ consumer
lending policies.
Public awareness have been increasing on alternative finance options from crowd funding to
mobile payment, from peer-to-peer lending to robo-advisors, and governments are updating
regulations to allow more investors to participate in these types of markets.
The idea with P2P lending is that it enables individuals to lend directly from individual
investors at a lower cost without typical financial intermediation thus involving more time,
effort and risk than traditional lending scenarios and this business has been growing
considerably for the past years in US and UK specifically. Furthermore, it enables borrowers
to obtain credit that banks are not willing to offer. The existence of such lending would do a
lot of assistance to borrowers with low credit ratings. The process include that those with “A”
ratings have the greatest likelihood of repaying their debt thus they receive the lowest interest
rates. However, the appeal lays where credit card rates are about 13% in the U.S which is
higher than the rate that borrowers with a ‘B’ rating get on P2P websites. Moreover, repeat
borrowers are able to get discounts which is a feature not available at banks. So the key
question is that can these websites provide lenders with efficient screening and monitoring as
in the case of traditional intermediation?
It is well known that banks, and financial intermediaries in general, have the expertise and
effective information collections to screen out good from bad borrowers as well as acquiring
the necessary collaterals to secure against potential defaults as part of monitoring; thus
dealing with the information asymmetries resulting from lending (the adverse selection and
moral hazard).
When dealing with P2P websites, as listed in the above article, they can manage the screening
process very well for they own credit histories and FICO scores to assess the creditworthiness
of their borrowers. However, when it comes to monitoring and dealing with moral hazard the
process is not as efficient. The P2P lending is unsecured/ uncollateralized thus not covered by
Government-backed Financial Services Compensation Scheme and there’s no guarantee that
borrowers won’t just take the money and travel to another country!
Moreover, an investor’s money might not be lent directly and no interest is paid in the
waiting process as such individuals might be losing an opportunity cost. Then again there’s
the risk of the P2P firm going bankrupt or bust in case of loss of confidence, and since
currently it is not backed-up by any safety savings guarantee by the government as such there
is no one to collect back the loans considering that the process is done technically between
the lender and the recipient.
However, supporters claim that today P2P websites are regulated by the Financial Conduct
Authority as of 1 April 2014 in UK. The new rules state that these firms/ websites must be
transparent regarding the information they give and the risks associated with such an
investment or else they will face sanctions and penalties! In addition, starting April 2017
firms are required to have at least £50,000 worth of capital (or more for bigger ones) as
reserves in case of financial shocks or difficulties.
From another perspective, banks also offer unsecured products like credit cards for instance,
and they usually charge relatively high interest rates to encourage healthy borrowers to repay
their debt quickly thus screening the good ones and they set spending limits on each card to
minimize losses in case of default. Similarly, P2P websites set limits on the amount of loans
given; however, the problem lays where P2P lending is offering lower interest rates initiating
the question of whether P2P screening techniques are superior to that of banks thus enabling
the lower rates offered.
In addition, when observing the return offered by P2P investment it would be around 4.34%;
compared to a Treasury rate of 0.25%, the promised return is relatively high. As such, the
other question that imposes itself is that is the high return reflecting the high risk associated
with the investment? And is the overall risk-adjusted return really appealing?
One thing proven over the years is that when people lose their jobs they tend to default on
their loans and more specifically their credit cards as is the case prior to 2008 financial crisis.
And since most of the P2P portfolio include credit card loans, a rise in the unemployment rate
could jeopardize the return and even the capital invested; noting that P2P lending offer loans
to those that are unable to obtain it from banks as such involving higher default risk. This
could be illustrated in the graph below whereby the rates moved 0.7 % for every increase in
unemployment rate; however, this value increased to be approximately 1% during the
financial crisis (the red points). Furthermore, in the years prior to the financial crisis, banks’
credit card operations enjoyed an average return in the range of 3¼%, the return decreased to
-3% in 2009 as the unemployment rate rose by more than 5 percentage points.
The real threat comes when investors start to believe that putting their savings in P2P notes is
as safe as depositing them at a bank as such I don’t agree with the writer when saying that
P2P lending should not be compared to banks. Peer-to-peer lending does have certain
privileges including lower operating costs typically linked to banks’ extensive branch
networks and IT systems which are more difficult to update given that much of P2P work is
being done on virtual networks (over-the-counter) and the ever-falling cost of software and
internet bandwidth, allied with the exponential growth of publicly available personal
information, means it is possible for machines to automate much of the bank risk assessment
processes at much lower costs thus allowing them to charge more competitive interest rates
relative to banks which in turn would improve borrowers’ success rates and their ability to
pay back loans. Moreover, banks try to minimize the moral hazard by acquiring a collateral
noting the increased probability that the increased loans have less creditworthiness and in
case of default the bank is ultimately selling at a loss or a low profit margin thus
collateralization is not ultimately eliminating the moral hazard, and banks are losing other
customers that are not granted for P2P lenders. Besides, regarding the capital requirements,
the minimal capital standard introduced by the FCA in UK is with a volume-based decreasing
rate where the highest rate is 0.2% over the first £50 million of total value of loaned funds
outstanding compared to a 3% minimum leverage ratio (that is, a capital floor based on gross
exposure) for large banks and building societies.
More importantly, P2P lenders are not using their own balance sheet. Not only do they
remove all the broker and fund manager costs, which reduce returns and add to borrowing
rates, they don't earn a margin (spread on interest margin) on the loan. Instead, they charge
fees, which vary from flat, one-off fees, to a few 5% of the amount.
The best scenario to deal with P2P lending is to diversify your portfolio i.e. spreading the
money across many loans and different platforms/websites while researching the other party
(borrower) thus resembling the risk sharing feature of banks and their diversification process.
Another thing would be re-investing your returns and preparing yourself for limited liquidity.
The ultimate question is that what other alternative offerings will we see disrupting the
traditional establishment? A whole new technology-driven model for insurance? Mortgages?
Peer-to-peer lenders are getting more credibility and the whole concept of the sharing
economy is expected to go into force in the financial services industry in 2016.
However, the fact that the financial sector is one of the most heavily regulated in the industry
proves that banks are not going to disappear anytime soon. Their compliance and money-
transfer systems are way too complicated to be replicated by start-ups; the main reason why
applications like Apple play are still built on top of existing bank systems and payment rails.
The presence of these P2P websites is constituting tremendous competition in the consumer
lending business. Hence, it would be more efficient replacing the most competitive card
providers with websites that would result in consistently higher returns to investors and lower
costs to borrowers still the idea is way theoretical!
Sources
http://www.telegraph.co.uk/finance/markets/questor/
http://www.investopedia.com/articles/investing/
https://blogs.cfainstitute.org/investor