What is P2P Lending?
Peer to peer (P2P) lending is a relatively new phenomenon where individuals bypass traditional financial intermediaries in order to make loans. Currently, the two largest P2P lending platforms are Prosper and Lending Club, and the rate at which they have been growing is difficult to ignore. Traditionally, people deposit money into a savings or checking account, and then the bank creates loans based on these deposits. The deposits that the bank holds for individuals generally pay relatively little in terms of interest rates; however, the interest rate on the loans that they make are substantially higher, which is where they get their profit. P2P lending platforms differ from this traditional model because they connect individuals wishing to invest money directly with people looking for loans.
Why is it gaining market share?
The founder of Lending Club, Laplanche, first noticed the potential for such a service in 2006 when he noticed on his bank statement that his credit card interest rate was 16.99% while the interest he was receiving on his savings account was 1%. The difference between these two rates was the revenue being generated by the bank, and he thought it seemed abnormally high. A basic tenant in economics states that abnormally high profits beckon potential entrants. Laplanche thought that this spread represented inefficiency amongst traditional banks, and he believed that he could perform this service more efficiently.
In a recent report, the Federal Reserve Bank of Cleveland finds that P2P lending is providing a crucial service to a demographic typically overlooked by conventional sources, individuals with short credit histories. In order to provide loans to applicants with little to no credit history, P2P services rely on other determinants of default, such as the source of income, housing situation, SAT scores, and loan purpose, and they are more willing to take on individuals with higher risk.
An additional appeal boasted by P2P services is the sense of control given to investors. Investors are able to select the target of their funds based off of characteristics of the loan, such as purpose, financial situation, credit history, etc. Due to this, investors can inject strategy into their investing and choose loans based on what they believe the corresponding risk to be, combined with the risk assessment of the provider. Lending Club releases significant amounts of data concerning default rates, which have allowed studies to be conducted assessing which factors lead to higher rates of defaults. Using Cox regression analysis for survival times, a group of researchers found that, when the purpose of the loan was for a wedding, credit card consolidation, car loan, major purchase, or home improvement, the loan was less risky than when it was for a small-business investment, medical bill, or for education costs. A dummy variable was used to indicate the purpose of the loan. (Table 2. shows the coefficients on other explanatory variables. A negative coefficient indicates that the variable was associated with lower levels of risk.) Using this information, lenders can target borrowers who fit their desired risk profile.
This same report compared average interest rates from P2P lending services with interest rates for credit cards and found that, for less-risky individuals, interest rates obtained through Lending Club were generally lower than what they could get through credit cards. For this reason, borrowers frequently borrow through P2P platforms in order to pay off higher interest credit card debt.
Foroohar proposes that the timing of P2P services played a crucial role in their success. Looking at Figure. 1, it’s evident that these platforms took off right around the time of the financial crisis, at a time when banks were notoriously stingy with granting loans. This opened up the market to non-traditional financial institutions. Traditional banks have become inundated with new regulatory costs since the recession, so they are hesitant to issue loans. The average small-business owner spends 24 hours applying for loans, and yet, they receive only 33% of requested loans. This means there is a large market that companies like Lending Club have begun to capitalize on. Using survival analysis, a recent study analyzed the probability of default based on the loan purpose and found that small-business loans were the most likely to default. After a 3-year period, more than 20% of small-business loans end in default, while credit card consolidation had only about a 7% default rate after the same time period. For this reason, traditional banks have tended to avoid small-business loans in favor of more stable investments; however, small business remains a vital part of our economy and must be funded somehow.
Are Existing Regulations Enough?
Currently, the market for P2P loans is relatively small; however, given the current growth rate of these products, P2P loans may have the potential to become a bubble in future years. Over the past few years, the rate of default for these services has been fairly low. Junk bonds have an average default rate around 6%, while high-grade bonds have an average default rate around 4%. These numbers remain untested during times of economic downturn, so when the next recession strikes, default rates could increase substantially, and individual investors would be the ones to bear the cost. Government regulatory agencies have implemented a few barriers in order to prevent higher default rates from devastating investors. These come, primarily, from financial criteria for investors dictated by the SEC in the United States. In order to invest, there is a crude set of criteria to ensure financial stability. Depending on the state of residence, there is a minimum income and net worth required for investors. Additionally, investors are not permitted to invest more than 10% of their net worth at any one time.
In the case of complete bankruptcy for these institutions, the UK government mandates that if a marketplace lender (MPL) goes out of business, then it must take reasonable steps to ensure that pre-existing loans continue to be paid until maturity. Unfortunately, there is no incentive for disintegrating firms to protect investors, so the likelihood that this regulation will be followed is slim, and officials won’t know how effective this regulation is until the market takes another downturn. Governments may need to step in during times of economic hardship in order to see that these commitments are followed.
With such rapid growth in recent years, do P2P lending services pose a threat to traditional banks? According to Deloitte, “…a bank’s broad cost profile is less sensitive to changing interest rates than that of an equivalent MPL.” Deloitte posits that due to current expansionary monetary policy, this structural price advantage banks have is not obvious, but will be evident when interest rates return to pre-crisis levels. Despite this, MPL’s offer borrowers a quicker, more efficient method to secure funding, especially in areas where banks have been hesitant to venture in recent years. Though they may suffer when interest rates rise, I do not believe they will be going away completely.
Areas for further research
In today’s financial environment banks are holding excess reserves that otherwise would be used to create loans. These loans would then be spent in the economy, and the multiplier effect would increase aggregate demand substantially. Unfortunately, the multiplier effect is not as effective as it used to be simply because banks are no longer creating loans at the same rate that they once were. P2P lending can take money, that would otherwise have been put into savings accounts and then would sit as excess reserves, and create loans without the need to go through a bank. Further research needs to be conducted in order to see if P2P lending services can stimulate the economy in a way that has typically been the role of traditional banks. If this is the case, then increased growth of these platforms will increase aggregate demand and should motivate the Fed to raise interest rates in the near future. Unfortunately, it is not clear if the money being put into this service is redirected from savings accounts or more risky ventures like stocks. If it is the latter, then it is not redirecting money that would have sat as excess reserves, but instead diverting money that would have been invested by companies.