Is peer-to-peer lending facing a reckoning?

Peer-to-peer lending has boomed in recent years, particularly in the US and the UK. And so has the funding funnelled to these companies. The VCs taking a particular interest in fintechs operating in the space. It had been also quite popular in China between 2011 and 2015, because lending there was really ripe for disruption. Until we realised that most Chinese P2P lenders were in fact Ponzi schemes, which led to the market collapsing almost entirely.

Peer-to-peer lending platforms allow individuals to directly lend to consumers, mostly through unsecured personal loans, for instance Zopa in the UK. On the other hand, some platforms focus on lending to small businesses, like Funding Circle in the UK and the USA.

Is it revolutionary? Not really. That is exactly what a traditional bank would do. Collect money from personal and business customers, and then lend it to other customers. This can be in the form of personal loans, mortgages and business loans, among other products. The bank takes a margin in the process — and so does a peer-to-peer lender.

What is novel is that the lending process is transparent, you know exactly where your money is going. Platforms like Funding Circle would even give you the breakdown of the businesses you are lending to for instance. And that is quite a cool feature!

How do peer-to-peer lenders manage to offer such attractive returns?

Peer-to-peer lending has attracted many investors with returns which are much more attractive than traditional lenders and their savings accounts. This is mostly down to two things.

Firstly, peer-to-peer lenders have very slick operations. No useless cost-heavy branch networks. No hundreds of relationship managers. End-to-end digital fulfillment which drives their overall costs down massively. It means that their cost-to-serve, the amount of money it costs them on average to sell to a customer, is a fraction of what it is for a bank. What that really means is that peer-to-peer lenders do not need to take a big margin to cover their costs. This makes a big difference as volume of lending grows.

Secondly, their risk appetite is very different. Traditional incumbent banks like low risk. Banks predominantly offer mortgages or lend to large corporates. That is what makes most of their balance sheets. The interest rates and margins are low, particularly in the mortgage market, but so is the risk. Very few loan defaults as a consequence. That is why customers are earning say 0.5%-1% on savings accounts because if the bank offers a mortgage at 1.5% or 2%, it seems logical that a customer would not get more. Peer-to-peer lenders like Funding Circle offer investors returns of over 5% because they lend to riskier profiles, small business customers, at a much higher interest rate. Defaults are also therefore more frequent.

What now for the peer-to-peer lending industry?

In a benign credit and low-rate environment, peer-to-peer lenders looked like a real disruption to banks. It was attracting yield-hungry investors tired of earning below inflation interest rates on their savings. But what happens in an economic crisis? They face a huge test now, with an impeding economic crisis, a global slowdown due to the coronavirus outbreak and interest rates going lower or even negative.

There are growing fears that the two lending segments that peer-to-peer lenders focus on, unsecured personal loans and small company loans, are going to see a massive rise in default rates. Banks are usually in trouble when this happens. However they take impairments throughout the years to face these situations, same for peer-to-peer lenders.

However, defaults are compounded by an issue very specific to peer-to-peer lending: liquidity management. For everybody, there usually tends to be a major challenge with lending, which is liquidity mismatch, the difference in terms of timing between customers depositing their money and the length of the loans. The former is short term whilst the latter is medium to long term. Banks have experience with liquidity management and can do that easily by tapping wholesale funding if need be.

Not so easy for peer-to-peer lenders that face investors trying to pull out their money whilst the platforms are trying to lend to customers. Even more to business customers during this downturn. In the UK, they are trying to access government funding to keep on lending. The platforms have tried to alleviate that issue over the years by getting larger deposits from institutional investors, but the problem subsides.

What comes next for the peer-to-peer industry? Well, a bumpy road that is for sure…