P2P (peer-to-peer) lending is the biggest and most developed form of alternative finance. But does it have any enduring value to add in the financial system?
P2P lending platforms have sprung up in many countries since the global financial crisis, particularly in China, where they are now in crisis. According to research from the Cambridge Centre for Alternative Finance at Cambridge Judge Business School, P2P lending is the largest category of alternative finance in Europe, with about €1 billion of assets across consumer, business and property lending. (The other major types are equity crowdfunding and invoice financing). Within Europe, the UK dominates, accounting for more alternative finance than the total of the other 45 European countries surveyed. In Asia, the Centre’s research (from 2017) shows China having 99% of the total for Asia-Pacific and 85% of the global total. The great majority of this is P2P lending. Even allowing for China’s large economy this shows that something special has been going on there.
But China’s P2P industry is in trouble. Total lending fell for the first time in July 2018 from RMB 1.3 trillion to RMB 1 trillion (about $145 billion) amid tougher regulation, panicking investors and the beginning of a sector shakeout that the Peterson Institute of International Economics argues will leave just a few strongly capitalised platforms providing funds to high risk borrowers.
In the UK, there has been no scandal or abrupt reversal but Bank of England researchers argued in early 2018 that most British P2P firms had yet to make a profit. They also asked the question, what exactly does P2P bring to finance and can it improve on what banks do?
In a pure peer-based matching system, P2Ps act as brokers or agents, connecting willing borrowers with willing lenders and charging a fee. The platform has no credit risk because each loan is matched with a lender, who bears the risk and takes the interest payable. On the face of it, this is not a promising model for the lender – how can you know the risk of the borrower? Checking creditworthiness is a core skill for banks. P2P platforms sometimes argue they can use cheap automated credit assessment methods to provide credit quality guidance to their customers. I’m not aware of any research on this. But of course any such system could be copied by banks or other alternative lenders.
One way in which P2P platforms have addressed this risk is by pooling loans. The lender credit risk is diversified across a range of borrowers, just like, well just like a bank. If P2P lenders evolve further in this direction they will look very much like traditional commercial banks. What would their competitive advantage be? Perhaps they have lower costs, compared with legacy banks with their expensive branch networks. But the banks are steadily closing branches in the UK and there are new bank entrants which don’t have either branches or the old computer systems that keep the older banks’ costs high.
Possibly P2P benefits from lower regulatory costs than banks. But if they gap between banks and P2P narrows then the regulation will presumably become more similar, and P2P will lose any competitive advantage.
The Bank of England argues that banks do some very economically very useful things, including assessment of creditworthiness, pooling of risks and transformation of maturities and liquidity. This last point is a crucial one: it means that banks routinely fund long term, illiquid assets (mortgages, car loans and company loans) with short term, liquid liabilities (current account deposits whose customers can withdraw the funds at will, 24 hours a day). This is both dangerous (which is why banks are regulated) and socially very useful, since otherwise there would be far less supply of long term lending (not many people want to tie up their money for 25 years).
P2P lending grew in Britain after the financial crisis when the main British banks were in serious trouble (Lloyds TSB, RBS) or sound but highly cautious (Barclays, HSBC). As in the US and Eurozone, banks wanted to shrink their balance sheets, meaning making fewer new loans than the redemption of old loans. This fall in credit supply was partly caused by the economic recession after the crisis but also contributed to it. There were plenty of creditworthy companies that could not get bank credit at any price. Equally there were plenty of reasonably wealthy individuals who, dismayed at the very low interest rates on their bank deposits, were attracted to the idea of getting a much higher rate, for an acceptable increase in risk. P2P platforms brought these two groups together in a mutually useful way. Consumer borrowers also joined in.
But now that the banking system has stabilised and the banks are starting to use more technology, will P2P lenders have a continuing competitive niche? Currently they still offer a much better interest rate than is available on bank deposits and so far credit losses appear to have been quite low. So there is no reason for a sudden exit. Possibly the system won’t be properly tested until the next recession, since SME borrowers are often the worst hit by recessions and these are the main customers for P2P (large companies use the capital markets). One of the largest UK P2P lenders, Funding Circle (in which I have a small amount invested) is planning and IPO, despite not yet making a profit. The IPO will be an interesting test of investor appetite for P2P businesses.
In China the growth of P2P seems to have been dominated by fraud, one of which allegedly took $7.6 billion from customers in a deliberate Ponzi scheme. As is often the case in China, the regulation has been partial and ineffective but recently the China Banking and Insurance Regulatory Commission (CBIRC) seems to have become serious about implementing the rules. It’s not just deliberate fraud that is a problem. It is often a concern in China that people believe they hold a low-risk product which actually exposes them to high risk company debt. If the debt defaults the customer may argue they have been mis-sold the product and demand that the banks (which often act as agents for new, higher yielding retail savings products) compensate them. The government doesn’t want long lines of irate customers. Guo Shuqing, Chairman of the CBIRC, was quoted in the China Daily in June 2018 telling investors that that they should be prepared to lose the entire amount of their principal for any investment with an estimated return of more than 10 percent.
Despite the large numbers, even a complete failure of P2P is containable in China’s vast financial system. The PIIE estimates P2P loans as less than 1% of total Chinese bank loans and the great majority of Chinese households have not lent them money.
Anything that helps connect lenders and borrowers is a useful contribution to the financial system. But any such connection needs to overcome the eternal problems of information and costs. It’s not clear that P2P offers any significant long term advantages that would make them a significant part of the financial system, but experimentation is a good thing and we shall see how the honest and efficient P2P platforms develop.
Peer to peer – scale and scalability (Bank of England)
Should peer to peer lenders exist in theory? (Bank of England)
Massive P2P Failures in China: Underground Banks Going Under (Peterson Institute for International Economics)
Financial innovation: peer to peer lending (this blog)
Expanding horizons: the 3rd European alternative finance industry report (Cambridge Centre for Alternative Finance)