This article gives us an idea of what peer-to-peer lending does in the marketplace and its ability to disrupt the lending market. While there is great need for this type of lending in a country like the Philippines, it is important like what is mentioned that good governance as well as risk and compliance practices are observed in the conduct of its business.
What you need to know about peer-to-peer lending
Peer-to-peer (P2P) lending is a fast developing market for individuals andsmall businesses looking to lend or borrow money. It has the potential to challenge the dominance of traditional financial institutions like banks, but involves new risks for both lenders and borrowers.
In its simplest form, P2P uses a web platform to connect savers and borrowers directly. In this form, the saver lends funds directly to the borrower. Few providers offer such a “plain vanilla” product. A P2P platform matches individuals using proprietary algorithms. It works like a dating website to assess the credit risk of potential borrowers and determine what interest rate should be charged. It also provides the mechanics to transfer the funds from the saver to the borrower. The same mechanics allow the borrower to repay the money with interest according to the agreed contract.
Local players in the P2P market (not all yet operational) include Society One, RateSetter, Direct-Money, ThinCats and MoneyPlace.
There are many ways that the basic framework can differ. This affects the types of risk faced by both lenders and borrowers. Protecting the borrower’s identity from the lender is important. What if the lender is a violent thug who takes umbrage if payments aren’t met? Protecting the borrower brings another risk. The lender must rely on the operator to select suitable borrowers and take appropriate action to maximise recoveries.
The operator can provide a wide range of services. For example, lenders might have a shorter time frame than borrowers, or discover that they need their funds back earlier than they thought. The operator may provide facilities to accommodate that. Or, rather than lenders being exposed to the default risk of a particular borrower, the operator may provide a risk-pooling service, whereby exposure is to the average of all (or some group of) loans outstanding.
The further these services extend, the more the P2P operator starts to look like a traditional bank – but not one reliant on bricks and mortar, nor on the traditional mechanisms of credit analysis relying on customer banking data. The explosion of alternative sources of information (including social media) about an individual’s behaviour, characteristics, and contacts for instance, provide new opportunities for credit assessment analysis based on applying computer algorithms to such sources of data.
While the traditional three C’s of loan assessment (character, collateral, cash flow) remain important, new data and ways of making such assessments are particularly relevant to P2P operators. Indeed P2P operators go beyond the credit scoring models found in banks in their use of technology and data, unencumbered by the legacy of existing bank technology and processes. It is partly this flexibility which explains their growth overseas and forecasts of substantial market penetration in Australia. Much of that growth can be expected to come from acceptance by younger customers of the technology involved – and about whom there is more information available from social media to inform credit assessments.
But also relevant is, of course, the wide margins between bank deposit interest rates and personal loan rates. With – arguably – lower operating costs and ability to match or better bank credit assessment ability, P2P operators are able to offer higher interest rates to lenders and lower rates to borrowers than available from banks.
For lenders, higher interest rates are offset to some degree by the higher risk to their funds. Unlike bank deposits, P2P lenders bear the credit risk of loan defaults – although P2P operators would argue the risk can be relatively low due to good selection of borrowers and mechanisms for enabling lenders to diversify their funds across a range of borrowers.
For borrowers, the main risks arise from the consequences of being unable to meet loan repayments. There is little experience available in the Australian context to understand whether P2P operators will respond to delinquencies by borrowers in a different manner to banks.
It’s important that P2P isn’t confused with payday lending where low income, high credit risk, borrowers unable to meet repayments can quickly find themselves in dire straits by rolling over very short term loans at high interest rates.
The two business models can overlap – with payday lenders offering loan facilities via web based platforms. One challenge for P2P operators is to ensure the community and regulators accept their model as one of being responsible lenders to credit worthy clients. They also need to convince regulators that these unfamiliar business models do not pose unacceptable risks to potential customers.
P2P lending could have major benefits to individuals who want to invest, lend or borrow money. Hopefully regulators will be able to distinguish between good and bad business models. If they can’t, they could prevent a profound challenge to traditional banking.