There's been a significant rise in the profile of peer-to-peer (P2P) lending recently, with various commentators preaching its virtues or warning of calamities to come. From April they can even be put into ISAs. Rather than wading into the practicalities, this post aims to look a little deeper at two fundamental questions I ask of all financial innovations: why does it exist and what function does it serve?
P2P and banks: the theory
The core principle of P2P is that people lend to other people, cutting out the middlemen: banks. This is not a new idea. Before banks existed those who wanted to borrow money had to find an individual with spare cash to lend them some. This was cumbersome, risky and inefficient. Banks – at least in theory – improve this process in three notable ways:
Risk pooling: by pooling money from many lenders and loaning it to many borrowers banks spread the pain of any borrower failing to repay across lenders. Most lenders would rather expect to lose 5%, especially as the interest would likely more than make up for this, than have a 5% chance of losing everything.
Assessing and monitoring creditworthiness: those with money to lend weren't necessarily experts on assessing which borrowers were good risks and rarely had the time to monitor their business activities to ensure repayment. Banks could employ experts to do this on behalf of many lenders, spreading the burden.
Finding a loan: by providing a central place for people who want to borrow or lend to go, banks reduce what economists refer to as search costs.
Given the risks and complexities involved in modern finance these 'middleman' functions still appear valuable. What has prompted the move back towards P2P?
The benefits of P2P?
The core reason given by P2P borrowers and lenders is interest rates. Interest rates have been stuck near 0% for years, pushing many savers to search for yield outside the traditional banking system. In contrast interest rates charged on credit cards, personal loans and to many small businesses are much higher. Many P2P borrowers and lenders feel this wedge between the rates banks offer to savers and those they charge borrowers has become too high and is no longer worth paying. There are three possible causes – inefficiency, regulation or illusion – each with a very different prescription for the benefit for P2P lending.
The financial crisis clearly showed flaws in how banks lent and investment money, with huge amounts lent against dodgy assets, especially those relating to housing or money lent between banks. Even now banks have been accused of applying crude, formulaic methods to assessing creditworthiness – “computer says no” – causing credit constraints among small businesses while continuing to fuel the housing boom. Technology offers an alternative, enabling P2P platforms to offer some of the centralising, monitoring and pooling functions of banks without taking full control. Could P2P platforms simply be performing the core functions of a bank without the overheads and superfluous functions, passing that cost reduction on in higher rates to savers and lower rates to borrowers?
Another possible cause is regulation. Banks face strict capital requirements and restrictions on where they can lend and how they must conduct themselves. Following the crisis these capital requirements have been significantly raised, and the need for banks to generate that capital led many to sharply cut their lending. These regulations may be necessary to prevent another crisis, but they are also costly. Could this cost of regulation be the reason banks can't offer the same interest rates at P2P lenders?
Alternatively the improved interest rates offered by P2P lenders could be illusory. P2P investments are risky as borrowers may fail to repay, and as they are not covered by the Financial Services Compensation Scheme there is no safety net to protect savers if things go wrong. Average default rates are built into the returns quoted by P2P lenders, which are still often far higher than most savings accounts can offer at around 4-7%. However these are average default rates in normal years, and the crisis vividly demonstrated that it's possible for returns and default rates to become far from normal with little warning, even when savings are spread across a number of borrowers. Could P2P lending be storing up a large amount of hidden risk, appearing safe the vast majority of the time but with the potential to all go horribly wrong if the economy turns, as Lord Turner recently warned “I strongly suggest that the losses on peer-to-peer lending which will emerge in the next five to 10 years will make the worst bankers look like absolute lending geniuses”? By cutting out banks does P2P lending cut out important safety features or regulations that only become apparent in downturns?
Why we need to know: is this time different?
I don't know whether P2P lending is a good investment or not. It is possible that technology has rendered many of banks' 'middleman' functions unnecessary, or that regulation has made saving through a bank prohibitively expensive. However we are in uncertain economic times and it is also possible that P2P lending carries significant risks that have not yet been realised. It is worth remembering that before the financial crisis an innovative new investment – securitised mortage-backed assets – appeared to offer high yields at low risk, performing spectacularly at the time, yet were highly susceptible to unforeseen turbulence in the economy.
Of course the rise of P2P lending may not be because it offers a financial advantage over traditional banking, it may simply be because P2P lenders aren't traditional banks. Many people lost their trust in banking with the financial crisis, questioning how it went so badly wrong and how nobody saw it coming. The same way many have linked the rise of UKIP with disillusionment with mainstream politics, people may be turning to P2P lending out of disillusionment with mainstream finance.
Whether the reason P2P lending is increasing rapidly is emotional or financial it is imperative that we analyse it thoroughly. Only by knowing what new function it serves and whether it offers real benefits over conventional finance can we learn from the mistakes of the past, guard against potential unseen risks, and ensure that this time it truly is different.
The establishment and activities of the Open University’s True Potential Centre for the Public Understanding of Finance have been made possible thanks to the generous support of True Potential LLP. True Potential has committed to a five-year programme of financial support for the Centre. Views expressed here are my own and may not reflect those of True Potential LLP.