Is Peer-To-Peer Lending The Future Of Banking?
Websites that allow you to lend money to a complete stranger are winning support in the UK and the US. But they don't come without risks.
“Never lend money to friends or family,” the saying goes. But how about complete strangers? Websites that match up borrowers and lenders are enjoying a new wave of interest after a series of high-profile endorsements.
First came Andy Haldane, executive director for financial stability at the Bank of England, who said peer-to-peer lenders could eventually replace high street banks. “At present, these companies are tiny,” he said. “But so, a decade and a half ago, was Google. If eBay can solve the ‘lemons problem’ [substandard products] in the secondhand sales market, it can be done in the market for loans.”
Then the government said it would channel £100m to small businesses through alternative lending channels, including peer-to-peer lenders, hoping to bypass the mainstream banks, which are reluctant to lend. The news caused a flurry of excitement among the few established players in the field, including Zopa, for personal loans, and Funding Circle, for small businesses.
These websites act as a kind of broker between lenders and borrowers. The idea is that without expensive branches and the weight of regulation, they can offer better rates to both sides. For a loan of £5,000 over three years, Zopa certainly comes out cheapest on moneysupermarket.com, offering 7.3%. And it says lenders on the site can expect returns of 5%-5.5% after fees and bad debts, which beats most easy-access savings products out there. The model is, however, not without risks. Lenders have to absorb any losses from unpaid debts and the industry is barely regulated, leaving it open to fraud.
So far, the established peer-to-peer lenders have kept bad debts impressively low. Zopa says they account for just 0.84% of the £200m it has loaned over the past seven years. Its chief executive, Giles Andrews, says the equivalent figure for mainstream banks is between 3% and 5%. Funding Circle’s bad debts are about the same, though it expects them to rise to around 2.8% as its loan book gets bigger.
Samir Desai, the 29-year-old chief executive and co-founder of Funding Circle, says it achieves these low levels because its risk management system is better than the banks’. He says: “We’re developing credit models. We’re adapting them and bringing in new swaths of data that banks don’t look at, like Twitter.” But he is vague about how that data will be used. “We’re still building these things in. You can see how active a business is [on Twitter], how big a public profile they have.”
Zopa is more cautious. Andrews says risk is one area where he is happy to learn from the banks and he only hires people with a financial services background. After an initial screening process using publicly available consumer credit data, Zopa’s underwriters call every successful applicant before offering them a loan. “Credit scores are good at looking backwards,” he explains. “You can have a high credit rating and lots of debt you’ve been able to service, but essentially it’s a house of cards. The object of that human review is to try and understand that. Our underwriters can get a feeling for: are they the kind of people to soldier on and pay their debts, or are they likely to file for an IVA [individual voluntary arrangement to write off debts] at the first sign of trouble?”
An unconventional approach to risk management has already scuppered one of the peer-to-peer lenders. Quakle, which went bust within a year of its launch, measured a borrower’s creditworthiness according to a group score, similar to the feedback scores on eBay. The model failed to encourage repayment and Quakle is thought to have incurred a near 100% default rate.
Andrews is suitably dismissive: “They believed you could use social media data to underwrite loans. They thought it would be clever to bypass that bit of banking. That didn’t work.”
Regulation is a thornier issue and one that the established peer-to-peer lenders want addressed. In a rare reversal of the norm, these brokers are asking for more, not less, regulation. They have already developed their own body, the P2P Finance Association, although membership is currently limited to its three founders: Zopa, Funding Circle and Ratesetter. The association sets minimum standards for its members, such as keeping client accounts separate from company money, and having arrangements in place to ensure the loans are serviced even if the broker itself goes bust.
Consumer groups have complained that these sites trample over important consumer protection standards upheld by the banks. Savers lending money on the sites will not be protected by the Financial Services Compensation Scheme, for example.
Desai says that is because it is not a savings account. “It’s completely different. If you are lending money to a business you are taking a direct contract with that business. If the underlying company goes bust you could lose your money. So it’s much more like investing in corporate bonds or shares, rather than putting your savings into a bank. It’s not a zero-risk product.”
So, with many savers likely to be cautious after watching Britain’s banking sector all but collapse during the financial crisis, it may be some time before Zopa or Funding Circle fulfil Haldane’s hopes and become the new Google.