Peer-to-Peer Lending—Disruption for the Banking Sector?

By Samantha Barnes – samantha.barnes@internationalbanker.com

Peer-to-peer lending (sometimes referred to as P2P lending, or abbreviated to P2PL) is a form of loan provision centred on an online marketplace forum structure. The forum is designed to match able lenders with suitably appropriate borrowers using an online platform. The online platform provides the interface for the loan sector—where supply may meet demand. The peer-to-peer lending, and peer-to-peer investing, industries have taken off well since the time of the global financial crisis seven years ago. Investors, who have been looking for alternative avenues of returns for their capital, have gained interest in the peer-to-peer sector. Key leaders in the sector include Lending Club and OnDeck, which have snowballed in take-up and have since gone public—floating their stocks in December of last year and establishing company values of $9.5 billion (£6.1 billion) and $1.5 billion, respectively. These firms are becoming increasingly attractive to investors looking to invest in P2P companies themselves, as well as utilise the services the sites have to offer in connecting lenders with borrowers. 

P2PL is the practice of lending money to unrelated individuals, or “peers”, without going through a traditional financial intermediary such as a bank or other established financial institution. This lending takes place online on peer-to-peer lending companies’ websites using various different lending platforms and credit-checking tools. By eliminating the need for traditional banks, P2P lending is designed to improve efficiency and unnecessary frictions in the lending and borrowing processes. P2P lending has been recognised as being successful in reducing the time it takes to process these transactions as compared to the traditional banking sector, and also in many cases costs are reduced to borrowers. Furthermore in the current extremely low interest-rate environment that we are facing across the globe, P2P lending provides investors with easy access to alternative venues for their capital so that their returns may be boosted significantly by the much higher rates of return available on the P2P projects on offer. The P2P lending and investing business is therefore disrupting, albeit moderately for the moment, the traditional banking sector at its very core. This trend looks set to continue as the banking and financial-services sector is undergoing a major phase change, fuelled by the growing developments in technology and application design combined with the evolving needs of customers to have access to more convenient online and mobile solutions for their banking and financial-services demands. 

Over the past 10 years, technology has revolutionised banking and financial-services sectors. The costs of technological-resources development and investment have fallen significantly lower over the past decade, allowing smaller firms to enter the market. This has improved the competition and efficiency in the market, whereas in the past these technological costs may have priced other contenders out of offering competitive and effective services when going up against the large established banking institutions. The gain in popularity and use of P2P lending and investing services marks a wider divergence from the traditional-banking infrastructure. As an example, millions of individuals and small businesses have looked to fundraising P2P sites such as Kickstarter and Indiegogo to help fund their ideas. Individual ventures can obtain more than $10 million in borrowing on these sites and other smaller P2P platforms such as RocketHub and GoFundMe. In the UK the government has gone so far as to publicly recognise and support the merits of P2P lending—as they have identified that it may help rebuild the economy and stimulate growth through a fast, cost-effective and efficient mechanism. Further they have noted that competition with the traditional banking sector is a positive change that will lead to improved efficiency, innovation and development. As part of this government support, they have announced a programme that will be implemented from April 2016, which will allow lenders to offset any losses from loans against taxes on other P2P income. The UK government has also outlined plans to review financial regulation that prevents institutional P2P lending. However there is the potential downside to this government recognition as they have also stated that they may introduce withholding tax on all P2P income in the future. 

P2P lending sites are ideal venues for small businesses to access funding to fuel growth. These parties are often overlooked by banks and traditional financial institutions, which consider smaller businesses high risks. If loans are extended by banks to these businesses, they are often at rates that are exorbitantly high and unmanageable for driving sustainable growth as intended, as the debt payments put too much strain on the businesses’ cash flows and overhead management. Since the global financial crisis seven years ago, from 2007-2008, the banking sector across the globe has been undergoing a major overhaul at all levels of operation. The global financial crisis led to a number of banking and financial-services institutions closing altogether—particularly those with balance sheets dominated by so-called “toxic asset” holdings. Out of those that survived the financial crisis, many have been struggling to regain growth and rebuild ever since. The credit activity and liquidity across global capital and asset markets has dried up, and the economy has showed only slow signs of rebuilding. However, the slow and lacklustre recovery worldwide has hit the financial and banking sectors hard. In addition, over the past three years global regulators, particularly in the Western regions of Europe and the US, have been clamping down on their new regulatory-policy regime. Designed to restore stability and remove volatility and systemic risk from the financial sector, so as to prevent a financial-system failure such as the credit crisis from occurring in the future, these new regulations have been under active implementation over the past few years. Elements of this regulation have been designed to restrict banking trading activity and also the holding of certain sizes, qualities and types of risky assets on banks’ balance sheets. Banks are now required to hold a higher ratio of capital in reserve to allow for certain downward shock scenarios to act as buffers to volatile market activity, preventing shareholders and taxpayers from having to bail out these banks in the future as they have over the past seven years since the 2007-2008 financial crisis. While the traditional banking sector has been placed under increased amounts of strain and restriction, the P2P industry has been flourishing—gathering increasing momentum and uptake each year since the credit crisis more than five years ago. 

The failings of the financial sector have made the entire industry less appealing. Adding to the negative sentiment the sector has been facing is the stream of scandals and misconduct activity that continues to surface even seven years after the crisis took place. This lowered opinion of the sector combined with economic tightening worldwide has fuelled anti-bank sentiment, much to the benefit of the P2P industry. Customers, of all types and sizes, do not trust the established banks as much as they did before the financial crisis, and the fall-out since that time has not done much to remedy this situation—in certain cases the distrust has only grown. Conflicts of interest are more common with larger banking institutions, and this has not helped matters. Further exacerbating the distrust are the legal battles against banks that have been growing in size and under media scrutiny over the past few years. In addition customers are not happy about government bailouts to banks, further feeding their distaste for traditional banking and diverting their interests towards the alternatives available, such as P2P lending. 

Although the P2P lending industry has disrupted the banking industry to a moderate, albeit useful and popular, degree to date, there are some factors that indicate that this disruption may have its limits. The threat to the conventional banking system is only small at the present—for example, the P2P lending industry is dwarfed by the overall size of the American consumer credit market alone, which is worth approximately $3 trillion. In addition, industry leader Lending Club arranged about 56,600 loans totalling $791 million in the first quarter of 2014, compared with JPMorgan Chase that over the same time frame delivered approximately $47 billion in consumer loans. One of the selling points of the P2P lending industry, for investors at least, is the ability to select the best investments for their money—those who seek the lowest-risk ventures may do so through these sites, which are good at placing and advertising low-risk, high-return ventures on their websites. These sites have grown their popularity by offering better interest rates for borrowers; for example, in Lending Club’s case they can offer an average interest rate of 14 percent, compared with an average of 16 percent among credit-card companies. Yet the company remains choosy in selecting loan applicants, allowing only 10 to 20 percent to eventually use its marketplace after the application and screening process. Their competitor, OnDeck, offers a different structure, requiring lenders to fund a 10th of their loans—and relies on debt facilities and selling debt-backed securities through the site. However into the future, as the size, scale and scope of the P2P lending industry develops, these sites may have to entertain higher-risk P2P business. Only then will they have the potential to truly disrupt the banking sector—as they will be competing in an area from which they have been relatively isolated to date. 

So far conventional banking institutions have not been taking steps to acknowledge or counter these P2P lenders in the marketplace—often failing to recognise them as competition altogether. For example, in the UK, Santander Bank actively refers small-loan-seeking UK companies to P2P lender Funding Circle when Santander’s capacity for making certain loans has been reached. Confident in their brands, skills and resources, these traditional banks are not showing any signs of concern about P2P lenders to date. Nonetheless the P2P sector is growing and moving forward in development. Lending Club has transacted more than $6 billion in loans through its platform and almost tripled its revenues to $98 million through 2014. Lending Club charges approximately five percent on each loan by charging fees to both lenders and borrowers. Further to this, Lending Club and other P2P firms have outlined plans to expand into other credit products such as student loans and mortgages in the future. Many financial-sector experts are now arguing that banks are taking on a growing risk by not taking the threat of peer-to-peer lenders seriously. The so-called “disruption of a market” practice has been spreading in industries across the globe—and has been particularly effective in industries in which the incumbents have grown complacent and inefficient, which is certainly the case for some of the traditional banking institutions. The hugely successful IPO (initial public offering) of Lending Club, raising $5.4 billion (£3.6 billion) and indicating close to $10 billion in market capitalisation for the future, has signalled that investors believe that Lending Club has the ability to grow, succeed and capture a large proportion of the financial-services industry. The company has already outlined a number of strategic expansion plans for its online product and service range. 

The days of high street banking are slowly falling into the past, and the key to success in the future hinges upon accessibility, convenience, creativity and problem solving through technological solutions. Options for traditional banks for the future may be to start their own online P2P platforms, acting as Lending Club does as an intermediary that captures a percentage of the loan, or to buy out these P2P platforms altogether before they have a chance to gain too strong a foothold in the industry. For the moment, banks appear to be content with letting P2P sites continue to grow unopposed. Perhaps these banks are reassured by the barriers to entry for the P2P industry. It has not been an easy endeavour for the established P2P companies to raise sufficient capital to get their businesses off the ground over the past five years. In addition, despite the improved returns, there are still a huge, and majority, number of sceptical consumers who are wary of using such online sites and platforms for financial matters. Although promising, for the moment the P2P sector has only a very short track-record window as compared to established banking and lending firms. The sector has undergone rapid expansion over the past five years that is eating into the traditional banking sector’s bottom-line performance. Banks, already short on capital given the changes in regulation and liquidity squeezes in capital-asset markets, should be prepared for the P2P sector to grow substantially. In today’s technologically advanced world, these types of changes can occur at an accelerated and unexpected pace. Established banks should act to counter this competition through improved service, innovation and development of their services and products—and further improve efficiency so as to offer competitive rates for financial transactions.