Peer To Peer Lending

P2P lending is the practice of lending money to individuals or businesses through online services that match the lenders directly with the borrowers. P2P lending platforms are thus, aggregators of lenders and borrowers.

The major incentive for the lender here is the opportunities for more rewarding and lucrative investments. They can earn much higher returns as compared to savings and investment products offered by banks. In India, the expected returns usually range between 16- 28℅.

At the same time the borrowers are assured of more affordable and less complex credit. This follows due to the much lower interest rates as compared to those at banks and other traditional financial institutions.

The question which now pops into our heads is how the P2P lending platform manages to simultaneously offer such contradictory benefits to its stakeholders.

·         Since all the transactions take place entirely online, P2P platforms can provide these services much more cheaply, given the significantly lower overhead costs incurred by them while doing so.

·         It eliminates the margin of the middlemen. Unlike in the traditional system wherein banks act as intermediaries and lend to and borrow from borrowers and lenders respectively, P2P lending merely provides a platform in return of a servicing fee. It does so simply by sharing the lists of borrowers and lenders.

·         The platforms undertake the credit scoring of entities registered as borrowers with them and make a profit from arrangement fees and not from the spread between lending and deposit rates as is the case with normal financial intermediation.*

The first company in the world to offer such a platform is Zopa in UK which was introduced in Feb 2005. The period of the financial crisis in 2008 was the time when P2P Lending manifested its significant form. The defaults on payment became frequent leading to unwillingness on the part of the investors to take on unnecessary risk and banks refusing to increase the loan portfolios.

As a result, more and more and more people resorted to P2P lending and borrowing.

There are a few salient functions of a P2P lending firm, as given below:-

Ø  It provides the basic information about the investors and borrowers. Thus, it is a platform for identification and attraction of potential matches.

Ø  It lays down all the rules and regulations, payment and remuneration methods involved.

Ø  It undertakes credit checks and filtering out of unqualified borrowers by verifying his/ her identity, bank account, employment , income etc.

Ø  It develops credit models for loan approvals and pricing such as higher interest rates from riskier borrowers.

Ø  It documents the lending and borrowing arrangement. The lender transfers money from his/her bank account to borrower’s bank account. The platform facilitates collection of post-dated cheques from the borrower in the name of the lender as a proxy for repayment of the loan.

Ø  It provides support services for the transactions.

Ø  It services the loans providing customer services to borrowers, processing payments from them and forwarding them to the lenders.

Ø  It ensures legal compliance.

Ø  It undertakes marketing and finds new borrowers and lenders.

P2P personal lending sites allow people to connect with one another to get loans online- with real money, in real time. They have duration from 1-3 years.

Payday loans or fast cash is one of the most popular financial services offered by them. They are relatively small amounts of money lent at a high rate of interest on the agreement that it will be repaid soon enough. 

Here, the interest rates can be set by:-

Ø  The lenders use reverse auction models i.e. an auction wherein the roles of the buyers and sellers, in this case the borrowers and lenders, are reversed. The borrower places a requested interest rate and the lenders bid to and compete by offering lower and lower rates.

Ø  The P2P firm lends on the basis of the analysis of the borrower’s credit score.

Ø  Cost plus model (operational costs plus margin for platform and returns for lender).

There is always risk to be faced in such scenarios, especially when the rate of return is very high, and the loans usually uncollateralized.

One may wonder how high the delinquency ratio must be in this case of unsecured loans, which is comparatively higher than other types of loans. But ironically, higher defaults may indicate a profitable venture. If defaults did not occur with frequency, peer-to-peer would not have such a high expected return. There is no guarantee that it will get repaid or of the rate of default which could be very high. Investors generally don’t like both risk and uncertainty. To compensate for these factors, peer-to-peer loans have much higher expected return than safer investments.

Thus, default on payment, bad debts or the bankruptcy of the P2P lending firm are the major risks faced by the lenders. Certain risk mitigation techniques which may be used are as follows:-

Ø  Choosing the borrowers according to the lender’s discretion. ( provided the platform provides this facility)

Ø  Diversifying the investment among different borrowers.

Ø  The P2P Company maintaining a provision fund to pay back in cases of default.

The P2P lending company is not an intermediary in a loan but a facilitator. Hence, in any event of default, it may assist the lender in the recovery of the money from the borrower to the extent of hiring a recovery agent but it shall not assume any liability of the repayment.

Also, it is essential to note that just like 1 investor can diversify his investment among different borrowers, 1 loan can be financed by multiple investors. But, this is not tantamount to pooling of money as in a Collective Investment Scheme, since each lender maintains his/ her separate account and manages the portfolio making an informed decision.

According to the data released by P2PFA, the cumulative lending through P2P has grown dramatically from 2.2 million GBP in 2012 to 4.4 billion GBP in 2015.

•       Lending Club, followed by Prosper (both US firms) is the leading P2P platform in the world.
•       Faircent, followed by i-lend is the most prominent one in India.

In India, there are over 30 P2P lending platforms. This market is currently unregulated** and there is a lack of awareness towards this type of debt financing. However, it has still managed to help a huge section of the society which was previously rejected by banks. It has also proved to be a boon for SMEs and Self-employed professionals who find it difficult to borrow from banks that usually have an asset based underwriting mechanism. It has also enabled socially conscious investments. This implies that assistance may be provided selectively to those engaged in occupations deemed morally positive to the community and avoid industries deemed detrimental for it.

Banks, financial institutions, community based financing, chit funds, cooperative societies; all have had the limitation of a lack of physical interface.

With the advent of technology, it can take lace online and the outreach of any person, to anyone across the world, even several people, simultaneously, raises manifold. In the lending business as well, this virtual interface is getting created.

The growth of P2P lending models, amplifying and revolutionizing the financial services in the world, is establishing itself in the mainstream steadily.

*The borrowers pay an origination fee (either a flat rate fee or as a percentage of the loan amount raised) according to their risk category. The lenders, depending on the terms of the platform, have to pay an administration fee and an additional fee if they choose to use any additional service (e.g. legal advice etc.), which the platform may provide.

** Regulatory Practices

P2P is approached differently by regulators in different jurisdictions across the world, treated as banking by some jurisdictions and as an intermediary in some others, while some jurisdictions like Israel and Japan have prohibited it altogether.

In India, this segment is currently unregulated but it is proposed that the P2P lending platforms be brought under the purview of Reserve Bank’s regulation by defining P2P platforms as NBFCs under section 45I(f)(iii) of the RBI Act.

Note that RBI has powers to regulate entities which are in the form of companies or cooperative societies. However, if the P2P platforms are run by individuals, proprietorship, partnership or Limited Liability Partnerships, it would not fall under the purview of RBI. Hence, it is essential that P2P platforms adopt company structure. The regulation would therefore specify that no entity other than a company can undertake this activity.

- Akshita Gupta