Traditional banking, as we know it, is undergoing a rapid transformation. The boom in financial technology (FinTech), in spite of the financial crisis, has caused a large transformation in financial markets and as a result peer-to-peer (P2P) finance is growing rapidly in popularity. There are a few categories to be considered when referring to P2P finance. Firstly, P2P lending is a method of non-traditional debt financing which provides loans to borrowers from institutional investors, such as banks or hedge funds or individual investors over P2P internet platforms. Secondly, P2P foreign exchange is the matching of individuals and companies attempting to send and receive money from abroad and connecting them online in order to exchange currencies. There is also P2P investing and foreign exchange hedging and P2P insurance. In this report we will focus on P2P lending (however, to understand the disturbance in the financial market we may sometimes consider P2P finance as a whole) and the challenges and opportunities firms face as a result of this new alternative. We will explore China’s P2P lending, given it has the largest P2P lending market in the world, and its recent growth in P2P lending over the last few years. Equally, this report will identify the nature of the disruption to the financial market and the existing traditional banks which previously dominated this area of the market. We also highlight some of the strategies that banks may take due to this disruption and some of the solutions for P2P companies, as well as regulatory bodies to overcome the challenges. (Moenninghoff and Wieandt*, 2012)
P2P lending is a part of banking where finance is obtained through online methods from the public. This is known as “crowdfunding” and, although it decreases the cost of lending and borrowing due to the fact that borrowers do not have to pay a transaction fee to the financial institutions who act as the intermediaries, it does involve more time, effort and risk than the traditional method of lending, especially for the investor. According to contemporary banking theory there are four main tasks that a bank performs: asset transformation, processing information and monitoring borrowers, risk management and payment services. In many functions, banks act as financial intermediaries to savers and investors. P2P finance is now encroaching on many of the financial services that traditional banks offer, however, it does so by disintermediating the service and does not actually perform the four tasks. (Moenninghoff and Wieandt*, 2012)
Traditional banks receive assets in the form of deposits and subsequently can transform these into loans depending on; size, duration, risk and the liquidity. P2P lending, however, allows multiple lenders to contribute to a loan. This also allows an investor to diversify his portfolio and spread the risk he could incur by funding multiple loans. The investor is also subject to the full amount of credit risk. In terms of liquidity, with the introduction of a secondary market for these loans, the two largest P2P lending companies in the U.S.A., “Prosper” and “Lending Club”, now make it possible for a loan to be sold before maturity. Therefore, apart from the combination of lenders to fund a loan, there is no transformation of assets that occurs. It seems clear then, that P2P lending provides a service of similarity to that of traditional banks. Having said that, it provides this service in a different way to that of banks intermediary functions, turning the tasks into basic brokerage functions. (Moenninghoff and Wieandt*, 2012)
When comparing the new P2P lending method with that of bank loans there are some cost advantages that arise due to the nature of P2P financing. Many of these advantages come from the low operational and transaction costs inherent in P2P finance due to the online nature of the service. Previously, banks would assume the risk management involved in lending money, whereas in P2P lending the participants will endure the full amount of risk involved. This is the price they pay for attractive interest rates, lower fees and liquidity. With the costs, and some benefits of intermediation, it begs the question whether a level of intermediation in this financial market, with especial regard to lending, is going to continue to be necessary. Or, whether banks are the excess link in the chain. (Moenninghoff and Wieandt*, 2012)
P2P lending has been subject to much criticism which we will discuss, along with numerous other advantages. Unlike normal savings, where the responsibility of safeguarding money for savers is assumed by traditional banks, money that is lent on a P2P lending site is not protected by the same government’s guarantee that normal savings are, the Financial Services Compensation Scheme. This scheme works to protect up to £75,000 of savings per person per banking licence as reserve sums are required by banks to protect them and savers against potential losses. This risk related with peer-to-peer lending, and the fact that lenders face exposure to defaults, is something which acts as a deterrent to many investors and is therefore a challenge to the popularity of P2P lending sites. Although there are prospects of high returns, there is also a possibility of losing your money without much legal recourse to bail you out. (Aveni, 2016)
As P2P lending is still a relatively new market, with many major companies such as Prosper and Lending Club having only been around for less than 10 years, its innovative model has not been tested over the long term. The unreliability and unpredictability nature of P2P lending gives rise to the fact that unexpected issues can arise at any time, and has been grounds for concern for many investors who are advised to diversify their methods of savings instead of putting all their ‘eggs in one basket.’ (Jolly, 2012)
The liquidity risk of P2P lending has also raised much speculation amongst critics. Contrasting to deposits made in a bank, which are readily available for withdrawals, it is a lot more difficult to access liquid assets on P2P lending platforms. Once investors enter into contracts with borrowers and lend money, theoretically, they should hold the investment up until the maturity date, which could be several years. The liquidity restraint of P2P lending is often considered one of the main deterrents of opting in to this type of lending. Having said that, if investors are in need of an earlier exit, they can sell their claims to other investors in the secondary market, which although is highly underdeveloped and subject to many flaws, provides a near solution to the liquidity problem. (Aveni, 2016)
Lastly, peer-to-peer lending puts not only the borrowers at risk who disclose personal information in order to secure loans, but also the investors who are exposed to high risk from unauthorized access, and identity theft. The online nature of the P2P lending industry means that many people’s information could be stolen fairly easily and this kind of online lending attracts criticism of fraudulent activity causing fear about how protected investors really are in the P2P industry. (Chen, 2013)
Given the many risks associated with peer-to-peer lending, we have analysed the opportunities that P2P lending gives to individuals and businesses, and several solutions that have been devised to reduce the risks associated with this form of lending.
For traditional banks, there is the opportunity to save money through the internet lending platform. The automation of the underwriting process, through Fintech, can now draw information about a client from many different sources (originally eBay, but now including databanks such as Amazon). As a result, overhead costs are reduced, and by steering away from traditional methods, loans are now being provided far more quickly and efficiently than the traditional banking system, due to its online nature. It acts as a quick and easy option for obtaining money, often given on the same day, compared to the bank's processing time which could be up to 7 days and furthermore, the lack of liquidity problem and the time it takes to obtain this liquidity is being solved with the introduction of the secondary market where investors can trade claims to loans for early exits. (Seidman, 2005)
The speed and the practicality of not having to visit a bank branch, coupled with the lower costs in P2P lending makes loans extremely more appealing for not only individual borrowers, but also small to medium-sized enterprises (SMEs). This presents opportunities for SMEs to access funds and increase capital, as liquidity is absolutely essential in allowing more and more firms, especially SMEs to grow and pursue business ambitions that were previously halted by the lack of financing from traditional banks. The growth of these SME companies is essential for economic growth in a country, and as we will discuss later, China’s growth in P2P lending is a huge factor in its economic growth. (Jardim-Gonçalves and Bonfatti, 2008)
Lower costs are passed on to both lenders and borrowers in the form of low fees and enticing interest rates. For investors, they receive a higher interest rate than they would have received by saving their money in a bank and lower their risk by investing in multiple loans allowing them to diversify their portfolio. Equally, investors can search for what they want in a P2P market. If they are willing to take a higher risk in order to obtain higher returns, they can opt for this option, as P2P lending gives different investors the opportunity of investing in different ways, making this type of lending advantageous to both risk averse investors and risk takers. For the borrowers, many of whom would have not had the opportunity of ascerting a loan from a bank due to low credit ratings, now have the chance, avoiding the huge overhead costs and high interest rates seen in the traditional methods. (Kiisel, 2013)
Several risk management practices have been put in place to target the high risk problem associated with P2P lending, such as credit risk assessment, portfolio monitoring and debt collection intervention. These rigorous initiatives are crucial to the survival of P2P lending and have been adopted to ensure that this form of lending is done with fairly credible people. This stringent borrowing procedure means that P2P lenders on average reject between 50% and 85% of loan applicants, and in 2010, Lending Club screened out nearly 87% of applicants in the first stage. This type of scrutinization, such as double checking personal records and contacting employers to verify stated income is absolutely crucial to lower the possibility of defaulting, which is seen as a principal consequence of P2P lending due to its lack of protection by the Financial Services Compensation Scheme. (FSCS) (Aveni, 2016)
Nevertheless, although investors are not covered by the FSCS, they are regulated by the Financial Conduct Authority (FCA) who ensure that investors are aware of the risk that they undergo and ensure that measures are put in place in the case of defaults. (Peer pressure, 2015) P2P lending, despite being subject to much criticism regarding the risk involved, is not as risky as advertised. Just like banks are forced to keep a certain amount of high quality capital available, in the event of a crisis, certain P2P lending platforms have created a provision fund, known as a contingency or reserve fund. The first company to adopt this was Ratesetter, a British P2P lending company, which raised money by charging a one-time fee to borrowers, dependent on their risk grade, and by pooling this money together, they were able to make a fund which was separated from the platform’s asset and used to pay back investors in the event of a default occurrence. (Aveni, 2016) Furthermore, in 2012, Lending Works became the first P2P lending company that also included an insurance policy to the lender, to protect them against potential borrower defaults, along with the reserve fund I discussed earlier. P2P lending is becoming as safe as the conventional traditional methods of lending and is continually growing and improving with the adoption of new rules and regulations currently in the midst by the FCA. For example, as of April 2017, P2P lending companies will be obliged to show at least £50,000 as a buffer so that they are protected against certain financial difficulties or defaults in the future. (Kiisel, 2013)
This graph, (Aveni, 2016) shows the forever improving and growing peer-to-peer lending market. It is clear from the graph that China holds a significantly high market share in the P2P lending market, with the country’s market reaching nearly $35 billion in 2014. In 2015, China’s P2P lending topped $150 billion, which is nearly 4 times the figure we saw in 2014. This shows us that P2P lending is being adopted by more and more institutional and individual investors and is becoming increasingly more popular within countries. (Aveni, 2016)
We will now look at the P2P market in China, the biggest one in the world. China’s P2P market is different to that of the US or UK, as it is much less dependent on technology. The P2P companies in China, often operate without licenses and are more focused on finding methods of bringing investors and borrowers together without the need of highly efficient and innovative technology. Although there are a few Chinese P2P lending platforms, such as Jimu Box and PPdai, which operate like their US and UK counterparts, the majority of them use existing distribution networks, joint with both online and offline tools which help to facilitate funding from investors to borrowers. (Aveni, 2016)
By using both offline and online methods, China can reach potential P2P borrowers and investors that would not have been reached through online portals alone. Furthermore, Chinese investors value the integrity of the brand and company far more highly than the technological advancements of the P2P lending market or whether their database is online or offline, so it makes their P2P lending companies much more flexible, which in turn has led to China’s P2P lending industry becoming a huge multibillion company. Wangdaizhijia (WDZJ), a website which monitors the Chinese P2P lending market, obtained figures for China’s P2P lending in 2013 and 2014. In 2013, China’s P2P lending market was roughly $16.2 billion, however, in 2014, this figure rose to an astonishing $35 billion, with the number of P2P platforms doubling to an astonishing 1,575. To put this into perspective, the United States P2P platforms issued a mere $5.5 billion in 2014. (Aveni, 2016)
China has done remarkably well in ensuring that their market is a highly important one in the worldwide P2P lending market. The main reason for their extremely high market share in P2P lending is the P2P business borrowing in China, roughly 20% to 40% of all peer-to-peer lending in China. Additionally, the large ‘institutional’ gap in the supply of finance to small, medium and micro enterprises, which I discussed earlier, has not only contributed to the growth in China’s P2P lending market, but also in China’s economy as a whole. Previously, the finance available from state-owned commercial banks (SOCBs) was mainly issued to large state-owned businesses and government-related borrowers. In contrast, the new P2P lending market ensures that finance is more readily available to SMEs, giving them the opportunity to grow and invest in capital, and although the institutional gap in the supply of finance to SMEs still exists, the P2P lending market as a whole, but specifically in China, is helping to bridge this gap. (The Rise of Peer-to-peer Lending in China, 2016)
China’s P2P industry is the largest in the world, roughly seven times the size of the peer to peer market in the US. The first Chinese P2P company, PPDai started in 2007 to serve China’s “underbanked” with free services provided to both investors and borrowers. Qifang, another popular P2P lending company in China, had different motives, mainly focusing on obtaining lenders who were willing to fund the tuition of university students from rural areas. Although models were fairly innovative, 2011 was the point where the acceleration of internet finance quickly emerged, especially in China, which mainly attracted young Chinese consumers and growing businesses, E-commerce and mobile payments became very popular. (Aveni, 2016)
Traditional banks are, of course, the most threatened by the rise and rapid growth of FinTech companies and P2P finance. According to a report by Goldman Sachs, over the next five years there is a risk of losing $11 billion out of $150 billion in profit (roughly 7%) due to the shift from traditional banking loans to marketplace lending. Although FinTech companies are growing swiftly, with the largest P2P lender Lending Club issuing 9 billion dollars in loans since 2007, it is still vastly in the shadow of America’s $885 billion credit card debt. Banks now have a decision to make. Will they join the rapid growth and steer away from traditional methods and collaborate with these new companies or will they attempt to compete in some form or another. (Lichtenwald, 2015)
One method of collaboration that a bank could pursue is by becoming an investor, adding P2P loans to their portfolios. Large investors have the opportunity to utilise the new technology and create algorithms that seek out loans that best meet their criteria and allow the investor to purchase these before at a greater speed than the individual investor. This is a potential option for traditional banks as it will diversify their portfolio and potentially see risk adjusted returns. However, they do not differ themselves from other investors in this manner and there isn’t a way to tie in other services they provide in this manner, which does not help customer awareness for the bank. There is a certain type of partnership, called a “white label” partnership, which is an attractive option for collaboration. In this partnership the P2P platform and bank would work together to co-brand their products. There are different ways this could happen in certain agreements, for example, if a borrower did not meet the bank's standard to approve a loan, the bank could direct them to the P2P platform in which their chances of receiving funds would be higher. (Peer pressure, 2015)
One notable bank that is approaching the emergence of P2P finance with collaboration in mind is JP Morgan. JP Morgan announced their partnership with OnDeck in December, 2015. JP Morgan will be offering loans among its four million small business accounts through OnDeck. OnDeck will use its underwriting technology to screen these loans and give approvals within hours, aiming for same or next day approval, achieving results that traditional banks would need a few weeks to meet. All the loans that are approved are to be labelled under JP Morgan. OnDeck will receive an origination fee and servicing fee for each of the loans. The partnership involves OnDeck providing a special white-label program to JP Morgan. (Financial Times, 2016)
The alternative to collaboration, would be for banks to compete directly with P2P lenders for market share. Innovation is a big part of how well financial institutions are able to keep up with technology. A possibility for banks now is to create their own P2P lending platform to compete through this new channel. The bank would operate the platform. This seems like an attractive option due to the growth of the market and the ability for a bank to utilise its expertise, such as; client base, credit underwriting and regulatory compliance. Due to the established brand that many banks have, they can separate their P2P marketplace from others and offer enticing rates and better customer service to mention a few. This is a good way to earn profits from a new income stream and claim a portion of this market, as well as promoting other features of the bank that might interest these new customers. However, this new innovation might not align with traditional methods and the bank might struggle to adapt. The new service might also take over from existing products and thus take money away from these other areas. (Peer pressure, 2015)
Goldman Sachs have reacted by deciding to compete against established P2P lenders. They are one of the first banks to start their very own online lending unit. In addition to having a deposit base of over $89 billion from its banking subsidiary, Goldman Sachs Bank has also announced the acquisition of GE Capital Bank’s online deposit platform, which has approximately $16 billion of deposits. Goldman Sachs has also announced that Harit Talwar, a former consumer credit executive from Discover Financial Services, will be the partner to lead the new online platform along with other experts in the sector. (Linebaugh, 2016)
Let it be collaboration or competition, the bubble of market lenders might soon burst even without direct involvement from traditional banks as financial regulators are looking to toughen the rules for market lenders to issue a loan. Following a report that Syed Rizwan Farook, one of the two shooters involved in the San Bernardino attack, received a loan of $28,500 that may have been used to finance the purchase of firearms through Prosper, the lending marketplace is now under serious scrutiny from regulators. While Prosper is not under investigation for the attack, government and financial regulators are definitely looking into additional regulations to prevent this and other issues occurring in this, still very new, way of lending and receiving money.
In this essay we have outlined and discussed the nature of peer to peer finance and the disruption it has caused the financial market. P2P finance offers services that are very similar to those offered by traditional banks, and the alternative way it goes about offering these services is what is causing the disruption in the market. If the challenges that P2P companies are facing are resolved, there is a good chance that the exceptional growth will continue and this will prove a continued threat for banks. Peer to peer lending has already grown beyond simple loans to consumers trying to recover credit card debt and there is a bright, however uncertain future ahead. With some banks mentioned above already starting to embrace the disruption, which inevitably brings opportunity, it is clear that there is change looming on the horizon it will be interesting to see the different strategies financial institutions will take in the near future.