P2P Lending Platforms and the Way Forward
What is a P2P Lending platform?
Lending platforms started off as a way for connecting prospecting lenders, with a surplus of cash, looking to get good returns, with potential borrowers, looking for credit at reasonable interest rates. Lending platforms offered customers the convenience and ease of borrowing with quick turnaround times, that are unmatched by other formal sources of credit, albeit at an extra cost.
As is the case with every platform, a lending platform consists of legs that support the functioning of the platform. The 2 legs of a lending platform are — the Lenders, who lend funds on the platform, and the Borrowers, who borrow credit on the platform by agreeing to the repayment terms and conditions. To ensure the efficient functioning of the platform, both the legs of the platform need to be balanced, i.e., the borrowing on the platform should match the lending and repayment on the platform and vice versa, failing which the platform ceases to function.
The Lenders’ Perspective
Lenders on Lending platforms are most often looking for marginally better returns than what is available to them via stocks and bonds, while understanding that they are also subsuming a relatively higher risk. However, in return, they do expect a minimum guarantee that their investments will be repaid in a timely manner.
The Borrowers’ Perspective
Borrowers borrow on Lending platforms either because they prefer it over other sources of credit or because they lack access to other sources of credit. As the case stands, it is safe to assume that most of the customers on Lending platforms are being pushed to use Lending platforms because they lack access to other sources of credit to fulfil their short-term requirements, as Lending platforms themselves started gaining traction as a means for customers to finance their credit card bills. (David Musto)
However, this does not indicate that these customers are those who possess a high risk and stand a high chance of defaulting on their credit. A customer might prefer to borrow on Lending platforms because of various reasons such as,
§ Customers being Unbanked — Unbanked customers and customers who have not had access to formal sources of credit historically, are difficult to assess in terms of credit worthiness and their capability of repayment. The lack of enough data to clearly assess the risk associated with a customer means that a customer must go through long drawn processes of due diligence to gain access to such credit. This proves to be a major roadblock for customers who are urgently in need of small ticket loans for their short-term needs
§ Quick and Short-term needs — Even banked customers who have access to formal sources of credit might in some cases prefer borrowing on a Lending platform because of the ease and convenience of borrowing that the platform offers
§ Lack of access to Formal sources of Credit — Customers might lack access to formal sources of credit due to reasons such as,
o Financial illiteracy or Lack of awareness about formal sources of credit
o Being classified as high risk as a result of poor spending habits or defaulting on repayments
Given that these factors do put the potential borrowers on the higher end of the risk spectrum, it is also important to note that the customer base that the Lending platforms cater to is also broadly different from those serviced by the formal credit institutions. These customers exhibit different behavior patterns as their entire borrowing is geared towards small ticket loans.
Thus, Lending platforms have come to adopt innovative and new methods of assessing and determining the risk levels associated with their customers, identifying potential good borrowers amongst the false negatives determined by formal credit institutions, also termed as the ‘Invisible Prime’. (Knowledge@Wharton, 2018) This has emerged to be a Unique Selling Point for Lending Platforms, thus bringing more traction to these platforms.
Peer-to-Peer Lending
The initial focus of lending platforms was centered on P2P lending, i.e., connecting individual lenders to individual borrowers. This concept of lending and borrowing between individuals has been proven to work well, time and again, in close-knit societies, where individuals have access to information about each other via their personal networks. (Faircent Bureau)
However, the same does not hold true on a larger scale. When the lending platforms expanded the concept of P2P Lending to a larger and wider network, they were met with some key problems.
§ The anonymity of the borrowers on the platform meant that the lenders on the platform lacked confidence in the credibility of the borrowers on the platform and their repayment capabilities.
§ The credibility of the customer’s data and hence the risk associated with them needed to be assessed and confirmed by the Lending platforms to provide confidence to the lenders lending on the platform
Failure to address these problems meant that the lending platforms risked losing Lenders on the platform, or incurring huge costs for the platform, the cascading of which poses the risk of the platform going bust.
Though addressing these problems required the Lending platforms to take on the risks of lending, it is in their best interest to do so. Taking up the task of providing a guarantee on the loans being issued via their platforms will put a huge onus upon the platforms to thoroughly analyze and assess the risk of the loans being issued and ensuring that the terms are being honored.
Taking all these factors into account, over the years it has become more and more difficult for the Lending platforms to keep the process of lending of funds a strictly one-on-one interaction, i.e., involving only one lender and a borrower. As the modern-day lending platforms have cast aside their focus on P2P lending, to focus more on aggregating and distributing loans through their platforms (Hinchiffe, 2020), it is very important that more attention should also be placed on addressing the key problem with such platforms — the inherent information asymmetry between the lenders and borrowers on the platform.
Addressing the Information Asymmetry
Some of the ways the Lending platforms can go ahead in addressing the information asymmetry between the Lenders and the Borrowers on their platform are,
§ Investing in Analytics to study and analyze customer’s borrowing and lending patterns and to ascertain their risk levels. However, this requires onboarding customers to the platform and incentivizing them to transact on the platform to gain access to such data. This is also a cash burning activity and runs the risk of bankrupting the platform as a result of onboarding to many bad customers at the same time
§ Structuring limits for borrowing and lending on the platforms based on calculated risk levels of customers and Designing structures to incentivize good customer behavior on the platform
§ Grouping and classifying customers based on their specific risk levels, thus creating bonds with different risk bands for potential lenders / investors. This method is being increasingly adopted by Lending platforms as a means for attracting institutional investors to invest in their platforms
§ Guaranteeing minimum returns on the Lender’s investments, to incentivize investments in their platforms
Striving to solve the information asymmetry between the Lenders and Borrowers will require a Lending platform to invest heavily in data and analytics. It might even require them to become an alternate source of credit profiling for customers and their behaviors associated with short-term credit needs that has been largely left uncaptured by other formal credit institutions.
References
1. David Musto, R. O. (n.d.). Lending, Crowdfunding, and Modern Investing — Introduction to Marketplace Lending. Retrieved from Wharton Online.
2. Faircent Bureau. (n.d.). Community Lending as a Business Model for India. Retrieved 2020, from Faircent: https://www.faircent.com/community-lending-as-a-business-model-for-india#.X-wK9jTis2w
3. Hinchiffe, R. (2020, October 9). LendingClub shuts retail P2P offering as it focuses on institutional investors. Retrieved from FinTech Futures: https://www.fintechfutures.com/2020/10/lendingclub-shuts-retail-p2p-offering-as-it-focuses-on-institutional-investors/
4. Knowledge@Wharton. (2018, November 27). How Fintech Serves the ‘Invisible Prime’ Borrower. Retrieved from Knowledge@Wharton: https://knowledge.wharton.upenn.edu/article/fintech-serving-invisible-prime-borrower/
