P2P Lending: Opportunity or Threat?

Why not banks?

P2P Lending seems to be a hot topic. Despite the catchy acronym, peer to peer lending is as simple as an online marketplace for business loans, helping the established businesses that are looking for finance find investors willing to earn attractive returns.

The range of investors is widely spread. Individuals willing to make nice returns are outnumbered by local councils and national governments which can also invest in the leading clubs, an extravagant name to for basic lending platforms. In addition to governments and public institutions, several large financial organizations are entering the business as investors, in order to jump on the train of FinTech Revolution.

How does the peer-to-peer lending system work?

Once upon a time, there was a business.

Usually, a SME that asks for an affordable credit. This request takes the form of an online application sent directly to the lending club.

Once the application is received, the lending provider verifies the borrower through a coverage of bank statements of 3 to 24 months of records, P&L and Balance Sheet information for the last financial year, Triple Credit Score and the last set of full filled accounts.

Accomplished this step the lender also looks at the specificity of the industry and the business. This fun phase ends with an output which is nothing more than a score, usually ranging from E to A+, where A+ represents a very low risk of default. This score will help both the borrowers and the future investors to agree on a fair rate of return.

The story does not end with the magic score. Subsequently, the underwriter will check again all the documents and will examine the people behind the business with the possibility of re-adjusting the credit score. At this point, the credit score is pretty much stabilized. Further assessments are only made to understand if the offer is affordable for the borrower and wether the loan fits the lending club criteria. If the application is approved it will result in an offer condition and a loan contract that the borrower can accept or reject. In case of acceptance the lending club will offer securities to the investors that will have the possibility to invest money into this company and earn a pretty nice amount of money.

From this moment the campaign starts.

It is interesting to note that the investors will not invest directly in the company but instead they will buy securities that come from the Lending Club. The Club will, in turn lend the loan to the borrower, earning a fee on the principal in the range between 1–3%. This two-sided game seems very appealing from the point of view of the Lending Club, which has the possibility to earn great returns.

Investors are the luckiest guys. They will earn a monthly repayment made of the principal plus interests lasting for a pre-fixed period of time (3 to 5 years). Usually, the interest that investors earn, range between 4–12% (src: Funding Circle analytic, 2015) depending on the credit risk score associated to with each company. The lending club instead, will earn a small fee over the interest of each monthly payment, ranging around 1%.

Long story short: which are the advantages of Peer-to-peer lending?

Directly lending to businesses means:

1. No middleman!

2. No banks!

3. No hidden fees!

That will lead to the ability to operate at a lower cost regime which makes our financial system better and leaner.

Traditional Banks caught the market opportunity and are investing in the platforms, not against them. As the CEO of LendingClub Corporation said: “It is very hard to the incumbent drive down costs, adopt new technologies and rapidly removing all the legacy system. As the bookstores have not been able to replicate Amazon, the Banks are finding difficult to follow up the new technology in the consumer credit field.” They should either adapt to the Fintech Revolution or stay behind and collapse.

All sunshine and rainbows. But do you see any problem?

There are mainly two risks related to the P2P lending system: the first and most important one is represented by the possibility of insolvency from the financed company, that will result in no principal reimbursement. However, this risk could be high diversifiable thanks to the possibility of creating a companies portfolio, with small amounts of money invested in each company.

Usually, the minimum amount of investment is 20£/€, which seems to be a ridiculously small amount for an investment. Also, several peer to peer platforms offer a free portfolio making tool, to make the investment diversification even easier.

The second risk presented by this type of deal is related to the possibility of bankruptcy of the lending club itself since the securities through which investors are repaid are issued by the platform. In case of bankruptcy companies will still owe monthly repayment to the lending platform, while investors will barely receive something.

Addressing these issues, along with the problem given by the illiquidity of the investment, will represent a key point in order to assess the future of Peer-to-peer leading platforms.