In 2011, the famed Internet entrepreneur and venture capitalist Mark Andreeson argued that “software is eating the world”. What he meant was that software products and online services, often created by new technology companies, were disrupting one industry after another, most dramatically in retail and media. Peer-to-peer (P2P) lending, which seeks to disrupt the bank lending business, is a striking example of this phenomenon. The basic idea is simple: a P2P lender provides an online platform which matches lenders and borrowers and chargers a fee for the service. Unlike a bank it doesn’t take deposits or hold the loans on its books and doesn’t make money off the spread between the lending and deposit rate.
The P2P lending business model was pioneered in the US and UK around 10 years ago and has since spread around the world. The sector expanded rapidly after the 2008 crisis when central banks everywhere sharply lowered interest rates. This raised the gap between the very low interest rates that consumers were paid on their deposits and the fairly high rates they still had to pay, for example, on their credit card loans.
This gap created an opening for P2P lenders whose basic value proposition was cutting the costs of intermediation between lenders and borrowers which allowed lenders to earn a higher rate of interest and borrowers to pay a lower rate. This was achieved by using large data sets and clever algorithms to determine the creditworthiness of borrowers using a range of variables like credit scores, financial history and social media usage. Over the years, the business model has evolved and in particular there has been a rise of institutional investors who use P2P platforms to build a loan portfolio.
In India, the P2P industry is still small with around 30 companies. Perhaps the most promising long-term application of P2P lending here is in enabling financial inclusion. For the last 50 years, a shortfall of lending to groups like small farmers and small enterprises has been a major concern. It is difficult for a conventional bank to serve these customers because it is costly to build bank branches and hire loan officers and therefore uneconomical to lend to customers who borrow small amounts. Such customers also struggle to produce the documentation needed to obtain a loan.
The promise of the P2P model is that information technology can help assess creditworthiness at a much lower cost and therefore make it easier to give loans to marginal customers. For this to happen, these customers will need a digital trail that can be analysed by software. However with rising ownership of smartphones and the rise of digital platforms which use Aadhaar, this is only a matter of time.
P2P lending requires a different set of competencies compared to traditional banking: access to large datasets about individuals, developing smart algorithms to make sense of this data and designing user-friendly online interfaces which will guide individual lenders to make the right loan. Large consumer-facing online companies like Google and Facebook are obvious candidates and both of them have explored collaborations with P2P companies. E-commerce companies and payment companies may also consider expanding into this space.
Is P2P lending a serious threat to conventional banks? Probably not in the next ten years as the total volume of lending is still tiny compared to bank lending. However as digital natives grow older and use more financial products and as the P2P lending industry matures and gains credibility it may gradually erode the conventional bank lending model.
Furthermore, the P2P model is in some ways safer than conventional bank lending which creates mismatches between short-term liabilities (such as deposits) and long-term assets (such as mortgage loans). This can make a bank vulnerable to large loan defaults or a sudden withdrawal of deposits. By contrast, in the pure P2P model, lenders are directly matched to borrowers and while a cluster of defaults would certainly hurt lenders, it would not necessarily bring down the lending company and trigger a wider financial crisis.
However there are risks in the P2P model as well and recently some P2P lending companies have hit a rough patch. The CEO of Lending Place, one of the oldest and largest P2P lenders, had to resign after an internal review revealed a violation of the company’s business practices. The massive P2P lending industry in China experienced serious problems in 2015 with more than a thousand lenders running into difficulties and hundreds of P2P bosses simply running away from their companies. Such events underscore the need for sensible regulation for the relatively new Indian P2P lending industry. In April, the RBI published a discussion paper with proposals for regulating P2P lenders. It suggested that they should act only as intermediaries between lenders and borrowers and not take on the functions of a bank and accept deposits. Some of the other proposals were a minimum capital requirement of Rs 2 crore, a leverage ratio to prevent indiscriminate expansion and a brick-and-mortar presence inside India.
These and other proposals need to be thoroughly debated so that a sensible regulatory regime can be created that finds a balance between enabling innovation and protecting stakeholders. If that is done, the long-term future of the P2P lending industry is bright and this new model has a lot of potential to expand access to loans.
N Sawaikar is core faculty in Economics at WeSchool. His interests include the technology sector and its role in economic development.