The Impact of Peer-to-Peer Lending on the Traditional Banking

Hélène Amendt, Vytenis Bagdonavicius, Olga Lazunina

February 2017

Innovation has always been an important driver of the banking system. Especially during recent decades banking industry was productive in developing and adapting products, services, and technology to meet the ever changing needs of the customers. However, the Global Crisis caused a wave of disruptions in the financial sector. Heavy losses slowed the innovation and forced banking system to become stricter regarding loan disbursements. The financial players became conservative and pessimistic. In 2009, former Federal Reserve Chairman Paul Volker put forward that modern advances in banking might have been the cause of the crisis famously stating that the only useful financial innovation in the last quarter century had been the invention of the ATMs.

The reduction in lending and innovation combined with the disruption and fragility in the banking system drew away borrowers. It also opened a void for a new alternative lending platforms. The result was the rise of peer-to-peer (P2P) also known as the marketplace lending, connecting individuals and businesses in need of a loan with lenders who can provide the necessary funds.

Currently P2P is among the fastest growing segments in the financial services industry. Even if P2P?s volumes are relatively small, it is a very prospective lending platform for consumer loans and could be a noteworthy future competitor of traditional banking. As the commercial banks are stronger compared to the period of the Global Crisis, they must compete with P2P platforms by adopting innovations while P2P lending has not gained popularity in the mass market.

Changing financial landscape

The banking industry is changing and still hasn?t fully recovered from the Global Crisis. Increased capital requirements and regulatory oversight caused banking system to deleverage and cut the balance sheets by decreasing the issuance of relatively risky consumer and small and medium-sized enterprise (SME) loans. Moreover, banking started losing customers due to prolonged period of low interest rates. In addition, the technological progress prompted the wider use of big data and advanced analytics. All of these changes paved the way for a new financial industry called FinTech.

FinTech offers an alternative way for paying and funding. While the traditional lending applicants have to meet numerous requirements in order to get loan approvals, FinTech lenders make use of proprietary algorithms which results into much faster funding. Among FinTech innovations is P2P lending. Its main idea is to eliminate the bank and allow the parties to get a better deal. With the launch of UK?s Zopa in 2005, P2P lending has been on the rise breaking ground in the countries around the world. Some of the most well-known marketplaces in the US and Europe are LendingClub Corporation and Funding Circle.

P2P lending is one of the biggest success stories in the financial market with a compound annual growth rate of 123% from 2010 to 2014. It is estimated that the current market could be worth approximately $100 billion globally and the prospects are that P2P lending can amount up to $480 billion by 2020, with an expected compound annual growth rate of 51% (Morgan Stanley, 2015).

P2P lending in principle

P2P lending platforms are two-sided online marketplaces where borrowers can seek funds from investors. Although the specific business models can differ between various platforms, they all work approximately the same; the P2P platform acts as a broker between a borrower and an investor. Credit is then provided through P2P agreements. Often multiple investors provide funds for a single loan and thus there consist multiple loan agreements with each of investors.

Online technologies help to identify and facilitate efficient and high quality direct lending opportunities. P2P companies earn a profit by charging the differing type of transaction fees, when the loan is originated. Usually, these loans run between 12 and 60 months. The platforms do not engage in costly maturity transformation which generates the investor substantial advantages in terms of returns.

The nature of P2P lending differs between borrower and investor. From the borrower?s perspective, P2P platforms offer sources of financing and services that compete with those offered by banking industry. The investor side is where the innovation takes place. Basically, investors own part of the cash flows of a lending business, tied to particular loans through the P2P agreement. The principle is quite similar to owning a portfolio of corporate bonds, but instead targeting SME companies, property and consumer loans.

Opposed to the banking model, P2P platforms are not directly exposed to the capital losses due to defaults. They exclusively serve as an intermediary between investors and borrowers by setting up the loan agreements. Nonetheless, P2P platforms are incentivized to properly conduct credit risk assessments. Due to reputational issues, it is in the platform?s own interest to ensure that lenders understand the nature of the risk they are exposed to. In addition, while loan portfolios of traditional banking are often opaque, within the P2P sector this information is more transparent. P2P companies tend to make their data on a loan-by-loan basis publicly available and provide a wide range of information about these particular loans.

The advantages of P2P

P2P industry offers its customers a high speed of service. While with traditional lending, applicants have to meet numerous requirements in order to get loan approvals, market place lenders make use of proprietary algorithms, which results into much faster funding. Due to minimal regulatory requirements, lack of capital and liquidity constraints and the utilization of new technologies and big data, P2P platforms are able to accelerate the processes of credit application, loan approval and funding.

Together with improvements in processing, the system offers lower interest rates and higher returns. By eliminating the intermediary, and thereby reducing operating costs, investors can obtain a portion of the cash flow which is traditionally bank?s profit.

The disadvantages of P2P

In spite of the hype and attractiveness of P2P services, there are a number of bottlenecks. One of the most obvious characteristics when it comes to P2P lending is the lack of trustworthiness. Most lenders do not have years-long expertise to assess the credit risks and the borrowers have an incentive to hide true information. Inherent free rider problems make the investors less willing to conduct screening and monitoring procedures, which exacerbates the problem of adverse selection and moral hazard. In addition, there is a high chance of mismanagement. It is not clear how well the P2P system is prepared to withstand technical crashes and fraud. In contrast, banking industry?s long history of risk management has led to enhanced information security and mature credit modelling. All the costs regarding security will be taken by the P2P platform, therefore diminishing its competitive advantages.

Another issue regarding P2P lending is the need to continually search for borrowers. A lot of the early success was based on algorithms that identified borrowers with low risk of default. However, P2P companies may soon be tempted to take on the riskier projects in order to maintain their rate of growth pushing the loan volume at the expense of credit quality.

Moreover, P2P platforms still have not been exposed to the full credit cycle of booms and busts, which is an inevitable feature of the market economy. A small number of defaults would not affect the P2P system, but a full blown crisis might destroy the industry. Not being part of the government safety net and a lack of provisions can lead to substantial uncovered losses.

The competition between P2P and banking system

P2P lending actively seeks to attract traditional banking clients. According to the results of Nesta?s survey in the UK, 59% of loan seeking respondents applied for a consumer loan in both systems: banks and P2P. 54% of them were granted a loan by banking industry but chose to fund themselves via P2P resources (Atz and Bholat, 2016). There are no signs of this trend being put to stop. Stale competition and a slump in demand for traditional lending to concerns about the profitability of banking industry.

Banking industry?s response to P2P lending

With the rise of P2P lending at least two outcomes for the banking system are possible: Either to ignore P2Ps or to innovate. It seems that more and more banks are choosing the second option.

With extensive customer information, risk management capabilities, and networks of payment systems, banking industry could certainly gain the advantage over market place lenders in the FinTech industry. For instance, in 2016 Wells Fargo launched P2P system for small business loans that allows its customers to send funds at no cost to any customer of a bank who participates in the real-time service. The success of Wells Fargo would be a clear sign for other banks to adapt P2P too.

The banking sector is also cutting costs and increasing the level of automatization which will help competing with P2P lending. According by Montijano and De Jong (2016), over 20,000 European banking jobs are set to go. This signals that banking is moving towards increased efficiency and the further development of machine learning techniques.

How should banking system change in response to P2P lending?

There is quite a lot of uncertainty in the banking sector. The banking supervisors are considering to introduce even stronger constraints regarding capital and reserves that might restrict lending supply. In that case banking industry willing to compete with P2P lending could consider broadening their operations in a less regulated shadow banking system or following the above-mentioned example of Wells Fargo.

However, if Federal Reserve increased interest rates, that would allow banks to increase the spread and continue competition with P2P without any significant changes. Further improvement of internet, mobile services and offering loans online could also help to attract more borrowers and improve customer relationships. In addition, banks could simply buy leading P2P companies and take the control of FinTech industry.

Considering all the above mentioned options for the banking industry it is quite evident that there is nothing to gain by ignoring P2P lending. For now P2P companies only target niche customers offering small to medium consumer loans but they might evolve to institutions-to-peers lending. From our point of view further banking technological improvement should take place.

Conclusions

Despite the rapid growth of P2P companies offering flexible services and attractive rates they do not draw the mass market customers, only the niche ones. In addition, banking industry still benefits from the name recognition, government-backing and extensive experience in boom and busts periods. That is why P2P companies do not cause a real thread to traditional banks. However, ignoring the competition of P2P companies could have severe long-term consequences as P2P companies have a potential to become big market players. To avoid these risks banking system should adapt the technologies used in the FinTech market.


References

  • Atz, U, and D Bholat (2016), ?Peer-to-peer lending and financial innovation in the United Kingdom?, Staff Working Paper No. 598, Bank of England.
  • Baeck, P, Collins, L and Zhang, B (2014), ?Understanding alternative finance: The UK Alternative Finance Industry Report 2014?, Nesta.
  • Deloitte (2016) ?A temporary phenomenon? Marketplace lending?, United Kingdom.
  • Montijano, M M, and D De Jong (2016), ?European Banks Cutting 20,000 Jobs as ING Joins Commerzbank?, Bloomberg.
  • Morgan Stanley (2015), ?Global Marketplace Lending: Disruptive Innovation in Financials?, United States of America.
  • Office of the Comptroller of the Currency (2016), ?Supporting Responsible Innovation in the Federal Banking System: An OCC Perspective?, United States of America.
  • Tata Consultancy Services (2015), ?The Bank of the Future?, India.

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