By Milind Sathye, University of Canberra
In a recent speech, Bank of England executive director Andy Haldane has said that peer-to-peer (P2P) lending through online sites has the potential to eventually replace old-fashioned banking. It was followed by a recent announcement by the British government that it would channel 100 million pounds to small business through alternative banking channels such as P2P.
This demonstrates the frustration of the Bank of England and the British government with the mainstream banks, which failed the ordinary taxpayer in recent years and were unwilling to cater to small loan needs. For example, as I write, a 100 billion euro (A$126 billion) Spanish banking bailout has been approved. The US bank bailout was estimated at approximately US$700 billion.
No wonder taxpayers ask: are banks a necessary evil that one has to put up with, or is there an alternative?
Why do we need banks? Why can’t we lend to each other? Just as we may borrow from friends and relatives, can we not borrow from and lend to strangers? Is there an alternative to old-fashioned banking, as Andy Haldane calls it?
The good news is an online alternative that could take on the banks – at least in the sphere of small loans – is emerging. It is called P2P lending.
The concept is simple. If you have surplus funds, then instead of making a bank deposit, you lend it through an online intermediary (such as Zopa in the UK), who would identify a borrower or a group of borrowers to whom the money would be lent and vice versa.
It is an online market place for money similar to eBay. Organisations such as Zopa (for personal loans) and Funding Circle (for small business loans) work on a margin of about 1.8 to 2.3% of the loan. For example, for a three-year fixed rate personal loan of 5,000 pounds, the lender gets a return of about 5 to 5.5% net, while the borrower is charged 7.3% interest. Zopa charges the margin for finding and screening borrowers. It claims that default rates are less than one per cent.
For a similar loan, mainstream banks such as Lloyds TSB and Royal Bank of Scotland (RSB) charge 11.1% and 17.9% interest respectively to the borrower online. Remember that these banks together received a bailout from British government of the order of $ 88 billion, approximately taking the British government’s stake in these banks to 43% and 84% respectively.
The advantage for the lenders through Zopa is higher return as compared to what one may get on alternate savings avenues which is about 3 to 3.5%. How does organisations like Zopa, afford to charge such low interest rates? It is because of the low-cost online model claims Zopa.
The Lending Hub states that “the interest rate on loans placed on Lending Hub are determined by the aggregate of bids placed by lenders (as long as the interest rate bid is under the borrower’s set maximum interest rate)”.
The Hub also charges a fee to borrowers from 1.25% to 4% and to lenders from 1% to 3%. Borrowers are also charged an application fee of $30. There is also a direct debit processing fee and late payment fee of $40.
So is P2P the answer? Can they take on our mainstream banks?
Though prima-facie, the idea of social finance or P2P banking looks attractive, there are a number of hurdles in the way. One would need to compare how does the lending through P2P which involves default risk and liquidity issues for the lender stacks up against having a simple bank deposit account which incidentally is now risk free (there is government deposit guarantee of up to A$250,000 per person per deposit-taking institution).
The P2Ps are really operating in small loans space. Though for loans of 5,000 British pounds the comparisons as indicated above may look attractive, as the amount grows P2P players are expensive as compared to mainstream banks. For example, when I keyed in the data for a loan of 7,500 British pounds for three year term, Zopa returned a headline rate of 7.2 per cent while Derbyshire building society showed a rate of 6 per cent and HSBC 6.2%. For a loan of 10,000 British pounds, Zopa rate was not available. Similar comparisons are not possible in Australia as Mozo – the comparative interest rate website did not return Australian P2P comparative with banks for personal loans.
Unlike in mainstream banking where banks bear the risk of default, in P2P, risk of default is borne by the lender who relies on the credit screening done by the P2P intermediary like Zopa.
IGrin states that it looks after “all of the contractual, payment and collection processes” but, if the borrower fails, what recourse does the lender have against the borrower or the P2P? From the information available at the website of some of the P2Ps, it remains unclear.
Once a loan is given through a P2P intermediary, there is no access to the money if the lender wants it back. Instead, if the lender keeps a deposit with a bank, there is no liquidity issue for the lender as the amount is readily accessible.
It is envisaged that they are “money eBays” – a market place for money. But in eBay one sees the product and then bids. In the ‘money’ e-bays, one puts full trust on the P2P. Trustworthiness of the P2P is therefore a major issue from lender perspective.
There are other hurdles in the way of P2P, which appear to have put a break on the expansion of these organisations. The investigation by Securities and Exchange Commission in the practices followed by Prosper – a P2P in the US – is a pointer. It is reported that borrowers rated as ‘A’ by Prosper had defaulted.
As reported in British media, the government of that country is considering channelling 100 million pounds through alternative banking channels including P2P. Governments routing funds through Zopa or Funding Circle seems attractive, but it remains to be seen what modalities are proposed. There may be a need to register such organisations since government funding may make P2P’s mushroom everywhere. Again, government assistance is unlikely to be without cost, which means cost to the ultimate borrower would increase.
What is the future for P2P lending?
P2Ps can operate in a space which is not filled by mainstream institutions; that is, microloans which range anywhere between $1,000 to $10,000.
Banks find that the operational and monitoring costs of such loan are high, so it doesn’t make economic sense for the banks to fund such microloans unless the interest rate is high. Commonwealth Bank, for example, charges interest rate exceeding 17% when it comes to small personal loans of $5,000.
Similar problems are likely to be faced by existing P2Ps when the volume of business grows.
It’s no wonder that despite some years of existence, the P2P concept has not really taken up in a significant way. eBay and money eBay are not the same thing, after all.
Milind Sathye is Professor of Banking and Finance at the University of Canberra and a former central banker.