The Failure Of Peer To Peer Lending

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Some background

I muttered of my distrust in peer to peer lending here back in 2015. Seven years ago at Forbes and elsewhere more recently. There’s also this from The Times:

As part of the fallout, RateSetter was this month sold to Metro Bank for an initial sum of just £2.5m. It was a dramatic fall from grace for one of the big three of the P2P industry, along with Funding Circle and Zopa….(…)… Even before the Metro sale, alarm bells had been ringing at RateSetter. In May, it halved the interest rates it paid to investors and said it would put the cash saved into a fund used to cover losses from loan defaults.

Please note that this isn’t about any specific stock in the sector. Nor about any particular platform that one might lend upon. Rather, I’m worrying about the entire idea itself. I don’t think it’s going to work out simply because it’s not solving either of the major banking problems.

Some banking background

There are really two major points in banking. The first is the theoretic, of huge importance to the economy but not so much to us as investors. This is maturity transformation. People tend to want to save for shorter periods of time than people want to borrow. Banks solve this problem by borrowing short and lending long.

For example, a bank will have a number of at sight deposits, some longer CDs and so on. And yet it will still wish to offer mortgages which are 30 year loans. Really, no one at all is willing to make a 30 years deposit with a bank. So, how do they fund that mortgage? By simply assuming that tomorrow, even if their specific deposits get withdrawn, that others will arrive. So, they can fund the 30 year loan with the series of short term deposits. That’s maturity transformation, we’ve converted short term savings into long term loans.

It’s possible to get much more complex about this and as we do we approach peer to peer lending. A large corporate might have medium or short term note programs which is really a peer to peer version of this. We’re lending to the note, which might be – say – 90 day paper but the company is assuming that it will always be able to roll over that paper. This is maturity transformation on a direct from lender to borrower basis, without the bank in the middle – so peer to peer – but it’s worth observing that only the very largest companies have a big enough demand that they can assume that the market will remain liquid.

This is not where the peer to peer platforms are and none of them look like becoming large enough to service this market in this manner.

The other banking problem is that it’s very easy to lend money and very difficult to lend it to someone who will pay it back. Adam Smith pointed this out over two centuries ago. The people willing to pay 10 and 12% interest are the “promoters” in his words, the very people who are unlikely to be able to pay it all back.

In our more modern world we’d probably put it that those who are creditworthy are already being serviced by the banks so peer to peer is left with the higher risk borrowers.

In theory this can be dealt with. The correct interest rate is not an absolute, it’s the correct rate for the risk being taken on. This was the high yield bond story. Sure, the credit event rate was high but the compensating interest was even higher. It’s also possible to reduce risk through diversification, taking a slice of many different loans.

The big question

In theory, yes, but in practice? That’s the pedal to the metal question and I don’t see that peer to peer lending is achieving that.

It’s not solving the maturity transformation problem in the way that either banks of MTN programs do mostly because it has not achieved the scale and liquidity. If it did solve that problem then I can see it continuing.

But being a fairly hardcore economics type I tend to think that methods of business only survive if they do actually solve a problem. If they don’t then they can carry on for some time because of fashion, or because we’re testing it, but it won’t survive long term.

The other problem that might be solved is finding some untapped resource of credit worthy borrowers – or even those able to pay sufficient interest to cover their risks – the current banking system doesn’t. I don’t think that promise has been fulfilled either.

So, while disintermediating around the banks is a great idea now that we’ve tested it I don’t think it has worked. That is, banks are banks for a good business reason, not just because they get to occupy – monopolise perhaps – the relationship between lenders and borrowers.

My view

This is rather gloomy I know, we’d all much prefer that the brave new world experiments worked. But I simply don’t think that peer to peer lending either has worked or will.

The investor view

As even the boosters of the sector agree it will take a recession to see whether the model has legs. Here is that recession and it’s looking like it doesn’t. But I am going a stage further and arguing that it just isn’t going to work out.

I would thus be departing any position in a peer to peer lender and also taking any money I had on such platforms off them. Great idea but just one that isn’t going to be profitable.

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john77
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john77

There is at least one P2P lender that takes out the credit risk problem that has sunk most of its rivals by getting the loans insured at Lloyd’s (the insurance market, not the bank). Of course this has an additional cost but it seems to be worth it, so far. Whether Lloyd’s will change its mind or, more likely, its price after Covid-19 is over remains to be seen.

MrVeryAngry
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MrVeryAngry

The other challenge, or the challenge to P2P (which you identify), is originating good loans. That is from credit worthy borrowers. They get approached by people who’ve been to their bank and been offered terms. The P2P offers its terms – which may better than the banks – if so the borrower goes back to the bank and gets a better deal. Why? ‘Cos the Bank, unlike the P2P, can create credit at will, money out of nowhere. If we truly had sound money and FRB was reformed (fat chance), then P2P could compete, despite the maturity transformation issue. Or… Read more »

Spike
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Spike

No indeed! In peer-to-peer banking, one peer lends his money to ONE other peer. Only the Bank has the sweetheart racket of being allowed to loan out each deposit dollar several times.

James
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James

True but not relevant. Banks have a cost of capital and are only allowed to create money to n times that capital. Therefore the money they create is not free to them.

Beyond that the maths is too hard for me.