Why Peer to Peer Lending is here to stay

Many commentators of the rapidly growing P2P lending market dwell on the factors behind its birth and development.  Inefficiencies within the banking sector pre-financial crisis and bank regulatory response post-financial crisis are frequently cited.  Does this mean that a more efficient banking sector which is evolving to cope with more stringent leverage, capital and liquidity rules will eventually displace the P2P lending market?

The answer is an emphatic “No”: P2P, also know as Marketplace Lending (“MPL”), is here to stay and is likely to evolve to compliment the banking sector rather than compete with it.  To better understand this bold statement we need to focus on the drivers for growth in MPL and the potential synergies with traditional banking.

Financial technology is one key driver for the rapid acceptance of MPL by both borrowers and lenders.  Not only do the MPL sites actually do what they claim to do, they do it very well, for most of the week and in a way that is appealing to the users.  Borrowers benefit from faster lending decisions via a process that reduces the need for a commitment of time during office hours; lenders benefit from a process that based on ten years of activity uses different data differently to produce attractive risk adjusted returns.

Whilst the borrower experience is compelling, the take up by potential borrowers is slow compared to the take up by investors: right now the market is skewed with too much liquidity chasing too few assets.  The appeal to investors is easy to understand: firstly, consumer loans, SME loans and SME factoring are not generally available to institutional investors; secondly, the absolute returns are very attractive in the current environment and the lack of volatility and correlation to financial markets is appealing.

It’s likely that a normalisation of interest rates will redress the cash/asset imbalance within the MPL market but in the meantime part of that rebalancing is coming from the banks.  Rather than turn down new borrowers, banks are starting to refer their turn downs to MPL sites.  This can be done in a number of ways: the most basic is to merely hand over a name and number to the rejected borrower; the more advanced is to partner with an MPL site and effectively white-label their site.  For the banks leaning toward the latter, the appeal is based on establishing or maintaining relationships without the balance sheet and capital drag of actually lending.

Separating risk from relationship is a relatively new concept in banking.  Until the 1990s most banking relationships started with a loan and that risk, funding and capital requirement stayed on balance sheet until the loan matured.  The only exception was securitisation which allowed periodic large block moves of loan assets to non-bank vehicles.  By the late 1990s the Credit Default Swap (“CDS”) market allowed banks to pass on the risk of positions that couldn’t easily or quickly be securitised.  The combination of the two transformed the way that banks managed risk, capital and balance sheet usage.  Unfortunately the genuine risk management applications of the CDS market were rapidly dwarfed by investor led applications during the 2000s with devastating results.  Whilst the CDS and securitisation markets still exist, the regulatory response to the financial crisis means that their applications are limited compared to pre-financial crisis.

Even if CDS and securitisation were alive and well they had virtually no relevance to consumer credit and SME lending.  The potential tie-up between banks and MPL sites could therefore represent an extension of credit portfolio management to the full spectrum of bank lending.  This isn’t going to happen over-night but such is the demand from investors for more origination that the economics for MPL sites and banks to collaborate are compelling.  One notable example if factoring: the bank capital demands for this sector are now multiples of what they were: a once lucrative business for banks now generates ROEs well below 10%.  For banks to maintain SME relationships and benefit from the associated fees but to partner with an MPL factoring site is a win-win for all.

MPL sites are distinguishing themselves on numerous fronts including the origination, risk assessment and distribution of consumer and SME debt.  The fact that so many institutional investors are happy to take illiquid, long dated, direct exposure on a matched-funded basis is evidence that the risk, liquidity and maturity transformation services of a banks are not always needed in these sectors.  As long as the MPL/P2P markets continue to satisfy the complimentary needs of banks, investors and borrowers then it’s probably here to stay.