If you live in the UK, you may have seen the Channel 4 television programme on 28th February this year (2013) entitled ‘Bank on Dave’. Burnley Savings and Loans to give it its other name, is a company (not a bank) which offers 5% ‘deposit’ rates to lenders and offers loans to those who cannot obtain funding from the high street banks. So how does Dave do this when the high street banks offer no interest at all or perhaps only ½ or 1%? In fact ‘Dave’ is one of a new breed of ‘brokers’ who simply introduce lenders and borrowers to each other. The key difference from banks is that banks have a balance sheet with a depositor contract on one side and a separate contract with its borrowers on the other whereas a peer to peer company has no such contracts and indeed is not even involved at all in borrowing or lending! This is because in P2P, lending contracts are directly between borrower and lenders and the P2P company does not take ‘deposits’ on to its own balance sheet or keep the loans its customers make on its balance sheet.
‘Dave’ is simply a broker who facilitates an introduction process, just as a dating agency introduces singletons to each other but once it has made the introduction, withdraws from what is a direct relationship. In practice, of course, ‘Dave’ does a lot more in that he is the one who undertakes the ‘underwriting’ process of assessing risk and pricing that risk in terms of a lending rate that is appropriate to the risk. He also, I presume, ensures diversification by breaking each loan into small pieces – perhaps £100 for each piece – and ensuring that someone lending £1000 is actually lending £100 to ten different people or businesses and not £1000 to only one. You should also note that ‘Dave’ does not claim to be a bank. The company is called ‘Bank on Dave’ which, in colloquial English, means ‘you can rely on Dave’. Also, and very importantly, the UK regulator the FSA has agreed that he is not running a collective investment scheme (because he has no balance sheet) which would be illegal unless approved by the FSA.
Is there a risk for lenders? The answer is yes – there is a likelihood of losses and therefore risk. In P2P, the lender takes on the credit risk of those he or she lends to whereas in a bank, the bank itself takes on the credit risk and expected losses. But actually the bank depositor is the one who really bears the cost of defaults in the form of a very low deposit rate compared with the rate the borrower pays. This is because a bank charges borrowers an interest rate which is expected to cover credit losses yet still enable the bank to make a profit on the loan. Given a bank’s high running costs, it can only hope to make a profit by offering depositors a very low deposit rate to ensure that the bank can cover all the expected losses on its loans from the huge gap between lending rates and deposit rates.
Looking at the graphic below, Prosper expects that loans to the lowest grade borrowers will experience a default rate of 16.5%! That might seem very high but, given that it recommends that its lenders charge such borrowers around 36%, there should be plenty of cushion to absorb such losses as well as the brokerage fee charged by Prosper and yet provide a much better return to savers than a bank can offer. The graphic below shows that in fact on HR loans, despite a loss rate of 16.5%, on historical evidence, lenders can still expect to make a return of 12.5%.
Hardly anyone had heard of the P2P mechanism a few years ago yet today there are frequent references to it in the press and in Parliament. Even the UK government is providing financial support to help its growth as one alternative to a banking system which seems increasingly unwilling to provide unsecured lending to households or small and medium sized enterprises.
The concept is not new – individuals have always helped others financially by directly lending them money. What is new is the shift in such direct financing from lending to’ friends and family’ to lending to those who they don’t know personally. As in so many things, it is the internet which has facilitated this so-called ‘dis-intermediation’ of the banking system and enabled pooling or gathering of funds, from a wide geographical area
The costs of running a P2P platform are dramatically lower than the costs of running a bricks and mortar (and internet) bank and thus the margin between lending and borrowing rates can be much less. That is the secret of the higher expected return to lenders. Its important, however, to distinguish P2P from ‘Pay Day Loan’ companies. These companies lend their own money, not money from the public. They are not brokers bringing people into contact but lenders who charge usurious
rates of interest. In addition, some have a fearsome reputation for their ‘recovery’ techniques if borrowers don’t pay interest on time and for allowing people to build up unaffordable debt.
P2P is also known as ‘Crowdfunding’. It’s similar to the concept of ‘pooling of funds’ which is what banks do by gathering deposits from a large number of people with small savings. Crowdfunding can be applied to personal lending, business lending and equity share issues. The difference between most P2P and ‘Dave’ is that Dave is not an internet based business and only accepts funds and arranges loans within the local area (there must be a personal interview with all borrowers and lenders). In the UK, Zopa.com was the first P2P personal lender and is the largest. Ratesetter.com is another. Fundingcircle.com lends to businesses. Crowdcube.com is an equity P2P which operates in a similar way to ‘angel financing’. It has been suggested that such equity financing has entertainment value just as gambling seems to have for some people. People like to ‘follow their horses’ and hope that they have made good judgements and can then tell friends at their local pub that they have been successful. But unlike gambling which simply transfers money between people (with the casino or other company taking its cut) and consequently is less than a zero-sum game, equity crowdfunding has a real social purpose and should be a positive-sum game for society as a whole!
It’s doubtful if P2P will ever eliminate banks. But if it became a well-established way of doing business (because of its much lower cost than intermediating through a conventional bank), I have little doubt that banks themselves would set up subsidiaries to operate their own P2P lending. It would be the final accolade for a remarkable innovation if one day we had Barclays P2P or HSBC P2P. Finally, I should disclose that I am a director of a P2P lending platform – lendloaninvest.co.uk – which expects to launch in a couple of months.
Professor Brian Scott-Quinn
Chairman and Director of Banking Programs
ICMA Centre for financial markets
Henley Business School