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Peer to Peer Lending. Speed Bumps Ahead..

by Eamonn McMahon

Contrary to what the newspapers will have you believe, peer-to-peer lending is no recent phenomenon. As far back as the early 19th century, an agricultural economist in Japan Ninomiya Sontoku, started lending programs, known as gojoukou, within rural villages. Loans were extended within the community for just 100 days. Interest free and bound by honour the burden of default would be shared equally across residents. Progressive for a time characterised by Oliver Twist and squalid work houses in Britain.

Forward to 2016. As we know the status-quo of channeling finance via banks, bodies endowed with credit and risk expertise, has taken a hammer blow. Over the last decade the application of ever more sophisticated and reliable technology to direct lending has been building speed. We are now accelerating with the foot fully on the pedal. Online platforms are facilitating connections  between non-financial entities; person to person, business to business, person to business. More connection points than interstellar stars and thousands of credit approval opportunities for the borrower. P2P lending is back fuelled by technology and civil empowerment in equal measure,  San Sontoku would surely be content.

Against this backdrop of financial and community cohesion it would be all too easy to be dragged away by a tide of euphoria. Sadly, many of the commentators following peer to peer lending indeed appear to be floating off. As much as these financial journalists were swept away by headline cheap financing rates during the securitisation and leverage orgy in the mid 2000’s, there again appears to be a noticeable lack of attention paid to the relatively dull job of assessing risk.

To be clear I am not suggesting that P2P is taking us towards a credit crunch. There is no systematic risk of that nature building up. It’s more we are accelerating fast and for the sake of, lets call him or her, ‘Jo Peer’, we should probably pause, breath and examine potential bumps on the road.

Sometimes even alternative routes face speed bumps..

Seven potential bumps that could rattle the P2P ride: 

Murkiness and associated confusion on fixed rate return versus guaranteed return products. Traditionally fixed rates were achieved on deposit accounts, bonds and government saving schemes. The effect is that amongst the financially naive there is a bias that fixed rate investment products are guaranteed return/zero risk investments. This absurdity isn’t helped by platforms and providers sometimes casually brushing these two concepts together! One example I came across today was from a bus company retail bond offering.The marketing went like this: “We are offering 1000 two-year fixed rate £100 community bonds at an interest rate of 6% per annum.  In plain English that means that if you invest £100 today, in two years’ time we’ll give you £112.36 – guaranteed” Pretty shocking and unapologetically blunt –  The interest rate may be fixed but it’s far from guaranteed! The FCA clearly needs to take action in situations like this.

Secondly, the increasingly popular trend of comparing p2p loans with bank interest rates. To illustrate let me continue with the above solicitation from a bus company for a 2 year peer-to-peer loan: “Better than the Banks. Currently Moneysupermarket’s featured ‘market-leading’ savings product is a two-year fixed rate cash ISA which earns 2% AER.  Invest with us and your money will be working three times as hard for you..”  Ouch. Funds on deposit in a bank or building society bank account are guaranteed up to £75k and are protected through regulatory and legal safety supports that ensure banks remain stable entities. Small and medium sized companies fail all the time. According to the RSA 55% of SME do not survive more than five years. Established SME will have a higher success rate but nonetheless the risk of business failure is very real and substantial. P2P lending should be compared with other credit investments not with cash.

Thirdly, a disturbing general assumption that the average person is ready and capable of doing credit analysis on sometimes complex and opaque credit. Test: Ask your husband, wife, father, mother, uber driver which is more risky; lending money to an individual or lending money to a company to grow… Most people believe lending to a person is more risky. Why? Well because the lay person associates size with creditworthiness. Also by inserting the word ‘grow’ into the question, a context of positivity is placed in the subconscious. Do platforms need to do more to educate lenders?

Fourthly, specifically in P2P business lending, a failure to distinguish between loans secured on the borrowers balance sheet via a debenture and loans secured on real recoverable assets. I recently viewed a platform that is hosting a company seeking a loan offering 7% return. The loan is secured on current but changing net assets of the company and this financing request was preceded by an exchange of ordinary equity for preferred debt..hmmm..  As security goes this is not very ‘secure’!  Very different to lending a money to a business with a first charge on real estate or another asset such as equipment or machinery. Investors don’t appear to realise or value this. Problem.

Finally, a tendency to focus on recent performance, generally years where we have enjoyed steady economic growth and accommodative interest rates. There needs to be much more forward-looking risk assessment incorporating stress testing of hypothetical economic and credit deterioration on returns.

Generally the P2P platforms, as financial pioneers go, are good ethical agents. Zopa for instance provide in-depth guidance on the performance and risk within their personal loan offering. Funding circle have invested heavily in recruiting of credit and compliance teams to ensure good a level of diligence to protect investors. Furthermore they actively promote the importance of diversification. Other platforms such as Landbay only lend up to a  conservative LTV and always on well supported property values.

In fact there are many areas where Peer-to-Peer platforms are doing a great job in mitigating risk. Generally speaking, platforms are doing very well at communicating clearly with the investor public who use their platform. The excellent work around detecting fraud and countering unscrupulous hackers is reassuring. Finally many of the top platforms are using credit models actually superior to those resident in banking. Lendinvest is one example of a platform with a sophisticated robust credit scoring system.

There are great platforms that will serve investors and the broader economy well for years to come.  For now we just need to sort the good from the bad and the plain ugly and importantly do so before hitting the speed bumps at too fast a speed. It’s too early and too expensive for online P2P to write off the suspension!