L12 - Peer-to-Peer Lending

Question 1

What is Peer-to-Peer (P2P) Lending?

Answer 1

• Peer-to-peer (P2P) lending – a subcategory of crowdfunding – is a relatively new internet-based financial activity.
• The possibility exists that this could take away the traditional business of the banks
• Borrowers, usually individual consumers or small to medium-sized enterprises (SMEs), apply for loans on a lending platform.
• Lenders can screen listed loan requests as well as all the information provided by the borrower and then decide whether they want to lend money. –> asymmetric information problems still exist though
• Loans usually consist of small contributions from a large number of lenders and are often either short-term or medium-term as well as being unsecured.
  
  • Lots of control can turn down loans
  • There is a pooling of risk as lots of people lend a small about

Question 2

How do P2P lending platforms differ from traditional banks?

Answer 2

P2P lending does not involve traditional bank intermediation. Because of this exceptional feature, it has often been argued that P2P lending “disrupts” traditional finance.

• Lower fixed costs - only real cost to lenders is their time and interest forgone
• therefore could change attractively low-interest rates and make higher returns than incumbent banks.
• unlike banks, lending platforms usually do not take on any credit risk.
• So who does? After all, credit risk doesn’t just simply go away Despite the risks, FinTech credit markets (of which P2P lending is just one form) are young, yet fast-growing. In some European countries, the annual growth rates of these markets have exceeded 100%.

Question 3

How does P2P lending work?

Answer 3

The flow of funds is directly between Borrowers and Lenders - no need for banks

• That’s why the people take on the credit risk not the platform

Question 4

What is P2P consumer lending?

Answer 4

individuals or institutions provide loans to individuals

Question 5

What is P2P business lending?

Answer 5

individuals or institutions provide loans to businesses (often SMEs).

Question 6

What is P2P real estate lending?

Answer 6

individuals or institutions provide loans secured against property to consumers or businesses.

Question 7

What is Equity-based crowd funding?

Answer 7

investors purchase equity issued by businesses.

Question 8

What is Real-estate crowd funding?

Answer 8

individuals or institutions invest in real estate.

Question 9

What is Reward-based crowdfunding?

Answer 9

contributors expect to obtain non-monetary rewards

Question 10

What is Donation-based crowd funding?

Answer 10

donors have philanthropic motives and do not expect any monetary or nonmonetary returns.

Question 11

What is Profit-sharing crowd funding?

Answer 11

investors purchase securities from a business and share in its profits.

Question 12

What are Debt-based securities?

Answer 12

individuals or institutions invest in debt-based securities at a fixed interest rate

Question 13

What is Balance sheet consumer lending?

Answer 13

platform entity lends directly to consumers and holds loans on its balance sheet.

Question 14

What is Balance sheet business lending?

Answer 14

platform entity lends directly to businesses and holds loans on its balance sheet

Question 15

What is Invoice trading?

Answer 15

businesses sell invoices or receivables to individuals or institutional investors at a discount.

Question 16

What is Pension-led funding?

Answer 16

SME owners/managers invest their accumulated pension funds in their own business.

Question 17

What are Community Shares?

Answer 17

investment into community shares issued by cooperative societies, community benefit societies and community-based charitable organizations

Question 18

What are Mini-bonds?

Answer 18

bonds marketed directly to investors and not listed on any stock exchange.

Question 19

What is FinTech credit?

Answer 19

• FinTech credit – that is, credit activity facilitated by electronic platforms such as peer-to-peer lenders – has generated significant interest in financial markets, among policymakers and from the broader public.
• Yet there is significant uncertainty as to how FinTech credit markets will develop and how they will affect the nature of credit provision and the traditional banking sector.
  
  • Some of this FinTech credit is being bundled up and sold to financial institutions - as they are unregulated this is extremely risky
• Indeed, growth of FinTech platforms seems to be slowing and the number of P2P platforms in the UK has fallen in the last two years

Question 20

How Big is the FinTech Market?

Answer 20

• Despite the impressive magnitude of the amounts involved, to date the entire amount of FinTech credit outstanding, including P2P credit outstanding, is a small fraction of the amount of total bank credit outstanding – but it is growing!
• According to Reuters, FinTech companies raised a record $39.6 billion in 2018.
• The global FinTech market was valued at about $127.66 billion in 2018, and is expected to grow to $309.98 billion at an annual growth rate of 24.8% through 2022. Growth in the digital payments sector is driving the market for global Financial Technology

Question 21

Where did P2P Lending begin?

Answer 21

• P2P lending began in 2005, when Zopa, the first P2P platform worldwide, started offering loans to U.K. consumers.
• In early 2006, the U.S. lending platforms Prosper and Lending Club started a business, with many others following.
• Ten years later, in 2015, there were more than 370 P2P platforms in China, over 140 in the U.S.A., over 90 in the U.K. and more than 220 in the rest of Europe

Question 22

How big is P2P lending?

Answer 22

Question 23

How are interest rates set on the online market?

Answer 23

1. Individual investors place bids and come to some bargaining arrangements - basically some kind of auction processing
2. Look at credit risk and credit scores - look at the points they have and set interest rates based on that
3. Look at what competitors are doing

Question 24

What is the general problem of the emergence of FinTech markets?

Answer 24

The emergence of FinTech credit markets poses challenges for policymakers in monitoring and regulating such activity. Having good-quality data will be key as these markets develop

• Flash crash is an example of this - as no one knew what the algorithms were doing let alone regulating them
• No one knows how they are going to regulated
  
  • the more they grow the more problems these could cause for financial instability

Question 25

What is Debt?

Answer 25

• Debt entails a promise to repay the principal amount and the interest on a loan. - there is always uncertainty here, this can be mitigated by due diligence of the lenders behave
  
  • Loan agreements are complex but can’t cover all eventualities thus will always be some risk
• This is a difference in what borrows and lenders prioritise:
  
  • lenders what relatively high returns but borrowers what lower cost
  • Lenders what higher level of liquidity
  • borrowers want longer terms whereas lenders prefer to lend for a shorter amount of time
• It always comes back to the information asymmetries between borrowers and lenders
  
  • P2P lending may attract low grade (risky) borrowers with a moral hazard

Question 26

How do traditional banks organise lending?

Answer 26

• Take advantages of economies of scale
  
  • pool risks - lots of savings from individuals - and make bigger loans
  • not much administrative difference from loaning £1000 to £1 million
  • loans stay on the balance sheet of banks, they are the main activity of banks where they get their profit from
• Banks take on credit risk
• Maturity transformation - Depositors and borrower profit from this
  
  • Depositors put money in and others are taking it out - stock banks own is rather stable
  • transformation of small deposits into loans, there is the uncertainty of when depositors will take money out but with so many people using the banks it’s not really an issue
• Banks also reduce credit risk in lending through specialized knowledge and diversification - due diligence
• Besides increasing private profitability, due diligence also improves social welfare as it contributes to a more efficient allocation of capital within the economy - fewer bad loans will be issued
• Banks usually require collateral to further reduce credit risk - also diversifaction

Question 27

How are loans in P2P lending covered?

Answer 27

• most loans funded via P2P platforms are unsecured - not covered by collateral so are risky
• However, lending platforms vary. For example, in the UK granting P2P loans does not require a banking license.
• In other countries such as Germany and the US, Bank-funded and balance sheet P2P lending prevails and here loan origination requires a banking license.

Question 28

What is the UK’s P2P lending model?

Answer 28

• In the UK model, the P2P lending platform matches borrowers and lenders, transfers money from lenders to borrowers after loan origination, and facilitates interest and redemption payments.
• They connect borrowers and lenders who communicate on their platform, P2P lenders take their cut for this service but then take on no risk in the transaction

Question 29

How does bank-funded P2P lending function?

Answer 29

the P2P platform also matches borrowers and lenders (like a kind of auction - just provide information to the platform)

• But the loan is originated by a funding provider, with the borrower signing a promissory note to the bank. (legal contract of what is being lender at what interest and when it matures etc.)

Question 30

How does the balance sheet lending function?

Answer 30

The third approach to P2P lending is balance sheet lending which comes closest to traditional bank lending.

• Bank will provide the loan and keep it on their balance sheet
• in that sense they will also take on the credit risk

Question 31

Why is the P2P lending model so innovative?

Answer 31

• The innovation of these various P2P lending models lies in their direct alignment of borrowers and lenders, that is, i.e. in the absence of a trusted third party.
• The platform acts merely as an exchange and does not perform either due diligence or any other intermediary functions, such as the transformation of risk or maturities.
• Before the Internet enabled the existence of this technology, the transaction costs of such an alignment process would have had a deterrent effect.
  
  • How would you set up a platform, and advertise it to borrowers and lenders without the internet
• Even regulated exchanges such as stock markets relied on the services of brokers who commissioned heavy fees - it would not be big business at all
• Modern information technology allows a swift exchange of data and reduces search costs significantly (these are the main costs they cut)
• For lenders who are willing to do without deposit insurance, P2P lending offers an alternative to bank accounts.

Question 32

How do banks reduce lending risk?

Answer 32

information asymmetries in lending create risks. In their capacity as financial intermediaries, banks apply their specialized knowledge in credit risk assessment and monitoring to manage such risks.

So although P2P lending offers lower, more enticing interest rates, they don’t have the specialised knowledge to combat the risk that occurs

Question 33

How can you reduce Peer to Peer (P2P) Lending Risks?

Answer 33

P2P platforms pursue various strategies to assess and reduce the risks for their customers:

• Most P2P platforms also provide “hard” information about borrowers as a way of supporting lending decisions. That perform checks on:
  
  • you
  • your creditworthiness
  • your history
• For instance, Prosper, the largest U.S. P2P lending platform, posts credit agency score information derived from its own scoring system as well as credit history, debt-to-income ratios and homeowner status of borrowers.
  
  • These systems are quite good actually as the approval rate is only 10-15% - so you can deceive these people but they are very good at finding out - although it can be inferred most borrowers from P2P lenders are of poor quality
• Borrowers themselves may also provide specific information to lenders. Such information typically consists of descriptions of the loan purpose, personal information and pictures.

Question 34

What are the Supply Side Drivers of to P2P Lending?

Answer 34

• Technological advances
• Ability to scale
• Lower costs compared to tradition lenders
• Traditional lenders have left room for new lending market entrants

Question 35

How have technological advances driven P2P Lending?

Answer 35

• in computing power, the internet, data storage and mobile technology have underpinned an innovation spiral in electronic platforms, including file sharing and cloud computing services and online marketplaces such as eBay or Alibaba.
• The online connectivity provided by these innovations has reduced individuals’ transaction costs and disrupted some traditional business models.
• FinTech credit innovations have emerged more recently. While digital innovations have been forces for change in banking and credit markets for some time, FinTech lenders may make more intensive use of digital innovations.
• For instance, (some evidence) FinTech lenders automate far more processes than traditional credit providers and thus provide a relatively convenient and quick service

Question 36

How has the ability to scale driven P2P Lending?

Answer 36

• is a typical feature of platform-based business models reflecting low incremental investment costs and digital contact with their potential customer base.
• One reason for this scalability is that the underlying financial activity is easy to standardise – for example, through the use of digital identification and standardised digital contracts - matching people with different packages/plans
• However, the extent of standardisation that can be achieved may differ across jurisdictions, in part due to different legal frameworks and credit market segmentations.

Question 37

How have lower costs compared to traditional lenders driven P2P Lending?

Answer 37

• traditional lenders have a relatively high fixed cost base due to their branch networks and their need to maintain existing IT systems. They also face higher capital and liquidity requirements on loans than lending through FinTech credit platforms outside the prudential regulatory perimeter.
  
  • This is, for now, regulations will come into place over the next few decades (especially if they keep growing)
• These factors represent the cost advantages for new online lending platforms. To the extent that they structure their activities in fundamentally the same fashion as banks, FinTech credit platforms could be considered to be benefiting from regulatory arbitrage.

Question 38

How has the room left for new lending market entrants by traditional lenders driven P2P Lending?

Answer 38

• because they withdrew from some market segments in the post-crisis period. In addition, banks often ‘under-serviced’ certain market segments, such as micro business loans.
• In some cases, tax policies and regulations may encourage lending by alternative platforms to these segments. In other cases, the level of rents earned by incumbents can encourage the entry of platforms.
• as incumbents charge a higher interest rate, it has left room for those will lower fixed costs to undercut them with a lower price due to their more economic costs

Question 39

What are the Demand Side Drivers of P2P Lending?

Answer 39

• Higher customer expectations with regard to convenience and speed etc
• Demographic factors
• The financial crisis
• A desire for higher returns in the face of lower yield
• Technology innovation often network externalities that drive demand

Question 40

How have higher customer expectations driven P2P Lending?

Answer 40

• Higher customer expectations with regard to convenience, speed, cost and user-friendliness of financial services because of the real-time transacting capability of internet-connected devices.
  
  • Impatient and expect things to be faster
• Consumer comfort with online financial transactions has also grown as online business innovations have deepened

Question 41

How has demographic factors driven P2P Lending?

Answer 41

related to the shift in customer expectations. Such factors include rising acceptance of new technologies and the growing financial influence of the cohorts known as “digital natives” and ‘millennials’ are driving demand being far more likely to adopt FinTech

Question 42

How has the Financial crisis driven P2P Lending?

Answer 42

• might have led to reduced trust in conventional lenders so that consumers may now be more willing to use the services of the lending market - because a generation of consumers have seen banks fail, there don’t trust them as much as previous generations and are willing to try other providers
• There may be a more general perception among some consumers that FinTech credit, and especially P2P lending, is more socially responsible and of greater social value than conventional banking.

Question 43

How has the desire for higher returns in the face of low yields driven P2P Lending?

Answer 43

• A desire for higher returns in the face of low yields has in several large economies provided FinTech platforms with a larger investor base, including from institutional investors.
  
  • Higher risk but that also equals higher returns
• Investors may regard FinTech loans as an alternative asset class that can add to the diversification of their portfolios.
  
  • possibility for diversification even within the sector

Question 44

How has Technological innovation that often displays network externalities driven P2P Lending?

Answer 44

Technological innovations often display network externalities that drive demand. In the case of FinTech lending, in principle, it is possible that the higher the investor demand to lend on platforms, the more borrowers may be attracted to use this lending

• The more people using the platform, the more that will want to use it

Question 45

What are the impediments to the growth of FinTech’s?

Answer 45

• There could be competitive responses from incumbent lenders to Fintech activities
• Business models that are not robust in a less favourable credit or funding environment
• Regulatory requirements on lending activities
• uncertainty about regulatory frameworks
• Possible reputation damage

Question 46

How could a competitive response from incumbent lenders impede FinTech growth?

Answer 46

• There could be competitive responses from incumbent lenders to FinTech activities. Banks have been building up their digital banking activities for some years, and the emergence of marketplace lending platforms has sped up this process E.g.Video banking, Arrange Loans online
• Where bank access is already high, clients may prefer digital solutions from incumbents. That said, there are also examples of cooperation among FinTech lenders and banks which may be of mutual benefits, such as knowledge sharing and funding.

Question 47

How could business models that are not robust in a less favourable credit or funding environment impede FinTech growth?

Answer 47

• Business models that are not robust in a less favourable credit or funding environment might impede growth in the FinTech lending industry.
• This might be because of some business models that are generally opaque and/or prove inherently risky.
• Moreover, most FinTech lenders have not experienced a full credit cycle (lending, redemption of the loan collecting interest rates, making another loan), and how their lending and their platforms will fare in a downturn is an important uncertainty

Question 48

How could regulatory requirements on lending activities in various jurisdictions impede FinTech growth?

Answer 48

• Regulatory requirements on lending activities in various jurisdictions such as the need to be authorised and regulated as an online lending platform, or the need to be licensed and regulated as a bank or a credit intermediary, in order to originate consumer loans or retain loans on balance sheet might impede the growth of FinTech.
  
  • This will increase costs and compliance issues (also more costs)
• For example, in Japan, legislative caps on interest rates make it difficult for FinTech platforms to lend to riskier consumers.

Question 49

How could uncertainty about regulatory frameworks impede FinTech growth?

Answer 49

• There is uncertainty about regulatory frameworks given the rapid development of the industry.
• Because FinTech innovations may change the nature of intermediation and introduce new processes not covered by existing bank regulation, there can be substantial uncertainty for market participants.
• In some countries, there is uncertainty about how legal frameworks will treat certain aspects of FinTech lending, such as consumer protection

Question 50

How could possible reputational damage impede FinTech growth?

Answer 50

• Possible reputational damage might be a factor impeding FinTech growth. As with any business, there is the risk that misconduct and/or the mismanagement within the industry could create reputational damage.
• This is especially relevant as many platforms are still establishing credibility with potential investors.

Question 51

What could be a major problem in FinTech Lending?

Answer 51

• The securitisation of FinTech credit obligations into large bundles potentially makes available to borrowers funding from different classes of institutional investors and allows FinTech investments to be actively traded.
  
  • Causes an issue not dissimilar to what could the financial crisis - while this isn’t necessarily an issue now due to its small size, in 10 years it may grow into a problem of a similar magnitude
• However, depending on its nature, increased use of securitisation may pose some financial stability risks distinct from other FinTech platform funding avenues.

Question 52

What risks can FinTech securitisation cause?

Answer 52

• First it increases the interconnectedness from securities being bundled up, this could link existing markets which would have a spillover effect that wouldn’t exist if Fintech couldn’t do this on an institutional level
• Issues about the reliability of the information - know the bundles are based on riskier assets but maybe even riskier as our information on they may not even be reliable or correct

Question 53

Crowding out Banks: Credit Substitution by Peer-to-Peer Lending?

Answer 53

(Wolfe and Yoo, 2017)

• Small (rural) commercial banks lose 1.8% (2.0%) of their personal loan volume for a standard deviation increase in aggregate peer-to-peer lending in addition to increases in loan delinquency and charge-off measures.
  
  • volume loss appears to be most sensitive to the inroads of lower credit grade peer-to-peer loans
• also show evidence that large commercial banks above $300 million in total assets appear to maintain loan volume.
  
  • Loan quality also deteriorates among the largest commercial banks despite their ability to maintain volume with increased competition from peer-to-peer lending
• large traditional financial intermediaries have begun to enter the space
• e detrimental effect on loan volume and loan quality for small/rural commercial banks as a result of increasing peer-to-peer expansion but also the benefit of increased access if commercial lenders can participate as investors.
• As more commercial bank segments become targets for non-bank expansion, our results emphasize the need for careful policy selection

Question 54

Peer-to-Peer Lenders versus Banks: Substitutes or Complements?

Answer 54

(Tang, 2019)

• consequences of P2P depends on whether the P2P industry merely displaces the incumbents or fills the gap in an under-served credit market
• Exploiting a negative shock to bank credit supply, I show that P2P lending expands in the markets exposed to this shock
• find evidence for substitution between banks and P2P platforms based on the fact that, when low-quality bank borrowers migrate to P2P platforms, P2P borrower pool worsens
• the other hand, P2P platforms complement banks by focusing on the market segment for small loans. The amount requested by borrowers migrating from banks to P2P platforms is larger than 90% of pre-existing P2P loans

Question 55

Critique of Peer-to-Peer Lenders versus Banks: Substitutes or Complements??

Answer 55

(Tang, 2019)

• Although the empirical analysis carried out in the paper uses data from the largest P2P lending platform in the U.S., two caveats are in order.
• First, the empirical analysis focuses on the unsecured consumer loan market. The results may not generalize to other markets such as the residential lending market, or to other countries with a different banking market structure than the U.S.
• Second, the landscape of the FinTech industry is changing rapidly. Therefore, P2P platforms may not operate as substitutes to banks in the long run.
  
  • That being said, it is noteworthy that notwithstanding the rapid growth of the sector, LendingClub was the dominant player in the P2P unsecured consumer loan market during my sample period 2019-12, and is still so in 2018, .

Question 56

The expansion of the peer-to-peer lending and barriers to entry

Answer 56

(Havrylchyk et al., 2018)

• P2P lending platforms have made inroads into counties that are underserved by banks and that their entry has been constrained by entry barriers and learning costs.
• Having controlled for demand factors, we find that borrowers from counties with lower leverage ratios are likely to borrow more from P2P lending platforms. This finding is consistent with the hypothesis that P2P lending platforms have partly substituted banks that have cut their credit supply (those most effected by the financial crisis)
• the entry of P2P lending is constrained by the high market concentration and branch density of incumbent banks. This has been interpreted in the earlier literature as entry barriers. Lower branch density could also be a measure of the financial exclusion, –> those far away from brick and mortar banks that have suffered long wait times and poor experience are more likely to turn to online lenders
• countries with higher population density, as well as a higher share of educated and young people experience higher growth of P2P lending.
  
  • Despite the online nature of the P2P lending, spatial effects play a crucial role, which could be another indication that learning costs are lowered by social interactions that allow to build trust in online markets.
• although P2P lending platforms require access to internet, we do not find any robust impact of Internet penetration on the expansion of the P2P lending. Neither do we find that openness to innovation, measured by number of patents per capita, is significant associated with P2P lending.
  
  • Hence, our results suggest that P2P lending is not a niche market, driven by new technology, but could be a substitute to banks’ lending.