P2P lending threatens bank marginalisation

Imagine if the retail banking system was to be rebuilt from scratch using technologies that exist today. It doesn’t take a particularly rich imagination to work out that it would look nothing like what is in existence right now.

Retail banks are the product of years of accumulation of branches, staff and legacy systems that add up to a highly inefficient and costly whole. Small wonder that a host of new entrants and technologically-savvy organisations are in the process of deconstructing the consumer banking offering and cherry-picking the most profitable parts.

To compound the problem (from a bank perspective) they are doing so on top of the existing banking infrastructure, positioning innovative and attractive “front-ends” while leaving the banks to handle compliance and other legacy costs.

The arrival of the internet and mobile banking has done away with the need for physical proximity and human interaction as essential components of the banking transaction. In tandem with the technological liberation that fintech start-ups now possess, there has been a raft of enabling legislation.

Consider deposit-taking. This fundamental service of a traditional bank was by necessity a highly-regulated activity. Consequently, the regulations attached to gaining a banking licence meant that obtaining a licence was only achievable by promoters with immense resources, effectively sustaining the status quo and preserving effective oligopolies.

As the attraction of the deposit-taking business has diminished, so the legislation governing other, more profitable aspects of the banking business such as payments, foreign exchange and even lending, has become far more liberal.

Nowhere is this more evident than in the world of lending, specifically peer-to-peer (P2P) lending.  This is an online credit market that allows masses of individual users the ability to buy and sell credit to each other at better rates than exist in conventional markets. A single loan is usually made up of contributions from many lenders in order that risk may be diversified.

Many commentators see peer-to-peer lending as the future of all small sum and short-term lending. Unlike P2P platforms, conventional banks have costs of compliance, infrastructure and client servicing. The writing is already on the wall with some banks already investing in and outsourcing their SME lending to P2P platforms.

Of course, one of the critical by-products of peer-to-peer lending is the collateral effect on the deposit business. In the post-financial crisis world, and indeed for most of this century, the retail depositor has had to endure effective negative rates of interest after taking into account the effects of inflation. That situation is unlikely to reverse any time soon. P2P lending gives those same depositors the opportunity to boost returns as they supply funds to the market directly without bank intermediation.

And the ripple effect doesn’t end there, according to John Egan, author of Innovation in Banking: “Increasingly, financial advisory services are advocating on behalf of P2P lenders as a portfolio investment for average bank customers, individuals who typically don’t have equity or debt investments. Part of the attraction is the ease and convenience of investment as well as the simplicity of the product and how it’s communicated. P2P lending is significantly easier to understand than, say, mutual funds and debt securities for a depositor with a low level of financial literacy.”

A similar role is provided by Crowdfunding, which is the process of raising money for a new product or venture by sourcing a large number of small contributions. Banks used to be exclusive arbiters of the credit decision – something that was bound up in the lending skills of the branch banker who relied on his or her judgment and probity and the assessment of traditional criteria such as character, creditworthiness and collateral. The arrival of P2P lending and Crowdfunding can be in a good part attributed to the de-skilling of branch staff, the centralisation of the credit decision and the accumulated discrediting of the banking system in general.

Indeed it is not so long ago that the notion that the bank could be so strikingly removed from its role as credit intermediary would have been treated as something fantastical, but the fact is that default rates in the P2P world have been more than acceptable – something that can be attributed to the robust credit criteria employed. A good example was set out in the Lending Club IPO prospectus where the world’s largest P2P lender successfully raised €250 million last year.

“After we receive a loan request from a borrower member, we evaluate whether the prospective borrower member meets our credit criteria. Our borrower member credit criteria are designed to be consistent with [our] loan underwriting requirements and require prospective borrower members to have:
•    a minimum FICO score of 660 (as reported by a consumer reporting agency);
•    a debt-to-income ratio (excluding mortgage) below 40%, as calculated by Lending Club based on (i) the borrower member’s debt reported by a consumer reporting agency; and (ii) the income reported by the borrower member, which is not verified unless we display an icon in the loan listing indicating otherwise; and
•    minimum credit history of 36 months; 5 or fewer inquiries on their recent credit profile in the last 6 month, and at least 2 current revolving accounts.”

These conditions imply access to a relatively sophisticated credit infrastructure is a prerequisite to P2P success and few if any economies can boast the same level in this respect as the U.S. Nonetheless, as these infrastructures improve, the P2P momentum as far as small loans goes seems unstoppable.