Bank upstarts’ rapid growth needs careful policing
By Neil Unmack and George Hay
The authors are Reuters Breakingviews columnists. The opinions expressed are their own.
Peer-to-peer lending is a rare thing in finance: an innovation that is actually innovative. Internet lenders are faster, more transparent and less systemically risky than traditional ones. But when the Financial Conduct Authority starts to regulate the sector next April, it needs to keep an eye on a disquieting new trend: some so-called P2P lenders are beginning to act more like banks.
There are three main P2P platforms in the UK – Funding Circle, Ratesetter and Zopa. In general, they follow a similar model, connecting lenders – typically relatively wealthy individuals looking for a return above bank deposits – with borrowers, like small businesses or consumers. Those wanting to play can generally only do so after some credit checking: the P2P platforms vet would-be borrowers and score their creditworthiness.
P2P platforms lack some of banks’ inherent advantages: deposit insurance, access to central bank funding, and a branch network. Yet they can compete in other areas. Loans can be approved in hours rather than weeks, making them more appealing to borrowers. And they don’t hold the same regulatory capital, since credit risk is borne by the lender, not the platform.
Right now, these advantages are enabling breakneck growth. The global P2P market is expected to nearly treble this year and should reach 17 billion pounds of loans outstanding by 2016, with 3.7 billion pounds of that coming from the UK, according to Liberum Capital. That’s peanuts compared to the 2.3 trillion pounds in loans to UK residents. Still, at a time when UK net lending by banks fell by 4.5 billion pounds in the year to May, P2P is clearly fulfilling a useful countercyclical role.
What’s less obvious is that the market is dividing into two camps. With Funding Circle, lenders get precise details of would-be small business borrowers, and pick who they lend to. That makes them more like an exchange. Ratesetter and Zopa are different: borrowers are anonymous, and the P2P lenders themselves choose what maturity or rate they lend at. It’s not the only thing that’s making their model look a little like old-fashioned banking.
For one thing, Ratesetter carries out maturity transformation, albeit on a very modest scale, by allowing lenders to make short-term loans of as little as one month that are rolled over to fund loans up to one year. More importantly, both it and Zopa now mimic a kind of deposit insurance: all borrowers pay into a fund, which can be used to offset losses. This kind of innovation will help attract the more risk-averse lenders.
Yet that’s one of the main reasons why the FCA needs to watch P2P particularly closely. It’s critical that lenders who use the platforms understand they are making a risky investment – P2P lending is not a form of deposit. They may be lulled into a false sense of security by protection funds and the fact that investors should soon be able to invest in P2P via tax-free Individual Savings Accounts.
If the FCA doesn’t keep its eye on the ball, a sudden spike in defaults could panic lenders. Although systemic risk is eased because the pain would be spread across investors instead of concentrated in a single massive bank, the reputational risk for the sector could be deadly. P2P protection funds, sized at about 2 percent of assets to cover expected losses plus a healthy cushion, are more thinly capitalised than banks. If they start to stretch maturity transformation, then runs could follow. With the eldest P2P only eight years old, platforms still need to prove themselves through economic cycles.
Finally, the regulator needs to keep tabs on how P2P could change even further. Booming revenues could attract less skilled or scrupulous imitators who could scrimp on the all-important credit quality monitoring that allows only the best borrowers to participate. Then there’s the chance that banks start to get in on the fun by funding platforms directly, or forming alliances with them. The risk is that platforms become a dumping ground for the weakest loans, or create implicit guarantees.
As long as the FCA can manage all this, P2P’s expansion should continue. In fact, the regulator’s only other goal should be to avoid over-regulation: the more vibrant and competitive the sector, the more efficiently it will compete with banks. It’s high time someone did.