Peer to peer lending: the murky future with America’s new consumer protector
By Alex Lee
NEW YORK, Jan. 25 (Business Law Currents) – With the promise of high yields, peer to peer lending is attracting record amounts from institutional investors and individual lenders alike, even in the face of a cloudy regulatory future. Potential uncertainty aside, the attraction of an estimated $2.5 trillion industry is proving too hard to pass up for investors. The two largest P2P lending companies, LendingClub and Prosper have funded loans so far to the tune of over $480 million and $290 million respectively.
By way of background, peer to peer (P2P) lending microcredit institutions sprang up in 2005 in order to provide needy borrowers with viable alternatives to normal commercial bank loans. This industry had as its backbone, the seemingly novel concept of stripping out intermediaries, such as banks, and allowing lenders and borrowers to connect to reach their own financial terms for loans via the internet. The nascent industry made significant strides when even credit-worthy borrowers were locked out of the commercial credit markets due to the credit crisis.
There are many benefits to P2P lending, and from the aspect of the lenders, the most significant could be that it offers an entirely new asset category to invest in. With hedge funds, pension funds, mutual funds and wealth-managers requiring better returns on their capital, any diversification of their portfolios or investment models that can promise returns of 10 percent or better will likely be approached with piggy-banks cracked open.
P2P lending companies do not operate on purely disintermediation models, where intermediaries, such as financial institutions, are removed from the picture. Contrary to what the industry mostly presents as its image, P2P lending companies are actively involved in all lender/borrower transactions, not only through their own proprietary fee generation, but also in terms of how the transaction processes on their sites operate.
Both Lending Club and Prosper have systems that rate potential borrowers based on their credit histories and submitted information. Notably, if a borrower’s loan becomes delinquent, the companies will appoint a collection agency to collect overdue amounts. Companies such as LendingClub and Prosper also have their hands in the proverbial profit cookie jar, as they take tidy sums from origination fees and loan servicing amounts.
The horizons looked rosy for P2P lenders, especially as their services came into demand as the credit crisis arose. The microcredit train came to a screeching halt in 2008 when the Securities and Exchange Commission landed a “cease and desist” order on Prosper. The heavy hand of the SEC came down on the industry, but more stringent regulatory oversight was always in the cards.
Prior to SEC intervention, the P2P lending industry was considered by many analysts to be far too lax. This was manifested in significant default rates which lenders had to bear the brunt of due to insufficient information when making their loan decisions. The SEC mandated clamp down on the industry was in direct response to default rates well above 20 percent on some platforms. In an industry where low default rates and high interest returns are the main attraction, the poor performances of the loans required the SEC to bring to heel the P2P lending companies in the interests of consumer investment safety.
The SEC clamped down on P2P lending by requiring companies to register their notes. LendingClub took the path of least resistance and filed a registration statement with the SEC in the middle of 2008. Perhaps envisioning the financial burden registration would take, Prosper took an alternative tack and was more direct with the SEC. It is no surprise now that LendingClub is the largest P2P lender in the U.S. By complying with the SEC early on, and applying more stringent qualifications on investors, the company able to re-launch in the second half of 2008 and quickly asserted a market leading position.
In an industry that has not yet had enough time to fully develop and is still incubating, the SEC requirements have directly contributed to another significant issue. The cost of complying with the SEC is extremely high and this has had and will likely continue to have an anti-competitive effect in the industry at large. The industry already has consolidated around the two leading companies LendingClub and Prosper, although there are a few other niche category platforms as well.
SEC regulations were cited by Zopa (a UK P2P lending company that is active in numerous other jurisdictions) as being a primary reason why they would not launch in the U.S. It remains to be seen just how large the effects of regulation will be in this industry. With no new entrants in sight and with only two major players, the impact on consumers will have to be considered in light of potential Dodd-Frank regulations and further oversight by the Consumer Financial Protection Bureau.
If the CFPB and its new director Richard Cordray have as their main goal the protection of consumers, any further regulatory activity in 2012 will have to address the issues of overly expensive barriers to entry, anti-competitiveness that may harm consumers and the capacities of regulators to deal with the ever evolving P2P lending industry. In response to requirements in the Dodd-Frank Act, the U.S. Government Accountability Office released a report in the second half of 2011 with respect to P2P lending federal regulation.
This report highlighted two approaches to future regulation. First, the SEC centered approach, whereby potential risks to lenders and investors are regulated at the federal level by the SEC. This is a two level approach where there will be wide exemptions to individual state level securities regulations for P2P lending companies that are in compliance with federal regulations. Potential risks to borrowers will be regulated by state regulators to ensure compliance tied to credit extensions.
The second option is a CFPB centered approach which would bring together monitoring of lenders/investors and borrowers commercial ties under the auspices of the CFPB. The most fundamental change under this approach would be that instead of being considered federally regulated securities, P2P lending investments would be considered consumer financial products. So instead of an SEC led model, the CFPB would instead regulate relations between lenders/investors and companies.
The report is not prescriptive and it seeks to provide an overarching analysis of how the approaches would function while also providing a perspective on the positives and negatives to potential regulatory strategies. The report also acknowledges that any shift to a new regulatory regime would be rather speculative at the moment. As the industry is in its infancy, there is also the looming prospect that P2P lending as we know it could morph into a completely different animal with potentially new products and services offerings in the future, further adding uncertainty to any proposed regulatory regime.
What is certain is that there will be inevitably increased regulatory scrutiny on this industry going forward. Although it is a rather nascent business model, the invasion of institutional investors has signaled some level of maturity and growth has been sensational. Only time will tell if individual lenders will begin to get squeezed out by funds and supply overshoots borrower demand. With a newly bolstered CFPB, future regulatory oversight could mean the difference between an industry that could expand with more platforms or could implode under the burden of regulatory hurdles.
(This article was first published by Thomson Reuters’ Business Law Currents, a leading provider of legal analysis and news on governance, transactions and legal risk. Visit Business Law Currents online at http://currents.westlawbusiness.com. )