A New Regulatory Model For Retail Finance - Update 1

"It's time for reflection..." FT.com

The fact that the US has taken the first step towards a 'Crowdfunding Act' requires an update of my earlier post on a new regulatory model for retail finance...

Non-bank retail finance models have been gaining momentum worldwide over the past six years, in spite of our creaking financial regulatory framework. Finally, it seems that framework is about to become more directly supportive. 

Since 2005 we have seen the launch of various innovative person-to-person, or peer-to-peer (P2P) finance platforms in the UK, US, Germany and elsewhere, which have been tracked here. These were launched by teams that spent considerable time and expense trying to accommodate existing regulation that favoured incumbents, with little or no regulatory assistance. Their goal was to enable those with surplus cash to connect directly with people who needed finance in a way that minimises costs and delay, and leaves most of the 'margin' with lenders and borrowers, rather than the middleman.

Meanwhile, we have all discovered that the existing financial regulatory framework, ironically designed to protect consumers, actually guaranteed the worst excesses amongst 'traditional' banks and failed to contain the risks posed by the "shadow banking" system. And although taxpayers have had to step in and effectively democratise the financial markets, we are still unable to extract badly needed funding from retail banks.

Against that background, it is perverse that the regulatory framework does not already directly facilitate simple, low cost, alternative financial services. And let's not forget that banks and other retail investment institutions continue to enjoy indirect tax subsidies through individuals' ability to off-set losses, as well as ISA and pension allowances for which unregulated alternative investments do not qualify.

While substantial innovation in consumer and small business lending has been possible, UK rules against marketing investments like bonds, shares and unregulated collective investment schemes, have made it much harder to offer direct, alternative funding for SME start-ups, trade finance and even social projects. Given a more proportionate investment regime, the likes of Crowdcube, MarketInvoice, Buzzbnk, Social Impact Bonds and the Green Investment Bank, for example, might operate rather differently. No doubt existing and new P2P platforms would take the opportunity to distribute multiple financial instruments, creating a far more substantial alternative to banks and other fee-hungry investment institutions.

Oddly, given its reputation for fast-paced innovation, the US has been (until recently) even less supportive of alternative retail financial models. Zopa, for example, which led the growth of P2P platforms with its launch of person-to-person lending in the UK, was unable to launch that model in the US despite lengthy consultations with securities regulators. And life has been unnecessarily complicated for the likes of Prosper and Lending Club ever since.

To help remedy the regulatory imbalance, as mentioned in August, three of the leading UK commercial P2P lending facilitators launched the Peer-to-Peer Finance Association (P2PFA) for platforms on which the majority of lenders and borrowers are consumers or small businesses (rather than, say, ‘investment clubs’ or networks of sophisticated investors). The P2PFA has adopted a set of self-regulatory measures that are based on similar FSA requirements for payment services platforms (which have a similar, low risk profile). In particular, the P2PFA Operating Principles require:

1. Senior management systems and controls;
2. Minimum amounts of capital;
3. Segregation of participants’ funds;
4. Clear rules governing use of the platform, consistent with the Operating Principles;
5. Marketing and customer communications that are clear, fair and not misleading;
6. Secure and reliable IT systems;
7. Fair complaints handling; and 
8. The orderly administration of contracts in the event a platform ceases to operate
9. Appropriate credit assessment and anti-fraud measures

Earlier this month, the US House of Representative has passed a Bill HR 2930 (still subject to Senate and Presidential approval) which would enable the issuer of securities to raise small amounts of money from many people (crowdfunding) on the basis summarised below. Please note that I've used the helpful summary from VentureBeat, but replaced "company" with "issuer", as I see no reason on my reading of the bill and the definition of "issuer" in the Securities Act 1933 why this would not enable person-to-person lending, rather than merely raising capital for corporations (please seek your own independent legal advice):

• "The [issuer] may only raise a maximum of $1 million, or $2 million if the [issuer] provides potential investors with audited financial statements.

• Each investor is limited to investing an amount equal to the lesser of (i) $10,000 or (ii) 10% of his or her annual income.

• The issuer or the intermediary, if applicable, must take a number of steps to limit the risk to investors, including (i) warning them of the speculative nature of the investment and the limitations on resale, (ii) requiring them to answer questions demonstrating their understanding of the risks, and (iii) providing notice to the SEC of the offering, including certain prescribed information.”

Will this work in practice?

Absolutely. The challenge (and benefit) associated with such 'safe harbours' is that there is very little room for fee income. This in turn favours 'thin intermediaries', like the new electronic finance platforms, as a means of broad, open distribution. Proportionately regulating platforms to address horizontal issues like those covered by the P2PFA Operating Principles leverages economies of scale, leaving product providers to focus only on vertical product-specific requirements. Specifically, the platforms can control operational risk (including anti-money laundering); deliver transparency through adequate product disclosure and ‘my account’ functionality; and centralise customer service and complaints handling, with ultimate referral to financial ombudsmen or other complaints handling bodies. In addition, because the platforms provide a reliable audit trail, tax rules should permit losses to be off-set against gains and income derived via platform-related activity. Similarly, there is no reason why instruments distributed via these platforms should not also qualify for consumers’ tax-free ISA and pension allowances.

Further, the 'horizontal' form of credit intermediation adopted by P2P platforms solves the problems identified by the NY Federal Reserve in the 'vertical' model adopted by the 'shadow banking' system. Since each borrower's loan amount is drawn from many lenders at the outset, there’s no need to engage split a single loan into many pieces by securitising later. Lenders also achieve diversification across many borrowers at the start, so there is no need for a series of bonds, CDOs and so on to ‘transform’ interest rates, maturity or borrower type. The facilitator is not a party to the loan agreements made on its platform and segregates lenders’ funds, so it has no credit risk (or ‘balance sheet risk’), and therefore no need or temptation to engage in regulatory/tax arbitrage that banks and shadow banks attempt. The one-to-one legal relationship between borrower and loan owner is maintained for the life of each loan via the same technology platform (with a back-up available), so all the loan data is readily available to participants and it's easy to assess the performance of the loan against its grade. Risk remains visible, rather than being rendered opaque through fragmentation, re-packaging and re-grading of the underlying loans, guarding against moral hazard. 

Finally, by enabling the efficient use of technology to facilitate consumers’ desire for greater control over their personal circumstances, governments will be helping to build a decent, sustainable financial services industry.

Consumers and small businesses should expect further developments in this space throughout 2012.