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Monday, 3 July 2017

P2P Lending Goes Global: FinTech Credit v OldTech Credit

Twelve years after the launch of Zopa and the peer-to-peer finance sector finally gets its first report from the Bank of International Settlements (BIS), the central bank of central banks. The report is surprisingly positive, given financial regulators' preference for the status quo. Basically, they believe that change increases risk and increased risk is bad, so innovation is both risky and bad. Similarly, they're fond of shoe-horning innovative services into existing regulatory frameworks without seeing that the innovation may itself be exposing and/or solving flaws in that system. At any rate, the banking situation must be pretty dire for the industry's global beacon to produce a positive report on alternatives...  But in the the interests of time I want to ignore the positives and answer a few criticisms:

Is P2P lending "procyclical"?


In fairness, the BIS report only suggests that P2P finance represents the "potential for ...more procyclical credit provision in the economy", but I still disagree that this is a feature of the model.

Bank lending itself is procyclical, which is to say that banks lend lots of money when the economy is booming, yet try to protect their balance sheets when times are tough and we need credit the most. In fact, this was such an alarming feature of the recent/current financial crisis that BIS itself introduced capital rules that it thought would force banks to become less procyclical. Recently, moreover, the BIS's own Basel Committee reported that these rules are proving ineffective. They think there is too much bank credit available and/or the quality of creditworthiness is in decline.

If that's the case, then we really are in trouble, since UK banks have been lending progressively less to real businesses, and we aren't exactly in the grip of an economic boom...

Compare this to the rise of P2P lending. We started Zopa in 2005 when the 'spread' between high bank savings rates and cheap credit was actually very narrow (heavily subsidised by PPI revenues) - yet proved that lending directly between humans without a bank in the middle produced a better deal for both lenders and borrowers. This is why P2P lending has become ever more popular since 2008, while banks have sat on the sidelines waiting for the good times to roll. Lenders get higher interest on their money, diversify risk by lending to lots of people and businesses who are starved of bank loans - apparently leaving the banks with leaner opportunities...

But I believe the banks have simply chosen to chase higher yielding loans and other assets because their cost base does not allow them to make money serving the better risk customers.

Indeed, the BIS report acknowledges that banks have "left room" for platforms that enable people to lend directly to each other "by withdrawing from some market segments" after the financial crisis (which, I'd like to emphasis, still hasn't ended).  The report notes that P2P lending equated to 14% of gross bank lending flows to UK small businesses by 2015... only 5 years after the launch of the first P2P business lending platform.

So, P2P finance is actually counter-cyclical by its very nature.

The real issue, perhaps, is what happens when banks start being able to offer better interest rates and cheaper loans. Yet Zopa's early experience shows the new platforms will still be able to compete successfully (especially because those PPI cross-subsidies are no longer available: refunds and compensation have now reached £26.9bn, according to the FCA!).

Is it likely there will be a 'run' on P2P lending?

No. Far from seeing a potential 'run' on P2P lending platforms by lenders trying to get their money out, many platforms are seeing excess lender demand due to continuing low yields on bank deposits (not to mention high fees on investment products). Zopa, for example, has been closed to new lenders for some months, even while seeing record borrower demand, yet still plans to offer P2P lending within Innovative Finance ISAs. Everyone is chasing yield, not just the banks. But, again, the early experience shows that the rates will still be more attractive if and when banks are able to offer higher rates to savers, because they need fatter margins than P2P platform operators.

Meanwhile, the P2P model has expanded from consumer and small business loans into car finance and commercial property loans. But so far the regulators have protected banks against head-to-head competition for other forms of finance, such as retail sales finance or mortgages, through lack of reform to arcane procedures dictated by consumer credit and mortgage regulation and refusing to allow longer term finance to be supported with short term loans - which banks are allowed to do all the time.

So, rather than a run on P2P lending, we're more likely to see successful P2P lending operators adding a bank to their group, at the same time as expanding their existing P2P offerings. In other words, a twin-track attack on Old Tech banks and banking models.

Will P2P lending help solve problems with banks' legacy systems?


There's no doubt that this BIS report and the regulatory obsession with 'FinTech' generally, springs partly from regulators' fervent wish that OldTech banks will simply take advantage of the latest trend to rejuvenate their systems for the longer term.

But there are many reasons why established retail banks won't do that - and will continue to passively resist regulatory edicts to do so. That's why the UK government had to impose the open banking initiative (not to mention sharing business credit information and declined loan applications); why the Bank of England has opened up the Real Time Gross Settlement system; and why PSD2 regulates a new class of  third party 'account information' and 'payment initiation' service providers.

Why won't the banks renew their legacy systems to save themselves? For starters, they don't actually have legacy "systems" so much as separate bits of very old kit connected manually by employees holding hands with electrical chord between their teeth using their own spreadsheets. So the shiny new government-mandated open banking interfaces will likely be connected to computers that aren't really party of any type of integrated "system" that, say, a Google engineer might recognise.

Aside from that insurmountable IT challenge, bank management teams are simply not incentivised or empowered to think about the long term, and all their key decisions are made (after a very long time) in committee to avoid personal blame.

So it's more likely that the aspects of 'banking' which are within the scope of P2P lending will gradually drift away from banks altogether, while activities outside that competitive scope will need to be reinvented by others, including new banks, from the ground up.

Will traditional banks launch their own P2P lending platforms?

Probably not.

Some have bought shares in such platforms and others have actually lent their own funds on P2P lending platforms. But that's a long way from allowing their depositors to lend directly to their borrowers.

That's because bankers make their money by keeping savers and borrowers separate of each other and treating deposits as their own funds. 

It's high time regulators admitted this to themselves and got on with the job of supporting more transparent, fairer mechanisms for allocating people's spare cash to other people who need it.

Is P2P lending an "originate-to-distribute" model?


Here, again, P2P lending is a reaction away from this type of model and is transparent enough to reveal attempts to introduce it. BIS says that "originate-to-distribute" refers to the fact that neither the primary lender nor the operator of the platform retains any ownership or interest in the loan that is agreed. But this does not fully describe the model or its potential hazards.

The "originate-to-distribute" model may have that basic feature but the point is that it's driven by a market for secondary instruments (bonds and other derivatives) that are based on underlying loan contracts, where demand in that secondary market has outpaced the supply of loans. In that case, loans may start to be originated solely to support the secondary market. This transpired in the context of the sub-prime mortgage crisis, where investment banks arranged bond issues in a way that effectively concealed the poor quality of underlying loans. From their own problems with undertaking due diligence, they knew that the underlying loan data was hard to find and in many cases unreliable (hence the related 'fraudclosure' issue of investors foreclosing on mortgages they could not prove they owned). That's why the banks involved have since been paid billions in fines and compensation towards the repayment of bailouts (at least in the US).

But, as the name suggests, P2P lending - at least in the UK - involves a direct loan between each lender and borrower on the same platform, where the data concerning the loans is available to the participants, including lenders who may receive assignments of loans already made on the same platform. The visibility of the loan performance data and reputational impact for the platform operator if all goes wrong limits the temptation to conceal the original credit quality or performance of the loan.

So, BIS's assertion that P2P lending represents the same model or suffers from the same potential for moral hazard is not right.

It is possible for a lender to ask a P2P platform to provide it with access to some less creditworthy borrowers to achieve a higher overall yield, perhaps even with a view to selling the resulting loans to other lenders or even securitising them; but even if you deem that to be 'originate-to-distribute', the 'moral hazard' is not there because the data is readily available for all to understand the lesser quality or performance of the loan.

The BIS report cites the Lending Club 'scandal' in 2016. But, ironically, Lending Club is not based on a genuine P2P lending model at all, because the SEC refused to allow direct 'peer-to-peer' loans without full security registration requirements (just ask Prosper!). So the regulators forced the US platforms to operate the same securitisation model that the banks pioneered in the sub-prime crisis... We abandoned attempts to launch the direct P2P model in the US because this model is nothing new - as well as being cumbersome, convoluted and expensive. But even there the relevant 'scandal' was 'only' that when selecting a portfolio of loans to issue bonds to the relevant investor, Prosper selected some loans that did not meet the investor's specified criteria. Not great where the data is available, but the point was that the problem was spotted quite quickly because the relevant data was readily available, so the loans could be re-purchased by the issuer.  

The report also cites the problems at Trustbuddy, in Sweden, but the problems there were again detected early by new management looking at the collections data, who promptly alerted the authorities; and Ezubao, in China, which was a ponzi scheme operated between July 2014 and December 2015 that was detected quite quickly - certainly faster than Madoff's activities in the supposedly heavily regulated US investment markets.

It is worth acknowledging, however, that there is always scope for something to go wrong. This is why the UK P2P lending industry pushed for specific regulation of P2P lending from 2011; and highlights why regulators should stop their hand-wringing about innovation and get on with the job of adapting to change.