In response to the financial crisis, banks improved their credit standards and one of the silver linings of the crisis has been an increase in financial creativity in how people raise money. Its not very clear if this is temporary or a structural change in the financial system, however, it has left certain profitable niches where smaller companies the so called “fintech” are trying to make their presence felt in the financial landscape.
Peer-to-Peer finance has been getting increased attention in the past few years. Its potential impact may be similar to what Napster did to the music industry. P2P platforms provide a web-based system which brings lenders and borrowers together in a market place. P2P lending is a form of crowd-funding unsecured loans which are paid back with interest. One of the major reasons for their popularity is that they are able to provide lower rates than those offered by moneylenders and offer higher returns to investors than what is available via conventional investment opportunities.
P2P platforms enjoy three advantages over traditional banks: (1) absence of legacy operating costs like branches (2) no need for access to payments infrastructure and (3) no capital requirements or charges for deposit guarantees.
Though it has not yet become a huge market in India, the cumulative lending via P2P networks touched GBP 5.1bn globally in March 2016 [P2PFA] (some estimates put it at a couple of orders of magnitudes higher than this as in essence chit funds are technically P2P lending). Key factors that may facilitate crowdfunding are: (1) Regulatory framework that leverages the transparency, speed and scale of the internet (2) Online marketplace that facilitates capital formation while providing prudent investor protection and (3) Collaboration with other entrepreneurs, events and hubs that creates trust in the marketplace.
The Reserve Bank of India recently released a consultation paper to regulate the nascent peer-to-peer (P2P) lending business in India. The major recommendations of the paper are:
1. Since the RBI has no jurisdiction over individuals, partnerships or LLPs, it has recommended that P2P lending companies be required to register as NBFCs.
2. P2P platforms can’t assure returns to any investor
3. The money should move directly from the account of the lender to the borrower account.
4. P2P lending companies are required to have a minimum capital requirement of INR 2cr.
5. There is a proposal to limit the leverage that the platforms can take
6. “Fit-and-Proper” criteria should be applied to the management of the company and a proportion of Board members should have prior experience in the financial sector.
7. Platforms will need to submit regular reports on their financial position, loans arranged each quarter, complaints and so on to RBI
8. Loan-recovery practices of the P2P platforms will need to adhere to existing guidelines on recovery practices.
9. The platforms will have to guarantee confidentiality of customer data.
Overall the recommendations of the RBI are well thought-out. However, they also show a lack of understanding of the business. Firstly, since the lending is from an individual/group of individuals to another individual/company, the concept of leverage should not arise. The platforms only operate as facilitators or as a marketplace and do not invest their own capital. Flowing from this, the minimum capital requirement of INR 2cr sounds prudent but in an unnecessary requirement and will raise the cost of starting a P2P lending service and hamper its development. If the capital is used to create capital buffers or some form of investor guarantee/insurance it would improve trust in the platform. Secondly, the proposal that the money should not be held in an escrow account but be directly transferred to the borrower takes the benefits of a platform away and makes it more burdensome for borrowers to monitor and repay. This recommendation should be repealed.
P2P lenders currently use CIBIL scores and their own proprietary methodologies to assess the creditworthiness of borrowers. The lenders on the other hand are made aware of the risks in investing in such products. Since transactions happen via bank accounts, RBI deems that the KYC has been done by the bank. In such a scenario, the recovery process and investor protections needs to be looked into. This could be a source of pain during an economic downturn and we would risk throwing the baby with the bathwater like it happened with microfinance.
The interesting thing about P2P is that it shows that it is possible to separate the business of deposit taking, payments and credit (this is not really a surprise because that is how banking originated). While banks and P2P lending are fungible from a borrower’s perspective, on the lending side, the investors are fully exposed to the credit risk of the borrowers. The threat to banks from P2P lending platforms is hence limited to the extent to which these platforms can mitigate credit risk and create capital buffers for investor protection.