The latest challenge to too-big-to-fail banking could come from individual investors, not regulators.
A new breed of investing platform is trimming the fat from personal and small business loans, allowing individual investors to facilitate transactions that might have taken weeks (or never) to fund through traditional means.
Think of it as an above-board spin on lending money to a friend or friend-of-a-friend, or anyone, really, to start a business or pay someone back. Only, you receive an interest rate based on the borrower’s credit rating and a secure platform that allows you to pick and choose who to fund, and even a chance to sell the loan on to someone else if you want to exit the “investment”.
This is peer-to-peer lending (P2P), or debt crowdfunding. The concept is growing— with several billion in loans funded over the past few years. And one of the largest platforms, LendingClub, is actively exploring an initial public offering.
For borrowers, it’s a new, often cheaper way to secure funding. For investors, it’s direct access to an asset class —personal loans — that have been holed-up behind the machinery of banks and other complex securities for decades.
“The financial crisis, central bank policies and evolving regulations have shifted the financial markets,” said Brian Stern, a managing director at BlackRock who led an investment for BlackRock Alternative Investors in in Prosper Funding, another US-based P2P platform. “This is creating new challenges for investors and consumers and new opportunities for ideas and businesses.”
In 2013, according to LendingClub data, the company facilitated nearly $2.1 billion in medium-term consumer loans (over terms of three to five years) and closed the year at a $241 million per month clip. In the UK, P2P lending volume has grown 107%, on average, over the past two years. “Peer-to-business” lending is up, on average, 203%, according to the UK Alternative Finance Benchmarking Report. And according to the Financial Times newspaper, major US lender Wells Fargo recently told its staff that participation in P2P lending platforms was a “conflict of interest” for bank employees.
Of course, that doesn’t mean you should jump in feet first. It might work for many people, but there are reasons to be cautious. For starters, the industry is mostly unregulated—that is, nobody is forcing compliance with strict rules meant to protect investors. Returns (and indeed your investment) aren’t guaranteed.
What to know
Here’s how P2P lending typically works: borrowers fill out a profile and detail how much money they are looking for and for what. They then set up a bank account for monthly interest payments... and wait to get funded. Borrowers open up: sometimes they spin a good tale about how they are disciplined enough to make their payback; and post their picture. Investors sign up for an investment account and filter through borrower profiles and then select loans to fund.
Sounds easy enough, right? And it’s appealing when savings accounts only earn fractions of a percent.
But just because there are new and more official ways to make money by lending what you’ve got, doesn’t mean you should be lulled into thinking it’s a worthy investment. For starters, this is still just like lending $1,000 to your best friend — you think he’s good for it, but there’s always the risk that he’ll come onto hard times and miss a payment or fail to pay you back altogether. And you don’t know the person you’re lending to, so you can’t even turn on the guilt.
“This further democratization of investing allows almost anyone to initiate a personal loan,” said Mark Israel, a vice president at technology advisory firm Sapient Global Markets in Boston. “But it brings with it the new challenge of how to calculate the risk on that loan.”
There are some indicators, although perhaps not enough. Just glancing through the offering documents for individual loans on platforms such as LendingClub or Zopa, gives you an idea of the interest rates (7% to 35%), fees and default rates for borrowers with specific credit profiles and financial situations (on the worst end, 20% and on the better quality loans, 2%).
Plus, the borrower profile makes you almost feel you know the person asking for the loan. And, after all, P2P offers one key traditional protection you wouldn’t get loaning money to your friend — the loans are official and become part the borrower’s credit report. It's easy to feel that the spectre of a reduced credit rating and higher borrowing costs in the future will keep borrowers honest.
There are, however, serious shortcomings to investing in P2P loans — they’re difficult to diversify (a vast majority of loans are for credit-card payoff or other debt consolidation), they’re challenging to value and they’re even tougher to trade if you want out of the investment.
The question for many, however, is will these platforms migrate to the mainstream — and if so, will individuals be able to evaluate them properly. Sapient’s Israel is starting to hear wealth managers consider having their clients participate in P2P as part of their overall portfolio and investment plan.
“These may be good tools for professionals, but how would you put them in the hands of individuals,” asks Israel.
And there’s the rub: to really know what you’re investing in through crowdfunded loans, you need to be able to study the risk the same way you can study the risk of say, a mutual fund or a simple government bond.
Of course, most of us don’t really read the fine print or fully understand how those work, either.
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