Nigel Glenday is an investment banker at StormHarbour Partners, a global investment banking firm providing strategic advisory, structuring and sales & trading solutions with offices in the U.S., Europe and Asia
Closely related to the crowdfunding phenomenon has been the evolution of the peer-to-peer (P2P) lending model.1 As the early standard-bearers of P2P prepare to enter the public markets, the model itself is poised for greater industry and regulatory visibility. So what has the undoubtedly impressive growth of P2P revealed thus far and what might it portend for a rapidly shifting and decentralized financial sector?
In short, P2P platforms offer lenders, both institutional and retail, the ability to provide credit directly to individual borrowers on a fractional (and, more recently, whole loan) basis. An online portal facilitates the application through funding process for both borrowers and lenders while the platform itself undertakes borrower marketing, credit scoring/underwriting and loan servicing functions. A more streamlined, web-based loan process has appealed to prospective borrowers as the public has grown increasingly comfortable with digital banking channels in general.
The loan funding mechanism, also maintained by the P2P platform, occurs through a marketplace in which institutional and retail investors subscribe to individual loans offered for syndication.2 These marketplaces allocate loans based, essentially, on a first-come-first-served basis, with the interest rate for each loan set by the risk scoring parameters of the platform.3 4 The platforms assess origination and ongoing servicing fees, but otherwise do not retain any credit risk directly.5 The most notable attribute is the extent of the individual borrower- and loan-level data transparency made available (via a website or API) to prospective lenders at the time of origination. The end result is a form of “just-in-time” funding by marketplace participants, many of whom have developed increasingly sophisticated techniques for loan selection.6 Interestingly, this data transparency has attracted several marketplace participants with backgrounds far afield from credit yet who have drawn parallels between the P2P model and other technology-enabled marketplaces (including high frequency stock trading, foreign exchange, digital ad exchanges, among others).
What began as a self-directed retail phenomenon (i.e., individuals extending credit to one another) has given way to an institutional investor base that has found relative value (in an otherwise low interest rate, benign credit environment) in the loans originated through these platforms. Exponential origination volume growth has been fueled by structural shifts in banking and cyclical market forces in the wake of the 2008 crisis. In the U.K. and continental Europe, a more concentrated and weakened banking system has provided even more fertile ground for P2P platforms, alternative lenders and challenger banks.
The P2P model has generated the most traction in relatively simple, homogeneous assets classes amenable to programmatic underwriting. These are asset classes that are in general: i) costly to originate; ii) under-served (or unattractively priced) by existing lenders; or iii) in which risk-based pricing applied to specific borrower segments can supplant “one-size-fits-all” pricing. As such, personal installment loans (largely for debt consolidation or credit card payoff), student loan refinance and, to a lesser extent, small business loans, have generated the most volume for P2P platforms.7
However, the future applicability of the P2P model to other asset classes (for which competitive markets exist today) will come down to platforms sustaining a cost-efficient, defensible origination strategy and the capacity for the marketplace funding mechanism to deliver attractive cost of capital relative to other financing arrangements. Cost-effective origination, even within the core markets of current P2P platforms, may require de-emphasizing direct-to-borrower marketing in favor of natural, captive distribution partnerships (e.g., point-of-sale financing options for consumer loans or online bookkeeping and financial productivity software for small-businesses). Short of this, whether these platforms can be adequately compensated over time for the functions they perform without monetizing credit risk remains an open question.8
The role of traditional banks, short of being displaced, is re-ordered in the daisy chain of intermediation. Traditional banks have provided wholesale funding for P2P loan investors who then retain the residual risk of the loans they fund.9 In fact, many traditional banks are well positioned to do this given that P2P-originated consumer loans are frequently used to refinance credit cards that may have been previously issued by the very same banks. Term ABS remains an attractive end-financing strategy and issuance has picked up, most notably in student loan refinance for which a deep ABS investor base already exists. Even efforts to arrange synthetic exposure and credit protection for P2P loans is growing.
While P2P-originated loans remain a small fraction of the $3.2 trillion in U.S. non-mortgage consumer credit outstanding, its exponential growth may very well the “tail wagging the dog” for traditional banks. Many are now emulating the online borrower experience characteristic of P2P platforms with some setting up their own online consumer lending portals. Others are seeking out new non-traditional credit scoring models to improve loan rejection rates (particularly for small business). If anything, P2P is simply accelerating a longer standing shift away from “brick-and-mortar” banking channels.
P2P platforms today still offer a limited set of credit products for specific market segments and cross/up-sell initiatives are just beginning to take shape. The model takes part in wider theme of bank disaggregation and decentralization that includes innovations in payments, mobility, crypto-currencies and all manner of “big data”. But, the lifetime value of multi-product customer relationships beyond credit (including deposit taking, cash/treasury management, wealth management, among many others) just might compel P2P platforms to re-create the very traditional financial institutions they sought out to dis-intermediate in the first place.
1 Also commonly referred to as online direct or marketplace lending; or crowdlending
2 Many platforms use a third-party sponsor bank to act as a lender of record upon loan origination after which economic interest in the loan is issued by the P2P platform (or a special purpose vehicle) to the end-investor through an SEC-registered security
3 Earlier attempts at auction-based pricing proved problematic in the absence of sufficiently sophisticated lenders experienced in pricing credit risk (a circumstance that may be changing as institutions become the principal investor base for these platforms).
4 Many platforms have been using a wider set of non-traditional borrower credit metrics, including social media, web-scraped credit data, internet browser behavior and other “big data” sources
5 Other non-bank lenders, frequently included under the P2P umbrella, rely on wholesale funding sources (e.g., accumulation facilities, term ABS, etc) and do retain residual credit risk
6 Distinct from, but related to, the “originate-to-sell” model in which the originator may retain some loan warehousing risk
7 A growing variety of asset classes are being pursued through the P2P model, including real estate, invoice finance and project finance (notably renewable energy). Insurance has also been suggested as a possible extension of this model.
8 Monetization through retaining credit risk on-balance sheet or through an auction-based, gain-on-sale model
9 Some banking institutions and finance companies also purchase loans directly from P2P platforms