Photo: iStockPhoto
Photo: iStockPhoto

Opportunity in P2P lending

The P2P firm provides a platform connecting savers and borrowers

As the global bellwether of tech stocks, the Nasdaq, sails past its dotcom peak and investors rush into tech start-ups creating “decacorns" (companies with valuations of more than $10 billion), there is little doubt that we are in the midst of a second information technology boom. Much like the first, there is euphoria, use of creative valuation metrics (price per “user" is the new price per eyeball) and blind buying of initial public offerings, or IPOs (e.g. Alibaba). However, many of these new businesses have created genuine value for investors either directly or through opening up new opportunities. One such case is the Fintech sector. Underpinned by Internet and mobile technologies, Fintech has “democratized" finance by largely circumventing banks and traditional financial firms specifically in the peer-to-peer (P2P) space.

Traditionally, banks have been the intermediaries pooling money from savers to lend to borrowers. However, post-crisis, battered balance sheets, subsequent onerous capital requirements and a less-certain economic outlook led banks globally to be less-generous lenders. Moreover, the extraordinary monetary policy pursued in developed countries led to a sharp fall in interest income to savers. Into this breach stepped P2P lenders using technology to allow savers to directly loan money to borrowers. Despite an economic recovery and the return of banks’ willingness to lend, P2P lending has grown as it typically allows borrowers a lower interest rate and a less-arduous loan approval process. On the other side, savers get a much higher rate compared with savings accounts and fixed deposits (FDs).

The P2P business model is simple. Typically, the P2P firm provides a platform connecting savers and borrowers, and rates the credit risk of the borrower using standard consumer credit databases. Information from these may be overlaid with analysis using proprietary algorithms that use publicly available data on borrowers (e.g. LinkedIn profiles). In return for matching savers and borrowers, the P2P firm takes a cut of the loan amount. There are variations of the basic model across lenders. A pure P2P lender will connect individuals to each other (e.g. Zopa in the UK) whereas a “marketplace" allows institutions such as hedge funds to construct loan portfolios (e.g. Lending Club in the US). In India, the two main P2P lenders, i-lend and Faircent, follow the former model*.

As an investor, the advantages of getting involved in P2P lending are obvious: a higher return (4-25% higher than three-year FD rates**), which is uncorrelated with other asset classes. However, as ever in finance, higher returns are only earned by taking higher risk. Bank savings accounts and FDs offer lower returns because the credit risk is borne by the bank while it guarantees your deposit*** (its guarantee in turn is wholly or partially guaranteed by the government through deposit protection). In contrast, a P2P firm passes on the entire credit risk to you****, only promising to help with the recovery process. While credit ratings provided on borrowers help by allowing investors to choose a particular risk level, it is dangerous to rely on them too heavily. The rating is an assessment that can turn out to be wrong (as demonstrated in 2008). This is especially pertinent for P2P lenders as most of their credit models have not been tested through an entire credit and interest rate cycle given their short life. In addition, default rates implied by ratings represent an average over similar loans and in a particular year. It is not the probability of default on individual loans. An investor’s experience may differ considerably from the rating unless a large enough portfolio of individual loans is constructed. Further, most investors are not credit risk experts able to judge and construct diversified portfolios that lower risk. They are in danger of anchoring themselves to one metric, which can be pernicious combined with the cognitive bias of overconfidence. These disadvantages are accentuated for the retail investor in P2P marketplaces where sophisticated investors are also present who can better perform credit analysis and portfolio construction.

However, unless you were thinking of loaning your retirement nest egg through P2P, the higher risks should not be a deterrent. While the standard caveat of risking only what you can afford to lose applies, the uncorrelated nature of P2P lending can benefit a cross-asset portfolio by increasing return at little additional risk. Moreover, spreading investments across borrowers with differing profiles helps diversify away the inherent credit risk. The relatively low investment required (in India, personal loans at Faircent are between 30,000 and 500,000, and at i-lend are 25,000 to 200,000) means that this can be done without a substantial outlay. The one thing to avoid is chasing yield. The promise of a 30% interest rate is usually there for a reason. A P2P platform is not geared towards high yield borrowers who typically require closer scrutiny and monitoring (that is why banks have stricter covenants and more frequent monitoring for high yield borrowers). Further, the post-default legal process is usually onerous and costly, leading to low recovery rates. Therefore, as long as some common sense guidelines are followed, P2P lending offers the astute investor a way to enhance risk-adjusted portfolio return.

Shashank Khare is an investment professional and writer. After studying engineering at IIT-D and business administration at IIM-A, he entered the world of credit derivatives before CDS became a four-letter word. Having successfully batted through the crises, he now indulges his passion for economics, finance and policy. Respond to this column at indulge@livemint.com

* Milaap and RangDe are not strictly P2P given their social bent

** Based on rates displayed at Faircent.com and ICICI advertised 3-year FD rate of 8.25% on 20-Jul-15

*** There is some merit in the argument that banks charge a higher spread between borrowing and lending rates to compensate for a larger cost base. However some of that cost base is payment for expertise to lower risk, e.g. credit risk departments which lower bank portfolio risk and hence reduce default risk for depositors

**** Some may have a deposit protection fund (e.g. Zopa in the UK)

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