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Shadow banking's 9-12% returns carry risks

The major risk in P2P lending is the default risk as they cannot guarantee loans. (AFP)
The major risk in P2P lending is the default risk as they cannot guarantee loans. (AFP)

Summary

Loss absorption by platforms through a buffer and easy withdrawals can make customers complacent

Peer-to-peer (P2P) lending is emerging as an alternative investment avenue. With this innovative instrument, you can invest for 6-12 months, at an agreed upon rate of 8-12%. At the end of the tenure, you will get the principal as well as the compounded interest amount. But, what sets P2P lending apart is flexibility, allowing withdrawals whenever you desire, in contrast to traditional bank fixed deposits (FDs).

While theoretical risks of borrower defaults exist, P2P lending platforms have taken measures to mitigate such risks. They tend to absorb losses within their buffers, minimizing the potential losses and adhering to principles of the BASEL III capital norms implemented for banks. However, this may create a false sense of security among investors. Initially, the idea was to connect lenders with individual borrowers directly but over time P2P lending has evolved to bring in an interesting mix of borrowers, diversifying potential opportunities within the industry.

Lending in partnership

P2P lending operates via two avenues: a traditional model connecting investors and borrowers directly, and where investors’ funds are disbursed via partner P2P non-banking financial companies (NBFCs), wherein a P2P platform serves as a sourcing partner for a P2P NBFC, which then lends to its own borrowers. Prominent players include 12% Club, Cred, Mobikwik, and Fi.

Certain partner P2P NBFCs allocate the capital toward Buy-Now-Pay-Later (BNPL) and no-cost EMI financing.

 

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According to data from P2P firms, BNPL and no-cost EMIs contribute to 55-60% of assets under management, while business loans is 35-40%. Traditional P2P lending constitutes a smaller portion, at 5-10%.

In traditional P2P lending, borrowers directly meet investors online to request for loans with varying amounts, interest rates, and tenures. The lending platform assesses the creditworthiness of a borrower through ratings or credit checks, or by leveraging artificial intelligence and machine translation algorithms to filter borrowers. Some companies adopt unique underwriting processes, such as physical verification and social credit principles. “We focus on women businesses and try to physically verify borrowers’ credentials and work on the principles of social credit underwriting: the Grameen Bank Model," said Neha Juneja, founder, IndiaP2P.

Interest rates on P2P platforms differ. BNPL and no-cost EMI involve fees of 10-20% per transaction, while business loans carry rates of 18-30% per annum. Traditional P2P lending can offer 15-40% interest per annum.

P2P platforms prioritise risk mitigation by diversifying exposure across 200-300 borrowers, using AI and ML matching algorithms.

Investor returns in P2P lending can be 8-12%, depending on loan portfolio performance and NPAs or non-performing assets. It charges borrowers an IRR of 21-25%, with 3-6% as a platform fee, and 7-9% for maintaining a safety margin. The remaining 8-12% is paid to investors. However, the returns are not guaranteed, as NPAs can impact actual returns. Defaults are typically absorbed within the 7-9% safety margin.

What’s on offer

Fintechs like BharatPe (12% Club), Cred (Mint), Fi, Lendenclub and Faircent, are major P2P firms. Returns depend on whether they follow traditional P2P methods or lend through partnerships (see grfx). The borrower profile also makes a difference to the final returns. LiquiLoans, referred to as SBM Bank of P2P lending, serves as a partner P2P NBFC for most tech firms such as Cred, Bharatpe, and Fi, which recently launched their own P2P products. In addition to these partnerships, LiquiLoans offers a direct investment option through its platforms.

For borrowers, LiquiLoans has partnered Upgrad, Dr. Batra, LifeCell, Propelld, Livspace, and DesignCafe, to tap into their customer base seeking loans. It offers no-cost EMI and BNPL services to these customers.

Though LiquiLoans claims to be the only rated P2P platform, note that only 6% of its loan disbursements underwent a Pass-through Certificate (PTC) transaction, rated by ICRA. However, this rating was later withdrawn as P2P NBFCs, such as LiquiLoans, do not lend on their own books nor sell their loans. PTC transactions involve bundling and rating loans when an NBFC raises capital by selling its loan book. As LiquiLoans does not lend on its own books, such transactions are not applicable.

LiquiLoans gross NPAs were below 1.3% even during covid. Currently, its gross NPA stands at 0.8%. It claims zero net NPA since gross NPAs are absorbed by its buffer (interest rate spread), while LendenClub has the highest gross NPA of 3.1%. In case of partnership models, investors must dig deep and check NPA of a partner P2P NBFC, as the primary platform is just a sourcing platform and will not have NPA.

Risks galore

The major risk in P2P lending is the default risk as they cannot guarantee loans. The platform charges an IRR of 21-25% to borrowers, of which 3-6% is platform fee and 7-9% is for margin of safety. However, if NPAs go beyond this investors may start losing their principal with no collateral to cover losses. In India, some P2P sites saw default rates of 10-12%, highlighting the importance of assessing risks before investing.

Note: even though P2P lending is regulated by RBI, there is no insurance or guarantee against loan defaults, unlike banks that insure deposits of up to 5 lakh through Deposit Insurance and Credit Guarantee Corp.

Money lent through BNPL and no-cost EMI services add to the default risk. Additionally, the banning of FLDG (first loss default guarantees) by the Reserve Bank of India (RBI) in March has made unsecured credit lines through BNPL platforms even riskier. The case of Zest Money, which faced challenges due to its zero-cost consumer durables loan book, serves as an example of the risks associated with precarious lending practices.

In some countries like China, the UK and the US loan guarantee plans are offered to investors in case of loan defaults.

The platforms that only look at Cibil of borrowers to gauge the creditworthiness also run the risk of lending to risky borrowers. For instance, the algorithm may fail to incorporate non-linear relationships between predictors or rely on inadequate datasets that overlook critical financial information beyond credit scores. Suppose a borrower with a 750+ CIBIL score wants to take a loan from a P2P player. The platform’s algorithms would instantly approve the borrower due to his high CIBIL score, showing linearity as an assumption. The algorithm may fail to take into account a case where the borrower might have exhausted his lending limits at traditional banks and NBFCs and is now coming to a P2P player for a loan at a substantially high rate of interest.

This can lead to flawed loan approvals, as the algorithms may not consider a borrower’s current financial situation and transactional behaviour.

Last, some investors of P2P lending told Mint that while most platforms offer a premature withdrawal option, the money actually takes up to four weeks to hit the bank account.

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