To start with a definition, peer-to-peer lending (sometimes called p-2-p lending) is lending between people online. Peer-to-peer is person-to-person, but on a large scale (and can be p-2-b, person-to-business). There is an intermediary or platform at the center of this transaction, but typically not a bank.
Each lender in the p-2-p transaction might lend money to many borrowers, perhaps only a small amount of capital to each: An individual might borrow money from many different lenders, who collectively offer the sum that the borrower requests.
In the traditional market for borrowing money, the bank accepts the deposit of funds from customers – depositors – and the bank then lends the deposited funds to other customers, other banks or governments – i.e. borrowers.
The bank typically pays interest to the depositors on the funds they have lodged with the bank. The borrowers, conversely, are charged interest on the funds they have borrowed.
The bank expects to pay the depositors less than they charge the borrowers. The difference between the rate changed and the rate paid – the margin – is used to cover all the bank costs. Costs include the fact that some borrowers will default on their loan and not repay. Also, the bank owners expect to earn a profit. The bank typically pays the owners compensation as dividends.
The differences between traditional, i.e. bank borrowing and p-2-p borrowing are mainly about risk and return.
In a traditional scenario (bank borrowing), the bank is solely responsible for assessing the risk a potential borrower represents and for dealing with a default, should one occur. The bank makes all of the decisions: The lender (the depositor) is isolated from the risk of the borrower defaulting on the loan. Of course, if the bank makes too many poor lending decisions, depositors’ capital will be at risk. Ultimately, the bank will fail if too many people borrow funds and don’t repay them. Governmental guarantees may be available in these circumstances to protect depositors funds.
If the depositor is dealing with a p-2-p borrower, then they will typically be more exposed to the loss in the event of a default by a lender.
P-2-p lending is more akin to lending money to a friend or family member. If a friend asks to borrow a sum, we typically discuss the purpose and the duration they wish to borrow for and how and when they will repay the debt. As the lender (depositor), we will also judge the risk, i.e. the likelihood that the borrower will default and not repay it. Unlike in the bank borrowing scenario, if a friend borrows a sum and does not repay it, we suffer the loss personally, and there is typically no compensation.
So it is with p-2-p lending. The intermediary platform, which connects the depositor to the borrower, will not compensate the depositor if the lender defaults: The depositor will see the deposit’s recorded level of funds on deposit reduced by the sum in default.
(The intermediary or p-2-p platform may offer some additional support, discussed later).
So why would a depositor use a p-2-p platform to lend their money, rather than the typical bank borrowing scenario, when doing so exposes them to so much more risk?
Along with the increased risk comes an increased return.
In the bank borrowing scenario, the bank uses the margin (the difference between the interest they pay the depositor and the rate they charge the borrower) to cover their costs, plus a sum set aside to deal with default (reserves) and a sum paid to owners of the business (usually share dividends). The rates paid and charged could mean that the bank pays interest at, for example, 0.5% on the sum deposited: The bank could have set the tariff to be paid by the borrower 5.0% interest, giving an interest margin of 4.5%.
The bank has to absorb all of the losses from defaults in this scenario. Management must set aside some funds to cover this. And the bank may also have dozens or hundreds of branches and other premises, plus thousands of employees and so forth. Shareholders will also expect a return on their shares, i.e. distributed profit.
P-2-p depositors, on the other hand, might see a much larger share of the interest charged to the borrower being paid to them.
Here are two examples:
Example 1: Borrower with an excellent credit rating, low risk of default. This borrower might be charged 4.0%, less than the traditional bank would have charged, making this route attractive to the borrower. On the other hand, the depositor may receive 3.25%, many times more than they would have received as interest from a bank. The p-2-p platform management uses the 0.75% margin to cover their costs and provide their profit. They have no default risk to cater for (born by the depositor), and they have, typically, much lower overheads than the traditional bank.
Example 2: Borrower with a low credit rating, unable to borrow from a traditional bank because of the higher default risk. Here, the borrower might be charged 12.0%, because of the risk of default. That risk is carried by the depositor, of course, so the p-2-p platform may still only retain 0.75% margin, paying the deposit maker the balance of 11.25% interest. It is for the depositor to decide if they want to accept such relatively high-risk loans. If the depositor decides to take this risk, rational behaviour assumes that a percentage will default. Knowing this, the depositor can set aside some of the higher amounts of interest received to off-set against the capital lost in those defaults.
Finally, the p-2-p platform may provide some other services. At its most simple, the platform management connects the person advancing money to the people who want to borrow. They may help manage the downside risk by only lending a small sum to each borrower. P-2-p management undertakes risk assessment and set interest rates accordingly. The platform might allow depositors to choose to accept or decline higher risk loans.
To learn more about this and other forms of finance, please visit Malaysian Financial Market (capitalmarketsmalaysia.com)
