It is not uncommon for us to lend money to our domestic help. And normally, there is a low risk of default associated as we know the person concerned and there is no interest payment involved. Transpose this scenario to one involving a money-lender, an informal, unregistered source of finance. Here, loans are given against a security and are taken with a high interest cost. The lending is normally to someone known and if there is a default, the security, which is usually gold, can be sold off.
If these two situations are combined and formalised on a trading platform, we have a peer-to-peer (P2P) lending model, a form of crowd-funding even. An individual seeking a loan fills in details on a platform, which is processed within seconds after ‘due diligence’ is done and the request is matched with people with surplus funds keen to lend at an interest rate that is linked with the credit score. An internet platform, thus, brings both potential borrowers and lenders together with no intermediary. Hence, the bank or financial institution is kept out and costs are lowered. It is analogous to going to the capital market and issuing a bond. But when the requirement is very low which does not tally with, say, even the SME platform, then this P2P model makes a lot of sense.
RBI is set to bring out guidelines on this mode of finance. At present, deposit-holders feel short-changed getting low interest rates, and would look for better avenues. Borrowers complain about high base rates and premium above this benchmark. If one is not a top-rated company and, say, a venture capitalist, the cost would keep increasing. These two parties would like to deal with one another and keep the banker out. This way, the saver gets a higher interest rate and the borrower a lower cost. This is truly a win-win situation.
There are two uncertainties in this mode. The first relates to the evaluation of the potential borrower. Banks normally have the expertise required and further diversify risk by lending to several entities. In the case of P2P lending, the platform provides a credit score and basic details of the potential borrower which can be used to take a decision. Just like a bank, the lender can lend to several borrowers and thus diversify risk.
The second relates to default. In case of a bank, the defaults are absorbed on the balance sheet and the deposit-holder is protected. In a P2P model, there is no cover as a default would mean loss of money. But the duty of the platform is to ensure that payments are made, and hence there is some cover provided to the lender. For this, a safety fund is created from where there can be draws in case of a default.
The P2P model looks alluring, especially for the small saver and borrower. In today’s context, where the focus is on small enterprise with various programmes on start-ups, this mode of finance makes a lot of sense. The trick is to have credit scores which are presently not available for the common-man; this has to be arranged by the P2P company/platform. How this differs from a bank transaction is that the saver can actually choose which borrowers would be a part of the individual’s lending portfolio.
P2P platforms are just about a decade old, but have proliferated in the US and the UK with fairly large volumes. Names like Zopa and Prosper are ofttold success stories. The default rates have been low and the models have worked well. PwC has estimated a size of $150 billion for this industry by 2025.
What must be done before embarking on this venture? First, the P2P player or platform has to be registered. This is so because besides being a platform supplier, the company has to also provide the credit scores and take the responsibility of filtering the borrowers. The challenge is that if left unchecked, everyone will flock to this market as there is limited recourse for savers. A rating of these P2P companies will be in order.
Second, we need to develop scores for each person that is borrowing in the market. This will mean going to the micro-level. An individual may not have a default but have limited ability to service the loan. How would such a person be scored? Information on income provided may not be accurate. Therefore, there needs to be an agency which collects and stores such information that can be verified.
Third, the potential savers have to be registered with the platform with KYC norms just like deposit-holders of a bank. This becomes important because in the current situation where black money and overseas accounts have surfaced, there could be a lot of such money coming into the lending space. Further, if loans that are disbursed have the option for conversion into equity (especially if the borrower is a start-up), then ownership becomes dodgy if such funds flow in.
Fourth, a question that needs asking pertains to interest rates. While this would be outside the banking field, the case of MFIs is relevant. In this case, the borrowers never minded paying 30%, but the adverse consequences made us sit up and regulate the structure. What should be the ideal rate here? If a borrower is paying say 15% today, he would be happy with 12-13%, while the saver will jump at this number considering that the banks are giving only 7-8%. If such activity proliferates, then it can skew the financial system; and banks at the margin will have a problem, especially where small customers are concerned.
Fifth, if these loans are to make sense, then they should be made tradeable. This will provide an exit route for the sell side of the loan. Hence, a trading platform should ideally develop simultaneously so that this option is provided to the customer.
Last, it needs to be cleared whether there is a need for a cap on the amount that can be borrowed, given mid-size units could also access this market even as banks may like to step in as suppliers of funds.
P2P lending has opened the doors for a new dimension in the financial system. We only need to ensure that we have the structures and regulation in place given the potential for this business.
If these two situations are combined and formalised on a trading platform, we have a peer-to-peer (P2P) lending model, a form of crowd-funding even. An individual seeking a loan fills in details on a platform, which is processed within seconds after ‘due diligence’ is done and the request is matched with people with surplus funds keen to lend at an interest rate that is linked with the credit score. An internet platform, thus, brings both potential borrowers and lenders together with no intermediary. Hence, the bank or financial institution is kept out and costs are lowered. It is analogous to going to the capital market and issuing a bond. But when the requirement is very low which does not tally with, say, even the SME platform, then this P2P model makes a lot of sense.
RBI is set to bring out guidelines on this mode of finance. At present, deposit-holders feel short-changed getting low interest rates, and would look for better avenues. Borrowers complain about high base rates and premium above this benchmark. If one is not a top-rated company and, say, a venture capitalist, the cost would keep increasing. These two parties would like to deal with one another and keep the banker out. This way, the saver gets a higher interest rate and the borrower a lower cost. This is truly a win-win situation.
There are two uncertainties in this mode. The first relates to the evaluation of the potential borrower. Banks normally have the expertise required and further diversify risk by lending to several entities. In the case of P2P lending, the platform provides a credit score and basic details of the potential borrower which can be used to take a decision. Just like a bank, the lender can lend to several borrowers and thus diversify risk.
The second relates to default. In case of a bank, the defaults are absorbed on the balance sheet and the deposit-holder is protected. In a P2P model, there is no cover as a default would mean loss of money. But the duty of the platform is to ensure that payments are made, and hence there is some cover provided to the lender. For this, a safety fund is created from where there can be draws in case of a default.
The P2P model looks alluring, especially for the small saver and borrower. In today’s context, where the focus is on small enterprise with various programmes on start-ups, this mode of finance makes a lot of sense. The trick is to have credit scores which are presently not available for the common-man; this has to be arranged by the P2P company/platform. How this differs from a bank transaction is that the saver can actually choose which borrowers would be a part of the individual’s lending portfolio.
P2P platforms are just about a decade old, but have proliferated in the US and the UK with fairly large volumes. Names like Zopa and Prosper are ofttold success stories. The default rates have been low and the models have worked well. PwC has estimated a size of $150 billion for this industry by 2025.
What must be done before embarking on this venture? First, the P2P player or platform has to be registered. This is so because besides being a platform supplier, the company has to also provide the credit scores and take the responsibility of filtering the borrowers. The challenge is that if left unchecked, everyone will flock to this market as there is limited recourse for savers. A rating of these P2P companies will be in order.
Second, we need to develop scores for each person that is borrowing in the market. This will mean going to the micro-level. An individual may not have a default but have limited ability to service the loan. How would such a person be scored? Information on income provided may not be accurate. Therefore, there needs to be an agency which collects and stores such information that can be verified.
Third, the potential savers have to be registered with the platform with KYC norms just like deposit-holders of a bank. This becomes important because in the current situation where black money and overseas accounts have surfaced, there could be a lot of such money coming into the lending space. Further, if loans that are disbursed have the option for conversion into equity (especially if the borrower is a start-up), then ownership becomes dodgy if such funds flow in.
Fourth, a question that needs asking pertains to interest rates. While this would be outside the banking field, the case of MFIs is relevant. In this case, the borrowers never minded paying 30%, but the adverse consequences made us sit up and regulate the structure. What should be the ideal rate here? If a borrower is paying say 15% today, he would be happy with 12-13%, while the saver will jump at this number considering that the banks are giving only 7-8%. If such activity proliferates, then it can skew the financial system; and banks at the margin will have a problem, especially where small customers are concerned.
Fifth, if these loans are to make sense, then they should be made tradeable. This will provide an exit route for the sell side of the loan. Hence, a trading platform should ideally develop simultaneously so that this option is provided to the customer.
Last, it needs to be cleared whether there is a need for a cap on the amount that can be borrowed, given mid-size units could also access this market even as banks may like to step in as suppliers of funds.
P2P lending has opened the doors for a new dimension in the financial system. We only need to ensure that we have the structures and regulation in place given the potential for this business.
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