Photo: Mike Bitzenhofer

Whenever media focus leans towards financial innovations, the conversations usually start and end with Bitcoin, possibly with some mentions of other cryptocurrencies in between. Unfortunately, Bitcoin hasn’t yet amounted to anything more than a speculative trading object, but innovations in finance do not have to be so radical – and there are many less obvious transformations happening nowadays, particularly in private lending.

The banking crisis and subsequent economic downturns have changed the way many people think about finance. Investors require more transparency and information; banks go after solvency, while governments limit their risks. Naturally, with these increased demands and additional limitations banks find it hard to stay as competitive as they were before the crisis. Does it mean that for the next decade or two the public will have to suffer from limited liquidity and growth and investors will have to make do with lower returns?

Perhaps so, but there is a way out for some sectors. Certainly, the increased regulation in the financial sector is very restrictive and the Basel accords followed by national legislation may even be too strict for the effective functioning of financial institutions. But even if those factors could be disregarded, there is still a significant loss of efficiency in the nature of banking systems themselves. Do we really need huge investment divisions within banks in order for us to get private loans? What is the added value for a borrower of paying a higher interest rate so that a group of bankers could have a nicer office and an unforgettable team-building weekend once in a while?

So what are we left with?

There are smaller banks that specialize in customer deposits and private loans, but they are still subjected to government licensing requirements, which are quite costly and inefficient in terms of the particular services that they offer. All of the abovementioned factors and the rise of financial transparency and payment systems indicate an opportunity an alternative way of private loan financing – Peer-to-Peer lending.

The idea behind P2P lending is quite straightforward – individuals are offered to bypass banks or any other intermediaries to borrow and lend money directly from each other. The current major players, like Zopa, Prosper, and Lending Club started as early as 2005, the former becoming the largest tech IPO of 2014 in USA. They are all marketplaces where potential creditors and borrowers are listed. These marketplaces are not required to hold traditional banking licenses or to have huge security departments to oversee their operations. Of course, there are certain legal restrictions and a number of licenses are needed – primarily related to the retention of users’ personal and payment information.

The key difference between P2P lending and banks is that users (lenders) personally choose whom to lend their money to. This key principle is what makes all the difference – both legally (no need for a banking license) and financially (lenders can access their risks and returns). When investors choose to make use of P2P lending, the marketplaces do a major part of due diligence on their behalf, listing all the borrowers with unified credit ratings to compare different options. Since borrowers have different backgrounds and credit histories, the eventual choice an investor faces is a choice not so different from that on bond markets. Because risk and return assessment is quite accurate, individual risks are almost fully diversifiable.

What matters most for borrowers, on the other hand, is the ease that is presented by P2P lending. With some marketplaces, the initial credit can be received within 15 minutes after registration – and there is no need to even step away from the computer. There might be limits on the amount of available credit, since lenders are more reluctant to engage in larger financing, but for most private loans the restrictions are inapplicable. The annual percentage rate for borrowers is slightly higher, on average, than in a bank. However, it is lower for borrowers with good history, since moral hazard and adverse selection problems are not as severe as the ones faced by banks.

Peer-to-peer crediting is still an emerging industry and many companies are just starting up. The companies that have helped to pioneer the concept now try to tailor their systems to different kinds of lending, virtually creating new industry. What we can observe is that P2P lending’s market share is growing rapidly and will soon create a lot of trouble for the traditional banks. The question now is whether the same story will develop with other banking products. If so, how will banks react to this unorthodox competition?