Digital Disruption: Peer-to-Peer

Platforms that connect household borrowers to household lenders will soon push banks aside. The only reason capital still flows through banks from savers to lenders in 2015 is because the banks have a historic monopoly. As soon as new platforms can be created to directly connect households to households, then borrowers will pay lower interest rates and savers will receive higher interest rates as the extractive bank middlemen are cut out of the process.

The paragraph above is the kind of fantasy that we still hear from some commentators who get carried away with the hype of the peer-to-peer lenders. The idea is that banks don’t add any value or don’t have any particular advantages in connecting savers to lenders; instead, they are just inefficient incumbents who will be blown away by new technology.

That is not right. The fact is that to intermediate between borrowers and lenders is not easy - difficult problems have to be solved. Banks solve those problems, and in doing so they create a lot of value. If there is not enough competition between banks, then banks will make larger than normal profits, but nonetheless, banking creates a lot of value. Moreover, banks have large advantages over others who seek to connect household savers to borrowers.

Cost of funding

Banks have a huge advantage over peer-to-peer lenders in their cost of funding because they are permitted to raise deposits. Savers will accept lower interest rates if their funds are not locked up for a longer term, and also if there is less risk of loss of their funds. Bank deposits have both these properties - they are short term and they are guaranteed by the Federal Government (up to $250k), so they are an especially cheap source of funding. Even long term borrowing by banks in the form of the bank bonds is made cheaper by the implicit ‘too big to fail’ guarantee that the largest banks have from the Federal Government.

On the negative side, banks do have to hold minimum amounts of equity capital, which increases their cost of funding, but this cost is small compared to the benefit of being able to raise deposits and implicitly guaranteed bonds.

Credit analysis

But what about credit analysis? Won’t peer-to-peer platforms be better than banks at understanding credit risks among potential borrowers? Won’t they be able to use advanced credit scoring techniques to more closely match the interest rates paid by borrowers to the risk they represent.

That is not obviously so. Even if peer-to-peer platforms had a current advantage in developing computer programs to assess risk, how will they sustain that advantage? But more importantly banks have a big advantage in credit scoring because they have the historical credit data that is the input to credit scoring models. Peer-to-peer platforms want the Federal Government to force banks to release that data, but even if the government grants that wish banks will find ways to not share it.

Another issue in credit analysis is that peer-to-peer companies will not have any ‘skin in the game’. They won’t be absorbing the credit losses on non-performing loans like banks do. They will really be more like portfolio managers, investing the funds of the lenders, but not suffering the losses from bad decisions. It is difficult to maintain proper lending standards in those circumstances.

Operating efficiency

Peer-to-peer lenders will have the advantage of being nimble start-ups that don’t have legacy computer systems, bureaucratic decision making or the heavy hand of regulation. That will certainly help them, especially in low volume niche markets.

But banks have many other advantages - the ability to provide lines of credit, bundling of credit with other products, powerful brands and more.

Medium term

Peer-to-peer lending is still a tiny part of the credit markets - SocietyOne, the biggest lender is Australia has only processed $50 million of loans. There is an expectation that these lenders can grow at the expense of banks, but I am not convinced that they can capture much more than niche markets. It might be different in the long term, but over a horizon of 5-10 years I am expecting that the peer-to-peer market will be for high risk borrowers that banks don’t want and it will end in tears for plenty of lenders.

Peer-to-peer is already here

There is a type of peer-to-peer lending that already exists and is massive - it is ‘trade credit’. Imagine my firm purchases $200k of goods or services from your firm. When the product is delivered and an invoice for payment in 60 days is sent, your firm has effectively made a 60 day loan to my firm for $200k. If each 60 days my firm pays the invoice and another invoice is sent for more product, so that there is always a $200k invoice outstanding, then your firm is effectively financing my firm with a permanent $200k interest free loan.

About $15 trillion of trade credit is outstanding at any point in time around the world. It is a massive form of financing and only a fraction of it involves banks or other intermediaries of any kind. Trade credit is pure peer-to-peer since there are firms on both sides.