The growth of peer-to-peer lending platforms and prospects for banks’ disintermediation – hype or real threat?

Paolo Siciliani.

Peer-to-peer lending platforms (P2P platforms) emerged after the financial crisis by catering for pent-up demand for unsecured borrowing from individuals and small businesses.  Ten years after the conception of P2P platforms, the question is whether they may soon start to penetrate more mainstream lending markets and thereby challenge high street lenders.  For example, according to the latest survey compiled by Nesta, P2P lending for the year 2015 was the equivalent of 3.9% of new loans lent to SMEs, although the outstanding stock of P2P lending is much lower.  This post considers how seriously in practice to take this threat to the traditional banking model.

Lower capital adequacy requirements

It is argued that P2P platforms typically enjoy three advantages over traditional banks:

• an absence of legacy operating costs, typically linked to banks’ extensive branch networks and IT systems which are more difficult to update;
• no need to obtain access to payments infrastructures; and,
• no capital requirements and no levies charged to belong to the public deposit guarantee scheme.

The first two items are not in question.  Regarding capital requirements, the Financial Conduct Authority introduced minimum capital standards with volume-based decreasing rates, where the highest rate is 0.2% over the first £50 million of total value of loaned funds outstanding.  This compares to a 3% minimum leverage ratio (that is, a capital floor based on gross exposure) for large banks and building societies.

As well as being subject to more stringent minimum capital requirements banks are also able to access the public deposit guarantee scheme (in the UK, the Financial Services Compensation Scheme), which means that they can raise retail deposits at cheaper rates than P2P platforms.  However, most P2P platforms have set up their own ‘provision funds’.  For example, Zopa’s Safeguard Fund has accumulated provisions of above £11MN against a stock of loans of around £625MN at the end of Q3 2015.

The rates offered on P2P platforms are generally higher than for comparable saving products offered by banks.  For example, Zopa currently advertises expected rates of 3.5% and 4.5% (with a 1% fee for early withdrawal) for loans up to 5 years, compared to top-ranking rates of below 3% for 5 years fixed rate bonds.  In contrast, borrowing rates are similar, with the likes of RateSetter and Zopa among the top 30 offers for personal loans, alongside traditional banks and other financial operators.

It therefore seems that the key to growing market share for the P2P platforms is their ability to raise large enough levels of funding whilst keeping funding costs at competitive levels.  In this respect, there seems to be two main options:

• Raise more from retail savers/investors, that is, notwithstanding the lack of public deposit guarantee: as put by the CEO of Ratesetter, “[i]f people start pricing us as a safe place then we will become much more competitive,” and/or
• Raise funds from institutional investors (such as insurers and other financial institutions).

Whilst the role of institutional investors is growing among UK-based P2P platforms, Nesta found that more than two-third of their funding is still based on retail investors.  In what follows we focus on the latter type of investor.

What it would take for P2P platforms to really disrupt banks

With respect to retail investors/savers, as the quote by the CEO of Ratesetter above suggests, the key factor could be whether retail investors come to believe that putting their savings in P2P notes is as safe as the comparable retail banking products, notwithstanding the existence of the deposit guarantee protection available for the latter.  The perception of the relative safety of P2P platforms could improve if they succeeded at poaching safer borrowers, thus yielding a stronger risk-adjusted return off their lending portfolios.

Assuming equal access to screening and monitoring capabilities for the sake of argument, P2P platforms’ lower operating costs (that is, notwithstanding the higher funding cost) would allow them to use lower lending rates (and/or larger credit limits) to cherry-pick lower-risk customers.  Lower rates in turn would tend to improve the risk profile of borrowers, thanks to a comparatively lower debt-repayment burden, which would also tend to improve borrowers’ success rate and thus ability to pay back the loan (so-called ‘risk shifting effect‘).

In the event that non-bank lenders succeeded in poaching safer borrowers from traditional bank lenders, it is possible that banks’ credit risk exposure would correspondingly worsen, given the increased probability that those being granted loans are relatively less creditworthy.  The resulting weakening of the risk-adjusted return of banks’ lending portfolios might then lead to a vicious cycle, whereby banks’ attempt to recover profitability, either by increasing lending rates and/or by reducing deposit rates, further improves the relative convenience of P2P platforms for both retail savers and borrowers.  Alternatively, banks might try to pre-empt cherry-picking by matching prices, thus cutting their net interest rate margins until the P2P challenge subsides (that is, akin to a ‘war of attrition’).

If played out on a large scale, such a disintermediation scenario could raise concerns about financial stability as traditional bank lenders would be weakened.  Meanwhile, P2P platforms might be exposed to a sudden halt in funding flows in case of a loss of confidence in their ability to screen and monitor borrowers were to crystallise.  This is particularly so if retail savers/investors in P2P platforms were under the impression that they could easily withdraw their money by promptly reselling their notes; whereas this is only to the extent that there are other investors willing to buy them (re., perception of liquidity).

Nevertheless, the plausibility that such a scenario could actually unfold depends on a number of factors.  On the side of borrowers, the initial disadvantage in the cost of funding faced by P2P platforms must not be so large that they can only target higher risk borrowers even within those lending categories where banks’ capital requirements are high (for instance, personal unsecured loan and credit card exposure).

On the side of lenders, it is questionable whether the average retail investor/saver has the level of expertise (or the inclination) needed to work out whether the risk adjusted return offered by P2P platforms is sufficiently higher to outweigh the advantage associated with the protection offered by the public deposit guarantee scheme.

The case for persisting concentration among P2P platforms

Indeed, it could be argued that it is thanks to that deposit protection that retail depositors may be more willing to choose a small/new bank over a large established incumbent.  In contrast, since lenders in P2P platforms are fully exposed to credit risk, retail investors might come to rely on attributes such as brand familiarity and/or relative size of the P2P platform in question as a proxy for the safety and soundness of the corresponding investing proposition.  For example, relative size may be taken into consideration when considering how easy it would be to promptly withdraw invested funds by reselling to other lenders.  Therefore, less established P2P platforms might find it difficult to challenge incumbent ones, thus raising concerns as to whether the resilience of this alternative lending channel might be jeopardised because of a persistently highly concentrated structure.

Arguably, the plethora of challenging P2P platforms might find it very hard to offset this disadvantage by credibly promising a risk-adjusted return that is higher than for established platforms (i.e., higher quality). Although the lack of expertise discussed above may over time be eased with the assistance of comparative tools such as so-called robo-advisors, it takes considerable time for this quality claim to be verified, given that the negative impact of defaults tends to accumulate towards the end of the loan term which is typically of 3 to 5 years. Therefore, it is plausible to argue that the observed very high levels of concentration among P2P platforms (in particular, when looking at individual lending categories such as personal loans, SME lending or property loans) is likely to persist.

Conclusion

Whilst traditional banks and P2P platforms are fungible from the perspective of retail borrowers, they differ from a retail saver/investor perspective.  The main distinction is of course that with peer-to-peer platforms retail investors are fully exposed to credit risk.

The threat of bank disintermediation is therefore based on the extent to which P2P platforms can mitigate this shortcoming.  In theory, P2P platforms could be able to poach safer borrowers thanks to their operational (and regulatory) cost advantage, and thus be able to promise a superior risk-adjusted return.  The extent to which this would be enough to persuade retail depositors to put their savings outside the scope of the public deposit guarantee is something that will need to be closely monitored in the future.  This is particularly true to the extent that the current level of concentration among P2P platforms is found to persist.

Paolo Siciliani works in the Bank’s Policy, Strategy and Implementation Division.

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