Crowdfunding is the practice of funding a project or venture by raising monetary contributions from a large number of people. It has emerged as a way to raise money without involving big lenders, and therefore is often used for projects that simply would not get funding any other way. But this approach is now spreading into the loans market, via peer-to-peer lenders. I, Anne Belder (AB) interviewed Thorsten Hein (TH), Global Principal Industry Consultant - Risk Research and Quantitative Solutions at SAS.
AB: How does peer-to-peer lending work?
TH: The idea behind peer-to-peer lending is simple: bring together those with savings and those who wish to borrow money. This is how basic crowdfunding platforms work: those who want to raise money offer incentives to investors for investing different amounts of money.
AB: But isn’t the lending market more complicated than that?
TH: Yes, because what you want back is your money, plus some interest, and you also have no real way to judge risk. The peer-to-peer lending platforms have therefore adopted approaches that look very similar to those used by institutional investors to manage risk. Zopa, for instance, a UK-based peer-to-peer lender, splits lenders’ money up into ‘microloans’, which means that the risk is diversified across the portfolio of loans, so that nobody loses too much if someone defaults.
AB: Is that the only way that risk is managed?
TH: No. Zopa offers three different ‘packages’ for lenders, to balance risk and return. And borrowers are divided into ‘risk markets’ from A* to E. The distinction is by credit history, with A and A* borrowers having low debt-to-income ratios, and good history of repaying loans on time or even early. D and E borrowers may have a limited credit history, so that it is hard to judge the level of risk that they represent. Lenders’ money is spread across risk markets depending on the product they choose: only experienced investors prepared to accept higher levels of risk will lend to D and E borrowers. The estimated rate of return also takes into account the expected level of defaults across all loans.
AB: What about the jurisdiction? Are these platforms working across regions?
TH: No. Zopa is only open to UK residents, both for lending and borrowing. This means that the regulation that governs the business is very clear, and there is no possibility of confusion in law. Funding Circle, another lender which lends only to businesses, rather than individuals, works across the UK, US, Spain, Germany and the Netherlands, but lenders from each country only seem to lend to businesses in that country. Again, it makes the regulation situation much clearer. It also helps that EU countries share some regulations.
AB: Are the peer-to-peer lenders covered by full financial services regulation?
TH: No, not always, although the industry is keen to stress its regulatory credentials. Zopa was one of the founders of the Peer 2 Peer Finance Association, and was involved in getting the Financial Conduct Authority to recognise the industry. Both Zopa and Funding Circle are regulated by the Financial Conduct Authority, although neither are covered by the Financial Services Compensation Scheme, which applies when a firm that you have a claim against defaults, and is therefore ‘compensation of last resort’.
AB: What do the traditional banks think of peer-to-peer lending?
TH: Opinion seems to be divided. Some are embracing the potential. Santander, for example, has encouraged businesses that do not meet its lending criteria to try applying to Funding Circle. It’s not exactly a partnership, but definitely a tolerance, and an understanding that these lenders serve a different market, and are perhaps filling a gap in provision.
AB: But doesn’t this encourage banks to withdraw even further from risky investments and loans?
TH: No, effectively the peer-to-peer lenders have extended the market to those who were being badly served before. Banks already refuse to lend to anyone that they see as a bad risk. And with the credit crunch, that’s now quite a lot of people who would have got loans a few years ago. So without the peer-to-peer market, these people would be unable to get loans at all.
AB: So are peer-to-peer lenders getting only the risky business?
TH: Well, you might have to go to a peer-to-peer lender if you couldn’t get a loan from a traditional financial institution. But it is important to recognise that most of the peer-to-peer lenders are able to operate more cheaply, and often more transparently than banks, because they simply don’t have the overheads. So both lending and borrowing can be much simpler, with smaller fees but bigger returns even without huge risk – and who could argue with that?
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