Peer to Peer Lending-Opportunity or Looming Risk
Banks are the primary lenders when it comes to satisfying individual and small business finance needs. Banks have expanded their network of branches, ATMs, BCs and alternate delivery channels under outreach programmes. As the economy grows more and more individuals and business entities are availing banking facilities. Government has also promoted it through various programmes and drives. However, there are sections of society which are un-served or underserved by banking system in the country especially for their funding needs.
Banks, being the custodians of public money, have developed robust risk management frameworks to secure the interests of all the stakeholders. Resultantly many customers do not satisfy the criteria set by the banks for granting loans. Similarly MSME units who operate with thin margins and do not have sufficient collaterals to secure their loans find it difficult to obtain unsecured loans at the lower interest rate. Such customers usually opt for alternate sources of finance.
Further banks run with brick and mortar branches leading to heavy operational expenses. Hence lower Net Interest Margin restricts the banks to offer lucrative rates on deposits. People chasing higher returns than FDs go for the alternate investment avenues and here comes peer to peer lending into the play.
Peer to peer lending refers to the loans extended by individuals and small businesses to another individual or small business without any intermediation from banks. P2P lending is a form of financial technology which helps the people to come to the P2P portal which is a marketplace of investors and borrowers. At P2P website those borrowers may get loans which are otherwise not eligible or do not meet bank’s criteria while investors may get higher returns than the traditional investments.
History and Market Overview
P2P lending commonly known as social funding or crowd lending is a relatively new phenomenon. P2P lending finds its origin in United Kingdom back in year 2005. Zopa was the first peer to peer lending company after which Prosper Marketplace launched in 2006 in United States. After financial crisis of 2007-2008 it gained momentum as more people turned to P2P lending sites while banks became more cautious and risk averse.
Afterwards the concept spread across the countries like China, Australia and New Zealand etc. In India it was 2012 when P2P lending was first introduced. Presently around 30 P2P sites such as LenDenClub, i2i, CRED, BharatPe are engaged in lending to individuals and small businesses. Owing to the higher returns, the innovative concept has witnessed consistent growth in the business and the market size is estimated to grow to USD 4 billion by 2026 as per a report by PwC.
LenDenClub is the oldest P2P lending platform in India operating since 2015 with over 1 Crore customers and over Rs.13000 Crores invested through this platform. It offers 12% returns on investments. It has different products wherein investors may invest in lumpsum or on monthly basis. Similarly funds may also be withdrawn at maturity or at monthly intervals. It boasts hyper diversification also known as fractional investment as its core values wherein investment is broken down to as low as Rs.1.00 to numerous loans to minimize the default risk.
Mobikwik Xtra has features like no lock in with free withdrawals and it offers additional 1% for fixed tenure investments. Investor community of 1.5 lacs plus has invested more than Rs.2110 Crore through this portal. It claims 12% returns to all the investors with zero investment fee.Some other platforms include Finzy which allows the investors to customize in terms of investment period, amount and risk while CRED credits the interest earned on daily basis so that investor may track the performance in real time basis. Faircent and i2i Funding boast returns as high as 20% and 30% respectively.
Many other players are also operating in the market with different positioning strategies through product differentiation in terms of segments, returns, ticket size, extent of assistance in recovery and customization in terms of lending.
As per an Experian report, around $350 billion has been given out digitally in the country till date out of which 36% customers are new to credit means they have started their journey of borrowing with a digital loan.
Process of P2P Lending
Usually a P2P portal or website facilitates the entire process. Both investors and borrowers register themselves at P2P portal by opening an account. Borrowers are classified into various credit risk categories based on the credit assessment model designed by the portal after analyzing several data points like qualification, occupation, credit history, income, social media activities and app usage etc. Data-driven approach, allows investors to have multiple options to choose from pool of credit worthy potential borrowers
Borrowers post their funding needs at the portal which is visible to all the investors registered at the portal along with the assigned risk category to the particular borrower. Interest rates and terms of finance are mostly decided by the portals. Investors may choose from any borrower class most suitable to their individual risk appetite.
Borrowers may also increase the rate of interest to attract more investors which increases the probability of getting an advance. Upon accepting the offer by both the parties lending transaction is carried out. Matching of the offers is technology driven.
P2P portals use electronic KYCs most of the time which saves on cost and time. Loan underwriting is data driven by way of proprietary algorithms. Loan documents are generated digitally and digital execution of loan documents may also be explored by these portals as it significantly reduces the handling, storage and retrieval costs. Disbursement is effected through digital banking while collection is done largely through e-mandates. Entire process is digital and tech driven, cutting the processing time and allows the portals fast disbursals.
Advantages of peer-to-peer lending platforms
P2P lending sites offer better rate of returns than bank deposits to its investors. It also offers availability of credit to those borrowers which do not have access to bank finance. Since entire process is online hence these companies operate with lower operational expenses resulting in lower fee to borrowers. Platform facilitation fee usually ranges between 1-3%. Cutting edge technology helps to render fast and quality service with customized products. Many P2P platforms offer higher rate of returns which may even go to 20%-30%.Needless to say that these investments are much riskier than the bank deposits and carry default risk which is directly borne by the individual investors.
Interest Income from P2P lending is taxable just like any other source of interest income such as FDs. So if someone falls under 20% tax bracket, post tax rate of return in above example would arrived at 11.20%.
Risks involved in P2P Lending
P2P lending sites only facilitate the lending transactions and their funds are not involved in the lending which means that funds of investors are directly lent to borrowers without any intermediation of any bank. Though these sites undertake due diligence and physical verification of credentials of the borrowers yet investors are exposed to the greater risk of default and fraud. Loss given default is further deteriorated due to the unsecured nature of advance. Majority of investors may not be capable to assess and quantify the risk involved in the transaction. As a risk mitigant, some companies like Zopa and RateSetter in UK maintain reserve fund to provide compensation in case of default.
Investor awareness becomes very important in such a scenario where unsecured loans are granted with higher rates as investors are exposed to so many risks. General prudence is advisable on the part of investors before entering the P2P lending market. One should understand the various types and extent of risks involved in the process to safeguard hard earned money. As P2P portals work on different set of terms and business models, individual lenders should compare them to find the best match in view of financial goals, risk tolerance, and investment strategies
In India RBI has prescribed an upper limit of Rs.50000/- single lender can lend to same borrower. This prudential norm ensures diversification to provide protection to the investors against expected level of loss.
In case of economic disruption as witnessed during covid pandemic, defaults and losses may increase substantially. Industry need to address such issues and educate the investors in order to enhance awareness among the participants.
Further in absence of deposit insurance the fate of public money in case of platform failure or operational failure and bankruptcy has not yet been discussed much. Although many sites, such as Zopa, allow investors to sell loans they hold for a fee. Cyber security and data leakage risk also need to be looked into.
In India several factors have impacted the growth of P2P portals. Turmoil caused by failure of IL&FS, one of the largest NBFC, triggered regulatory tightening and limiting the regulatory arbitrage by RBI. Loan app scams mainly by unregistered Chinese entities and reported incidents of suicides in some parts of country on account of unethical means of recovery had also prompted the regulator. Covid caused economic slowdown was also among some major issues which the sector faced.
Regulatory Framework in India
RBI issued guidelines in regard to P2P lending platforms in October 2017 giving all the P2P platforms a legal recognition. Now P2P lending companies have to register themselves mandatorily with RBI. Based on the technological, entrepreneurial and managerial resources along with capital structure, approval is accorded by RBI.
P2P lending company can act as an intermediary providing an online marketplace or platform to the participants involved in Peer to Peer lending however it cannot accept deposits or lend on its own. Only unsecured loans are permitted. P2P lending company is entrusted with responsibilities of undertaking due diligence on the participants. As per RBI guidelines P2P portal will also be responsible for credit assessment and risk profiling of the borrowers, documentation of loan agreements, assistance in disbursement and repayments of loan amount and recovery of loans originated on the platform. Leverage ratio has been capped at 2. Aggregate exposure of a lender to all borrowers at any point of time, across all P2P platforms, is capped at Rs.50,00,000 while aggregate loans taken by a borrower at any point of time, across all P2Ps, is capped at Rs.10,00,000. Maturity of the loans not to exceed 36 months. Fund transfer between the participants on the Peer to Peer Lending Platform shall be through escrow account mechanisms which will be operated by a bank promoted trustee. NBFC-P2P has to become member of all CICs and submit data to them.
Road Ahead
Despite these challenges, peer to peer lending remains a viable option for those looking for alternative investment opportunities with potentially higher returns than traditional bank deposits. After the legal recognition by RBI transparency has increased which will improve the sense of confidence in the minds of investors. Government’s promotion to digital economy through Public Digital Infrastructure, India Stack and Aadhar enabled services have also helped to a great extent in rise of digital lending. Technological advancements such as Block Chain and Machine Learning has changed the lending landscape as the process of frictionless lending and rendering customized financial services has significantly improved. Further historical data relating to the returns provided by existing P2P players is also attracting new pool of investors. Market size of global P2P lending was approximately at USD 153 billion in 2022. Large players such as Amazon, Google and Face book have entered into the market of digital lending which may prove to be threat for smaller firms yet with the expected standardization in the industry, demand from SMEs, Real Estate and consumer credits the industry is bound to grow in coming years. Indian market is likely to grow at a CAGR of 21.6% between 2021 and 2026 and same is likely to reach at USD 10.5 billion by 2026 as per a report of IndustryARC.
Banker’s Perspective
Commercial banks have evolved their process of service delivery through adopting latest technologies such analytics/machine learning. Traditional banks as well as new age banks are trying their level best to keep up the pace with ever changing needs and expectations of Gen Z customers who want innovative solutions at lightning speed. Availability of easier solutions on finger tips with utmost convenience and least time has become the key criteria for selecting service provider. Gone are those days when customers used to visit bank branches frequently for trivial tasks. In fact fierce competition and expectations have rose to the next level that banks are investing heavily in latest technology to analyse the trends, understanding the customer behaviour, pattern and their needs so that innovative solutions may be provided which paves the way for sustainable growth. Recent digital transformation and technological disruption to provide frictionless credit has changed the lending landscape in India. Be it emergence of Fin-techs and Lend-tech or digital payments through UPI or digital lending through pre approved loans entire industry is undergoing transformation which not only provides business opportunity for the banks in form of new avenues of generating revenue and enhancing customer base but also throws challenges in regard to stiff competition from new age banks and fin-techs who offer faster delivery of services with customized solutions. Banks usually follow the traditional methods of lending involving paperwork and formalities which are time consuming and cumbersome while P2P platforms lending depend on data-driven AI and ML technologies.
As far as the P2P lending is concerned it cannot be considered as a significant threat to the banks as long as it caters to the underserved segments. Owing to the huge difference in brand image, skills and resources, currently banks do not see them as competitors. However as it gains momentum with the standardization in the industry, increased awareness among borrowers and more capital providers adopting the digital mode leading to the softening of interest rates, it is quite possible that P2P platforms may diversify their products into education loans and mortgage loans in future. Capitalizing on the accessibility, convenience, innovation and tech driven solutions experienced P2P platforms may create disruption in the industry and resultantly eat out the market share of banks specifically in personal and MSME segments as many customers prefer easy, fast and unsecured loans setting aside the interest rate as ticket size is smaller and these loans are granted for shorter duration.
Rather than competing with P2P platforms banks may consider collaborating with them. Collaborating with a P2P platform will provide banks opportunity to serve the big chunk of underserved segment at lower cost. This will help the banks strengthen their balance sheets and improve bottom lines. Legislation and regulatory guidelines play a key role in this partnership. For example, UK banks must refer the borrower to an alternative lender which they have returned or rejected as per the legislation. Banks may utilize the tested algorithms and proven technologies of P2P platforms to serve small businesses wherein they may get credit in a day. Banks may also explore a new revenue source by selling pool of high yielding loans of P2P platforms to the investors.
Conclusion
Evolving needs of customers and technology has revolutionized the industry leading to the rise of frictionless credit. Peer to peer lending is likely to create a disruption in future and may bring transformation. It has the potential to change the way of lending. Putting in place the measures to protect Investor money is a key challenge which may be addressed through applying risk mitigating strategies and awareness among all. Platforms need to strengthen their internal system along with highest levels of corporate governance while investors have to manage the risks effectively. Government and regulator play a crucial role to promote the digital lending by adopting self regulation or least regulation strategies in initial phases. Banks may become partners to be a part of growth story while individuals and small businesses being the biggest beneficiaries of frictionless and easily accessible credit.
