Making Sense of P2P Lending

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P2P lending is about connecting lenders and borrowers on a platform to achieve a win-win situation.

Lenders are usually individuals (like you and me) although institutions and funds are increasingly allocating capital to this asset class.

Borrowers can be individuals who seek loans to pay for big ticket personal expenses, credit card bill consolidation, downpayment, studies, wedding, you name it. But businesses globally are also using P2P lending and crowdfunding platforms to fund their working capital, expansion plans, new product development (3D printer, movies) etc.

What are the reasons for investing in P2P lending?

You can find a useful list of the top 10 reasons here at lendacademy.

In summary, it’s about investing in real people and making real impact. It’s about individuals being empowered with more choices to invest, in an inclusive, accountable and transparent manner.

From the rational perspective, it’s about delivering potentially competitive fixed income returns and adding diversification to one’s portfolio.

As an investor/lender, what should you look out for before investing?

A recent study by Nesta found that the interest offered, risk rating and the financial track record of the company were deemed important factors in a lender’s decision at FundingCircle.

Some platforms categorize borrowers into different credit rating bands and assign borrower interest rates accordingly; others depend on market demand and supply of funds for each loan request to determine the final interest rate via an auction or bidding process.

Although high interest rate is a pull factor, there is no free lunch. Investor should assess expected returns along the risk-reward paradigm – consider returns against the risks of default. The 5Cs can be a good starting framework to get a sense of the borrower.

Beyond (naive) Credit Scores

However, banks have become rather mechanistic when it comes to credit scores. Credit scoring has become a cookie-cutter, one size fits all approach that ignores many other salient information about a borrower. A borrower’s profile in the larger community such as awards, endorsements, brand, ethics and social responsibility can be assessed and should be taken into consideration. These “softer” qualitative aspects give much more insights than naive credit scores alone on a borrower’s reputation and trustworthiness. Credit scores and financial ratios are just subsets of a company’s personality.

This is where p2p lending can make a difference in this age of connectivity. Traditional bankers have no time to assess the other parts and find it too painful (read unprofitable) to lengthen the discovery process for small loans. They make do with the minimum and brandish “take it or leave it” propositions for the small borrowers. A new breed of lenders – p2p lenders, can do a better job in enhancing information discovery with collective wisdom, and rehash the status quo towards a more inclusive financial system that could benefit many.

 How viable are P2P loans as an investment after all?

As there is no data in the local context, let’s draw inference from the U.S. and U.K.

P2P Platforms Country Borrower Average net return Default rate / loss rate Members / Accounts Loans made to date
Funding Circle UK Corporate 6.2% 1.6% 46,693 £109,302,160
ZOPA UK Individual 5.0% 0.8% 500,000 £315,730,870
Lending Club US Individual 9.5% 4.0% 56,042 $1,874,124,150
Prosper US Individual 9.3% 7.7% 1,600,000 $500,000,000

Sources: compiled from respective P2P platforms

 

How did P2P loans perform during market turmoil?

During the global financial crisis and the ensuing deep recession, S&P 500 saw an annualized loss of about 6% from 2007 to end 2009. Correspondingly, Prosper reported that the median return across all its lenders was negative 3.2%. Ask any fund manager, that’s relative out-performance!

Comparative Non-Performing Loans and Default Rates

More recently, Moody’s reported that the default rate for global speculative-grade (most risky) corporations at the end of first quarter of 2013 was 2.4%. The default rate for this category of corporations was 2.9% and 1.8% in the U.S. and Europe respectively. Further, according to data from the World Bank, bank non-performing loans (NPL) to total gross loans in the U.K. and the U.S. was around 4% in 2011-2012.

In Singapore, if we use corporate bankruptcies and banks’ NPL to SMEs as proxies to default rates, the case for lending to local companies is encouraging. As you can see from the charts below, there were very few bankruptcies (relative to the system) and NPL ratios of SME loans are not only on a downward trend but at only slightly over 1%, it is far more benign compared to U.K. and the U.S.

Screen-Shot-2013-06-11-at-1.12.47-AMScreen-Shot-2013-06-11-at-1.12.33-AM

So, will you consider lending to a group of Singapore SMEs?