S 2 - P2P lending Market

B B Chakrabarti
Professor of Finance
Forms of Investor Exposure to Lending
 How Does P2P Lending Work?
• P2P lending business model is different from that of banks.
• P2P platforms do not lend their own funds. They act as a
platform to match borrowers who are seeking loans with
investors who purchase notes or securities backed by notes
issued by the P2P platforms.
• Borrowers benefit from a streamlined application process,
quick funding decisions and 24/7 access to the status of their
loans.
• Investors benefit from the interest paid by the borrowers net
of fees and charges retained by the P2P platform.
• P2P platforms generate revenue from origination fees charged
to borrowers and from a portion of the interest paid by the
borrowers as servicing fees, as well as additional charges such
as late fees.
 Functions of P2P Platform
• Verifying borrower identity and characteristics;
• Assessing credit quality to ensure that interest rates for
borrowers are risk reflective;
• Processing payments from borrowers and forwarding them
to investors;
• Making data available to investors to inform their
investment decisions, such as details about loan book
performance;
• Collecting debt in cases of arrears or default;
• Conducting anti-fraud and anti-money laundering checks,
and ‘know your customer’ assessments
• Legal compliance and reporting.
• Services to borrowers, including innovative loan features
or assisting borrowers in putting appropriate propositions
on the P2P lending platforms.
 Functions of P2P Platform
• Determining the interest rate for investors, which will vary
depending on the risk profile of the loan. For some platforms,
investors can participate in an auction in which they indicate the
interest rate at which they would be willing to fund a loan
• Auto-allocation of investments to loans to help ensure portfolio
diversification within the remit or product selection set by the
investor. Some platforms automatically allocate investors’ funds
to a portfolio of loans, while others provide the option of
automatic allocation
• Buffer funds designed to cover default losses in ‘normal’ times.
With ‘tail’ risks of more extreme events (e.g. a severe recession),
when the fund gets depleted, the fund can no longer cover new
losses to investors.
• Secondary markets where investors can exit their investments
by selling the remaining loans to another investor
 Credit Risk in P2P Lending
• P2P lending also attracts borrowers who, because of their
credit status or the lack thereof, are unqualified for
traditional bank loans.
• Because past behavior is frequently indicative of future
performance and low credit scores correlate with high
likelihood of default, P2P intermediaries have started to
decline a large number of applicants and charge higher
interest rates to riskier borrowers that are approved.
• Some P2P lenders are also instituting buffer funds into
which each borrower makes a contribution and from which
lenders are compensated if a borrower is unable to pay
back the loan.
• It seemed initially that one of the appealing characteristics
of P2P lending for investors was low default rates.
• The actual default rates for the loans originated were in
fact higher than projected.
Assessing Creditworthiness of Borrowers (India)
• The borrowers are checked, verified on many grounds
before they are listed on the platform.
• P2P companies follow different parameters to evaluate the
borrower with identity, risk profile and credit history being
the major factors.
• A borrower is required to furnish his PAN, address proof,
bank statement and income details with the lending
platform. Most of the P2P platforms ask for an annual
income of Rs 2-3 lakh for salaried class.
• After online deliberations, P2P companies undertake
rigorous verification of the borrower at his residence as
well as workplace.
Assessing Creditworthiness of Borrowers (India)
• A good borrower can be live within 2/3 hours. If he is in a
remote place, it may take longer say 48 hours, post the
physical verification.
• Unlike banks, P2P platforms do not solely rely on salary
slips and Form 16 for giving personal loans.
• Self-employed individuals can also avail unsecured loans on
the platform, provided they fulfil the eligibility criteria. In
case of self-employed individuals, earning Rs 5 lakh
annually, it is checked whether they have been filing ITR on
a regular basis or not.
• They can be given loans once their bank statement is
verified along with their proof of identity and address.
Assessing Creditworthiness of Borrowers (India)
• Online lending companies may also refer to unconventional
sources like Facebook, Twitter and e-commerce sites to
assess a borrower’s credit worthiness. This means, if you
have checked for credit card offers and personal loans too
often, it may not leave a great impression with these data-
driven lending firms.
• Most P2P lending companies use technologies like data
analytics, social modelling to understand the borrower
profile. P2P companies look at alternative means to verify
applicant’s personal details, cash flow and repayment
record.
Assessing Creditworthiness of Borrowers (India)
• Risk Categorisation
People with credit score below 700 are highly unlikely to
get a bank loan. But P2P companies divide borrowers in
different categories -- namely very high risk, high risk,
medium risk, low risk and very low risk. Depending on an
individual’s financial history, income and repaying capacity-
the borrower is given a rating by the concerned platform.
• Can anybody get loan?
• Despite the flexibility, the KYC norms and credit assessment
algorithm are in place. For about 40,000 applications, only
1500 people go live. That is, only about 4-5 percent get
approved.
 FICO Score
• A FICO score is a type of credit score created by the Fair
Isaac Corporation. Lenders use borrowers' FICO scores
along with other details on borrowers' credit reports to
assess credit risk and determine whether to extend
credit.
• FICO scores take into account various factors in five
areas to determine credit worthiness: 1) payment
history, 2) current level of indebtedness, 3) types of
credit used, 4) length of credit history and 5) new
credit accounts.
• To determine credit scores, the Fair Isaac Corporation
weighs each category differently for each individual.
However, in general, payment history is 35% of the
score, accounts owed is 30%, length of credit history is
15%, new credit is 10% and credit mix is 10%.
P2P Average Loss Rate
 Interest Rates
• One of the main advantages of P2P lending for borrowers
can sometimes be better rates than traditional bank or
other borrowing rates. The advantages for lenders can be
higher returns than obtainable from a savings account or
other investments, but subject to risk of loss, unlike a
savings account.
• Interest rates and the methodology for calculating those
rates vary among peer-to-peer lending platforms.
• The interest rates may also have a lower volatility than
other investment types.
• The spread between borrower and investor interest rates is
about 4%.
• The returns to the investors in P2P platforms are broadly
consistent with the typical yields of high-yield corporate
bonds with ratings of BB or B. This is broadly in line with
what one might expect given the risk–return trade-off.
 Managing Risk for Investors
• P2P platforms have to manage individual loan
default risk, liquidity risk and platform risk.
They carry out the following functions:
• Credit risk assessments and interest rate
management
• Diversification
• Smoothing returns with buffer funds
• Providing liquidity through Secondary market
• Managing platform risk
 Managing Risk for Investors
• Credit risk assessments and interest rate management
• P2P platforms operate credit risk assessments in line with
those used by other lenders (including banks and non-
bank lenders) and produce similar outcomes in terms of
losses due to default.
• They use credit risk models broadly similar to those used
by traditional lenders using data from credit reference
agencies and other sources. These assessments are used
to credit-score borrowers and to take decisions about
whether to facilitate loans to them, and in determining
the risk-reflective interest rate.
• The range of credit scores accepted varies across
platforms, depending on the business model.
 Managing Risk for Investors
• P2P platforms use the credit risk assessments, along with
other mechanisms, to help manage the interest rates
that are set to produce appropriate rates of returns for
investors (i.e. ensuring that rates cover at least expected
loan losses).
• Diversification
• A key benefit of P2P lending is that it enables even
relatively small investors to benefit from risk
diversification by, first, offering a new asset class for
them to invest in and, second, enabling them to spread
their total invested amounts over a large number of
loans through the P2P platform.
• To encourage risk spreading, a number of P2P platforms
are employing auto-diversification tools, some of which
are optional (typically with business lending) and some
mandatory (typically with consumer lending).
 Managing Risk for Investors
• Smoothing returns with buffer funds
• A number of P2P platforms have developed buffer
funds to help cushion investors against default
losses. Buffer funds can therefore change the risk
profile faced by investors.
• These funds can be expected to reduce or remove
the uncertainty created by default during ‘normal’
times (at the cost of lower return rates), but in more
severe economic scenarios could become depleted
and no longer cover default losses.
 Managing Risk for Investors
• Providing liquidity through Secondary market
• Most P2P platforms are facilitating loans with durations of a
number of years. Investors therefore value mechanisms put in
place by platforms that create the possibility to sell their
remaining loans to another investor (if there is another
investor willing to take on the loans), to allow them to access
their funds before loans are repaid.
• Most platforms therefore provide secondary markets where
investors can sell their remaining loans to other investors.
• The underlying asset remains the key determinant to the
liquidity of the investment, and the ability to sell the
remaining loans is not guaranteed.
• Most platforms charge for the use of the secondary market,
and investors may also face additional costs or losses when
they sell their remaining loans if interest rates have moved
against them.
 Managing Risk for Investors
• Managing platform risk
• For investors, another key risk factor is likely to be platform
risk—in particular, what would happen to their investment if
the platform were to fail.
• This is also an area of importance for regulators, in terms of
both ensuring that financial markets work well and in the
interests of consumers, and in ensuring financial stability.
• Some measures taken by platforms are:
a) Resolution plans describing how loan repayments will
continue to be collected. These include features such as fully
funded run-off plans, contracts with back-up services
providers, and the setting-up of bankruptcy-remote
vehicles/SPVs that these providers can administer in order to
wind down portfolios of loans
b) Minimum capital requirement
 P2P Operational Business Models in India
• P2P lending platforms are largely tech companies, acting as an
aggregator for lenders and borrowers thereby, helping create
a match between them. Once the borrowers and lenders
register themselves on the website, due diligence is carried
out by the platform and those found acceptable are allowed
to participate in lending/borrowing activity.
• The companies often follow a reverse auction model in which
the lenders bid for a borrower’s loan proposal and the
borrower has the freedom to either accept or reject the offer.
• Some platforms provide several additional services like credit
assessment, recovery etc. In most cases, the platform
moderates the interaction between the borrower and the
lender. The documentation for the lending and borrowing
arrangement is facilitated by the P2P platform.
 P2P Operational Business Models in India
• The lender transfers money from his/her bank account to
borrower’s bank account. The platform facilitates collection of
post-dated cheques from the borrower in the name of the
lender as a proxy for repayment of the loan. The P2P forum, in
general, also helps in the recovery process and as part of this,
follows up for repayments and if need be, employs recovery
agents too. Though these platforms claim to follow soft
recovery practices, the possibility of use of coercive methods
cannot be ruled out.
• In this elementary model, the lending is primarily from one
individual to another. The regulatory concerns in such cases
would relate to KYC and recovery practices. Since all payments
are through bank accounts, the KYC exercise can be deemed
to have been carried out by the banks concerned.
 P2P Operational Business Models in India
• In India, some P2P lenders are involved in the business targeted at
micro finance activities with the stated primary goal being social
impact and providing easier access of credit to small entrepreneurs.
One of the main advantages of P2P lending for borrowers has been
lower rates than those offered by money lenders/unorganized
sector and the advantages for lenders are higher returns than what
conventional investment opportunities offer.
• Interest rates and the methodology for calculating those rates vary
among P2P lending platforms. They range from a flat interest rate
fixed by the platform to dynamic interest rates as agreed upon by
the borrowers and the lenders to cost plus model (operational costs
plus margin for platform and returns for lender).
• There is no credible data available regarding total lending through
P2P platforms in India. There are around 30 start-up P2P lending
companies in India.
 Crowdfunding vs P2P Lending
• Crowd Funding
• “Crowd Funding' generally refers to a method of funding a project
or venture through small amounts of money raised from a large
number of people, typically through a portal acting as an
intermediary.
• There are numerous forms of crowd funding: some are charitable
donations that provide intangible benefits but no financial returns;
others, such as equity crowd funding would fall within the domain
of financial markets.
• Peer-To-Peer Lending (P2P Lending)
• P2P lending is a form of crowd-funding used to raise loans which
are paid back with interest. It can be defined as the use of an online
platform that matches lenders with borrowers in order to provide
unsecured loans.
• The borrower can either be an individual or a legal person requiring
a loan. The interest rate may be set by the platform or by mutual
agreement between the borrower and the lender.
 Crowdfunding vs P2P Lending
• Fees are paid to the platform by both the lender as well as the
borrower. The borrowers pay an origination fee (either a flat rate
fee or as a percentage of the loan amount raised) according to
their risk category. The lenders, depending on the terms of the
platform, have to pay an administration fee and an additional
fee if they choose to use any additional service (e.g. legal advice
etc.), which the platform may provide.
• The platform provides the service of collecting loan repayments
and doing preliminary assessment on the borrower’s
creditworthiness. The fees go towards the cost of these services
as well as the general business costs. The platforms do the credit
scoring and make a profit from arrangement fees and not from
the spread between lending and deposit rates as is the case with
normal financial intermediation.
• While crowd funding - equity, debt based and fund based- would
fall under the purview of capital markets regulator (SEBI), P2P
lending would fall within the domain of the Bank.
 Regulation of P2P Lending
• Arguments for regulation
• Considering the significance of the online industry and the
impact which it can have on the traditional banking
channels/NBFC sector, it would be prudent to regulate this
emerging industry. In its nascent stage, this industry has the
potential to disrupt the financial sector and throw surprises. A
sound regulatory framework will prevent such surprises.
• P2P lending promotes alternative forms of finance, where
formal finance is unable to reach and also has the potential to
soften the lending rates as a result of lower operational costs
and enhanced competition with the traditional lending
channels. Therefore, the importance of these methods of
financing needs to be acknowledged. If properly regulated,
the P2P lending platforms can do this more effectively
• If the sector is left unregulated altogether, there is the risk of
unhealthy practices being adopted by one or more players,
which may have deleterious consequences.
 Regulation of P2P Lending
• Arguments against regulation
• Regulating an exempt or nascent sector may be perceived as
rubber stamping the industry through regulation, thus lending
credibility to the P2P lending. This could attract lenders with
low awareness to these platforms who may not understand
the risks involved specially in the context of susceptibility of
these platforms to attract high risk borrowers.
• Regulations may also be perceived as too stringent, thus
stifling the growth of an innovative, efficient and accessible
avenue for borrowers who either do not have access to formal
financial channels or are denied loans by them.
• The market for P2P lending is currently in a nascent stage and
they neither pose an immediate systemic risk nor any
significant impact on monetary policy transmission
mechanism.
 Top 5 Global P2P Lending Sites
Venture Inception Activity

Lending Club, US 2007 Consumer loans, small business loans, medium

sized business loans, patient solutions, education
loans
Upstart 2012 Student loans, credit card refinance, personal
US loans, car loans, medical loans

Funding Circle, 2010 Business loans

UK, Europe and US

Prosper Marketplace 2005 Business loans, personal loans, medical loans,

US debt consolidation

SoFi 2011 Student loan, medical / dental loan, mortgages,

US personal loan, parent loan,
 Why Platforms Fail?
• The reasons for exit include:
1) Failing to develop sufficiently effective credit risk
assessments - Ex: Quakle, YES-secure
2) Failing to develop an effective business model
for reaching the market for borrowers and
investors – Ex. LendingWell and Fruitful in UK
3) Acquisition by a competitor – Ex: Mayfair
Bridging and GraduRates in UK
4) Misconduct, fraud etc. – Ex: Be The Lender in UK
 Case Study – P2P Platform Closure
Platform Start Description Reason for Exit Impact on
/ End Investors
Quake 2010 Providing consumer Borrower assessment 100% investor
UK 2011 loans. based on group scores losses
One of the smallest ’similar to seller
platforms in the UK, feedback scores on
and is understood to Amazon’. Ineffective
have only lent £16,000 risk-assessment with
in total. default rate close to
100%.
YES 2010 Borrowers were often Focus on high-risk Investors’ loans
-Secure 2014 individuals who had borrowers, late were bought
UK been denied funding payments and defaults. out and likely
elsewhere. High-risk that all
funding with relatively investors
high yield of up to received their
18%. money back.