How Should Banks Respond?
P2P is probably most readily associated with the
consumer-focused Zopa, which claims to have created the market almost ten years
ago. However, the Chart shows that small businesses are also benefitting from
this new technology:
P2P Lending: 2013
There is potential for P2P to change the way that businesses are
financed. A key question for banks and other organisations serving small
business is:
Is this an Opportunity or a Threat for Banks
The answer to this is, in part, dependent upon whether P2P is
here to stay.
P2P has started to do something that banks either cannot or will
not – filling the “financing gap”. Bankers have typically complained of the
high “costs to serve” and lack of transparent financials associated with small
businesses. Have P2P platforms cracked something that the banks have struggled
to do for decades or even centuries?
Algorithms Linked to Social Networks
Are the P2P algorithms, with their linkages to social networks,
really so much more robust than those developed by leading banks? Does this
mean that they are better able to understand risk than the banks?
Traditionally, lending to small business has been relationship
driven, which tends to be high cost in terms of both attracting suitable
borrowers and in the credit analysis process. It is not difficult to imagine
that there can be efficiencies in web-based customer acquisition, but this is
available to online lenders without their being P2P. The P2P platforms could
really have a sustainable advantage if their credit analysis is capable over
the complete cycle of predicting probabilities of default (“PDs”), loss given
default (“LGDs”) and the resultant Expected Losses (“ELs”). So, if P2P
platforms remain better able to mine useful credit intelligence from social
networks, the banks could face increasing competition.
Pricing Decisions
Lenders are probably not being altogether altruistic when they invest surplus funds across a P2P platform. The vast majority will, of course, be seeking to achieve a higher return than they could expect from a bank deposit. It is likely that all, or most, such lenders will appreciate that there is a significantly different risk profile in cutting out the middleman – i.e. a bank with deposit protection. Does the P2P lender: (i) have access to the risk adjusted return models which are standard in the banking industry, and (ii) have the ability to make informed investment decisions based upon these?
Funding Cost Advantage
It is true for the vast majority of P2P lenders that they do not suffer the formal requirement to allocate shareholder capital against their lending as is imposed upon the banks through the Basel regulations. While P2P lenders might consider their opportunity cost of capital to be low, this might be a little misleading relative to the funding advantages (leverage and often zero interest deposits) enjoyed by the banks. Banks have learned over many decades how to price for increasing tenor and this is something that might be new to P2P lenders.
Portfolio Diversification
One of the attractions of P2P lending appears to be that the transaction costs for lender are very low, meaning that it is quite easy to construct a portfolio of loan participations. The ability to diversify across several (or many) borrowers might be a comfort to lenders, but do they have the tools to assess whether they are achieving diversification benefits? How significant is the potential that their portfolios contain unrecognised concentration risks? In banking, there is a saying:
“Concentration kills”…
Investor Protection
Several P2P platforms state that they are able to offer varying levels of investor protection, and if effective this could be a good mitigant for the above objections. For example: Landbay says it offers “protection funds”; Lending Works says it has “insurance”, and Madiston LendLoan Invest advertises its “compensation scheme”. The devil is always in the detail, and it is important to have a concept as to how these mitigants operate and who stands behind them
Attractions to Borrowers from P2P
Just why are small businesses starting to use these platforms? Is it because the P2P process is quicker and less bureaucratic? Are they able to source cheaper, longer term funding from P2P compared to banks? Are P2P lenders financing borrowers who would be turned away by the banks? Or are the P2P platforms cherry-picking the banks’ best small business prospects? Can banks enjoy a better relationship with customers who source their financing from P2P lenders, enabling the banks to cross-sell non-credit products? The answers to these questions are likely to be central to the type of competitive response from the banks.
Some Key Challenges for P2P Business Models
Incentive Problems
This is essentially a broker model, wherein the provider of the P2P platform takes little or no financing risk. A root cause of asset bubble driven banking crises has often been a skewed reward structure wherein relationship managers have been incentivised to generate asset growth with little or no regard for the risks that they have piled onto their employers’ balance sheets.
If the P2P platforms have no risk of capital loss, could this mean that credit quality within the system might deteriorate and simply be passed around many P2P lenders rather than (as is currently the case) remaining in the hands of the originating bank?
Monitoring and the Identification of Early Warning Signals
Through the inclusion in their credit algorithms of behavioural factors (often drawn from social media), it is conceivable that the P2P platforms will do a better job of identifying developing problems than incumbent lenders (who have struggled with this since the beginning of time!).
However, it will be important to see how much attention the platforms will pay to advising their lenders of changes in the borrowers’ credit quality.
Without question, the earlier that problems are identified, the better the lender’s prospects of making a full recovery.
Problem Loans
Who will take responsibility for negotiating restructurings when problems develop? This is a highly specialised, time-intensive and costly process. Loan workout and restructuring skills and cultures vary widely between existing lenders. How will P2P platforms perform?
Education of Lenders
Banks have invested huge sums in training their staff in credit analysis and associated topics. Will all (or even a reasonable percentage) of P2P lenders have the same or better understanding of these principles and techniques? And if the P2P platforms are to educate/ train potential lenders, is there not a significant conflict of interest?
There are, of course, myriad other issues for P2P platforms to manage, not least of which are potential fraud, anti-money laundering and KYC. However, within this article I have sought to identify some of the strategic questions and challenges with a view to providing bankers with a starting point for framing their strategic responses.
For assistance with developing your strategic response, training relevant staff or to provide feedback/comments on this article, please email me at:
adrian.grant@bgconsulting.com
