In a recent survey by Gallup, bankers were among the lower end of professions viewed as honest or ethical at 25% in the U.S. This is up slightly from a low of 19% following the 2008 financial crisis. Enduring hostility from banks due to the financial crisis as well as recent false account scandals from Wells Fargo as well as other banks, has raised the public distrust of the banking sector. Though positive regulations since the financial crisis have pushed up the opinion of the general public on bankers, people have started looking at alternative financial service companies.
The alternative financial services sector has seen a significant boost because of this shift as an investment has risen dramatically in the fintech sector. According to a report by the Cambridge Center for Alternative Finance, the alternative finance industry generated $21.1 billion in revenue in 2017, up 17% from 2016. Lending has been at the forefront of this shift in recent years led by Peer to Peer Lending (Marketplace lending) in particular.
So what is Peer to Peer Lending?
Peer to Peer Lending (or P2P Lending) is the process of facilitating lending between individual lenders and borrowers. The P2P Lend platforms simply act as a middleman between an individual lender and borrower. These platforms handle all the documentation, loan processing and background checks for the borrowers. The lender just fronts the money and chooses who the money is loaned to. The repayments are then transferred back to the lender minus a small transaction fee (typically 1%-5% depending on the platform). This loan can be for any application – ranging from consumer loans, business loans through to education and student lending.
The main drawback, however, is these loans are unsecured – any defaulted loan result in a complete loss to the lender. With Financial Institutes and banks getting into P2P lending, the question is, are P2P loans a good investment for an individual? To understand whether it is a good investment, we need to first understand whether the regulations behind P2P lending are safe enough for a lender to be sure of a return as well as the proposed changes in these regulations over the next few years.
P2P Lending Regulations– The changing face of the industry
Although P2P lending companies started functioning in 2006 in the U.S, the SEC did not start regulating the till the financial crisis in 2008. With default rates of over 10% in the industry, the SEC felt it was a tie to step in and bring P2P lending platforms under the 1933 Securities Act. Although leading companies such as Prosper and Lending Club were compliant and were able to register with the SEC, many other leading companies such as Loanio and Pertuity folded as they could not comply. In recent years, P2P Lending has come under the same regulations as consumer credit companies – Truth in Lending Act, Equal Credit Opportunity Act, Fair Credit Reporting Act, Gramm-Leach-Bliley Act, Electronic Fund Transfer Act, and Fair Debt Collection Practices Act. These regulations mainly dealt with registering each loan with a bank or financial institution prior to completing the loan process thus decreasing the security of these loans. Adding an extra financial intermediary during the loaning process which makes the lenders the underwriters rather than the investors has raised the risk level of the investment.
With the SEC (Securities and Exchange Commission), FDIC (Federal Deposit Insurance Corporation) and CFPB all battling over the regulatory process of P2P Lending, an uncertainty had crept in recent years regarding the P2P Lending market. With this uncertainty, many states have stepped in with their own regulations. While most states have introduced a minimum income level to become a P2P lender (around $70,000 on average), a few states still have no limit on income levels. The U.S has largely focused on making the loaning process and loan information transparent. Detailed information of the borrower (except the actual borrower identity) and a regularly updated catalog of loans have been mandatorily required by the SEC. The SEC also makes these reports available to the public via their EDGAR (Electronic Data-Gathering, Analysis, and Retrieval) system. These regulations ensure that lenders and borrowers
Unlike the U.S, the U.K has focused significantly on improving the lender and loan security. These FCA (Financial Conduct Authority) regulations have focused on ensuring the P2P platforms do not provide misleading information to consumers, minimum as well as maintaining contingency plans in case of platform failure. Although P2P loans don’t qualify for protection from the Financial Services Compensation Scheme (FSCS), which provides security up to £75,000 per bank, for each customer, regulations mandate the companies to implement arrangements to ensure the servicing of the loans even if the platform. Lenders also can invest a maximum of £20,000 in P2P loans per year with any interest earned being tax-free. Banks have also been required to refer rejected loan customers to P2P lending and other alternative lending platforms thus driving the market forward. Independent financial advisers (IFAs) were also permitted to recommend P2P investment to clients. All these regulations have significantly raised the security of loans during the P2P lending process.
Many other countries have followed suit with improving transparency and security of P2P lending. Countries such as Australia and Canada have created a regulatory sandbox for new entrants to ensure the proper functioning of the platform. India, South Korea and Ireland have introduced maximum limits for P2P investment and raised the security of the process as well. Although these regulations limit the growth of the market they provide an important security blanket for the lenders. Countries, where P2P lending is still a nascent market, will also focus on similar regulations to prevent a situation similar to China.
So what happened to the P2P Lending Market in China?
China is the largest P2P lending market in the world with over $195 billion in outstanding loans in 2018. However in recent years with Ponzi schemes, shadow-banking platforms and operators fleeing with lender money, the unregulated market has come under the scrutiny of the Chinese government. Protests from lenders who have lost money in unscrupulous organizations over the past few years have prompted this development. The Chinese government have massively cracked down on the unregulated market and have prevented the formation of new P2P Lending companies unless they meet the rectification guidelines. The rising number of companies coming under police investigation for illegally absorbing public deposits has been at the forefront of this.
More and more small P2P lending companies are shutting down as the lost lender confidence has resulted in lack of investment into the platforms and default rates rose to over 30% in some organizations. In 2013, 93 platforms shut down. In 2018, over 6,300 companies collapsed or shuttered their doors. Analysts predict that the number of companies will continue to fall and stabilize when the number of companies diminishes to around 2,000. Despite this massive scandal, with stringent regulations coming up in P2P lending platforms globally, the situation in China is not expected to be repeated elsewhere. So does this make P2P lending a viable platform for consumers to invest their money?
Is P2P Lending a Viable investment?
To understand if P2P lending is a viable alternative, we need to look at alternative forms of investment and the relative returns of these investments. This involves a comparison with the stock market, bonds, commodities, and gold – The alternatives to P2P Lending.
Note – Average 10 Year Returns are utilized for all investments
Source: NASDAQ, Forbes, Guardian
Although comparatively, P2P Lending has high risk, the returns on investment, low capital required as well as lack of capital gains tax can make P2P lending a viable alternative. P2P lending can be an alternative for the stock market and real estate investments as a portfolio diversifying investment. With the better returns offered and relatively low capital required, P2P lending if invested carefully can be a viable alternative.
With the rising shift away from traditional finance, alternative finance and lending options are witnessing significant growth. Despite the high risk, the substantial return on investment generated through Peer to Peer Lending has made it a viable alternative that has witnessed rising adoption in recent years. This Peer to Peer Lending can be a feasible alternative lending market in the next few years provided there is more government insight to prevent fraudulent platforms from taking hold.
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