The new lords of lending?

Peer-to-peer (P2P) finance is doubling every year. It appeals to SMEs and consumers that existing lenders can’t reach. Some major players are moving in. Ian Henderson asks whether it’s time banks notice.

Like other disruptors, firms like Zopa “take a product (lending), and we simply do it better.” Giles Andrews, CEO of Zopa

“For investors, shares in P2P providers can look a better bet than conventional banks: the lender carries no risk itself if its loans go bad and capital requirements are much lower.”

“P2P does seem to represent real competition in what has been a closed market for a very long time.”

Shopping. Listening to music. Finding a taxi. The list of ways in which the internet continues to change all our lives grows daily. We can do things faster, cheaper, better – wherever we are, whatever we’re doing. And businesses which can’t keep up simply get left behind. Could banks be next, joining the angry shopkeepers, record company honchos and cabbies who have seen their livelihoods threatened seemingly overnight by Amazon, Spotify and Uber?

The most basic functions of a bank – taking in funds and lending them out again with interest – can now be done directly from lenders to borrowers “about ten times more efficiently” through peer-to-peer (P2P) websites compared to conventional banks, according to analyst Cormac Leech at brokers Liberum Capital. Growth is already exponential – and he sees that as the UK Government brings P2P inside ISA and SIPP tax wrappers, even a tiny fraction of the £2tn invested would accelerate growth still faster.

Sam Ridler of the Peer-to-Peer Finance Association, which represents providers, adds that a number of convergent trends are powering growth:  the British public are increasingly eager to transact online round the clock; ‘big data’ has removed the banks’ information advantage and the need for expensive infrastructure; current low interest rates have raised the profile of alternative investments; and P2P providers are able to offer a better customer experience than banks are able to offer.

Changing the lending landscape

Led by the UK, US and China, P2P is still only a small part of the global banking landscape. But that won’t be true for much longer – the UK sector reached £1.74bn in 2014 and conservative predictions show over £4.4bn in 2015. P2P was pioneered in the UK back in 2004 by Zopa’s consumer credit (alongside newer entrants like RateSetter) but is now showing its fastest growth – 250% in a single year – in finance for business.

That accounted for over £1bn of financing for more than 7,000 businesses in 2014, or 2.4% of cross-national lending to SMEs, through sites like Funding Circle and ThinCats. Credit is by far the largest part of the UK alternative finance sector, although invoice trading and especially equity crowdfunding (at a staggering 410% a year) are also growing fast. Peer-to-peer, non-banking finance is simply too big to ignore any longer – which is why a research report published in December 2014 by Nesta (with PwC and ACCA) makes interesting reading.

For example, although 44% of SMEs surveyed were familiar with some sort of alternative finance, less than 10% had approached one of the platforms. Those who have like the better interest rates, speed, ease of use and higher levels of customer service they get from alternative finance providers. More than half of P2P business investors intend to lend more next year, and 86% of borrowers would look to P2P finance first, even if a bank were to offer funding on similar terms.

So, it seems that, beyond the rational decision, people actually prefer peer-to-peer lending. Giles Andrews, CEO of Zopa, says the banking industry has “forgotten who its customers are.” He claims that, like other disruptors, firms like his “take a product (lending), and we simply do it better.”

Banks in on the act

Richard Woolhouse of the British Banking Association accepts that there are challenges for traditional banks (especially in lending to SMEs) and that P2P providers are answering a need. However, he points out that the sector is relatively untested and not subject to the same regulatory and competitive forces – the technology is relatively easy to replicate by established players, for instance.

He sees the link-up in SME lending between Santander and Funding Circle (RBS are talking about a similar partnership) as one mutually beneficial way forward where banks work alongside P2P lenders to provide “the right finance at the right stage in a company’s growth.” In the medium term, he and Sam Ridler agree there is room for different models to co-exist – although longer term, Ridler sees banks becoming “more like P2P lenders than vice versa.”

Zopa’s Giles Andrews believes existing banks “need to identify what is really important to their customers and simplify their businesses accordingly.” Encouragingly for him and other ‘disruptors’, many users would consider peer-to-peer services that aren’t yet available – like currency exchange, insurance and even mortgages – so banks can’t even assume the threat is limited to what P2P currently offers.

If there is some reassurance, most of their customers are still either unaware of peer-to-peer finance or say they would be unwilling to use it without significantly better returns or some form of guarantee that their money was safe. Quite a few (31%) worry that P2P is more ‘risky’ than a bank – but to a similar number (28%) P2P feels more ‘socially responsible’.

The Nesta report shows most SME P2P borrowers (79%) had already tried a bank before turning to a platform like Funding Circle or ThinCats, but only 23% had been made an offer of funding. The borrowing was usually for expansion or working capital, and 95% reported that their business had performed better since the funding – suggesting relatively low risk.

On the consumer side, Zopa and Ratesetter have been around long enough to get their algorithm-driven lending criteria right – rejection rates are still high (up to 90%) and default rates extremely low (under 1%). Although it produces some very satisfied customers (both borrowers and lenders) this cherry-picking approach may suggest a limit to P2P lending growth as it will eventually need to attract higher-risk borrowers.

Future of lending?

Some major players clearly think P2P is here to stay, especially in the USA. Lending Club, the biggest of them all with $6bn lent so far and a spectacularly successful IPO last December, quotes Larry Summers (ex-Secretary to the Treasury and Lending Club board member, along with Morgan Stanley’s John Mack), as saying: “Lending Club’s platform has the potential to profoundly transform traditional banking over the next decade.”

For investors, shares in P2P providers can look a better bet than conventional banks: the lender carries no risk itself if its loans go bad and capital requirements are much lower. As with any newly disrupted sector, growth will be uneven and there will be reverses – we can safely predict media coverage turning more negative, and more regulation as the sector expands.

Sam Ridler reckons: “The sustainability of P2P platforms depends on their ability to effectively assess credit risk. If investors start seeing that they are not making money due to bad debt levels… then they will find other places for their money.” Liberum’s Cormac Leech thinks the long-term growth of the P2P sector is assured, but will depend on robust credit checks alongside continued transparency and keeping margins low. He also believes platforms should have ‘skin in the game’ to align their objectives with those of users; without the right incentives he predicts “some blow-ups” as the sector expands.

There may be significant threats for the banking industry from other disruptors (the widely-rumoured FaceBank, for example), but P2P does seem to represent real competition in what has been a closed market for a very long time. So far, the industry’s response has been described by the Financial Times as “laid-back” – perhaps in the expectation that the P2P audience will be limited to its current small pool of credit-worthy ‘super-prime’ borrowers – and there’s no sign of the copycat platforms, legal challenges or buyouts that disruptors in other markets have faced. It may also be that the shrinking tenure of the average bank CEO means they don’t expect to be in the job long enough for P2P to matter.

P2P finance does make clear a real consumer desire which the banking industry will soon have to answer – or, like those shopkeepers, record execs and cabbies, risk getting left behind.