"Many firms are being supported by equity injections (crowdfunded by retail investors), but given their high cash burn, it is simply a matter of time before they too fail."
The abundance of peer-to-peer (P2P) lenders offering high yielding loans has been recently getting the attention of regulators.
Many P2P lenders target unsophisticated retail investors who can invest as little as £100. There is a relatively high cost to on board small investors, such as handling customer calls, know your client and anti-money laundering requirements.
There have been dozens of P2P failures, but Lendy’s closure has shocked the industry. It was a high-profile P2P lender, accruing more than £160m on its loan book and by the time the administrators were called, £90m was believed to be in default.
Many firms are being supported by equity injections (crowdfunded by retail investors), but given their high cash burn, it is simply a matter of time before they too fail. Some P2P providers offer woefully inadequate provision funds which give a false sense of security. When Collateral collapsed last year, it emerged that they did not have the correct regulatory permissions.
Profitability aside, there is a fundamental issue with most P2P firms. They are just a data intermediary between borrowers and lenders, rather than a financial intermediary. They earn fees based on volume of transactions, regardless of the underlying loan performance, whereas financial intermediaries, such as banks have obligations to repay depositors when loan investments go bad.
Without this alignment of interest, the level of due diligence performed during the underwriting process is limited and the onus is on the investors to understand the risks and read the terms and conditions. Many investors who are keen to sign up, do not bother reading the small print, which is usually signed electronically at the click of a button. Often, investors are unaware of the risks they may be facing.
Clearly, more needs to be done to protect investors. Recent regulatory changes to protect investors include a cap on investor wealth in such investments. However, minimum standards of underwriting criteria should be introduced by the FCA (e.g. valuation methodology, borrower’s solicitor requirements etc) so that investors’ risks are managed.
In Germany for example, a banking licence is required by all lending firms. Obtaining this is a more thorough process to check that the lender’s systems and staff are appropriate.
Default rates are currently artificially low as at the end of a loan term, borrowers easily jump ship to another P2P lender eager to lend money. The shortage of good quality loan opportunities means that small P2P players, who have no established broker relationships, will end up lending on risky assets and borrowers. Both borrowers and brokers are wary of the ability of P2P lenders’ ability to raise a sufficient quantum of funds, within the timescales required.
Furthermore, the weak underwriting process of some P2P firms means that they are mispricing the loans, so ultimately the investors are insufficiently compensated. P2P firms have not been in existence before the 2007 crisis, so like a game of musical chairs, when the credit cycle turns, no one wants to be holding the loans when the music stops.