Peer-to-peer lending, or P2P as it’s known, is a juggernaut financial-services Disruptor.
But thanks to its supercharged growth, P2P lending has attracted the attention of regulators and other financial-market overseers. They’re scrutinizing this new form of lending from multiple angles – fearing it may be too disruptive for its own good.
The U.S. Treasury Department, the Consumer Financial Protection Bureau, financial services regulators, bank and finance company lobbyists and, most recently, the U.S. Court of Appeals for the Second Circuit are weighing in on P2P lending.
There’s a lot at stake here…
- For borrowers in love with lending platforms that give them access to money that would otherwise be hard – even impossible – to get.
- For private lenders who loan money to borrowers at above-average rates.
- And for the owners of sites that match lenders and borrowers for a fee, including investors in publicly traded ventures like LendingClub Corp. (NYSE: LC).
There’s even more at stake for the stock market and the economic health of the country.
The issues aren’t complicated, but tackling them will be.
Here’s what you need to know to avoid getting caught on the wrong side of the tracks if this Disruptor train gets derailed…
When Banks Aren’t Banks
While Disruptors can upend the status quo in any industry, not every disruptive business model plays out as their creators plan.
That’s especially true when the industry being disrupted – in this case, financial services – is one the most powerful sectors in the world.
Banks and formerly successful consumer-finance companies weren’t initially concerned about P2P lending when the new lending barbarians, led by Prosper Marketplace Inc., opened up in 2006.
Of course, 2006 led into 2007, which was the beginning of the end for a lot of banks and consumer finance companies.
While traditional lenders struggled to stay open during the credit crisis and through the Great Recession, P2P lenders honed their business models and extended their reach globally.
Today, P2P lenders are a growing threat to banks and consumer finance companies trying to reestablish themselves. The traditional lenders have unleashed their lobbyists to undermine P2P lenders before they get much bigger than they already are.
According to research from Morgan Stanley (NYSE: MS), marketplace lenders – that’s what P2P lenders are calling themselves now – are expected to account for more than 8% of consumer-unsecured loans and 16% of small-business lending by 2020.
Here’s the knock on marketplace lenders by their more traditional competitors.
Marketplace lenders are non-banks that don’t directly issue loans, that don’t keep any credit risk on their books after they match up borrowers and lenders, that use small Federal Deposit Insurance Corp. (FDIC)-insured specialty banks to facilitate their banking services but don’t pay into the FDIC safety-net fund, that don’t have lots of assets or capital, that add leverage to the economy, and that generally act as banks but don’t have the regulatory burdens of banks.
Constituents and lobbyists are bombarding legislators, asking them to look into these issues. And, in turn, those legislators are prodding regulators and the Treasury Department to step up their game.
On July 16, the Treasury Department issued 14 questions for public comment. The preliminary information-gathering inquiry on marketplace lenders and lending practices asked market participants for comments on:
- The different models used by marketplace lenders and how these models may raise different regulatory concerns.
- The role electronic data plays in marketplace lending and the risks associated with its use.
- Whether marketplace lenders are tailoring their business models to meet the needs of diverse consumers.
- Whether marketplace lending expands access to credit to underserved markets.
- The marketing techniques utilized by marketplace lenders.
- The process marketplace lenders use to analyze the creditworthiness of borrowers.
- The relationship between marketplace lenders and traditional depository institutions.
- The processes marketplace lenders use to manage certain client operations, including loan servicing, fraud prevention and collections.
- The role the government could play in effecting positive change in the marketplace lending industry.
- Whether marketplace lenders should be subject to risk retention rules.
- The harms that marketplace lending may pose to consumers.
- Factors that investors should consider when making investment decisions.
- The secondary market for loan assets originated in the peer-to-peer marketplace.
- And whether there are other key issues that policymakers should monitor.
The Consumer Financial Protection Bureau (CFPB) is looking into the marketplace for consumer loans and what protections borrowers have.
Even the U.S. Securities and Exchange Commission is looking into P2P lending. Both in the funding process and when loans are purchased from sites and packaged, securities are created. That’s the SEC’s beat.
The real threat P2P lending poses is to the economy, which is only now coming into focus thanks to lobbying efforts to bring it to everyone’s attention.
The truth is, this financial services Disruptor could upend the economy and should be closely scrutinized.
The Economy Problem
There are three fundamental and alarming problems with the P2P lending model.
First, lending sites aren’t banks. Instead of relying on a stable deposit base against which loans can be made, marketplace lenders originally relied on peer-to-peer (meaning person-to-person) matching, where a private lender agreed to fund a borrower’s loan request and each paid a transaction fee to the platform provider.
There’s very little P2P anymore. Institutional investors such as hedge funds, private equity shops, insurance companies and even bank subsidiaries are raising short-term funds in the capital markets to buy up huge quantities of platform-generated loans. Regulators worry about their ability to roll over their short-term borrowings to continue to fund consumer loans if capital markets experience anything akin to 2008, when they ceased up entirely.
Second, most consumer loans are unsecured loans made to individuals who are consolidating higher-interest loans. Any prolonged economic slump would devastate the ability of borrowers to keep up with debt-service payments. And because there’s no recourse on unsecured loans, it’s easy for borrowers to simply default.
The effect of cascading defaults on marketplace loans would cause lenders to cut off funding, further choking consumers who, under present growth rates for marketplace lenders, are increasingly likely to turn to these non-bank or even “shadow bank” lenders.
Third, without access to bank loans, because they’re being shunned for marketplace loans that have different credit-profiling techniques, consumer spending could come to a standstill and squeeze the entire economy.
These are legitimate concerns that are only now being addressed.
Whether or not the Treasury, SEC, CFPB or other regulators apply heat to marketplace lenders and their Disruptor model, P2P lenders may be disrupted sooner rather than later by the U.S. Supreme Court.
The U.S. Court of Appeals for the Second Circuit recently overturned a lower court’s ruling that allowed “appointees” of banks to charge high rates in any state regardless of where the appointee itself was located. The Court of Appeals overturned that ruling in Madden v. Midland Funding LLC, saying essentially that any issuer of a loan that isn’t a national bank has to abide by each state’s usury laws.
Marketplace lenders use small banks to facilitate the actual loan-making process, and those small specialty banks have been bypassing state usury laws.
Midland Funding is trying to take the decision of the Appeals Court to the Supreme Court to get it reversed. If there is no reversal of the Appeals Court’s ruling, the marketplace lending business model itself will be seriously disrupted.
Investors in LendingClub Corp. who aren’t aware of the Appeals Court’s ruling may be wondering why the shares they hold have dropped 30% since the beginning of June. Now they know.
The slippery slope that the great P2P Disruptor model is facing should give investors pause. Until there’s more clarity on the profitability of marketplace lending going forward, venturing into a marketplace lender like LendingClub should be done gingerly – at best.
For investors ponying up funds as private lenders on platform sites, a good look at the direction of the economy is mandatory. Making loans in good times doesn’t count for anything if hard times befall borrowers who can easily default.
For my money, the great Disruptor of financial services is being given a run for its money, and I’m anxious to see how this Disruptor might get disrupted itself.
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- DeBanked: Madden vs. Midland Funding LLC: What Does It Mean for Alternative Small Business Lending?