Peer-to-peer lenders are just banks — without the capital and regulation

Hey! I’ve got this great idea. We persuade lots of people to put money into a pot, and then we lend it out to other people who need money, at interest. Of course, we make sure the borrowers are good citizens and repay the money. And we keep a little for ourselves!

That must have been roughly how the conversations ran in the coffee shops of Shoreditch and Brooklyn when tech whizzkids were dreaming up peer-to-peer lending. And, for that matter, in medieval Florence and Genoa when they were founding the first banks.

Remarkably, the P2P crowd have pulled off the coup of making their crop of platforms seem like something completely new.

It isn’t, of course. But amid the wreckage of the financial crisis, everyone — from private savers and entrepreneurs to politicians and regulators — has been happy to listen to the idea that peer-to-peer lending is a “new model” for retail and small business finance. Especially when it comes with no baggage of past sins, stylish websites and hip names like Zopa and Lending Club.

There are, it is true, many varieties of bank. Among the variables are how much care the bank (or platform) takes about choosing its borrowers; how readily investors can withdraw their money; and how the intermediator is paid.

But the starting point for understanding peer-to-peer lenders has to be a recognition that they are banks.

How do they differ from traditional banks? Most obviously, they are a lot smaller, have little or no capital and are much more lightly regulated. Happy with that? If not, read no further — put your money somewhere else.

Among the earliest claims was that P2P platforms could bypass sclerotic, unnecessary and inefficient banking bureaucracies and connect lenders directly with borrowers.

One of the attractions was, and with some platforms still is, the idea that you could know where your money was going — in some cases, as P2P shades into crowdfunding — the precise name and details of the business, person or project being funded.

With equity investments this is usually desired, and even with loans it has an attraction. It makes lending more fun if you know where your money is going. And this remains a true and valid aspect of some P2P finance platforms.

To the extent that lenders know where their specific money is going, P2P does offer something different from banking, which can help to attract funds from certain kinds of investor.

But this comes with a huge increase in risk. Diversification is the first way to reduce investment risk — and giving it up means you stand to lose big chunks of your money if things go wrong. Linking lender to borrower directly also means the lender cannot withdraw his or her money until the borrower chooses to repay.

It was to solve these problems that modern banks evolved. By pooling all the money from savers into all the loans, risk is shared, making it much more predictable, while savers can move money in and out, as long as the bank retains confidence. Add a layer of owners’ capital and it can do that.

Another claim for P2P is that their technology is superior to the banks’, enabling them to make loans better or more efficiently. But ever since the internet took off 15 years ago, banks have offered loans online in a matter of minutes, to anyone who can fill out a brief questionnaire, prove their identity, credit history and so on. So P2P platforms are not new there. Where they may depart from the banks is by having looser standards.

P2P lenders have tried to pretend they are different from banks, but the pretence is wearing thin. Most now split each saver’s money up among a pool of loans, even if those are still identifiable. Fundraising is no longer just from individuals — institutional money has buzzed to the honeypot, whether through direct investments, securitization or even bank involvement, like Santander’s partnership with Funding Circle in the UK.

Never has the illusion of novelty been allowed to slip more than with Wellesley’s announcement today of a retail bond issue, to be listed in Dublin and offered to UK savers through an Individual Savings Account, which allows you to invest up to £15,000 a year tax-free.

The three and five year bonds pay 4% and 5.25% — substantially more than the highest yielding fixed rate savings bonds of equivalent maturities listed by Moneysupermarket.com, offered by lenders such as Malta’s AgriBank.

Wellesley claims to be the UK’s fastest growing P2P lender, having made £165m of secured loans, often for property development. And it proudly notes: “The firm is also the only Peer-to-Peer lender to lend its own funds into every loan and will take the first loss if a borrower fails to meet loan repayments. Additionally, all lender funds are evenly distributed into every loan and therefore maximum diversification is guaranteed to all investors regardless of size.”

In other words — ‘trust us, we are like a bank’. The pitch goes on: “Wellesley has recently added increased visibility on its website on its total Financial Resources, including its provision fund, which is seen as a ‘safety buffer’ in front of all of its P2P lenders and a potential loss. The firm currently quotes that it has in excess of £9m of financial resources available.”

In other words, a capital ratio of 5.4%.

That’s better than Barclays, which had £1.37tr of assets at its last results, supported by £68bn of regulatory capital, £60bn of shareholders’ equity or £47bn of tier one capital — ratios of 5% to 3.4%, depending on how you look at it.

But unlike Barclays, Wellesley is not obliged to maintain its capital ratio, and its assets are a lot less diverse. Some other P2P lenders do not even make such claims.

Wellesley may have found a good model for P2P lending but everything the firm is proud of about this makes it more like an ordinary bank.

And judged by that standard, it is a small, undiversified, recently founded, unreliably capitalised and unregulated bank.

That is a microcosm of P2P as a whole. They are small, primitive banks with very little oversight.

There is definitely a place for peer-to-peer lending. It is fresh and it suits some borrowers — just like the subprime lending markets that were its immediate forerunner.

P2P also offers savers higher returns than old-line banks. There are at least six possible reasons for that: P2P is genuinely more efficient (unlikely, given banks’ massive experience, high use of technology and economies of scale); its equity investors are less greedy for returns (possible, but unlikely to be sustainable); there is less equity to be fed (yes); it is making riskier loans (almost certainly true, since higher return tends to follow higher risk and there is much less diversification); some of the borrowers are lazy and find it easier to borrow from a P2P lender, even if this costs more (possible, but not inspiring); and finally, that there are genuinely good risks out there that the banks, through their own rigidities, are missing or mispricing.

The last is certainly possible, even likely, and is the reason why P2P should be permitted, as an alternative to regulated banks.

Retail savers should not be mollycoddled. If they are allowed to invest in shares, why not in loans? Risk-taking can be good for the economy. But investors must be open-eyed about what they are getting into, and ready to bear the losses if it goes wrong.

Governments and regulators should be very wary of extending any cloak of official protection or endorsement to P2P, such as including it in compensation schemes. It would be quite wrong to guarantee deposits in these unregulated firms.

And if P2P ever becomes big enough to matter — so that its collapse would actually damage the economy — it will have to be regulated. This will have to be bank regulation, as the platforms are functionally banks.

Shall we guess 2018 for the first P2P additional tier one CoCo bond?