Using the social network to source funds
Peer to peer lending in its current format is a phenomenon born out of developments in available computing technology, and the desire to make lending more readily available to individuals and businesses.
Necessity is the mother of invention, and the need to raise funds from other sources due to little or no lending from the banks was the driving force behind the revolution.
Also known as P2P or Person to Person lending, the principle is to bring people or organisations that want to earn a better return on their cash together with people who want to borrow it.
The removal of banks, funding brokers or agents from the lending process is known as disintermediation – stripping out individuals or organisations from the middle. In theory, this should bring about benefits to the lender and the borrower, as there are fewer fees due to the middle men (intermediaries).
The creation of the direct relationship between person with the cash, who wants to lend it to the person who needs the cash, brings both its advantages, and drawbacks.
Peer to Peer Lending – Issues
In principle, the absence of the restrictions of operating a large and regulated financial institution, and the expenses of maintaining such an organisation, such as a branch network, should deliver significant benefits to a potential borrower in terms of making more funds available, and – as mentioned earlier – saving on arrangement fees.
While it is true that the costs of establishing and maintaining a peer to peer lending internet presence is significantly lower than a bank, it is not without its drawbacks.
The first consideration is one of regulation. Banks are overseen by powerful regulatory institutions, who ensure that they make adequate provisions for bad debts, and maintain sufficient capital to weather financial storms (although one could question the validity of the size of these reserves given the turmoil in the capital markets, and the billions that the public purse has pumped in to lenders to keep them in business.)
A peer to peer lending organisation acts more like an agent, taking both a fee from the lender for registering (they will benefit from a better return on their capital) and a fee from the borrower for making the funds available in the first place.
Person to Person Lending – Bad Debt Risk
This naturally leads one to think about risk. If you are on the lending side of the equation in a person to person lending relationship, then naturally you should be concerned about what happens if you don’t get your money back. Each of the P2P lenders deals with this issue in a different way:
Zopa, the first peer to peer lending business, packages its cash into 10 unit parcels and distributes them across as wide an array of borrowers as possible, so the risk is considerably diversified.
Another, charges the borrower a fixed percentage of the loan amount, to build up a bad debt reserve, that can be drawn upon in the case of default.
As the default rate is such a sensitive issue for potential individual lenders, then each of the P2P businesses are keen to show they have robust controls in place, and also low default rates. Watch out then if these kind of statistics are readily available and you are going to be earning 20%. You will be exposed to more risk than you think you are.