Traditional banks may be viewed by the government as too big to fail, but they aren't too big to face a growing level of competition from a new, technology-driven lending platform.
This platform is known as peer to peer lending. In this nascent lending dynamic, online intermediaries bring borrowers and lenders together without the need for a big bank or financial institution. Lenders in a peer to peer setting are not large, structured entities such as banks, but individual investors seeking a more profitable alternative to traditional bank deposits.
Peer to peer lending took hold in the United States in early 2006 with the launch of a company called Prosper. A similar company, Lending Club, was formed a few months later. Today, Prosper and Lending Club remain the two largest peer to peer lending companies in the world.
Their timing was impeccable, too. Within two years of the inception of Prosper and Lending Club, a veritable credit crisis had taken hold in the United States, big banks were struggling just to remain in business -- and in many cases were only able to do so thanks to a massive government bailout -- and even the most qualified borrowers were being turned down for loans amid the resulting credit freeze.
As a result, a major vacuum materialized in the credit markets, with thousands of qualified borrowers begging for loans and very few banks being willing or able to make them. Peer to peer lending took off during these years, as more and more borrowers began to discover that they could obtain credit without going through a traditional bank or financial institution -- and often with more competitive rates and terms.
It hasn't been just borrowers who have benefitted from peer to peer lending during the economic turmoil of the past few years. Investors have found that lending money to their peers provides better returns than deposing their money at a bank, given how the government's policy of quantitative easing has depressed interest rates as of late.
What are the defining characteristics of peer to peer lending and what sets it apart from the traditional lending industry? The basics are as follows.
- Loans traditionally are unsecured, although there is a growing market for peer to peer real estate, business, and payday loans.
- Business is conducted for a profit.
- Loans are considered securities, and they can be sold to other lenders.
- A peer to peer lending company, rather than a traditional bank, serves as the intermediary between borrowers and lenders.
- Transactions take place online.
- Unlike traditional banks, peer to peer loans are not secured or protected by government insurance.
So is peer to peer lending the future, or is it just a fad that filled a niche during the financial crisis but will gradually fade away as traditional banks continue to regain their stability?
Every indication is that this type of lending will only continue to grow and become more popular, as it offers myriad advantages to borrowers as well as lenders versus the traditional bank model.
The advantages of peer to peer lending to borrowers are as follows.
More flexible credit requirements. While almost all lenders who issue credit peer to peer do their due diligence and review potential borrowers' qualifications before approving a loan, credit requirements generally are not as rigid or objective as they are with traditional banks. This enables borrowers who may not have the best credit qualifications on paper but who can document non-traditional yet legitimate reasons they are deserving of a loan to obtain the credit they wouldn't be able to get from a traditional lender.
Here's an example: A bank may have as a requirement for obtaining credit a minimum FICO score of 680 and a minimum of two years at the same job. These requirements would exclude, for example, someone with a perfect history of paying bills but who has only been out of college and working for a year and who, because of his youth, has yet to establish sufficient credit for a high FICO score and thus sits at a 660. Common sense indicates that this is a borrower who is qualified to receive a loan in some capacity; however, banks' requirements typically are unbending. With peer to peer lending, he can easily find someone to lend the funds he needs.
More attractive rates and terms. Peer to peer lenders frequently offer lower interest rates and more attractive loan terms than traditional banks. A big reason for this is that they have much less overhead, so they don't need to turn as much of a profit on their loans. Another benefit to borrowers is that rates are set by an individual rather than by a behemoth institution with many layers of regulation to navigate; therefore, borrowers have a much greater ability to negotiate rate and term on an individual basis.
Peer to peer lending offers benefits to lenders as well, such as:
Ability to diversify investments. Savvy investors are always looking for new ways to diversify their portfolios. Peer to peer lending offers them a way to make a defined rate of return in a defined period of time. The risk of such an investment is relatively small. Prosper reports that the default rate for its A-paper loans is only 2 percent.
Freedom to choose rate of return. By lending money in the private market at a personally negotiated interest rate, an investor has the freedom to pick the exact rate of return he will see from his investment. This is a benefit over stock investments, which are largely unpredictable, and traditional bank deposits, for which the interest rate certainly is not negotiable.
Even as traditional banks have regained their footing amid a fledgling economic recovery, peer to peer lending's growth has not slowed a bit. The major players such as Lending Club and Prosper reported big gains over the last few years. New companies are jumping into this industry every day to meet the ever-increasing demand.
Because of their sheer size, traditional banks will always be capable of doing things that smaller competitors and individuals cannot, and therefore it will probably be a long time, if ever, before they are phased out completely.
But peer to peer lending is a very real and very legitimate alternative to traditional lending channels, and by all indications it will be a major feature of the lending landscape moving forward.
