Peer to Peer Lending: Lending Club

peer to peer lending: lending club

By Yixiao Zhang

Technology is changing financial markets. Fintech (financial technology) such as internet banking and cryptocurrency offers unprecedented opportunities to optimise financial decisions. Peer to peer lending has sprung up among these changes as part of an effort to improve financial services available to the public. Traditionally, individuals have borrowed money from financial intermediaries or from a limited circle of personal relations, and only eligible institutions could access funds in the capital market. Peer to peer lending aims to bypass the complications and red tape of bank loans, build new channels for lending and investment, and decrease expenses on funds. 

However, after making major strides up until 2016, this industry is now facing various accumulated financial and ethical problems. This article explores the situation using industry pioneer Lending Club as a model.

Peer to peer lending 

The Oxford Dictionary of Banking and Finance defines peer to peer lending as “the growing practice in which those with spare funds lend money to small businesses or private borrowers via a dedicated website” (Jonathan Law). Peer to peer lending companies run websites or other mechanisms to facilitate this kind of lending. As this service is generally provided online, the overhead is lower than that of traditional financial institutions and the profit margin is therefore higher (Moenninghoff and Wieandt). This means that borrowers can obtain funds at a lower cost and investors can gain higher returns (Cunningham et al.). However, there is a higher risk of default in the industry for two related reasons: first, peer to peer lending is usually unsecured; second, it is commonly a last resort for people who cannot access traditional funding sources because of low credit scores or a lack of collateral. 

The first peer to peer lending company, Zopa, was launched in 2005 in the UK (“Q&A: Online Lending Exchange”), and followed in the U.S. by Prosper and Lending Club in 2006 and 2007 respectively (“Peer To Peer Lending Crosses $1 Billion In Loans Issued”). The industry grew rapidly in the following years: the chart below shows the rise in newly issued loans by the five largest peer to peer lending companies in the world (“From The People, For The People”).

Regulations have had some difficulty in keeping pace with this rapid growth in a new industry. In the UK, the industry became subject to oversight by the Financial Conduct Authority only after 2014 (“Peer-To-Peer Lending Needs Tighter Regulation”). Meanwhile, until Lending Club’s corporate governance scandal of 2016, U.S. law required only securities of peer to peer lending companies to be registered with and regulated by the SEC (“Lending Club: Bob and Weave”).

Lending Club 

American peer to peer lending company Lending Club was the first to register with the SEC and have its loans traded on the secondary market. It began as a Facebook application launched by Renaud Laplanche in May 2007. After attracting a handful of borrowers and investors, Lending Club entered a “quiet period” in April 2008 (“Lending Club”), pausing its service to apply for a license to issue notes. It completed SEC registration of US$600 million in loans in October of that year and began to issue its own notes. The company then began to attract more capital from the market: US$24.5 million from Foundation Capital, US$25 million from Union Square Ventures and Thomvest with an unspecified amount from Peter J. Thomson, US$15 million from Kleiner Perkins Caufield & Byers,and US$2.5 million from John J. Mack (“Lending Club”).

In 2012, the company issued a total of US$600 million in loans, renewed its registration to US$1 billion, and continued to attract investment and partners. In 2014, it began its IPO.The stock ended the first trading day up 56%, valuing the company at $8.5bn, and it raised almost $900 million in the largest U.S. tech IPO of 2014. Despite its rapid growth, the company has sustained losses which have caused a constant fall of its stock price. The public governance scandal of 2016 exacerbated this situation and two years later it still has not fully recovered. 

The peer to peer lending process in Lending Club 

Lending Club was initially a platform to establish connections between borrowers and lenders through algorithms, enabling them to complete transactions directly. Because of the disintermediation in this procedure, the rates are more beneficial to both parties (“Lending Club Founder and CEO, Renaud Laplanche – Interview”). After registering with the SEC, the company began to issue its own notes. This meant that investors, by buying the notes, took securities in Lending Club; there was no longer a direct legal relationship between borrowers and lenders. This changed, and to some extent, reduced the advantage of disintermediation. However, investors could still purchase certain shares of a loan or customise the structure of their portfolio. Moreover, the company still offered a wider variety of loans than traditional institutions, along with its other advantage of using unique technology to help match loans with investors. 

Individual borrowers can go to Lending Club’s website and apply online by providing information about themselves and how they will spend the money they borrow. They can choose a secured or unsecured loan to borrow for three years or five years. If successful, they are given a loan of up to $40,000, which must be repaid along with interest and an origination fee. The monthly payment is fixed so that borrowers can know from the beginning the date when they will complete their repayment. The interest rate is generated specifically for each individual according to the borrower’s credit status, including her credit rating, and is generally lower than the interest rate offered by banks. Apart from these personal loans, the company also offers auto refinancing services, patient solutions, and small business loans, with similar policies and processes.

Investors using Lending Club begin by opening an account and depositing a minimum of $1000. They can then buy notes representing individual $25 investments in particular loans. When designing their portfolios, investors can either manually choose which notes to buy and how to allocate the number of notes to each loan, using information from online listings (e.g., credit scores, interest rates, terms, a loan’s purpose and even borrower location), or select their investment preferences or criteria and let the automated investing tool choose for them. Investors are paid back monthly a proportion of the principle with interest according to the borrowers’ performance, deducting a service fee which goes to Lending Club.

Credit ratings are a crucial part of this process. Loans are graded from A to G, where A is the highest grade and G is the lowest. In each letter class, the loans are assigned a subgrade between 1 and 5 where 5 is the lowest. A loan with a high grade enjoys a low interest rate and will cost the borrower less money. When deciding a loan’s grade, Lending Club will consider the borrower’s “credit score, credit history, desired loan amount and the borrower’s debt-to-income ratio”.

In this business model, credit requirements for the borrower are lower than those of banks, and the process is simpler. Meanwhile, investors buy something akin to a security, but the back of this security is an unsecured personal loan rather than company debt. Unlike securities, investors need to anticipate and bear the whole credit and liquidity risk—or at least a risk proportional to the degree of disintermediation within Lending Club—as the assets are illiquid. Establishing a secondary market for the notes improves the liquidity problem, but market risk is still heightened for these loans (Moenninghoff, and Wieandt).

Problems in Lending Club

Banking without banks 

Although Lending Club began as a peer to peer lending company, it has grown into a hybrid bank and financial company, with the assistance of Fintech and by operating through the internet. When lending to borrowers, it plays the role of a bank, checking the credit conditions of borrowers, ranking them, and approving their applications, rather than merely listing them on a system. This means it is granting credit to its customers. However, when granting credit, banks also perform a “delegated regulatory” function. When examining credit, banks are monitoring the credit market; they have access to the credit status of nearly all the participants in this market, and can thus provide proper guidance to borrowers. As a burgeoning company in a partial market, Lending Club cannot do this function. Moreover, although Fintech can improve the accuracy of credit ratings, Lending Club has no obligation to use this information in the way a bank would, and no incentive to do so. 

This brings us to the problem of regulation and supervision in the peer to peer lending industry. Lending Club’s business model is new to regulators as well as to the public. Peer to peer lending appeared at the beginning of the 21st century and has existed for little more than a decade. For most of this period, the market environment has been favourable to the development of this industry. There is not enough precedent or experience to provide a legislative basis to regulators. Moreover, until 2016, the problems in this industry had not yet attracted the attention of market watchdogs. Lending Club, in its guise as a peer to peer lending company with no intermediary function, has escaped regulatory notice and remained unbound by the rules governing banks when performing their intermediary functions.

Challenges of the changing market

What challenges this company now is a number of changes in once-favourable market conditions. First is a rise in interest rates. After the financial crisis of 2008, interest rates remained relatively low until December 2015, when the Federal Reserve began to raise the federal funds rate, causing a corresponding rise in the market interest rate. When interest rates rise, people are more willing to put their money in banks rather than purchasing peer to peer loans, because the gap in interest rates is small, but the bank deposit is almost risk-free. Individual investors are more sensitive to risks. With less funds flowing in, Lending Club has less money to lend, and the amount of money loaned will need to be reduced to maintain a balance between money input and output. Because Lending Club’s revenue comes from the origination fee paid by the borrower and the service fee paid by the lender, the decrease in loans has a direct negative effect on profits. 

Second, the company is also suffering from fiercer competition and tighter regulation. These circumstances lead to higher operating expenses because the company needs to spend money on sales, marketing, and compliance, causing a further decrease in profits.

In order to profit, Lending Club needs to obtain more funding. For individuals, the main reason to choose Lending Club rather than depositing their money in banks is the high yield and bearable risks. When the yield is no longer attractive, they are unwilling to take risks. A major part of Lending Club’s funds come from institutional lenders, who are more willing to take risks than individual lenders. However, relying too much on institutional funds can cause latent problems. As Todd Baker said on the American Banker website:

“Reliance on wholesale funding will be the Achilles heel of online alternative lenders — just as it was for the paper-based finance companies that all failed, were bailed out or became banks in the period leading up to the 2008-2009 financial crisis” (“Reality Check for Marketplace Lenders”).

Credit risk and moral hazard

The greatest risk associated with Lending Club is credit risk, which is determined by the nature of peer to peer loans. Although defaults on loans will not directly affect Lending Club’s balance sheet, because the credit risk is borne by the investors, defaults will influence revenue indirectly. Failure to repay affects the credit conditions in this market. Investors are risk-sensitive, and any sign of trouble prompts them to leave. Furthermore, many borrowers borrow money to repay other loans; when one defaults, or the funds decrease, liquidity will be affected and there will be a domino effect in the market.

In order to avoid these problems, Lending Club needs to reduce bad loans. There are two ways to achieve this: the first is to improve credit requirements for borrowers; another is to increase the total number of loans, which could reduce the ratio of loans defaulted on to loans repaid. The former is the only way to truly decrease credit risk in the market, while the latter is only an accounting trick to cover up and delay the risks. 

Furthermore, as Lending Club itself is performing a credit rating function in this process, a moral hazard emerges. When this company is badly in need of funds, it is likely to overestimate the value of loans and their credit rating, creating bubbles in the market which would cause financial crises. To expect that a company will choose, unprompted by regulations, to protect a stable market instead of saving its own life seems unrealistic. 

Faced with all these problems, Lending Club is struggling to move forward, as is the industry as a whole. Although they are far from replacing banks as a primary lending service, they unquestionably play a supplementary role in this market and offer their own advantages in managing credit risks and operating costs with the help of Fintech. Therefore, some banks choose to cooperate with Lending Club, selling some personal loans through the company (“Nimble Start-Ups Move into Established Financial Institutions’ Territory”).

In 2015, Citigroup entered such a partnership with Lending Club, to fulfil its obligation under the Community Reinvestment Act, “a 38-year-old law obliging it to direct a portion of its lending to deprived areas” (“Lending Club Strikes $150M Deal with Citigroup”). This suggests that the peer to peer lending industry can reach borrowers who have traditionally been marginalised by banks, providing equal opportunities to them to improve their lives. This potential positive impact on society should not be discounted.

What is the future of these peer to peer lending companies? Will they become distinct components of Wall Street, or will they become departments of banks? This will be determined by how they manage recent and upcoming challenges.

Reference

  1. Oxford Dictionary of Finance and Banking. Oxford University Press, 2018.
  2. Moenninghoff, Sebastian C., and Axel Wieandt. “The Future of Peer-To-Peer Finance”.Schmalenbachs Zeitschrift Für Betriebswirtschaftliche Forschung, vol 65, no. 5, 2013, pp. 466-487. Springer Nature, doi:10.1007/bf03372882.
  3. Cunningham, Simon et al. “P2P Lending: What Is an Expected Return? A Survey of Industry Voices”. Lendingmemo, 2013, https://www.lendingmemo.com/peer-to-peer-lending-return/.
  4. “BBC NEWS | Business | Q&A: Online Lending Exchange”. News.Bbc.Co.Uk, 2005, http://news.bbc.co.uk/1/hi/business/4325761.stm.
  5. “Peer to Peer Lending Crosses $1 Billion In Loans Issued”. Techcrunch, 2012, https://techcrunch.com/2012/05/29/peer-to-peer-lending-crosses-1-billion-in-loans-issued/
  6. “From the People, For The People”. The Economist, 2015, https://www.economist.com/special-report/2015/05/09/from-the-people-for-the-people.
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  8. “Lending Club: Bob And Weave | Financial Times”. Ft.Com, 2018, https://www.ft.com/content/c9bdc88c-9a8a-11e8-9702-5946bae86e6d.
  9. “Lending Club”. En.Wikipedia.Org, 2019, https://en.wikipedia.org/wiki/Lending_Club.
  10.  “Lending Club”. En.Wikipedia.Org, 2019, https://en.wikipedia.org/wiki/Lending_Club.
  11. “Lendingclub Founder And CEO, Renaud Laplanche – Interview”. Centernetworks, 2007, https://web.archive.org/web/20120308063509/http://www.centernetworks.com/lendingclub-founder-and-ceo-renaud-laplanche.
  12. Lending Club official website, https://www.lendingclub.com/
  13. “Reality Check for Marketplace Lenders”. American Banker, 2016, https://www.americanbanker.com/opinion/reality-check-for-marketplace-lenders.
  14. “Nimble Start-Ups Move Into Established Financial Institutions’ Territory | Financial Times”. Ft.Com, 2014, https://www.ft.com/content/3315f98e-3cbc-11e4-871d-00144feabdc0.
  15. “Lending Club Strikes $150M Deal With Citigroup | Financial Times”. Ft.Com, 2015, https://www.ft.com/content/8602eb62-e29c-11e4-ba33-00144feab7de.