Current Affairs

Is P2P lending stress tested?

Ah, the recession. Tough times those were for the UK indeed; characterised by high unemployment, widespread bankruptcy, bailouts, five consecutive quarters of negative growth and even bank runs. A deadly cocktail of factors precipitated this dreadful sequence of events, but, within our borders, the one to incur the greatest scrutiny was the ability of banks to create too much money.

Huh? Create money? As Deity-esque as it may sound, that is indeed what banks did, and still do. Banks benefit from what is known as leverage, meaning that they can lend out a lot more money than they actually have. In fact, for every £100 banks lend out, they are only required to have a minimum of £3 in capital reserves.

Great news for them (and their sizeable executive bonuses) when times are good, and UK banks more than doubled the amount of money and debt in our economy from 2000-2007 as a result of being granted such free rein.

The problem was that just 8% of all that money created by banks went to businesses outside the financial sector, and instead went towards pushing up house prices and speculative investments in financial markets.

The killer, though, was that an astonishing 8% went into credit cards and personal loans, and when the recession hit and good debts went bad, banks were left badly exposed due to the lack of capital they had to provide against losses to default. And once these reserves were depleted, the remaining options were bailout or bust – not too dissimilar (albeit on a smaller scale) to Greek banks at present.

And so, P2P was born!

Well, not really. Peer-to-peer (P2P) lending in its current form has been around since 2005. Actually, the concept has been around since the ancient Greeks and Romans used to lend directly to each other thousands of years ago.

Anyway, technicalities aside, there is no doubt that the global financial crisis cultivated the perfect breeding ground for P2P lending. Banks went from lending to anybody to lending to nobody, and their reputation among consumers plummeted further.

Both businesses and ordinary people then began to reap the benefits of these more efficient peer-to-peer platforms, and by the end of 2014 more than £2bn had been loaned within the UK sector. And, given the imminent inclusion of P2P loans as part of the new Innovative Finance ISA, this number is set to rocket to more than £45bn in the next few years.

From a global perspective, the peer-to-peer lending book currently stands at less than 0.01% of bank assets, so there remains an almighty gap to be bridged. But with growth rates in excess of 100% per annum, P2P is emerging from the shadows at a rate of knots.

Can P2P cope with a recession?

Ahem, back to the aforementioned technicalities – it already has! Borrower default rates in the UK remained between 2-5% throughout the recession, and lenders emerged from the ashes with their capital fully intact.

This didn’t happen by luck either. The crucial difference between banking and peer-to-peer lending is the latter’s ‘pound-for-pound’ model. For every £1 put in by a lender, £1 is lent out to a borrower. There is no leverage or fractional reserve banking (‘money creation’), and P2P platforms are thus more in tune with the real cycle of money.

True, recessionary times shrink the economy, and people who are tightening the purse strings will reduce investments across the board. Lending capital in P2P could thus potentially suffer. However, given that existing lenders are not exposed to leveraged losses in the way banks are - and can still expect steady returns - there would be less cause to hit the panic button.

In turn, corresponding financial misfortune might see potential borrowers affected in terms of risk grade and their ability to make repayments. However, provided that sound underwriting standards are maintained, the flow of creditworthy borrowers need not be significantly affected either.

So will P2P hold up just fine next time things go south?

We need to compare apples with apples here. In the days before the recession of the late 2000s, the non-bank sector was largely made up of investment securitisers selling loans (secured and unsecured) to investors chasing a quick (and hefty!) yield. That lot came unstuck in 2008, and the securitised mortgage asset class as a whole has only recently shown signs of recovery.

Peer-to-peer as a model is completely different, and the direct matching of lender funds with specific borrowers steers it more towards the path of economic efficiency than it does to the muddy waters of securitisation. The biggest threat to platforms in a recession is thus likely to be excessive borrower defaults which lead to a sustained drought of incoming lender capital. With a lack of liquidity provided by a steady flow of new lenders, lending volumes may be restricted to a level insufficient to support the platform’s ongoing operational overheads. Yet for banks, such threats are just as dangerous, along with a host of other complex ‘sharks in the water’.

Of course, there is a fair bit of theory to the above, and some may argue that the proof is in the pudding. Peer-to-peer lending survived the recent recession with minimal fuss, but did so as an unknown quantity.

Yet as the recent banking crisis proved, the level of establishment of an empire doesn’t necessarily correlate with its performance during a recession. So if surviving tough times while in the spotlight is the acid test for peer-to-peer lending garnering the full trust of sceptics, then we have three simple words: We’re not afraid!

Main image "Recession" by Simon Cunningham (LendingMemo.com). Image subject to copyright. A link to the image and appropriate licence can be found here. You must not use or reproduce this image other than in accordance with the licence.

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Michael Todt

Mike joined Lending Works in early 2015 with a background in marketing and journalism. Having long held a passion for economics, he is now the chief contributor to the Lending Works blog, and regularly writes about all things peer-to-peer lending, fintech and personal finance.