Last week, I started writing about social lending with Peer-to-Peer Lending: You’re Kind Of Doing It Already, which was mostly an explanation of why P2P lending makes sense. In today’s post:

  1. How peer-to-peer lending works; and
  2. How it could all go horribly wrong.

The Technical Details

The basic idea behind social lending is simple:

  • There are depositor-lenders with money that they’d like to save in a place that offers a higher return than a fixed deposit;
  • There are borrowers that either would prefer to pay lower interest rates (than, say, the interest rates on credit cards and payday loans) or want their loans in increments (for example, small companies that are looking to expand but want a series of small loans rather than the large upfront one being offered by the bank).
  • These people need a marketplace in order to transact.

That marketplace is provided by the social-lending company, which invests its start-up capital in building a platform that is secure and user-friendly (the place), and in gathering enough depositors and borrowers to make the whole thing flow smoothly (the market). The lending process runs via an auction, where depositors “bid” to lend money to borrowers.

In practice, if you wanted a loan, you would do the following:

  1. You’d register with the social-lending platform (much like signing up for a facebook account – although you’d need to submit a bit more self-identification that just a verification email, because you’re basically opening an online bank account).
  2. You fill in a loan application form, giving your background, how much money you want, for how long, the maximum interest rate you’d be willing to pay, and how long a period you’d like your “auction” to run for.
  3. The platform will run a background credit check and then allocate you a credit score based on your credit history over the last three years.
  4. The depositors can then bid to take up your loan (or a portion of it) during the course of your auction period. If you successfully raise the loan based on your parameters and the depositor-investor appetite for your interest, then money will be transferred from the depositors’ accounts on the platform into your online account. You can then on-transfer the loan money into your normal bank account.

The social lender makes no guarantees on repayment of loans – they are not a bank. Basically, the principle operates something like insurance: if there are plenty of depositors lending to multiple borrowers in small slices (they recommend that lenders give plenty of small loans rather than one or two big loans), then a single default will just lower your returns slightly.

At the same time, if a borrower does default, then the social lender will usually try and recover the loan through all the normal channels (debt-collectors, legal action, etc). And the borrower then gets kicked off the platform rather publicly.

The whole principle seems to work well. Borrowers have a clear incentive to develop good credit ratings by repaying their loans (because it’ll mean transparent access to lower rates and faster loan issues), and depositors get to make good (and low cost) returns for relatively low risk investments. The social lenders get to earn a fee. And the whole process is mostly unregulated, because it’s new and no one has gotten badly hurt yet.

The market is growing rapidly – according to some of the lending websites, at 105% per year. There are already established P2P lenders (like Zopa in the UK), and even South Africa has its own platform (Rainfin, which is 49% owned by Barclays bank).

The Trouble With Social Lending

So the theory is that all financial crises start with a really great idea that spins rapidly out of control. Well, social lending is a really great idea. It’s disruptive, and it forces the banks to re-look at their administrative size. It could drive up interest rates offered to savers (who have the option of taking their money elsewhere), and drive down interest rates for borrowers (who now have the option of obtaining their money elsewhere).

The problem, really, is that we’re dealing with credit here. And credit… credit is really the art of money creation. But it’s all really a bit relative to time, so maybe let me explain this in the context of a month.

  1. Let’s assume that we live in a country in which there is only one company that everyone works for (the Super Market), and its also the company that everyone buys food and supplies from (it is, after all, the Super Market).
  2. Everyone earns a salary of $10,000 per month, which they can either save or immediately spend at the Super Market, buying the food and supplies that they helped to produce.
  3. Then a lender arrives on the scene, who says “let’s lend each other money”.
  4. The people that were saving their money (let’s say they were keeping $5,000 per month in their mattresses) now give it to those people that want to spend it.
  5. The people that were spending $5,000 per month are still spending their $5,000 per month.
  6. The people that were spending their full $10,000 per month are now spending $15,000.
  7. In terms of buying power, where before there was only $15,000 being spent, there is now $20,000 being spent. Meaning that there is more money chasing the same amount of goods (because nothing else has changed).
  8. So the Super Market attempts to produce more to meet the demand, meaning higher salaries and bonuses (which the borrowers can use to repay the lenders).
  9. And where production can’t be increased, prices start to creep up (inflation).

When the whole credit process is moving in a positive direction, it’s all good. Credit tends to magnify optimism by taking the optimism and turning it into low interest rates and easier access to money – which has a self-fulfilling aspect to it.

But credit also magnifies pessimism. Let’s say that something sparks off a run at the lender – maybe a large borrower gets out of control, and people start to panic that they’re not going to get paid back. What happens? Everything seizes up:

  1. The lenders start demanding money back, so the borrowers have to cut their spending from $15,000 down to $5,000 per month (they lose the first $5,000 because the lenders are no longer lending, and the second $5,000 because they have to repay what they’ve already borrowed).
  2. The lenders are still only spending $5,000 per month.
  3. Where $20,000 was once being spent, there is now only $10,000 flowing around.
  4. So the Super Market cuts production by half, fires people, and orchestrates pay cuts (making the problem worse).
  5. Cue: Depression.

Credit is the source of the boom and bust cycle. People shift between greed and fear like sheep in a flock – and those emotions are amplified by the credit process.

What Reserve Banks and governments attempt to do is manage those emotions. They put in place deposit insurance schemes to keep depositors from worrying that their money is safe. They make banks keep reserves to try and assuage the fear that the bank might fail. And when there is a credit crunch, the Reserve Bank goes on quantitative easing sprees to try and make sure that the borrowers (the spenders) have money to continue spending and stimulating.

Peer-to-peer lending is great while the industry is small. But what happens when it rides high on the wave of optimism, and becomes a significant component of credit in the economy? All it needs is one large P2P lender to get too greedy, and get a little lax with its credit-scoring. The default rates climb a little too high, and then the investor herd starts to slow lending. The existing borrowers then lose the incentive to repay their loans (why repay when you’re not going to get any more in future?).

And the economy seizes.

It’s happened before, after all. And it’s not even taking into account the fact that peer-to-peer lending has no reserve system – meaning that the money creation is almost exponentially-related to the amount of time that social-lending rides that wave*.
*For an explanation of the reserve implications, I wrote about banking reserves here: What is all this talk about banks and Basel?