4 ALTERNATIVE LENDING

 

Generally called Peer-to-Peer (P2P) lending, alternative lending can be found under other names as well (online lending, marketplace lending etc). As the name suggests, P2P lending platforms connect savers with money to lend with individuals or small businesses that need to borrow, creating thus a market place.  In its initial form, alternative lending eliminates financial institutions from the lending process, simply making it easier for an individual to lend money to another, charge interest and wait for the repayment of the loan. The loan experience through an alternative lending platform is generally entirely digital (including application, origination, underwriting, servicing) and the approval is very often received by the applicant almost in real time, which makes it significantly more efficient (in terms of costs and time) than the traditional loan experience through a bank, which can even take weeks for approval sometimes. However, meanwhile the financial institutions have seized the opportunity and the threat posed by alternative lending and many of them have launched in such projects themselves or partnered with dedicated startups in order to be able to provide similar services.

Although they are often used interchangeably, the various names used for defining alternative lending DO have some subtle differences among them. The most widely used (and the initial term) was peer-to-peer lending. This term referred to an online platform which would simply connect borrowers and lenders. However, as the sector evolved with the involvement of institutional players and the emergence of balance sheet lending provided by online platforms, the term P2P lending was not comprehensive enough anymore. Thus the term marketplace lending (MPL) has started to be used.  Online lending is another term which is general enough to cover the different evolving characteristics of the sector, but maybe not specific enough.  Last but not least, alternative lending is general enough to exclude the lending performed through traditional banking methods and channels, but possibly too general, as it lacks the reference to the technological nature of the sector. Since there is no standardization in the relevant literature, in the current chapter I will be using all four terms interchangeably. 

One of the first areas to be explored by fintechs, alternative lending has been around since 2005, when the UK-based P2P lender Zopa was founded, followed in 2006 by the launching of Prosper Marketplace and Lending Club in the USA and Paipaidai in China in 2007. One decade later, in 2017, among the 25 fintech unicorns identified by CB Insights globally, many of them were alternative lenders{34}: Affirm, Kabbage, SoFi, Credit Karma, Funding Circle, GreenSky, Lufax, Avant, Prosper.

Meanwhile, other important milestones have been reached. Several alternative lenders have gone public, with the all-time high of equity funding for the alternative lending sector reached in 2015 (USD 6.3bn collective equity funding). In addition, consolidation became an important trend in the sector, with a peak in the number of acquisitions, mergers and shutdowns reached in 2017{35}.

However, as the industry matures, skepticism has also increased in relation to the business model of alternative lenders, which still remains to be tested in times of downturns, increased regulatory requirements, increasing operational challenges related to scalability (internal controls, risk management, loan servicing) and increasing concerns around cybersecurity{36} and rising interest rates.  Any of these factors could put pressure on the borrowers and lead to an increase in defaults.

While at its inception, Zopa was promoting the concept of “alternative finance” as something revolutionary (“finance by the people, to the people”), according to FT (2016), a decade later, the P2P was transformed from alternative finance into “another lending channel for banks, hedge funds, pension funds and others”, or in other words it is becoming more and more “a part of mainstream finance”.  On one hand, one may consider that the involvement of traditional financial institutions in the alternative lending sector may squeeze out individual investors. On the other hand, growing and achieving scale would not be possible without the institutional money{37}. Consequently, the involvement of the financial institutions in the area of alternative lending should be seen just as a natural step in the evolution of the sector. According to Forbes (2018), in 2016, a significant part of the alternative lending business was funded by institutional investors such as banks, pension funds and asset managers (45% of P2P consumer lending and 29% of P2P business lending){38}.

On a different note, one should note as well the difference between P2P lending and microfinance. Both services refer to the intermediation of online loans among peers. However, microfinance refers to loans of very small sizes (under USD 1,000) and are usually run by non-profit organizations. One such example is Kiva.

This chapter will focus on P2P lending rather than on microfinance.

 

4.1 Driving factors

 

4.1.1 The emergence of the peer-to-peer economy

 

It is natural to assume that the development of the peer-to-peer lending activity has been partly correlated with and influenced by the development of the peer-to-peer economy in general. The peer-to-peer economy (or sharing economy) refers to all the activities through which the owners of various assets or capital agree to share it directly with potential users against a fee, without the involvement of an intermediary. Some of the best known examples include Uber (car sharing) and AirBnB (flat sharing). Uber is such a famous example within the sharing economy category, that sharing economy itself is sometimes called uberization.

In relation to the sharing economy, FT(2014) explains, “finding new ways to monetize used or existing assets has the obvious and immediate effects of raising their value and the wealth of their owners, while simultaneously reducing the value of comparable stuff owned by incumbent companies […] who find themselves burdened by the newly competitive environment. […] And all without any new stuff actually having to be made”{39}. The driving factors behind the growth of sharing economy, highlighted by FT (2014), citing Arun Sundararajan (NYU) are:

- the consumerization of digital technologies, meaning that in the past few decades, radical innovation has been driven more by the needs of consumers than by the needs of companies or government, which is in contrast to the previous times. The direct consequences of this phenomenon have been easy access to the new digital technologies and familiarity with them for the consumers, which can then enable the use of peer-to-peer platforms for various exchanges.

- the emergence of digital institutions – this refers to “digital technology-based platforms that facilitate exchange in the same way that economic institutions historically have done”. Examples include platforms which perform digital identity verification or credit scoring systems, which subsequently “facilitate trusted economic exchange in hundreds of different peer-to-peer marketplaces”.

- urbanization and globalization – the space constraints that urban residents are faced with makes them favour the sharing economy approach. In other words, they often prefer to pay for access to an asset or a resource instead of owning it.

- ecological and resource considerations – these refer mainly to the fact that sharing economy most often implies a more efficient use of resources as well, which increase its attractiveness for the larger and larger number of people concerned with such issues.

 

4.1.2 Macroeconomic environment

 

The macroeconomic environment has been in many ways accommodating for the development of alternative lending. First of all, following the financial crisis in 2007, many banks reduced lending volumes, with the most significantly affected segment being the SMEs.  The alternative lending platforms seized the opportunity occurred from the needs of such clients and took advantage of it. Although currently the banks’ appetite for lending is back and their interest to get involved themselves in alternative lending is high, the sector is well-established and mature enough to resist, which means that the most likely further development would be in the direction of partnerships among traditional banks and alternative lenders.

Secondly, the years of low interest rate environment that followed the financial crisis have lead professional investors in the search of investment opportunities with higher potential yields, and online lending (through securitization, but not only) positioned itself as such an...