The recent mushrooming of P2P lending websites in India has just made credit much more accessible to everyone, eliminating the lengthy paperwork and cumbersome process. While this is a boon for borrowers, lenders may find themselves in hot water in times very soon to come.
The P2P Ecosystem
The bone of contention in the business of lending and borrowing is not the amount but the rate. The rate goes high if the risk involved is higher and the risk means, necessarily, someone is going to default in the whole system. The banks are overburdened with demands of loans that they can never fulfill. So they look for most secured applications and disburse loans against fitting collaterals, sometimes rejecting even creditworthy applications.
The unfulfilled demand finds its recourse in the unorganized informal market, which through technology, the P2P lending websites are trying to plug themselves in. By model, P2Ps eliminate the requirement of collaterals, essentially facilitating unsecured loans to anyone from anyone in the system while they provide almost no guarantee of repayments. P2P websites offer three important differentiating characteristics: convenience of an easy online loan approval process, reconfiguration of the data to assess realistic creditworthiness and a seemingly low rate of interest. Technology facilitates the ease and the optimistic assessment, but the rates ought to be significantly less as P2Ps do not have the burden of the cost of capital.
However, the reality remains just the inverse. Banks in India may provide personal loans starting at 11.99% to a maximum of 24%, but P2P lending websites in India offer anywhere from 12% to 36%, and their average interest rate of all the lending comes about to be around 22-24%. On the surface it might appear that they are facilitating expensive loans, contrary to what they claim. Rather, the mix of borrowing on P2Ps majorily comprise the risky category of borrowers, most of whom are very probable of having been rejected a bank loan, and for this riskier class the opportunity cost of acquiring capital is apparently cheaper on a P2P than what they could have been paying elsewhere.
So, for lenders on P2Ps, initially the profits appear much higher but instead, are way too riskier. Almost all P2P platforms have an in-house credit assessment system that is claimed to be more comprehensive and may apparently throw up ‘realistic’ credit scores on the basis of a wide array of historical data and metrics. Bhuvan Rustagi, founder, Lendbox.com confirms “While banks look for a CIBIL score of upwards to 800, we help provide loans to people even with a CIBIL score of 600. Students and small scale entrepreneurs with no prior credit history find it difficult to get loans from banks. This category necessarily should not be considered as willful defaulters.”
But nonetheless, there is a greater level of risk associated with these investment opportunities, and so may appear the chances of profiting for lenders.
The Larger Picture
In markets like China, US and UK, the digital revolution and infrastructure capabilities enabled the internet ecosystem progress much faster than in India, which is the reason why P2P lending websites in these countries have flourished and are at an advanced stage to give the nascent Indian market an insight of what might go wrong with them in near future.
Incidentally, the infrastructure boom in China had declined, leading investors to look for alternative avenues as even the official interest rates had declined to 1.55% for a 5 year fixed deposit. Investors found immense potential with Chinese P2Ps which were very poorly regulated then and thus large sums of capital started flowing in on these platforms making credit readily available to consequently render borrowers overleveraged.
P2P lending in China exceeded $400 billion in the first half of 2016. About a year ago, once China’s biggest P2P lender- Ezubao was revealed to be operating a ponzi scheme which led to a capital loss of about $7.6 billion to over 9,00,000 investors. What is more alarming is that there are about 4000 P2P lending websites in China out of which 2000 were incorporated in 2015-16 and 1598 have failed or disappeared till now with billions of dollars of more funds missing. Similarly, promoters of Esudai, a small P2P lender in China that has disbursed $1.7 billion in loans from 3,33,000 investors were caught misappropriating funds and masquerading as regular users to post fake borrowing requests on their website.
In UK, reports have revealed that banks and hedge funds are behind 26% of the lending done on these platforms. This means, what for all practical purposes came as an alternative to banks, are now being increasingly run by banks. So supposedly, if a borrower in UK was rejected a loan by a bank due to lower credit score, he runs a chance of indirectly getting funded by the same bank at a much higher interest rate on a P2P website because he could be easily expected to trade off the higher rate of loan as an opportunity cost of getting the loan approved in the first place.
In US, loans on P2P platforms like Lending Club are being securitized by SEC and states, which experts hint is just another subprime crisis in the making as any securitization generally degrades underwriting standards and bad loans will eventually be sold as CDOs. This is probably why a state like Texas has banned P2Ps from operating within its boundaries. According to a 2015 PWC report titled ‘Peer Pressure- How peer-to-peer lending platforms are transforming the consumer lending industry’, “For US P2P platform, approximately 80% of funding comes from institutional investors.” The trajectory of the P2P lending industry in US is just a reflection of what India may most probably anticipate in the long run.
Rajat Gandhi, Founder and CEO, Faircent opines, “What we are doing is disrupting the banks… as it comes out that P2Ps are an attractive destination for investments, maybe down the line, we expect banks to partner”, essentially meaning that banks are themselves poised to disrupt P2Ps when they think is the right time. In India, Fintech is relatively a new term and P2Ps have just evolved almost about a decade after they had been swiping the developed markets.
Prableen Bajpai, CFA and founding director at FinFix explains, “There is no regulation for Bitcoin in India maybe because it is insignificant here. But for P2Ps, RBI has come out with a consultation paper aimed at regularizing the sector to treat P2Ps as a special category NBFC. It means the government realizes its potential (and thus the risk of what might go wrong).”
P2P websites in India, like anywhere else offer customers small to medium loans to pay for various short term needs like an electricity/mobile/credit card bill, EMIs, etc which essentially means a refinancing of an already existing loan into an unsecured personal loan. The loan cycle on P2Ps can range from anything between a few weeks to about 36 months, and it can be well argued that the existing loan defaults are only being deferred while the credit risk is being transferred from a few large financial institutions to millions of private, unsuspecting individual investors on these platforms.
Soon, the defaults that P2P loans paid for (including accrued interest) will accrue more interest on P2Ps which will spiral out of control for borrowers and it is just a matter of time when a large chunk of borrowers become overleveraged and are unable to pay back lenders on P2P platforms. When a large number of such defaults start boggling a particular P2P platform, it will ultimately, hit the wall.
It is crucial to understand that P2Ps are not just an alternative but an additional platform to raise credit which did not exist earlier. So, a borrower may even approach a P2P to refinance its existing loan on another P2P. The RBI regulation thus needs to watertight these structural gaps. Mohandas Pai, Partner, Aarin Capital who has invested in Faircent.com also feels, “Some regulation is necessary for orderly growth (of the sector) as it deals with money of investors.”
P2Ps generally charge about 1-5% of total loan amount as origination fees from either lender, a borrower or both depending on the risk factor. Also, most P2Ps only earn when a new loan is being disbursed. This means the platforms do not face a loss directly upon a default and their focus remains on facilitating higher volumes rather than better quality of loans. This model makes the P2Ps riskier.
Dr. Dhruva Nath, Professor and Chairman (Centre for Entrepreneurship), MDI, Gurgaon and an Angel investor who has mentored over 25 digital business start-ups tells us, “Two P2Ps had approached us for funding but we said ‘no’ to them. In absence of proper regulatory clarity, it is a risky proposition. We would not invest in it.”
Abhinav Johary, founder, i2ifunding.com and Bhuvan Rustagi, founder, Lendbox.com confirm “Over the last 12 months, the average rate has been coming down,” hinting towards some improvement in borrower profiles expected in the times to come. But this is a global trend and in absence of concrete oversight of the regulatory framework, the very mechanism of credit assessment by in-house teams of P2P lenders can be challenged as possibly arbitrary as there remains a propensity for inorganic manipulation of the same. Until there is a substantial clarity on its regulation, P2P lending websites in India will remain a highly unsecured space for prudent investments.
(This article was first published in the March issue of Entrepreneur Magazine. To subscribe, click here)