BG Consulting (Financial Training) discusses the potential impact and risks involved in the growth of peer to peer lending platforms (P2P). What is the likely impact on banks, and how should they best respond?

1. BG ConsultingGroup Ltd. 2014 1
Peer to Peer Lending
(“P2P”) Platforms
How Should Banks Respond?
P2P is probably most readily associated with the consumer-focused Zopa, which claims to have
created the market almost ten years ago. However, the Chart shows that small businesses are
also benefitting from this new technology:
P2P Lending: 2013
(Source: derived from www.p2pfa.info, quoting Nesta briefon “The Rise ofFutureFinance”)
There is potential for P2P to change the way that businesses are financed. A key question for banks
and other organisations serving small business is:
£287m
£193m
£97m Consumer Lending
Business Lending
Invoice Trading

2. BG ConsultingGroup Ltd. 2014 2
Is this an Opportunity or a Threat for Banks?
The answer to this is, in part, dependent
upon whether P2P is here to stay.
P2P has started to do something that banks
either cannot or will not – filling the
“financing gap”. Bankers have typically
complained of the high “costs to serve” and
lack of transparent financials associated with
small businesses. Have P2P platforms
cracked something that the banks have
struggled to do for decades or even
centuries?
Algorithms Linked to Social Networks
Are the P2P algorithms, with their linkages to
social networks, really so much more robust
than those developed by leading banks? Does
this mean that they are better able to
understand risk than the banks?
Traditionally, lending to small business has
been relationship driven, which tends to be
high cost in terms of both attracting suitable
borrowers and in the credit analysis process.
It is not difficult to imagine that there can be
efficiencies in web-based customer
acquisition, but this is available to online
lenders without their being P2P. The P2P
platforms could really have a sustainable
advantage if their credit analysis is capable
over the complete cycle of predicting
probabilities of default (“PDs”), loss given
default (“LGDs”) and the resultant Expected
Losses (“ELs”). So, if P2P platforms remain
better able to mine useful credit intelligence
from social networks, the banks could face
increasing competition.

3. BG ConsultingGroup Ltd. 2014 3
Pricing Decisions
Lenders are probably not being altogether
altruistic when they invest surplus funds across
a P2P platform. The vast majority will, of
course, be seeking to achieve a higher return
than they could expect from a bank deposit. It is
likely that all, or most, such lenders will
appreciate that there is a significantly different
risk profile in cutting out the middleman – i.e. a
bank with deposit protection. Does the P2P
lender: (i) have access to the risk adjusted
return models which are standard in the
banking industry, and (ii) have the ability to
make informed investment decisions based
upon these?
Funding Cost Advantage
It is true for the vast majority of P2P lenders
that they do not suffer the formal requirement
to allocate shareholder capital against their
lending as is imposed upon the banks through
the Basel regulations. While P2P lenders might
consider their opportunity cost of capital to be
low, this might be a little misleading relative to
the funding advantages (leverage and often
zero interest deposits) enjoyed by the banks.
Banks have learned over many decades how to
price for increasing tenor and this is something
that might be new to P2P lenders.
Portfolio Diversification
One of the attractions of P2P lending appears to
be that the transaction costs for lender are very
low, meaning that it is quite easy to construct a
portfolio of loan participations. The ability to
diversify across several (or many) borrowers
might be a comfort to lenders, but do they have
the tools to assess whether they are achieving
diversification benefits? How significant is the
potential that their portfolios contain
unrecognised concentration risks? In banking,
there is a saying:
“Concentration kills”…

4. BG ConsultingGroup Ltd. 2014 4
Investor Protection
Several P2P platforms state that they are able
to offer varying levels of investor protection,
and if effective this could be a good mitigant
for the above objections. For example:
Landbay says it offers “protection funds”;
Lending Works says it has “insurance”, and
Madiston LendLoan Invest advertises its
“compensation scheme”. The devil is always in
the detail, and it is important to have a
concept as to how these mitigants operate and
who stands behind them.
Attractions to Borrowers from P2P
Just why are small businesses starting to use
these platforms? Is it because the P2P process
is quicker and less bureaucratic? Are they able
to source cheaper, longer term funding from
P2P compared to banks? Are P2P lenders
financing borrowers who would be turned
away by the banks? Or are the P2P platforms
cherry-picking the banks’ best small business
prospects? Can banks enjoy a better
relationship with customers who source their
financing from P2P lenders, enabling the
banks to cross-sell non-credit products? The
answers to these questions are likely to be
central to the type of competitive response
from the banks.

5. BG ConsultingGroup Ltd. 2014 5
Some Key Challenges for P2P Business Models
Incentive Problems
This is essentially a broker model, wherein
the provider of the P2P platform takes little or
no financing risk. A root cause of asset bubble
driven banking crises has often been a skewed
reward structure wherein relationship
managers have been incentivised to generate
asset growth with little or no regard for the
risks that they have piled onto their
employers’ balance sheets.
If the P2P platforms have no risk of capital
loss, could this mean that credit quality within
the system might deteriorate and simply be
passed around many P2P lenders rather than
(as is currently the case) remaining in the
hands of the originating bank?
Monitoring and the Identification of Early Warning Signals
Through the inclusion in their credit
algorithms of behavioural factors (often
drawn from social media), it is conceivable
that the P2P platforms will do a better job of
identifying developing problems than
incumbent lenders (who have struggled with
this since the beginning of time!).
However, it will be important to see how
much attention the platforms will pay to
advising their lenders of changes in the
borrowers’ credit quality.
Without question, the earlier that problems
are identified, the better the lender’s
prospects of making a full recovery.

6. BG ConsultingGroup Ltd. 2014 6
Problem Loans
Who will take responsibility for negotiating
restructurings when problems develop? This
is a highly specialised, time-intensive and
costly process. Loan workout and
restructuring skills and cultures vary widely
between existing lenders. How will P2P
platforms perform?
Education of Lenders
Banks have invested huge sums in training
their staff in credit analysis and associated
topics. Will all (or even a reasonable
percentage) of P2P lenders have the same or
better understanding of these principles and
techniques? And if the P2P platforms are to
educate/ train potential lenders, is there not a
significant conflict of interest?
There are, of course, myriad other issues for
P2P platforms to manage, not least of which
are potential fraud, anti-money laundering
and KYC. However, within this article I have
sought to identify some of the strategic
questions and challenges with a view to
providing bankers with a starting point for
framing their strategic responses.
For assistance with developing your strategic response, training relevant staff or to provide
feedback/comments on this article, please email me at:
adrian.grant@bgconsulting.com
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