Banking is one of the oldest institutes founded by man, with the earliest merchant banks making grain loans to farmers and traders who carried goods between city circa 2000 BC. Later in Greece and the Roman Empire, lenders based in temples made two significant innovations: they accepted deposits and converted currency. But the banks as we more or less know today, with their bookkeeping systems and ledgers, were established with the advent of the Renaissance period in Italy and the founding of Banks by the Bardi and Peruzzi family. The most famous bank of that age, of course, was the Medici Bank founded by Giovanni Medici, and even kids know that name thanks to the Assassin’s Creed games with its fictional depiction of Renaissance Italy. Since then, the world has become accrual place.
Sorry, couldn’t resist.
But after witnessing the life changing, paradigm shifting, globe-spanning, epic disaster that was the 2008 financial meltdown, more and more people questioned the big banks and the regulations governing them. The much-touted corporate concept of “Too big to fail,” which was popularised during the industrial age, couldn’t find a foothold in the information age. People didn’t appreciate losing their retirement fund just because some sleazy guy in a suit thought it would be okay to sell homes to people who couldn’t even pay their apartment's rent! The whole world turned upside down.
And amidst this uproar, like in any great revolution, the landscape was slowly but surely changing. Power was being wrested bank and forth. New business models—revolving around the set-in-stone concept of lending and borrowing—were evolving, and the banks were either demonising them or trying to emulate them.
Even if the financial crisis hadn’t happened, the monopoly of the banks, their closely guarded trade secrets, and their tendency to collude allowed them to have a death-grip on their customers and an unfair advantage over any new entrants, which in turn led to a lot of resentment and distrust.
The greatest breakthrough happened when the mechanics of peer-to-peer (P2P) economy was applied to banking. Would you lend money to a stranger? Probably not. But what if a middleman did a thorough vetting process for the borrower, assigned him a credit rating, and you could invest towards a small portion the capital required by him and others like him, thereby building your portfolio, diversifying your risk, and earning a good amount of ROI in the process? Suddenly the prospect doesn’t look so bad, does it?
It is a little more complicated than that, of course. Otherwise everyone would be doing it. As can be seen from the image below, Borrowers apply for loan through the platform whilst lender commits to paying a part of the capital to the borrower via the same platform. The lending platform reports to the Partner Bank that the borrower is verified and the investor has committed. During this phase the platform also does due diligence on the borrower (in the form of credit checks, background checks, etc) to try to mitigate the risk for the lender as much as possible. The bank facilitates the money transfer and issues the actual loan to the borrower. The borrower in turn transfers the loan note to the bank. The lending platform in question purchases those loan notes using the cash that the lender provides to the platform. When the loan is re-payed in instalments by the borrower, the platform handles the transactions and gives the investor his principal plus the interest he has earned. The lending platform makes money via processing fees as well as taking a small percentage of the interest earned by the loan. Since the loan note has been purchased from the bank by the platform, the bank doesn’t hold any liability and only provides the actual cashflow, so to speak.
The greatest risk for the P2P lending platform is default rates. If too many borrowers are unable to pay their monthly instalments or end up absconding, the platform will have to pay back the investor. Thus, it becomes of paramount importance to have good quality, reliable borrowers. This is ensured via credit checks, background checks and any other means at the platform’s disposal. This method, of course, is not 100% efficient and there is a percentage of users who end up defaulting on their loans. However, by keeping this percentage low, the platform can still earn a profit while keeping its reputation intact and its investors happy.
And this model is doing pretty well for itself. One such success story is that of Lending club, a US-based peer-to-peer lending company that was founded in 2006. They are the leaders of P2P lending platforms, being the first such company to have gone public. They boast a total of $15.9 billion worth of loans disbursed as of 31st December, 2015.
Further details about the business model—and how it compares with the traditional model—can be found in my report below.