The Spectacular Rise and Fall of Peer Lending

Before the financial crisis, peer lending (P2P) was to be the next great disruptor. Just as the mobile phone had disrupted the telecom industry, p2p was going to democratize banking and lending in America.

Even just after the crisis, peer lending rebounded quickly and there was still hope that it would live up to the enthusiasm.

More than a decade after the launch of Prosper Marketplace in 2006, the hope of p2p disrupting traditional finance seem to have all but died out. The industry is still growing and continues to take loan share from traditional channels but funding of new peer lending platforms and p2p investor returns have weakened dramatically.

Can peer lending still fulfil its role as a disruptive force in banking? How far can p2p go and how will it affect borrowers and investors?

Early Peer to Peer Lending and Industry Mistakes

Peer lending is the natural evolution of banking in the social media age. Instead of borrowers going to a traditional bank, they can go directly to investors through an online platform that facilitates the lending process.

The lending platforms take a borrower’s application, perform all the credit qualifying a traditional bank would and manage the payment process. Borrowers repay loans on a monthly basis, paying interest and principal. The p2p platform takes a percentage for management costs and then deposits the rest into investor accounts on a pro-rated basis.

For investors, the idea of buying loans is nothing new. In the past, banks would bundle their loans and sell them off to institutional investors or brokers. P2P investing simply allows the investor to cut out the middleman and invest directly in loans.

Peer lending didn’t come to the U.S. until 2006 with Prosper, followed soon after by Lending Club. There were skeptics but the industry soon won over a vocal army of supporters for its potential to democratize lending.

P2P lending was to be a massive disruption in finance, less bound by strict lending requirements and capital controls, to speed the use of investment capital from investor to borrower.

Nearly $20 million in loans were issued on the Lending Club platform in 2008, a 316% increase on the $4.8 million issued in 2007.

Early peer lending platforms had few restrictions. The only requirement was to register with securities regulators in each state where business was conducted. It wasn’t until 2008 that the Securities & Exchange Commission (SEC) required platforms to register with federal regulators as well.

Unfortunately, internal problems with the industry as well as the global financial crisis brought the early enthusiasm for p2p to a swift end. The lending models and borrower approval process at the major platforms failed to hold up against the biggest financial crisis in nearly a century. Investor adjusted annualized returns sank to just 2.4% on loans issued in the first two years through 2008.

Where is P2P Lending Now?

The financial crisis could not halt the rise of peer to peer lending but it certainly slowed it down and created a skepticism among the public. While loans on the Lending Club platform have increased to $6.4 billion issued in 2016, the platform had no loan growth from the prior year.

Lending Club, the world’s largest p2p platform, didn’t help the industry’s image when it was found in 2016 that the company had changed data on some loans to qualify for resell to a large institutional client.

Competition in online loans as well as tightening loan standards at some of the platforms seems to be weighing on investor returns. Returns on loans through the Lending Club platform were 8.3% in 2013 but have since fallen to a net annualized return of just 6.7% for those issued in 2015.

As traditional banks recovered from the financial crisis and loosened credit standards, the p2p industry seems to have become the lender of last resort for bad credit personal loans. Borrowers are first applying at local banks and drawing on their credit cards before finally going to peer lenders. This is increasing default rates on loans and causing p2p platforms to tighten standards.

What does the Future Hold for Peer to Peer Lending in America?

The recent problems for peer lenders of higher defaults and shrinking investor returns doesn’t mean p2p is dead as a financial disruptor.

Goldman Sachs, traditionally an investment bank rather than a deposit-taking institution, launched its personal loan service ‘Marcus’ earlier this year. While not technically a peer lender, the platform does validate the bridge between traditional banking and online lending.

As with most bubbles, early peer lending proponents started on rational expectations that just got ahead of themselves. Peer lending does carry several advantages over traditional banking from convenience to lower operational costs. It also brings some distinct disadvantages and risks like loss of the personal touch in banking and heightened risk of borrower fraud.

PwC estimated in 2015 that the p2p market could reach $150 billion by 2025. That would require growth of around 35% annually over the next seven years. It’s possible considering the current p2p market is just a fraction of the $800 billion in revolving consumer debt and the $1.4 trillion of non-revolving consumer loans.

Online and peer to peer lending still may be the way we borrow or invest money in the future but it’s clearly not the immediate disruption early adopters hoped. Like most technological disruptive forces, it will become mainstream through fits and starts.

Joseph Hogue, CFA is a financial analyst and blogger writing in topics from peer lending, personal finance, investing and making money online. A veteran of the Marine Corps, he has appeared on Bloomberg TV and on several online news channels including CNBC and Morningstar.

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