The P2P lending revolution: goodbye to the high street bank?

Opinions expressed whether in general or in both on the performance of individual investments and in a wider economic context represent the views of the contributor at the time of preparation.

Executive summary: seven-in-ten young people would rather visit the dentist than engage with their high street bank. Such a statistic is perhaps not that surprising given the perceived inflexibility of banks and the fact that both savers and borrowers are currently getting poor returns. Hence the growth in peer-to-peer (‘P2P’) lending. The industry has doubled in size every year since 2010 and is worth at least $12bn at present, yet accounts for little more than 2% of all consumer and small business lending. Cost advantages and network effects should drive significant further growth from here, resulting in a range of potentially attractive investment opportunities.

The high street bank, with its beaming manager able to grant loans to needy borrowers and find creative solutions for hungry depositors, seems like little more than a quaint notion from a bygone era. The reality is that banks are far from being the hub of local communities. More pertinently, most that use them are fed up – rates are high for borrowers and not even keeping up with inflation for depositors. This seeming paradox, where savers have rarely had a worse deal yet credit is both scarce and costly, is attracting new business models and enterprising new organisations. A combination of technology and regulation is helping to empower peer-to-peer (or marketplace) lenders, operations that are – in contrast to their more traditional peers – free of bad balance sheets, high costs and poor reputations.

Peer-to-peer lending can be defined as the practice of lending money to unrelated individuals (or ‘peers’) without going through a traditional financial intermediary such as a bank or other established financial institution. Online platforms originate and distribute, thereby effectively disintermediating banks. In other words, P2P lending platforms match borrowers and lenders directly, using sophisticated software and risk management tools. Both parties benefit, respectively, from lower costs and better returns than would be achieved otherwise. Moreover, lenders effectively mitigate the risk that borrowers will not pay back the money they received by choosing which borrowers to lend to, and diminish their overall risk by diversifying their investments among different borrowers.

The addressable market opportunity is significant. According to the Federal Reserve, there is over $800bn of unsecured consumer credit and more than $500m of small business debt in the US, while the European Central Bank estimates that the comparable figure for Eurozone consumer debt is at least €530bn ($600bn). Figures from the Bank of England calculate that small businesses in the UK have borrowed cumulatively more than £130bn ($200bn). Even if marketplace lender origination has doubled every year since 2010, its overall share of the market is still very small, accounting for just 1.1% of consumer loans originations and 2.1% of small business issuance in the US during 2014, according to Morgan Stanley. These figures are likely to be similar in other geographies too.

Nonetheless, there are many structural reasons why the industry should continue to grow and lenders gain share. First, it makes sense to understand how marketplace lending came into existence and developed to its current size. Initially, the global financial crisis resulted in banks pulling back from consumer and business lending after suffering heavy credit losses. This was compounded by increased regulatory oversight and capital requirements which made certain loan types unattractive to banks. Elsewhere, the greater availability of data sources and the improvement in data analytics technology have helped marketplace lenders to develop ever more sophisticated underwriting models that typically have greater predictive ability than more conventional approaches.

In addition, consumers and small business owners (especially 18-34 year-olds, or the millennial generation) have become increasingly comfortable performing transaction online and through mobile channels. A recent survey of millennial small business owners by Bank of America found that 14% of them are already using non-banking finance while a third believes they will not need a bank within the next five years. Another recent study, by Foundation Capital, a US venture capital firm, reports that 70% of young people would rather visit the dentist than listen to what banks are saying.

The final part of the picture is provided by the current environment of low interest rates. Not only has the general credit situation been relatively benign, helping marketplace platforms to establish themselves and hence their credibility with potential investors in loans, but low rates/returns across multiple asset classes have led to an increased appetite for alternative assets that can deliver attractive yields. Most institutional peer-to-peer lenders are targeting in excess of 5% (and up to 8%) annualised returns for their investors over the next five years, well ahead of that which would potentially be achievable with high yield, investment grade, treasuries or via money markets.

Marketplace lenders operate with high capital efficiency and no capital requirements, matching assets and liabilities with lower regulatory overhead costs (because they do not take deposits). Conventional banks typically have costs that are 2.5 times those of an online lending platform (in other words, an operating expense ratio of 5-7% versus 2-3%) owing to their regulation and reserve requirements, branch networks, outdated technology and slow decision processes. Just 30% of the world’s top-500 banks improved their cost efficiency between 2009 and 2012 according to a recent McKinsey study.

A superior cost structure implies lower costs for borrowers and higher returns for investors. Based on a survey of more than 20,000 borrowers, the interest rate paid on loans availed through LendingClub (the leading marketplace lender in the US) is, on average, some 7 percentage points below the rate on their outstanding debt. Put another way, the APR for typical borrowers falls from 21.8% to 14.8%. Meanwhile, lenders on the LendingClub platform have been able to earn a median loss-adjusted return of 8.6% on a three-year loan, meaningfully ahead of the 1.0% APR that depositors would receive from funds kept in a three-year certificate of deposit account.

Although the principle of matching borrowers and lenders was initially developed with a focus on consumer and small business loans, the concept is now being extended into many other areas such as education and healthcare financing as well as auto loans and even wedding and funeral loans. Estimates suggest that there are now over 300 lending platforms in the US and Europe alone, with many offering multiple and overlapping services. Although the UK was the first market globally to offer P2P loans (Zopa launched its services in February 2005), the US is currently the world’s largest market, with marketplace lenders having originated around $10bn of total loans by the end of 2014, compared to about $2bn in the UK. Numerous other countries have also begun to see the emergence of such platforms, with France and Italy being leading proponents in Europe and Australia and China elsewhere in the world.

There are many reasons to believe that the expansion of the industry will continue. Most importantly, there are clear network effects. The growth in borrowers should improve the robustness of credit models and hence the performance of the platform, reducing the required risk premium for investors and interest rates for borrowers. Marketplace lenders also cite the benefits of creating a self-sustaining community of interlinked borrowers and lenders. The best evidence for this is the acceleration in the growth of the industry. The two largest players in the US (LendingClub and Prosper) originated just $332m of new loans in 2011. Last year, this figure had reached $6bn, taking the cumulative size of loan origination to approximately $10bn. Similarly, in the UK, new loan origination from Zopa and Funding Circle (the two leading players) had reached £500m ($785m) last year compared to £72m ($113m) in 2011. Total UK loan origination now exceeds £1bn.

Critics are concerned that the peer-to-peer business model remains relatively untested and unproven, particularly should another major financial crisis prevail. Although the relatively benign credit environment over the last few years may have made it more difficult to differentiate good underwriting models from bad ones, it is worth bearing in mind that big data and machine-learning have made the process generally more efficient and robust. Zopa also notes that it only approves 1-in-5 applicants for a loan, implying that its process is judicious. This appears to be the industry standard for larger operators. Moreover, the industry’s most established players had in fact all launched their operations prior to 2008 (Zopa in 2005, Prosper in 2006 and LendingClub in 2007). Elsewhere, greater regulatory scrutiny of the industry over time may diminish some of the cost advantages that currently accrue to marketplace lenders. At present, however, regulators have tended to be relatively supportive, noting that such platforms can help lower costs and increase transparency.

If industry estimates are close to being correct (Morgan Stanley predicts the market could be worth $220bn by 2020, while Foundation Capital asserts that the industry could be worth up to $1trn by 2025), then it is important for investors to consider how they can profit from this dynamic. We offer two perspectives. First, very few peer-to-peer lenders are currently listed, with LendingClub (capitalised at $6.0bn) and On Deck Capital (at $860m) being the major ones. Both have seen their share prices fall in 2015 with analysts highlighting current valuation multiples and competitive threats as factors. Other similar businesses may clearly come to market over time, but the majority of lenders are currently owned privately, often with venture-capital involvement. Some mainstream banks have begun to respond by expanding their own online capabilities (e.g. Barclays and Santander), partnering with established lenders (e.g. Citi with LendingClub) or investing directly in online lenders (e.g. Westpac with SocietyOne in Australia). Expect this trend to continue.

From an asset allocator’s viewpoint, P2P lending can be considered as a new asset class with potentially superior returns. Indeed, more than 60% of the loans facilitated by Prosper and LendingClub are now thought to be funded by institutional investors. As a result, a number of dedicated specialists have emerged in this area including several listed investment trusts in the UK such as P2P Global Investments (managed by Marshall Wace and Eaglewood Capital), GLI Finance, VSL Speciality Lending and Ranger Direct. Although these ventures are all still small today, investors should note the words of Andrew Haldane, Chief Economist at the Bank of England: “at present these companies [peer-to-peer lenders] are tiny, but so, a decade ago, was Google.”

Alexander Gunz, Fund Manager, Heptagon Capital