Keeping banks on their toes: Credit crunch creating new opportunities for P2P finance

Whether it is in the form of microfinance, crowdsourcing or services that match lenders directly with borrowers, peer-to-peer (P2P) finance is beginning to emerge as an alternative to the traditional banking sector.

Key industry trends spotted by Euromonitor:

  • Taking microfinance a step further
  • Bridging the gap to emerging market entrepreneurs
  • Helping others to help themselves
  • Credit crunch creates a fertile environment for crowdfunding
  • Conventional funding model biased towards large transactions
  • “Everybody wins, except the fat cats”
  • Algorithms replace relationships.

Commercial opportunities

  • Although the concept has been around for almost three decades, microfinance has benefitted hugely from P2P finance as it facilitates the building of personal relationships between lenders and emerging market borrowers who cannot access capital through established channels
  • Crowdfunding has the potential to revolutionise the way in which small companies fund themselves
  • Disenchantment with the banking sector is fuelling the interest of developed economy consumers in alternatives forms of lending and borrowing like Zopa

P2P finance generally refers to interpersonal lending that is conducted without bank intermediation. Such P2P lending services as Zopa in the UK, Prosper in the USA, Smava in Germany and DhanaX in India are not financial institutions, as they do not guarantee deposits or set interest rates. In essence, they act as an exchange or intermediary that facilitates the matching of lenders and borrowers, as well as the transfer of funds and payments. Loan amounts are generally small, usually ranging from US$1,000 to US$25,000, and they are spread out over a large number of lenders who can loan as little as $50.

A type of eBay for loans, these websites take advantage of social networking to virtually aggregate lenders to fund loans, a model that some claim (probably fancifully) could eventually usurp traditional financial institutions. They often incorporate social networking features, such as photos, borrower Q&A, friends, borrower recommendations and community. By incorporating such features as mutual feedback and transparency, eBay became a marketplace based on informed strangers trusting one another. This philosophy now underpins a host of emerging ventures in sectors ranging from personal loans to venture capital, all based on informed cooperation.

Taking microfinance a step further

P2P finance evolved in part from microfinance or microcredit. A decentralized activity, microfinance is typically used to finance labour-intensive, small-scale trade and industry, filling a gap between the regular banking sector and poorer individuals with entrepreneurial ambitions. The concept was pioneered by Bangladeshi economist Muhammad Yunus in the mid 1970s. The driving force behind microfinance is the difficulty many less affluent individuals in emerging market have accessing credit through the banking system.

Per-household consumer credit outstanding balances in selected markets: 2009US$ per household

Source: Euromonitor International from trade sources/national statistics.

Bridging the gap to emerging market entrepreneurs

P2P technology has helped the microfinance sector to greatly expand the scale of its operations. USA-based P2P microcredit platform Kiva, which means “unity” or “agreement” in Swahili, works with microfinance initiatives (MFIs) to transfer non-interest-bearing loans from private individuals and civil society organisations to small-scale entrepreneurs in developing countries as interest-bearing loans. It was founded by Matt and Jessica Flannery in 2005 after they attended a lecture by Muhammad Yunus.

In contrast to the traditional model of retail lending, Kiva does not vet its borrowers directly. To even attempt to do so would be folly. Entrepreneurs in the developing world are digital ghosts, for whom electronic data simply does not exist. Instead, Kiva rigorously checks, evaluates and monitors its field partners – 111 MFIs in 52 countries through which it distributes its loans. Typically, a $1,000 loan on the site will be funded by 20 to 30 lenders around the world.

One of its partners is Angkor Microfinance Kampuchea (AMK), which specialises in microloans to the rural poor in Cambodia. Operating in 6,253 villages nationwide, AMK has almost 220,000 active borrowers (85% of whom are women) and a loan portfolio worth nearly US$25 million. 91% of its loans are for sums of less than US$300.

Helping others to help themselves

The potential of this mechanism to transform the day-to-day lives of those on low incomes can hardly be overstated. Take the example of 27-year-old Cambodian weaver Kakda Sun, who was able to leave a harsh textile factory environment and become self-employed after she joined forces with some of her neighbours to buy rolls of thread, which cost US$300 each, together with a new loom costing US$500, enabling her to work from home. She says that “Since borrowing money, I’ve been able to work at home. I can rest when I need to. We’ve also been able to buy a motorbike. Business is going well.”

The original loan has now been repaid in full, and a total of 64 people have since financed a second loan for Kakda and her neighbours. Among their number is Scott, a US marine from Dumfries, Virginia, who has served in the military for 24 years and believes in “helping others to help themselves.” He selected Kakda’s project after coming across her profile on Kiva.org.

According to 36-year-old Russ Schoen, a corporate trainer from Chicago, who has made 35 Kiva loans to entrepreneurs in 12 countries, “It’s the personal story which makes me want to lend. All my money has come back so far, and when I log on to Kiva and see there’s $200 in my account, my first thought is ‘Who should I lend to next?”

Credit crunch creates a fertile environment for crowdfunding

In the area of venture capital, crowdfunding took off during 2009 as traditional sources of financing suddenly evaporated. Crowdfunding is a P2P method of financing a venture by raising small sums from a large group of informed strangers. Developed in creative niche industries like movies and music, it is now being applied much more widely.

In 2009, London-based social-analytics firm Trampoline Systems raised £250,000 (US$380,000) in equity using this method after its original hedge fund backer took fright as the global economy threatened to go into meltdown. According to Trampoline CEO Charles Armstrong, “We saw a ripple going through our own social networks. Introductions were made and that chain of trust extended.”

Conventional funding model biased towards large transactions

Armstrong argues that “There are very clear inefficiencies in the conventional funding model, not least because they have an inbuilt bias towards certain types of transaction. The cost to a venture capitalist of due diligence and completing a transaction of £100,000 is more or less the same as for one of £10 million. So there’s a pressure to invest larger sums in a single transaction. People have been talking about the funding gap for the past 20 years, but the last 18 months have exacerbated the problem. Transactions from £100,000 to £1 million are going to turn out to be very well matched for crowdfunding and other innovative models.”

“Everybody wins, except the fat cats”

The role of the recent surge in anti-banking sentiment in the growth of P2P finance should not be underestimated: According to one UK-based Zopa user, “I’d always felt dissatisfied with the way the financial system worked. Here was a novel approach in which end-users benefit from each others’ cooperation. It just seemed a better use for spare funds than a bank, which would make more profit from my money than I would.”

Giles Andrews, CEO and co-founder of Zopa, agrees. He says that “I think people are also coming to us because they are fed up with the banks… People feel their money is disappearing into some sort of weird casino which bears no relation to the real world.”

Algorithms replace relationships

Unlike Kiva, which achieves rock-bottom default rates by vetting its field partners, Zopa uses proprietary algorithms to screen out risky borrowers. Applicants that survive this vetting process are then assigned one of five categories in ascending order of risk. The riskier the category, the higher the interest rate charged. As of July 2010, the annual rates of interest it charges were in the range of 9-13%. Zopa has a borrowing limit of £15,000 and says its bad debt rate is about 0.7%, which compares favourably to the mainstream banking industry. According to the company, “everybody wins, except the fat cats.”

Just as eBay shook brick-and-mortar retailing to its foundations, the P2P lending model, though still marginal, poses a real threat to traditional retail banking. With public faith in banking severely undermined by the fallout from the 2008 financial crisis and credit still hard to come by in many developed economies, new forms of trust-based lending could eventually become a real alternative to traditional lending.

Meanwhile, P2P technology is likely to drive a surge of growth in microfinance, as savers with an altruistic urge find it increasingly easy to identify potential borrowers in emerging markets, providing them with a source of satisfaction that money cannot buy.

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