P2P Lending: The Torrent of Credit?

India has been facing a credit and liquidity crunch for more than a year now. What started as a AAA credit-rated NBFC, the now-infamous IL&FS defaulting on its credit repayment, has led to a domino effect of other NBFCs seeing their credit rating falling drastically and funding drying up. Banks are wary of lending to NBFCs because of their high-risk lender profiles. This has led to the low net worth individuals with bad or no credit profile, and MSMEs, their primary borrowers, and other businesses like Realty Developers, Auto Dealerships etc running out of liquidity, leading to stalling of business, loss of jobs and eventual slowdown in consumption.

Amid this widespread collapse of the shadow-banking sector in the country, the industry found a solution in P2P lending platforms, a concept that might solve a considerable chunk of the problem created by the credit and liquidity crunch the industry is facing right now. It came up on the market in the US after the 2008 financial crisis, but has gained footing in India only in the past couple of years.

The power of peer to peer (P2P) is increasingly being put to use in all sectors, a concept whose most significant application might undisputedly be the Blockchain and the resulting ecosystem of decentralized banking it helped create, but the most famous application might be the torrent.

So, what is a P2P lending platform?

Just like an ecommerce marketplace brings a host of sellers and buyers in contact, and helps them with the ensuing sale of the product, a P2P lending platform also bring together lenders and potential borrowers in contact with each other and charge a small fee for the same.

P2P Lending explained in layman's terms

The platform helps the creditors review the risk profile of the borrower by assessing the financials of the borrower and accordingly suggests an interest rate, which both parties might also negotiate upon. A major factor in the success of such platforms is that while interest rates for applicants with good credit are often lower than what banks offer, the creditors here obtain a better rate for their cash savings than deposits with banks. Interest rates for sketchy applicants, however, may be higher than what banks offer.

There are different models that different platforms might follow to make revenue. One option for the platform is to charge an origination fee from the borrower, while another option is for the platform to charge a service fee from the lender on every repayment. In case of a default on a repayment be the borrower, the platform make considerable effort to recover the amount. The platform may charge heavy fees from lenders in such cases, depending upon time spent, amount of loan or repayment and litigation involved.

But this is fairly simple, does not sound as revolutionary. Why the buzz?

The promise in P2P Lending lies in the sheer scale it can achieve. Since it is a tech-enabled platform, it can scale up with ease and less cost both in terms of number of creditors and borrowers and also geography.

Particularly in the period after the market was hit by the crisis in the shadow banking sector, the 19 P2P lending platforms have facilitated disbursals of around Rs. 500 crores. Faircent, a popular player in the sector, says it has seen monthly loan disbursal grow from a meagre Rs. 2.5-3 crore per month to a whopping Rs. 110 crores per month, which underlines an astounding growth of around 50x in a single year.

The success has not only been from the demand side, with P2P lending emerging as a prominent option for investing money in alternative asset class, and retail investors flocking at such platforms. LenDenClub claims to have attracted over 25,000 retail investors who otherwise invest in mutual funds. Faircent says it partners with 300 odd wealth management services who pitch P2P investing as an alternative asset class.

Innovation is the name of the game

While there are players in the sector which provide specialized services, for example, credit in Realty space, or MSME space. Services might sometimes be as specialized as it gets for offering a network of doctors who offer financing programs with prospective patients. Borrowers can get creative with these platforms and use the comparative lower rates available here to finance their credit card debt, which might have a considerable difference in interest rates for borrowers with good credit profiles.

Risks and caveats

While the size of the P2P Lending market in India is pegged to be around Rs. 300 crore currently, which is not much considering the size of the economy in India and the potential for growth this sector has given majority of small borrowing in India is done through informal means outside the organized financial structures, the RBI is treading this line with caution.

At present, the RBI’s regulations restrict the average exposure of an investor to all borrowers on a P2P platform at Rs 10 lakh at any point of time. No single investor or lender can provide the same borrower with loans exceeding Rs 50,000, according to the RBI’s regulations.

The menace of fraud and default has already put China’s P2P lending market in jeopardy with the government leading a crackdown on platforms, that had grown to 50 million retail investors with a total of $150 billion loans outstanding.

P2P lenders being online tech-enabled platforms may have an inherent advantage of scaling up, but they are distant and therefore the collection mechanism is weak. P2P lenders cannot provide the financial discipline knowledge to their borrowers, mostly retail investors, required to identify risks and stress in the environment of lending and hence may err in lending more often than not.

Also, since they are at a very nascent stage and distant being established already, if there are loan defaults or dues are not collected properly, the borrowers’ credit score might get adversely affected and might lead to them getting locked out of the formal financial system and lead them back to the informal money lending system. What remains to be seen is how does this model pan out in India, and if Indian players and regulatory authorities learn from other markets to better enable the sector to flourish, or will regulatory pressures and a generally more risk averse Indian retail investor mindset will prove to be a bane for the sector.