Peerless? The emergence of a new funding model

So far Australia’s banking sector has remained relatively unscathed by the devastating structural change the internet has imposed on a raft of industries, such as media and retail. Unlike their overseas counterparts, our banks’ resilience during the GFC put them in good stead to focus on growth and adapting to new technologies.

But one potentially disruptive force is beginning to take a foothold in the market that may at least threaten the status quo: peer-to-peer (P2P) lending.

Most of the public are unaware of the concept. P2P lending removes the middle man (the banks) by connecting borrowers and lenders through a low-cost online platform.

At least one of our banks has recently realised the threat – and opportunity – of P2P lending. This month Westpac invested $5 million in Australia’s leading P2P lending platform, SocietyOne, through its venture capital fund Reinventure.

Other major players are also recognising the potential growth across crowd funding platforms. On March 13, Lloyd’s of London signed a deal with Sydney-based Airtasker – an online platform provider that enables people to complete tasks for each other for an agreed price – to insure up to $20 million in property damage and injuries.

P2P lending – the basics

P2P lending attracts investors because they can essentially take the position of a bank, receiving 10% plus interest on loan repayments – well above what they could receive in a term deposit. Borrowers get access to more competitive interest rates.

The models these platforms use varies. SocietyOne rejects most borrowing applications, only accepting those above a certain credit score based on credit information provided by Veda Group (VED). It then allocates them an interest rate that lenders can pick and choose from.

Borrowers can take out a loan for $5,000 up to $30,000 for between a 12 to 36-month period. They can use the credit for a range of personal purposes, from debt consolidation to funding an overseas holiday.

The strength of P2P lending is transparency. Along with the interest rate of each borrower, most platforms display an explanation of what the loan is to be used for and other financial information.

Most platforms use a client-segregated account model where all funds from lenders and borrowers are separated from the platform’s balance sheet and instead go through a legally segregated account. This means that if the platform collapses the P2P lender cannot make a claim for the funds, and that the contractual obligations between the borrower and lender will still stand.

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Currently only sophisticated investors (someone with net assets of at least $2.5 million or annual incomes in excess of $250,000) can invest through SocietyOne. They are responsible for selecting how much of each loan they invest in their portfolio as well as the interest rate of each loan. P2P lenders generally advise their clients to pick a large number of loans to diversify risk.

In Australia, investors are locked in for the duration of the loan, unlike in the US where there is a secondary market, called FolioFN, to trade these loans.

You can find out more about how SocietyOne works and whether you should consider investing in it in Tony Rumble’s article from today’s edition.

Australia’s slow uptake

The P2P lending market is expanding rapidly globally: it has doubled each year for the past five years and accounts for approximately $US6.4 billion of loans outstanding, according to the latest International Organisation of Securities Commission (IOSCO) data. The world’s largest peer-to peer lender, Lending Club, has been valued at over $2 billion and is expected to IPO in the US this year.

Lending Club is drawing a lot of interest from institutional investors and high-net wealth investors (including family offices) who take up about a third each of its total loan volume, with the rest made up of retail investors.

“P2P lending is a product of the digital revolution and to an extent – particularly overseas – the credit crunch where there was a pull-bank from lenders,” says Ian Pollari, KPMG’s sector leader of national banking.

With the opportunity for much higher yields than through traditional means in a low interest rate environment, the supply side is growing from investors eager to supply these loans, Pollari says.

But P2P lending in Australia hasn’t seen anywhere near the level of growth the US and the UK have. Though it’s doubled in the past year, in its two years of existence SocietyOne has originated just $2 million worth of loans.

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According to Pollari and other industry experts, there are several reasons why P2P lending has been slow to pick up in Australia.

PwC partner Stuart Scoular highlights the fact Australia is a small economy and didn’t experience the credit crunch as severely as other markets. Our big four banks have excellent credit ratings. This means their cost of funding is relatively low, so they can price their loans more competitively.

And though our term deposits fall short of the returns on offer from SocietyOne, they are the highest in the developed world and are guaranteed by the government. Loans from P2P lending, on the other hand, are unsecured: investors take them on at their own principal risk.

Professor Milind Sathye, head of accounting, banking and finance at the University of Canberra, points to the difficulty P2P lenders have had in obtaining capital backing. Under Australian Securities Investment Commission (ASIC) regulation entities need “sufficient financial resources”, to obtain an Australian Financial Services Licence (AFSL) and therefore to be compliant, something only SocietyOne has achieved.

Meanwhile in the UK the federal government handed out £55 million to Europe’s leading P2P lenders last year and has pledged another £40 million this year under the “Funding for Lending” scheme. The capital is for the purpose of distribution to small-to-medium enterprises, which the European banks had been reluctant to do.

A disruptive force still

Given the regulatory hurdles and relatively competitive offerings our banks can offer, the experts are unconvinced that Australian P2P lending can imitate the growth shown in other developed countries.

“P2P lending has its place to play in the marketplace,” Scoular says, “Having said that I think it’s likely to be more niche than main play.”

The key risk to P2P lending – of participants defaulting – is also relatively unknown. Though SocietyOne boasts a solid default rate of 2.3% and Lending Club says its default rate is around 4%, Pollari stresses that it’s still early days for the nascent industry.

Pollari does, however, point out that new Australian regulation should help P2P lending in this respect by making investors more informed about whom they are lending to. Last Wednesday “positive credit card reporting” came into effect, whereby positive events (like making payments on a loan) are recorded, and people more than five days later on their credit card or home loan payments get a black mark on their credit report.

Experts also don’t deny the impact such a fast-growing industry can have on the wider sector.

Indeed, comparisons can be made to online retail – a more matured industry. Though online shopping only accounts for around 6.5% of total retail spending, its incredible growth has wreaked havoc on retailers too slow to respond, like David Jones and Myer.

Milind says our banks – unfettered by the legacy issues plaguing their peers – are unlikely to be caught out in such a way, with more potentially following Westpac’s lead in looking for opportunities in the space.

“The banks may start their own arm of P2P lending – that may be a possibility,” he says.

Another factor to consider is the federal government’s upcoming financial services inquiry, which Pollari says will most likely encompass P2P lending and other potentially disruptive players. The UK and the US already have a level of regulation in the industry.

“To have the financial services authority providing a regulatory framework for P2P lending adds credibility to the emergence of these business models,” Pollari says.