It always seemed to me that traditional banks tend to make most of their money on the backs of people that pay penalties for small errors rather than just charging for capital as their business model might otherwise suggest. Credit card companies seem to be doing the same thing, jacking rates to the maximum allowable limit if their customer goes late on a payment. All of this makes it look like the traditional banks and credit card companies are making money by being deliberately opaque, hiding their true cash cow of fees in fine print.
The peer to peer lending market has been exploiting the opportunity this opacity creates. Who would have thought these peer to peer lending sites had a chance against traditional banks? But borrowers and lenders warm up to them because they strive to become as transparent as possible.
But why do I have to get a loan for a specific need like an addition to my home? I don’t get a credit card for a particular need, its just so I have it if I need it. The reality is that the current peer to peer lending market is uncollateralized. I can’t go hold a chunk of a house ransom if a borrower doesn’t pay me back for a home improvement loan I gave him. I can’t “repo” the motorcycle I helped that guy in Utah purchase if he defaults, so what sense does it make that these are specific loans for specific goals? I’m merely making uncollateralized loans to individuals for whatever purpose they want. Its really just a bet on the person’s credit rating and “confirmed” financial situation.
So why couldn’t we think of it more like revolving credit? Why couldn’t I get a Visa or MasterCard from a P2P loan site instead? The P2P lending company would sponsor the process issuing a credit card to borrowers funded by lenders pooling their money. Adding to the existing P2P loan benefits, the lender makes more money because revolving credit interest rates are higher than “standard loans” and the borrower has much more clarity into the factors that can make his APR go down and credit limit rise over time.
Since there is no one purchase the borrower would be arguing for in their loan application, their listing would be a generic revolving credit application. Lenders would fund slices of the pool the borrower sees as available credit and the APR and size of the credit pool would be the principal negotiating factors when setting up the account. Over time, as the borrower proved a good repayment reputation, a “credit review” would automatically go up for bid again, potentially increasing his credit limit and decreasing his rate.
This would make the peer to peer lending market a little bit more realistic. P2P loans are generally uncollateralized, just like revolving credit. Give borrowers an easier way to access their P2P credit by issuing credit cards and lenders will make more money without a change in risk. Both will benefit from a much more transparent process.
Hi Anders,
thank you for describing this interesting idea. May I pose a question that struck me when reading the article?
How do you propose to match the lender funds and the credit cards usage?
If lenders supply “too much” money then the available credit is only partly used by borrowers – resulting in deposited money that yields no interest.
If on the other hand borrowers need more credit – but supply of money by lenders is low, then credit available for use would be restricted.
Unlike on a fixed term loan, fluctation in demand might be very volatile and can not (easily) be predicted.
One further point: To issue a credit card the service would have to partner with a bank which offers a whitelabel solution for the card? Right? Or is there a better way?
This model doesn’t work because banking regulations require that the lender have the full capital amount committed to revolving credit lines. For example, if you have a $10,000 credit line, the bank (or peers funding the facility) has to have $10,000 in capital to offset it. Lets also say that you use $5,000 to buy a widget and pay the high rate of 15% interest. Even if you only paid interest for a year, the lender would only be grossing an actual 7.5% on their investment. It is actually a bit lower considering the minimum payments usually include 1-2% of principle. From this you subtract servicing fees and it looks worse. P2P lenders are losing money hand over fist and they already charge 1.5% servicing. That high 15% interest rate would only net the lender 6%.
So, would you invest in something as risky as a P2P loan where in the *best* case you would make (1.5%) [they might not carry a balance] to 15% [maxed out] with the most likely return around 6%?
Excellent post! I could not agree more, and I am surprised that it has taken P2P loan companies actually that long to figure this out.
The closest competing product in the market is credit card so in addition to basic amortising loans that the P2P sites offer, there should be an option to have a revolving facility for certain borrowers with good credit history.
Wiseclerk: Thanks for the comments. As Will suggests, I think it comes down to the capital requirements to hold a line of revolving credit open. I don’t think you have to have the entire credit line liquid at all times though. If this were the case, the bank wouldn’t make money on credit cards either.
There is risk to the lender that their money goes un-invested. (maybe that sits in a money market or other instrument so inflation doesn’t outpace them) On the flip-side, the maximum credit that can be given out is also constrained so you don’t want to err on the other side either. It does come down to the requirements here. It is a profitable business so I’m sure there is a way to strike the balance.
So to think through this, It wouldn’t be “direct” like a traditional P2P loan where you bid to buy a slice of a loan. Your capital might go un-invested if you set your minimum APR too high or nobody you choose to lend to uses their card. You would be funding a pool at the parameters you specify. As stated above, there would be some chunk of “overcommit” you would do with your money and the P2P pool would have to be diverse enough to absorb some card user that suddenly and unexpectedly charges a large dollar amount. Now when Visa comes asking for the money, the lenders funding that pool cover the cost, making it so they can’t lend to others. They are “in that line of credit”. Admittedly it gets dicey when you want to figure out exactly when a lender is out of that line of credit but that would be something that would have to be figured out.
I’m trying to get around just funding a pool and giving credit cards out from that. It seems to make more sense to allow the lenders to pick what borrowers they will fund and, given that, let the market set the APR and credit limit.
As far as getting a card service up and running, I suppose the P2P company could partner with a bank or maybe there is a relationship directly with a clearing company like Visa or MasterCard to be done. Thoughts?
Will: Where do you get your information on the requirement of the bank to hold 100% of the credit line? If you’re right, it wouldn’t make much sense to do this yet banks do. Most people aren’t maxed out so I’m sure they don’t hold all the cash in reserve. In fact I wouldn’t be surprised if they have insurance that covers that. Anyone have more information on this?
@Anders I should have been more specific. I was referring to book capital, not actual cash on hand. Banks are allowed fractional reserve lending that I don’t think you could get away with in a non-bank. Under Basel II it is just shy of 8% of the advanced amount. If the bank gets into a liquidity crunch, they can simply borrow from the Fed, but a non-bank cannot. If the borrower maxes out and defaults, I don’t know where the extra capital would come from in a P2P setting.
If you are talking about just pooling everyone’s deposits to give lower credit card rates, wouldn’t that just be a credit union?
P.S. – Sorry, forgot to tell you great post!
@Anders,
I agree with you – the way to do it would be to let the lender select a set of parameters (e.g. credit score, income,…) of the borrowers he wants to lend to. Then match borrowers that fit these parameters. There could be an option to exclude or add borrowers manually. More the way Lending Club does it then Zopa. This way it would be really peer to peer and not an anonymous pool – and that would differentiate the model from the credit unions as in Will’s remark.
One way to lessen the impact of the regulation might be to use credit lines that start low (e.g. $1000) but are expanded according to individual demand (e.g. if $800 of the $1000 is used, increase it to $1500 – provided the borrower has beend checked to be able to afford this amount.
But still there are the issues that Will has raised.
The advantage of the concept in my eyes would be that the service will build a long-time relationship to the borrower. In existing p2p lending services the relationship to the borrower usually ends when the loan term is completed (unless borrowers take out more than one loan).
@Wiseclerk That’s a good point. The direct relationship would last for many years building an open credit history.
@Will Maybe someone else with more knowledge in this area can chime in here but as I understand it, a bank that takes deposits would be regulated by The Federal and State Banking Commissions. They stipulate a capital reserve (not taken from deposits) for revolving credit. A wel capitalized bank can go as low as 1% but given the risk and the reserves we would be likely to see, I’m sure a P2P institution would be upwards of 10% or more.
If you aren’t a bank that takes deposits, and are simply a consumer credit lender putting the house’s equity money at risk, the regulation will be lighter. The regulation would probably deal more with lending practices than with reserving money to re-coup the loan losses. Other laws may come into play, such as pay day lender laws, so there would be some homework there.
It comes down to how the institution is structured. If it is merely a coordinating body that doesn’t have a direct hand in the underwriting, then there is quite some latitude as long as the legal side is taken care of. If the institution is involved with the underwriting, it would be regulated.
Hi all. Great to see this discussion. As a lawyer with some experience in this area, I’m confident that with enough liquidity/demand, the prime-end of all current forms of consumer credit and SME trade finance should be possible to fund on a person-to-person basis. Personal loans are simply the best first step on a long journey that has barely begun. SME trade finance would be my next bet (see (http://sdj-pragmatist.blogspot.com/2008/11/early-payment-of-sme-invoices.html and http://www.receivablesxchange.com/opencms/opencms/index.html)
Best
SDJ
Hi,
We’ve considered this idea but unfortunately it has a small problem.
Credit cards usually have a 60 day no-interest period during which the lenders wouldn’t earn anything.
This would mean that the lenders money might be tied up with-out generating any returns at all.
All the best,
Pärtel
@Partel I don’t think 30 or 60 days of grace period is a bad thing. To begin with, the P2P card doesn’t have to do that but even if they do, chances are people will still use the credit. Personally, I’d take that chance. I’d bet over 80% would end up using the credit and paying me for it. IMHO, if this weren’t the case, banks wouldn’t get involved with credit cards to begin with. The fact is, its a profitable business.