Digital innovation and technology are transforming finance around the world at an unprecedented rate. The rise of the FinTech ecosystem, encompassing an emerging "new mosaic of technology-assisted customised financial services", introduces new concepts like cryptocurrencies, smart contracts, and Peer-to-Peer (P2P) lending platforms. In this new environment, FinTech has attracted the attention of regulators due to its growth outside the traditional financial and banking system, which often involves non-intermediated transactions. P2P lending has been characterised as a milestone. Only sixteen years after the launch of Zopa, the first U.K. platform, P2P lending is now recognised as part of the world's financial landscape and an important alternative source of finance. In its simplest form, P2P lending facilities allow access to finance by directly linking borrowers and lenders through an online platform, making the banking middlemen the surplus link in the chain.
The expansion of P2P lending:
The expansion of P2P lending has been spurred on following the financial crisis. In this era, the banking sector was weak and deleveraged, and regulations were tightened to a point where banks expected almost guaranteed repayments before issuing a loan. The small and mid-size enterprise (SME) has been hit the hardest, as the tightening of capital adequacy rules led to a dramatic increase in unsuccessful loan applications by SMEs. Their inability to access alternative sources of finance, such as bond markets, made them even more vulnerable. Indeed, by recognising the issue of restricted lending, the U.K. government introduced the National Loan Guarantee Scheme aiming to deliver more than £20 billion in lending to SMEs from banks. Nonetheless, the rapid technological evolution led to P2P lending platforms responding more quickly to lenders' and borrowers' increased demands.
How P2P platforms operate:
Although the P2P market is heterogeneous with different business models in place, the process begins with the prospective borrower applying for a loan. P2P platforms have their own assessment criteria and calculate the underlying credit risk and set a risk-appropriate interest rate using the applicant's information. During this filtering procedure, the platform will use 'hard information' to track the individual's financial profile by collecting variables such as the borrower's income and previous loan repayments. Crucially, technology has transformed the collection process and how information is communicated, with many platforms counting their assessment on soft information, which is "mostly qualitative, personality transmitted and accumulated over time.” Accordingly, 'soft information' includes the borrower's personal and social profile, implied by the borrower themselves in descriptive loan texts. The platforms often use such factors to reflect the borrower's repayment willingness and form the borrower's credit profile. Once the platform issues the loan request, lenders can place their offers to provide small portions of the required financing amount. If the sum offered matches the required amount, the loan is originated. In this way, creditors are lending capital directly to their peers, mediated by the platform, bypassing bank intermediaries. Nonetheless, taking out the middlemen as a risk buffer unsurprisingly leads to a higher degree of individual risk. Unlike traditional banks that accumulate risks in their balance sheets, platforms decentralise the risks by spreading them to their users. The platform's profits come from origination and service fees provided by the borrowers and lenders. Crucially, as lenders require some asset liquidity, the platforms' ability to operate a secondary market where loans can be traded before maturity is an essential feature. P2P lending platforms have developed in slightly different paths following national regulations, and the process described is more applicable in the U.K. Typical U.S. platforms, such as the Lending Club, transfer the funds to the lender through a bank because only licensed banks are entitled to originate loans. In both cases, the noteworthy part is that the platform's role is only "to collect, bundle and transfer the capital."
The rise of TechFin:
Although P2P platforms such as Zopa have been formed from scratch, there are now resource-rich and digitally native firms joining the market by forming their own platforms. Technology giants like Amazon in the U.S., Rakuten in Japan, and Alibaba in China, have started to offer an ever-wide range of financial products, creating a new strong player under the name of TechFins. By forming a customer-centric, unified value proposition, TechFins are bridging various industries' value chains to build ecosystems that reduce the customer's costs and increase convenience. TechFins' entrance into this market has made P2P lending even more recognised and used due to consumer's trust over these firms' provision of services.
Does Peer-to-Peer lending affect banks' stability?
The operation of P2P lending platforms raises the obvious question of how this new market will affect bank stability. Indeed, there has been extensive discussion on whether the P2P industry merely displaced incumbents or instead filled gaps in an underserved credit market. For instance, Tang (2019) argues that a way to assess whether P2P and bank lending are complements or substitutes is by assessing if the P2P borrower pool worsens or improves in quality where there is an exogenous shock on bank supply. By finding an increase in P2P loan applications and a decline in the P2P borrower’s quality, Tang (2019) suggests that P2P lending replaces, to a certain extent, bank lending. Importantly, Nesta's survey indicated that in the P2P market for personal loans, 59 percent of applicants also sought funding from banks, with 54 percent of them being able to obtain one but still preferring to fund themselves via the platforms. In contrast, 79 percent of business loans in the P2P market sought funding from banks, but only 22 percent were granted. Implicitly, P2P platforms are pushing away some customers from banks in the unsecured personal loans market. Similarly, TechFins have often been described as heavyweight competitors with the adoption of their strategies being challenging for incumbent banks and often 'stealing' away banks customers, revenues, and profits, with research from McKinsey not only validating but quantifying these concerns. Commentators argue that real disruption may come from the full-scale entry of top digital internet companies, and their remarkable effectiveness is problematic for banks.
On the other end of the spectrum, there is empirical evidence in Balyuk et al. (2019) that FinTech lenders will be less competitive than banks. Similarly, an analysis found in 'The Business Models and Economics of Peer-to-Peer Lending' suggests that P2P lending is best viewed as complementary to conventional bank business models. Additionally, it is often argued that online credit serves low and middle-income individuals. Where the loan amount requested is relatively small, there is a need to provide only some basic personal information, and no guarantees are expected. The use of soft information allows ambitious individuals (which may not have a credit profile and therefore being unable to access bank credit) to promote and support their ideas in their P2P platform application form, and thus be more easily entrusted by lenders, funding through P2P platforms their business plans or student loans. Therefore, P2P lending can serve any customer's funding needs that banks did not cover in the past. Crucially, FinTech can bring financial inclusion in a world where about 60 percent of adults in developing countries do not use any formal financial services due to constraints arising from lack of physical access to bank branches or borrowers' lack of documentation and credit history.
Indeed, the debate as to whether P2P supplements or competes directly with traditional banking has been heavily discussed in the literature, with both sides providing convincing arguments and evidence. However, the focus should be turned towards ensuring financial stability since the entrance of FinTech has transformed the financial service landscape. Trusting that banks' uniqueness will allow them to maintain a role in providing financial services, it is better to focus on creating a setting where P2P platforms can operate effectively. Banks cannot realistically keep key players such as Tech-Giants from maintaining a place as credit providers in the financial world, a role which is growing in dominance since their introduction.
What makes traditional banking unique?
Although online credit can arguably disrupt traditional bank credit, the decisive feature of banks remains intact, proving the bank's continuing role in the market, regardless of the competition which may (or may not) exist by the operation of P2P platforms. Accordingly, the crucial difference between banks and non-banks is a bank's uniqueness as a deposit-gatherer, with specialists in screening, monitoring, and relationship banking as well as the provision of liquidity. Bank deposit individuals have the right to draw deposits on demand by requesting cash or using the bank's payment instruments. The economics of scale flowing by providing these liquidity services allows banks to exploit them by lowering their funding cost and boosting their lending returns. Crucially, the large size of banks enables them to borrow and lend in money markets to manage temporary surpluses or shortages of liquidity. In contrast, a borrower's ability to access funds in a P2P platform depends on the lender's appetite to provide credit. Although P2P platforms can provide liquidity by their operation in secondary markets, they are still at a competitive disadvantage relative to banks with access to money market funding or central bank liquidity. Consequently, deposit insurance and the need for safe assets give banks a funding cost and trust advantage over other lending providers.
The debate of whether P2P platforms threaten traditional banking is implicitly suggesting that banks are enjoying a monopoly power in credit provision with the introduction of Fintech disrupting such setting, something which is at best inaccurate. The growth of shadow banking has been widely recognized for over a decade now, with entities such as hedge funds and money market funds providing services, including credit. Undoubtedly incumbent banks have been influenced by the introduction of shadow banking. Still, their survival should give some reassurance that the arrival of FinTech will not mark the end of traditional banking.
Where does this discussion leave us?
The different nature of P2P lending platforms combined with the expansion of the credit market leads to the conclusion that banks and P2P platforms may target different customer groups and product positions, and the two sides won't compete fiercely. Therefore, instead of arguing whether "the universal banking model is dead," it is better to focus on creating a financial landscape where P2P lending is a safe, alternative source of finance, proving that the two can co-exist in an ever-expanding credit market.