P2P lending: What's to worry?

The model looks promising but regulators need to provide more guidance so investors are protected, says former FDIC chairman Sheila Bair.

(Money Magazine)

Investors are making good money extending credit to their fellow Americans via peer-to-peer lending platforms (P2P), such as Lending Club and Prosper. P2P is also good news for borrowers -- most of whom are consolidating debts -- because they can often get interest rates lower than those offered by banks.

Mon dieu! Decent investor returns. Cheaper loan rates. Could this actually be a good financial innovation? Perhaps, but I see some causes for concern.

Securities regulators fret about potential fraud, since the companies don't always document borrower incomes. The cops also worry that investors can't understand how the companies determine the likelihood of default. Says David Massey, North Carolina's Deputy Securities Administrator: "Peer-to-peer investors generally don't have direct access to the information that might let them know whether they're buying into a loan that's going to pay them back, or whether they're taking a flier on a situation that's going to end in a default."

Lending Club CEO Renaud Laplanche acknowledges that about 30% of Lending Club's borrowers do not verify income, but he notes that this is clearly disclosed to investors. "When we ask borrowers with the highest credit quality to verify their income, they often prefer to not do the extra work and just drop out of the process," he explains.

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He also says unverified loans perform slightly better than verified ones.

A lower vetting bar gives P2Ps an advantage over community banks, which argue that P2Ps can underprice them not because the newcomers have built a better mousetrap, but because they have fewer regulatory costs. To be sure, failing to document 30% of their borrowers' incomes would land the banks in the doghouse pretty fast.

To their credit, the leadership of both LC and Prosper seem to be taking regulatory issues seriously, for nothing could disrupt the P2P model faster than a headline-grabbing scandal.

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Lending Club's planned IPO next year will let it offer its platform nationally to investors, up from 27 states now. The Securities and Exchange Commission should work with states to develop standards for default loss projections. And bank and consumer regulators should try to rationalize income documentation standards for all lenders, bank and nonbank alike, particularly given the country's dreadful experience with undocumented subprime mortgages.

The competitive impact on community banks also deserves attention, since we don't know how well P2P will hold up in a downturn. Investors may flee as defaults rise. In that case, borrowers may again need to turn to community banks, which did a far better job of maintaining loan balances during the financial crisis than did the mega-institutions.

Let's hope that the local guys are still around and that less regulated competitors haven't already done them in.