P2P lending platforms earn fees from matching borrowers with investors, but investors bear the full risk if loans default. Several failed crowdfunding schemes were reported in the newspapers recently. Some of the cases may be due to platforms churning out risky loans. Investors should pay attention to the risks associated with the “originate and distribute” model and look for lending platforms whose interests are aligned with investors.
Origination and Distribution of P2P Platforms
One criticism of p2p lending is that the lending platforms merely originate and distribute loans, but do not invest their own capital along with outside investors. The lending platforms earn fees from successfully matching borrowers with investors. But when loans turn bad, the platforms – unlike investors – do not suffer significant financial losses. Some platforms are also uninterested in helping investors pursue their bad debts from errant borrowers.
In economics, this is known as principal-agent problem. The problem occurs when the agent’s incentives do not encourage it to act in the best interests of the principal.
In the context of p2p lending, the “principal” is the investor and the “agent” is the lending platform. The investor’s main goal is to make money by investing in quality loans, while the lending platform’s main goal is to make money by successfully matching investors with borrowers.
An irresponsible lending platform can increase its loan volume quickly by relaxing its loan approval criteria. By doing so, it originates more loans and earns more fees. Loan defaults will come later, but the costs will be borne mostly by investors rather than the platform.
Flashback to the Global Financial Crisis
Actually, criticisms of the originate-and-distribute model and the principal-agent problem are not unique to p2p lending. In the run-up to the Global Financial Crisis of 2008, US banks created a tremendous amount of risky subprime mortgages and sold them to unsuspecting investors. Because the interests of the banks and the investors were not aligned, most of the subprime mortgages created and sold were of questionable quality. Ultimately, the entire financial market seized up when subprime losses became too overwhelming.
How to check if the interests of platforms are aligned with investors?
The interests of lending platforms and investors are not always perfectly aligned. Most lending platforms are volume-driven businesses – higher loan volume means higher fees. On the other hand, investors’ returns are driven mainly by loan quality and not loan volume.
To find out whether the interests of platforms are aligned with investors, investors can check if the platforms have any financial incentives (or disincentives) tied to loan repayments.
Skin in the Game
When lending platforms co-invest in loans along with investors, they send a powerful message: the platforms have “skin in the game” and are confident in the quality of the approved loans. However, there are limitations to co-investing. If loan volume increases quickly, the platform may not have sufficient capital to co-invest in every loan.
Distribute platform fees across loan repayments
A common structure among p2p lending platform is to charge a 3-5% fee from the borrower, paid upon successful disbursement of funds. For investors, this arrangement incentivises successful matching but not successful repayments.
An alternative fee structure, in which fees earned by lending platforms are distributed across each loan repayment, would better align the interests of platforms and investors. Capital Match and Funding Societies follow this approach. In other words, these platforms earn their fees progressively when borrowers make successive repayments on their loans. If the loans default, the platforms will not earn their full fees.
Don’t forget the track record
The lending platform’s track record also clearly show whether the interest of platforms and investors are aligned. Platforms that show sharp growth in loan volume with high and erratic default rates are probably prioritizing its own short-term interests ahead of investors’. Conversely, platforms that show moderate loan growth and low default rates are likely to be stringent in screening out the risky loans. Over time, these loans should provide investors with good and sustainable returns.
Have you ever lent to a platform whose interest does not seem to be aligned with yours? What other ways can investors do to guard against interest misalignment? We’re love to hear your thoughts below!