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Social lending - back to the roots of banking

Is this crisis the end of social lending? Yes and no.

Majority of the social lending services which have been shut down (Prosper and Zopa US, to name the famous ones) were actually more like traditional banks presenting themselves as new kind of financial institutions. Prosper was a bank with a core idea to securitize loans. Zopa US facilitated their operations by being active in interbank markets. Social lending as a traditional banking business will not work.

Traditionally banks core activity has been about delegated monitoring. Banks take in deposits and guarantee to pay them back, assess loan applications, give loans and monitor borrowers. The value added of a bank is to provide liquidity and to analyze information. Now technological development has decreased the costs to analyze information. We can collaborate to monitor. We can collaborate to provide liquidity. 

In fact, social lending includes features that are familiar from co-operative banks and savings associations. In the past co-operative or saving associations operated locally in small villages where people knew each other. Similarly in social lending service each and everyone creates a reputation for themselves.  And lenders can create their association which is a group in the social lending service.

This crisis will be a starting point for social lending, since it is free of leverage. When banks give credit they take in deposits, face 8% capital adequacy requirement  and can give 12,5 times the amount of deposits as loans (roughly said, see more in: http://en.wikipedia.org/wiki/Basel_II). The banking system is highly regulated due to this money multiplier functionality or call it plain leverage.

Social lending can never substitute banks'  elementary role in payments or in the implementation of  monetary policy or ensuring the supply of capital for economic growth. But well considered social lending can provide a stable alternative without bank-related systemic risk as lenders and borrowers bear the risks, not the system. Basically, social lending is about returning to the roots of banking. Now it is only taking place digitally without any other barriers than trust and security of the process. 

Comments: (1)

A Finextra member
A Finextra member 29 January, 2009, 11:46Be the first to give this comment the thumbs up 0 likes

I'm afraid I have to disagree that the crisis will encourage social lending. If anything, the requirement for social lending is a hangover of the days of excessive consumer leverage. A quick preview of borrowers profiles on social lending sites will demonstrate this quite clearly.

There are fundamental issues with the social lending business model (capital tie-up, time investment to maximise returns and increasing borrower risk profile in a downturn) that will start to show more prominently as the year progresses.

Your comment that the lenders and borrowers take the risk is also not correct. The lender takes all the risk and it's pretty one sided. Banks play a very valuable role in the lending process and can allocate capital, create portfolios and manage risk much better than an individual. (While I agree they have to do this much better going forward).

Theoretically, technology makes it possible to dis-intermediate the banks. In reality it comes at a cost. A cost that I think most lenders are unwilling to accept. I have seriously investigated placing some of my risk capital into social lending and I decided it was not and investment I was willing to make. I would be interested to hear from social lending investors if it has proved a rewarding investment of time and money.