Professor Gianfranco Gianfrate of Edhec Business School presents research findings that casts doubt on the sustainability of crowdlending, highlighting the risk of underestimating the potential inefficiency of this alternative mode of finance.
Peer-to-peer (P2P) lending, also known as crowdlending, refers to the money-lending activities - to individuals or businesses - through online platforms that match lenders with borrowers. P2P lending is part of the FinTech “revolution” aimed at disintermediating financial services. In fact, P2P lending platforms claim they can challenge traditional banks by providing a better (online) match of supply and demand of capital more cheaply than traditional financial institutions. Crowdlending promises not only to replace traditional banks but also to become an inclusion opportunity for unbanked people and firms, including innovative start-ups.
According to some estimates, the UK crowdlending market has reached a volume of about £17 billion to date, positioning itself as one of the largest and most vibrant globally. In light of potential gains from disintermediation, the rapid growth of this innovative financial service is understandable. Nevertheless, it has also resulted in the failure of some platforms and reported cases of malpractice or dysfunctionality. In May 2019, Lendy, a UK P2P focused on the housing markets, went into administration and the same happened to FundingSecure just a few weeks ago.
The news raised concerns about the quality of loans transacted in this mostly unregulated segment of the FinTech industry. No wonder that the Financial Conduct Authority (FCA) introduced last June more stringent requirements for transparency and risk assessment of P2P crowd loans. There are apparent critical risks associated with proliferating crowdlending activity. Firstly, there is the risk of misallocation of capital in the economy due to the absence of relevant incentives for the crowdfunding platforms to select and monitor borrowers. This is not only because they do not generally retain any part of the loan on their own balance sheet, but also because they need to deal with a huge volume of demand for both loans and investment opportunities. The result of this situation is that low-quality borrowers will be flooded with capital and nobody is monitoring the issued loans or bonds. Secondly, the surge in crowdfunding activity has been realised during a relatively booming phase of the economic cycle. This fact, coupled with a degree of piling up happening due to the increasing involvement of institutional investors in crowdfunding, may generate an accumulation of risks that could be very dangerous if higher than expected insolvencies were to occur.
Moreover, there are risks connected to the bankruptcy of the crowdfunding platform, which would cause in many cases the interruption of the debt servicing activity they provide on outstanding loans. Therefore, it is important to ensure that platforms have good risk management systems. Platforms are experimenting with new methods of credit scoring that rely on big data and machine learning. While these techniques are promising, in many cases they are still untested. Importantly, due diligence and scoring models are currently not supervised.
A recent study carried out at EDHEC Business School examined 6000 loans transacted on 73 distinct European P2P crowdlending platforms from 2012 to 2018. Data shed the light on the relation between promised returns and risk profile of the borrowers, showing that the returns are not consistent with the riskiness borne by lenders: high risk loans offer, on average, low returns. The mispricing of loans is particularly pronounced for the loans to green businesses: investors seems to be willing to accept low returns for initiatives that will benefit society at large. However, the apparent mispricing characterises also non-green projects, indicating that there are likely structural flaws in the way the promised returns are set.
Therefore, the research casts several doubts on the sustainability of crowdlending and highlights the risk of underestimating the potential inefficiency of a growingly important segment of FinTech. Financial regulators are right in keeping an eye on crowdlending and more stringent regulation may be needed soon. People should be extremely careful when investing their money on crowdlending platforms and remember that there is no savings safety guarantee: the entire investment can go bust.