NB Financial Health
Beyond the Lending Club Scandal – Why Marketplace Lending is Still Needed in Emerging Markets
Renaud LaPlanche, the entrepreneur CEO who practically created the marketplace lending industry and made Lending Club a force to be reckoned with, resigned in May amidst rumours of fraud and malpractice. Since then, critics have been trying to write off marketplace lending (or peer-to-peer lending as it is commonly but mistakenly called) as a flawed business model. But it surely is too early to discount the value of the entire industry, especially in the highly evolved and regulated markets in the U.S. and most of Europe.
Marketplace lending has created an important bridge between small borrowers and both institutional and individual lenders. Even lenders as significant as the U.K. government have chosen to lend to small businesses through a marketplace – Funding Circle, in the U.K.’s case. The system works because it uses technology and high amounts of data analysis to both originate and underwrite loans, reaching a critical mass and achieving sustainable growth over a decade.
U.S. markets went through significant regulatory overhaul during this time, and marketplace lenders not only survived that, they even emerged stronger at the end of it. Case in point: LaPlanche swiftly departed for what was essentially an internal and minor transgression, providing proof that these controls and regulations actually work. With a large number of institutional investors in the fray, all ready to spot risks, the likelihood of a material fraud or Ponzi scheme emerging in the U.S. or Western European marketplace lending industries seems remote.
China, on the other hand, is an entirely different story. Completely unregulated so far, the reportedly 2,000+ players in its marketplace lending industry dispense billions of dollars in loans, often at exorbitant rates. Despite the presence of large, credible platforms like CreditEase, stories of questionable practices by smaller private lenders abound. Since mid-2015, several marketplace lenders have either failed or have been held accountable for defrauding lenders.
So what does this mean for the industry that is taking its first baby steps in India? I foresee the Indian industry developing more like its U.S. counterpart, rather than emulating the unruly markets of China. The regulators have jumped into the fray early enough, with the Reserve Bank of India (RBI) already issuing its first consultation paper on regulating marketplace lending in the country. These proposed regulations are far from perfect – for instance, the consultation paper suggests that these lenders be given minimum capital and leverage ratio requirements like traditional banks, even though these platforms have no loans on their own books. But nevertheless, it is heartening that the RBI chose to consult the industry first, providing early entrants like Loans4SME (of which I am the co-founder and CEO) an opportunity to give inputs based on their on-the-ground experience.
Even in these early days, it is clear that this collaborative approach is wise: Governments need to put regulatory norms in place to avoid frauds, but only the industry itself can enforce ethical practices consistently. That’s why marketplace lenders need to set standards for the industry to succeed and become a positive force in boosting small business growth in India. At Loans4SME, we believe that three factors will be essential to the industry’s success:
- Choosing Investors Carefully: About 70-80 percent of the transactions at marketplace platforms globally are with institutional lenders. But with individual lenders still a significant number, it is tempting to pitch high-return credit instruments as investment of choice to everyone from moms to pensioners. The best platforms self-regulate and sell only to people who understand credit risk. In the U.S. and several other countries, high-risk private instruments are sold only to accredited investors (typically high net worth individuals with financial markets knowledge or experience). Indian regulations, both in equity and debt investing, are long overdue for our own definition of such accredited investors.
- Solid Risk Assessment: Alternative data sources, technology-driven algorithms and efficient data analysis are all factors that help marketplace lenders make better credit calls than their traditional peers. As social media replaces direct human interaction, data becomes a substitute for the local knowledge your friendly neighbourhood bank manager once utilized to inform credit decisions. But this doesn’t for a minute mean that there will be fewer defaults. What data does here is create an effective mechanism for ranking the relative riskiness of loans so they can be priced correctly.
- Transparency and Ethics: Lending Club prides itself on disclosing pricing for each loan given out on its platform. Transparency – be it in the form of disclosing the basis for credit scoring or providing both lenders and borrowers with an open mechanism to discuss price-setting norms – is the final key to the long-term sustainability of marketplace lending. When defaults happen, as they will invariably do over time, the processes followed when originating the loan and the disclosures made to investors become paramount. Equally important is the restraint a lender shows in its collection processes. The stories of some Chinese lenders demanding nude pictures of women students as coercive collateral may point to a small population of rogue elements in the industry, but it should also serve as a warning to all players to follow ethical practices – not just when originating a loan but also when collecting on a defaulting one.
So yes, the Lending Club scandal has raised questions about the industry. But marketplace lending will survive – and not simply because of how large the industry has become in the past 10 years. Marketplace lenders are thriving around the world because these platforms address a critical market need. Small businesses are growing because they get adequate, timely and well-priced funding thanks to the evolution of marketplace lenders. Institutions and governments have both found efficient ways to lend to these businesses, thanks largely to the technological evolution driven by these new players. This alone should be motivation enough for us to look beyond this moment of turbulence and create a strong industry that makes the world a bit more equal for the small borrower.