The greater user interactivity and collaboration developed by the web 2.0 opened a window for new virtual communities and online markets.
A recently emerging application is P2P lending, which connects lenders and borrowers virtually, completely bypassing traditional financial institutions. Although these marketplaces offer a higher return to lenders due to lower transactional and operational costs, it’s essential for investors to accurately evaluate the credit risk of the different loans when considering capital allocations.
The difficulty in distinguishing between solvent borrowers with a willingness to repay debts and those with higher default probabilities is one reason financial institutions exist.
To mitigate this risk, banks use historical information, meet clients in person and employ risk experts to categorize borrowers according to their credit risk.
The information asymmetry of P2P lending platforms therefore puts lenders at a disadvantage when discriminating between different borrowers’ creditworthiness. To deal with this, P2P lending platforms have oriented their lending process into a more transparent environment. Lenders are provided with detailed information about the loan itself and historical information about the borrowers regarding paying off previous loans.
Moreover, many P2P platforms have partnered with credit rating agencies to provide investors with accurate information on loan quality. That said, a major concern remains on whether investors have the knowledge and information necessary to make efficient investment decisions according to their preferences.
Who bears the credit risk?
While financial institutions are experts in dealing with credit risk, P2P lending carries more risk for individual investors since the loan is directly funded by them, and not the platform, which transfers the risk. Further, collateral loans, certified accounts and regular reporting mechanisms used by banks are difficult to implement by online platforms, a reason why loans are often unsecured.
Due to lack of collaterals, it is essential for lenders to accurately understand and assess default risk.
As lenders are not necessarily risk experts, lending platforms assign a grade to each loan with the intention of capturing the risk of default. Assuming that the credit rating is precise, the higher the grade, the lower the default risk, and loans within each group are assumed to have the same risk. Since investors are allowed to partially fund across loans, they can diversify by investing in different risk groups according to their risk-return preferences.
Therefore, lenders need to decide how much money to allocate in each loan and how to distribute their investments within the different credit rating groups. This decision is often challenging and time consuming for an inexperienced investor. For this reason, many platforms offer matchmaking systems which minimize lending risks by investing in a high variety of loans and create portfolio recommendations based on each investor’s preferences.
How to properly estimate default risk?
Determining default risk of borrowers is the biggest challenge that investors face and is entirely based on information provided by the marketplace operator. Lenders are able to allocate their money efficiently if they know which characteristics determine the borrowers’ credit risk. Hard information provided by platforms regarding the creditworthiness of the borrowers includes annual income, indebtedness, past delinquencies, credit history, loan size and maturity. They also provide less quantifiable information such as the loan purpose, gender, age, country and in rare instances the borrower’s picture.
Credit scores determined by platforms should be the best indicator of default risk due to the sophisticated models used based on the hard information provided. On the other hand, reverse auction methods implemented in some platforms can improve predictions by including the soft information in the interest rate settlement. As the interest rate for a particular loan is determined by the weighted average of the bids made by lenders, it implicitly reveals the market perception of the creditworthiness of the borrower.
Although it is important to determine the relevance of information provided by platforms for the lenders decision-making, what is certain is that as platforms build historical data and with it, consumer insight, the technology should allow credit scoring and rates to become more accurate. Meanwhile, marketplaces should focus on attracting borrowers with good credit rating and improve mechanisms to recover funds when borrowers default, in order to reduce overall credit risk in this fast-developing market.
José Torres, Grow Advisors
Financial Analyst and Master of Finance with double concentration in Corporate Finance and Financial Engineering. Use this link to contact José.
Grow Advisors is proud to support the transition to digital finance around the world. Our team offers consulting and professional services on online asset and wealth management solutions, lending and p2p, crowd investing and fund raising around the world. We are uniquely placed to cover both planning and executional aspects of all our ideas.