| Sep 04, 2013
Australia’s big banks have little incentive to introduce pricing on personal loans that is more closely aligned with individual borrowers’ credit risk. “If someone can come in and disrupt that, I think the banks are vulnerable,” SocietyOne CEO Matt Symons says. Photo: Rob Homer
In June, 400 lenders gathered in New York for the inaugural LendIt Conference. But this was not your traditional congregation of financiers.
LendIt, rather, was a gathering of peer-to-peer (P2P) lenders, who are “revolutionising the credit markets and transforming the global banking industry,” according to the sold-out event’s promotional material. The Convene Innovation Centre on Seventh Avenue was buzzing that Thursday morning in the early summer. Blogger Peter Renton described a “palpable feeling that this was the start of something big”. Investment bankers were also there, searching for deals: many swarmed around Renaud Laplanche, the chief executive of Lending Club, a P2P lender that started as one of the first Facebook applications in 2007 and has surpassed $US2 billion ($2.18 billion) in personal loans.
P2P lenders, who match borrowers and investors through an internet-based platform, offer a compelling win-win. Borrowers, especially those of high credit quality, can receive lower rates than banks offer for a personal loan or credit card, along with a vastly improved customer experience. Investors, meanwhile, make a flexible, short-term commitment and receive a better yield than many fixed-income products by targeting one of the most profitable lines of banking – the provision of personal loans.
Lending Club made a profit in the second quarter of this year and its loan book has doubled in the past nine months. Its board includes former US Treasury Secretary Larry Summers and former head of Morgan Stanley John Mack. In May, Google took a stake valuing Lending Club at $US1.55 billion, three times what lenders paid to invest in the platform just over a year ago. So, with Lending Club earlier this year flagging its intention to list on the public markets, the bankers at LendIt were keen for a piece of the action on what is shaping up as the blockbuster float of 2014.
Many had flown to LendIt from across the Atlantic. In the United Kingdom, P2P lending is also taking off: the market will be worth £1 billion ($1.69 billion) by 2016 if it continues its current pace of growth, according to Bank of England-supported research by the Open Data Institute, released in July. The UK market has trebled in size in the past three years; between October 2010 and May 2013, almost 49,000 investors funded loans worth more than £378 million. This new crowd of lenders are being supported by Prime Minister David Cameron, whose Conservative government has been investing alongside them to boost credit. Other powerful champions of P2P include the executive director of financial stability at the Bank of England, Andy Haldane, who noted the potential of P2P lending earlier this year. “At present, these companies are tiny,” he said. “But so, a decade and a half ago, was Google.”
While P2P lending conjures images of desperate borrowers arriving onto an obscure internet site, cup in hand, after being turned away by a prudent bank, this is a misnomer. Lending Club, and many of its competitors, are largely chasing high-quality credit risk. About 65 per cent of Lending Club’s loans are for refinancing credit card debt. In order to attract investors onto the platforms and provide them with attractive yields, P2P lenders are incentivised to conduct thorough credit checks of applicants before accepting them. At present, Lending Club has a default rate across its loan book of just over 3 per cent. At Zopa, the UK’s largest P2P lender, the default rate is 0.93 per cent.
In Australia, P2P lending has been slow to get off the ground. It has hardly been mentioned in the business media. But the potential power of P2P lending was recognised by the Australian Centre for Financial Studies in its Funding Australia’s Future report, released in July, which pointed to technological advancement, innovation and regulation as three factors changing the banking industry.
“Arguably, we are at a point in history where the interaction of those factors is pointing towards a significantly lessened relative role for traditional intermediation,” the report said. While there has been very little direct financing by savers of borrowers in Australia to date, it added that “developments in technology and information availability could facilitate” P2P lending in the future.
Conditions in Australia, for both borrowers and investors, seem ripe for P2P lending to emerge. Australia’s big four banks have failed to adapt their personal loan products to changing times. Their one-size-fits-all approach to personal credit doesn’t properly price risk, meaning good-quality borrowers receive largely the same interest rate as poor ones (effectively subsidising them), while service is generally poor. Meanwhile, on the investor side, Australia has a technologically savvy population with a high level of savings searching for better yields and a stronger sense of community.
In August 2012, Matt Symons – who was also at the LendIt conference in New York – co-founded Australia’s only active P2P lender, SocietyOne. It has made almost 150 loans, totalling $2 million.
Symons and the other investors in the Sydney-based company anticipate P2P lending volumes will grow sharply in the years ahead, just like they have in the US and Europe.
“P2P lending offers a very different approach,” Symons says. “This model becomes really powerful when it supports a return to community, grass-roots, real-people lending, and away from what the banking institution has become.”
Symons’s eyes were opened to the potential of P2P lending while he was working in San Francisco, where Lending Club and countless other fintech firms are based.
A former technology lawyer at Minter Ellison, Symons left the law in the late 1990s to establish Memetrics, a data and digital marketing business that was sold to Accenture in 2007, two years after Symons had moved to the US West Coast with his wife and baby. As an Accenture partner, he spent three years embedded inside big banks, helping them to develop analytic tools for their online businesses to help with customer interaction in the digital realm. During this time – the peak and aftermath of the global financial crisis – the banks Symons worked with were under immense pressure and largely unable to allocate the necessary headspace to technology, given the inevitable focus on regulation, he says. “It was an environment where they had the right aspirations – but some combination of legacy systems and understandably distracted management teams meant most of the innovation was coming from outside the industry.”
Symons first heard about Lending Club in 2009. “My first impression was ‘wow’, that’s a great idea,” he says. “Creating a marketplace for consumer credit is a very clever way to offer borrowers access to better-priced credit and at the same time offer investors access to an attractive asset class.”
Symons returned to Australia in 2010 and was fortuitously introduced to Greg Symons (no relation) by an angel investor the same year. At the time they met, Greg had spent 13 years with a team of engineers developing receivables management software, including for point-of-sale credit. The platform was being used by Rabobank to manage billions of dollars of agribusiness in Europe.
Three years earlier, in mid-2007, Greg had discovered P2P lending. “There was then not even a search term recognised by Google. I got instant religion,” he says. He then re-orientated his ClearMatch platform towards P2P. It is now the proprietary software of SocietyOne, of which Greg is the other co-founder.
A GAP IN THE MARKET
“As someone who has invested in a lot of early stage businesses this seemed to be a really unique asset,” Matt Symons recalls. He continued his due diligence by going to interest rate comparison websites and applying for some small loans at various banks. He realised that, once the application had been submitted and accepted, if he was unhappy with the offered rate and attempted to discover a better price at another bank, his credit rating would be adversely affected because the next bank could only see that an application for credit had been made but not taken up. It would assume their competitor had identified some hidden gremlin on the credit file, rather than presuming a potential customer was seeking a better deal.
“I really got religion [on P2P lending] when I actually looked at the personal loan application process itself. I found the market conditions to be ripe for disintermediation.
“The more a creditworthy borrower tries to do price discovery, the further away they get from a decent price. That is wrong; it is not sustainable. Then I looked deeper, and I saw that even if you do get accepted [for a loan], you are paying the same rate as everybody else. I thought the front end of this product experience is rubbish for a lot of consumers. It is crazy there is no risk-adjusted pricing.”
Australia’s big banks have little incentive to introduce pricing on personal loans that is more closely aligned with individual borrowers’ credit risk because unsecured personal lending delivers them big profits. According to figures from the Australian Prudential Regulation Authority, retail banking made up 42 per cent of banking profits in 2011, or $7.4 billion. Of this, personal lending (credit cards and personal loans) comprised 16 per cent of the profit or $1.2 billion (deposits and mortgages made up the rest).
“If someone can come in and disrupt that, I think the banks are vulnerable, because I can’t see the banks competing either on rate or on experience,” Symons says.
PROFITABLE ASSET CLASS
Stuart O’Brien is a brand consultant, who has worked for Qantas, Lend Lease and Macquarie Group. As well as being an investor in the company, he has been lending on the SocietyOne platform for eight months. “Touch wood, I have had no defaults,” he says.
Asked what attracts him to fund loans through the platform, he immediately replies: “11 per cent”.
In fact, O’Brien’s annualised return is 11.67 per cent. He admits he had a hard time convincing his wife and his accountant about SocietyOne initially, but says they have now been won over. “Once Australia understands how P2P lending works, I expect it will be quick to catch on,” he says. “This unlocks one of the most profitable asset classes, one that has been protected by the big banks. That is a big opportunity for me.”
O’Brien, who is a sophisticated investor as defined by the law (lending through SocietyOne is not yet available for retail investors) says he is aware of the investment risks. Unlike a bank deposit, there is no government guarantee against losses. He points to the risk of mass defaults on the loans, but says with his diversified portfolio of around 100 loans, 20 per cent of lenders would have to default before he felt an impact. (SocietyOne’s default rate at June 30 was 2.3 per cent.)
Another key risk is investing in poor credit. The banking editor of the Financial Times, Patrick Jenkins, criticised the lack of clarity around the credit-checking process for many P2P lenders in the UK, and their lack of “skin in the game”, meaning they had “no explicit interest in making sure the loan is a decent one”.
“Banks might have done themselves and the world a lot of damage in recent years, but they are still better judges of risk than the average investor,” Jenkins wrote.
An examination of SocietyOne’s credit-checking processes suggests the company is aware of such concerns. While it has made $2 million worth of loans, SocietyOne has asessed over $17 million in applications, so only 11 per cent of applicants are approved and moved onto the platform and made available to lenders. This is around half the number of traditional banks for first-time customers. It is designed to increase the investment performances of the early vintages and provide investor confidence. This will assist SocietyOne in mounting an argument to open the platform to retail investors as early as next year.
The credit assessment process is also highly automated. Using Yodlee, applicants for loans provide SocietyOne with six months’ worth of bank statements allowing SocietyOne to verify income and examine their personal PNL; their proprietary systems analyse statements to determine spending patterns and hence credit risk. Once a borrower is approved, SocietyOne assigns them a credit risk category from AA to D and a sliding scale interest rate is attached. For example, AA borrowers can receive an interest rate of 10.15 per cent to 11.75 per cent, while D borrowers receive 14.1 per cent to 15.6 per cent.
Investors are able to bid for loans within each band, creating a market for each loan while avoiding irrational pricing. SocietyOne receives gross revenue of around 5 per cent. This comprises a 1.25 per cent “receivable management fee” from the investor, and an average 3.5 per cent origination fee from the borrower (who only pays if the loan passes the credit assessment and is originated). The origination fee actually varies based on the credit grade (1.5 per cent for AA to 4.5 per cent for D) and is levied as a percentage of the total loan. Late payment fees are equivalent to banks; there are no servicing fees and no pre-payment fees.
Investors nominally match their commitments to particular loans but money which comes in from investors is pooled into a trust, a wholesale unregistered managed investment scheme that provides a single source of money that goes out to borrowers. The trust has been created as a bankruptcy remote vehicle which cannot fund SocietyOne’s liabilities. SocietyOne is the lender of record and loan originator and holds an Australian Credit Licence. SocietyOne conducts the day-to-day administration of the loans on investors’ behalf.
When an investor logs on to SocietyOne’s platform, they enter an online marketplace not unlike eBay. The actual identity of borrowers is not revealed, but before they hit a loan, plenty of information is made available to inform their credit assessment: an investor can see a borrower’s suburb (displayed on a Google map); a summary of their personal profit and loss account; various financial ratios, such as debt to income; and the borrower’s explanation of why they want the loan. (For one live loan for $31,350 on the platform last month, the description was for an “October wedding in Perth”.) Once loans are originated, an “activity feed” updates users of all actions.
Leah Renwick, who has borrowed $30,000 through SocietyOne at 15 per cent inclusive of costs, says the story provides the investor with “a safety net. It is not just based on a credit score – they need to see the story as to why they should invest in you,” she says. “If I run up a world of debt because I am ignorant and only work casually, then no one is going to buy your loan.”
But five investors bought into Renwick’s loan, which was first hit five minutes after going onto the platform and closed after 22 minutes.
ALTERNATIVE TO THE BIG FOUR BANKS
Renwick, who works at the Finance Brokers Association of Australia, discovered SocietyOne through comparison website RateCity while seeking an alternative to the big four banks to consolidate her debt. “I was paying too much on two credit cards – 29 per cent – and had other debt at 19 per cent,” she says. “It is lot easier to pay back a two-year loan term than trying to pay off credit cards each month for 10 years.” The loan application process was more rigorous than with a big four bank, she says, but the experience was superior. “If more people understood how P2P worked and there were more P2P lenders out there I think the big four would have a lot of questions that their customers would want answered.”
As with any new area of consumer finance, regulators have been circling. The acceptance of P2P lending in the US followed a period of legal uncertainty in the early days, after the Securities and Exchange Commission took P2P lender Prosper to court in 2008, alleging violations of the Securities Act when it sold loan notes without an effective registration statement. (Lending Club was forced to close for six months while the SEC approved its registration, while Zopa was forced out of the US market during this time.)
As P2P platforms grow, and as more institutional money enters the sector, regulatory risks are likely to increase in the future. In the UK, a regulatory framework for P2P lenders, who are represented by their trade group the P2P Finance Association, will be established in 2014 and the sector regulated by the Financial Conduct Authority as part of that body’s adoption of wider consumer credit responsibilities.
The Australian Securities and Investments Commission is watching the P2P sector and Tim Gough, the acting senior executive leader of deposit takers credit and insurers at ASIC, says Australia’s new consumer credit laws are not a barrier to P2P models working.
As SocietyOne considers registering its managed investment scheme to allow retail investors onto the platform, Gough says if investment in P2P was available to retail, ASIC’s scrutiny “comes down to the level of disclosure a P2P lender provides to investors”.
“You can see from [the SocietyOne] website, even in the absence of a product disclosure statement, there are some warnings there for investors – they make it pretty clear the rates of return of over 11 per cent are not guaranteed, and rely on loans being repaid without impediment. It would be unusual to be carrying a loan book with no level of impairment. It is clearly an investment that carries some level of risk . . . and that is what investors need to understand.
We are a bit surprised P2P hasn’t taken off more quickly [given the overseas experience], but this may be the start of something that will grow more rapidly. We are not a gatekeeper to this type of product being made available to consumer investors.”
THE START OF SOMETHING BIG?
The growth of the P2P sector might also be supported by the positive reporting reforms, which have been approved by both houses of the commonwealth parliament and are set to come into force next March; they will expose more information about the credit history of individuals, allowing new credit providers to make a more meaningful credit assessment.
“The advantage the big banks have had in seeing more data and being better able to discriminate is being eroded,” Symons says. “This is fuel for this larger trend towards risk-based pricing. It is going to make it much easier to see who are the people living within their means and are low default risks, who are higher default risks, and who are in the middle. It will let you price better and make the market more efficient.”
The P2P market will also allow investors to construct receipts to meet cash-flow needs, making P2P an attractive alternative to traditional fixed-income investments, which can be locked up. With Australia going to a federal election this coming weekend, Symons says governments of either political stripe are aware of the need to develop a greater range of fixed-income asset classes in Australia that offer reasonable returns.
But the real allure of P2P lending comes from something more elusive: the power of a “crowd” of investors to validate the lifestyle choices of borrowers and reward them for that, as opposed to a faceless credit department of a bank applying a one-size-fits-all to customers, and in the process, penalising the diligent borrowers.
Seen in this light, P2P lending looks like an attempt to take banking back to its community roots.
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- The Australian Financial Review, Capital