FinTech, P2P Lending and New Frontiers of Financial Intermediation: Mapping the Risks
In my recent paper, titled “The Promise and Perils of Alternative Market-Based Finance: The Case of P2P Lending in the UK”, I addressed a number of issues related to the development of alternative channels of credit intermediation in the UK, and the potential risks that they pose to the financial system.
The rapid growth of the P2P market in the UK, and more generally of the whole FinTech sector, has its roots in a number of factors, primarily recognised with the reputational distress of large banks in the post-crisis years, together with their conservative lending behaviour. A more subtle analysis also recognises that, beyond providing more cost-effective and streamlined modes of credit intermediation, alternative lending platforms have effectively sought to re-establish the fundamental intermediation and allocation functions that large banks no longer perform in modern economies.
Interestingly, and inevitably perhaps, the growth and development of this market raised some concerns as to its ability to keep up with its initial socio-economic promises. Despite offering better returns to lenders, and an easier and cheaper access to credit to prospective borrowers, most platforms have struggled to secure a sufficient volume of investors in order to match borrowers’ demands. This drought of funding was countered in two main ways, namely through synergies established with mainstream financial institutions, and through recourse factoring whereby platforms would essentially facilitate a secondary market for P2P loans. Following on from the US experience, the UK secondary market soon embraced the practice of P2P securitisation. This in turn entailed both P2P lenders securitising pools of loans, and also platforms directly tapping the wholesale market via securitisation.
All in all, the growth of the P2P market in the UK was characterised by a sharp institutional and transactional interaction between the platforms and the wholesale segments of capital markets.
The boom and hype associated with P2P finance were more recently halted by an increasing rate of defaults in P2P loans. Questions thus started to emerge as to the riskiness of investments undertaken by lenders in P2P platforms. The poor comparability of data – which is an intrinsic feature of how platforms operate – results in a problematic assessment of risk for investors. And unlike depositors in banking institutions, lenders in P2P platforms are not safeguarded by any deposit insurance protections schemes or by lender of last resort arrangements. Hence they bear the full credit risk of their investment.
Together with the question of credit risk, another fragility started to become more apparent, namely the systemic risk arising from the interconnectedness between P2P platforms and wholesale intermediation channels. This however seems to have remained under the radar, given that a number of commentators deemed the UK market not large enough to trigger systemic risk concerns.
In July 2018 though, the UK Financial Conduct Authority (FCA) published a proposal for a new regulatory framework applicable to P2P platforms. This represents in many ways a stark change from the initial facilitative regulatory environment that the FCA had established in 2014 with the Project Innovate centred on the Innovation Hub.
The analysis of the FCA proposal shows that the UK regulator is proposing to tackle with some vigour issues of credit risk. In particular, provisions related to the risk management of P2P platforms, their corporate governance, and the marketing restrictions to non-sophisticated investors, would drastically limit the amount of risk-taking that retail investors can get exposed to. At the same time though, this proposal would further move P2P platforms away from the retail market, towards institutional lenders and wholesale funding channels, increasing therefore the systemic risk concerns already highlighted.
On this last point, the FCA has not devoted much attention and it has probably underplayed the industry’s links with wholesale capital markets, in particular through securitisation. What has probably not been sufficiently appreciated is that the use of securitisation compromises the simplicity that is necessary for the P2P model of intermediation to maintain its promises and perform allocative functions. Questions of financial stability should also be raised, because if regulators fail to scrutinise the growth of P2P platforms through wholesale capital markets, risks of correlation and contagion, similar to those experienced before 2008, could spread through the whole financial
Vincenzo Bavoso, Manchester University School of Law