Peer Pressure: How do Peer-to-Peer Lenders affect Banks' Cost of Deposits and Liability Structur
Cycles of innovation have repeatedly disrupted and transformed the financial intermediation market. Recently, new digital technologies have allowed Peer-to-Peer (P2P) lending platforms to grow rapidly and provide individuals and institutions with new investment opportunities. In 2016 approximately $25 billion was invested through online peer-to-peer (P2P) lending platforms in the US. Approximately one third of these funds are supplied by private investors (Claessens et al., 2018). P2P lenders therefore present a new, and growing, challenge to banks as they compete for deposits to fund their activities.
P2P loans typically offer investors a higher rate of return compared to bank deposits. The entry of a P2P lender provides depositors with a risky substitute to deposit accounts. As depositors with low risk aversion invest in P2P loans, the supply of deposit funds contracts, and banks are forced to increase equilibrium deposit interest rates to prevent a drain on liquidity. Moreover, when faced with a contraction in deposits, banks may shift towards more costly non-deposit funding sources such as subordinated debt, Fed funds, and brokered deposits. P2P lenders therefore provoke an increase in banks’ cost of deposits and lead to greater reliance on non-deposit liabilities.
We test these hypotheses empirically by examining the response of banks’ cost of deposits and liability structure following the entry of P2P lenders into local US banking markets. At the heart of our identification strategy is the staggered removal of P2P investing restrictions by US states. The removal of P2P investing restrictions is due to regulators’ concerns about protecting P2P investors from fraud and losses, and are exogenous with respect to banks’ cost of deposits, liability structure, and conditions within the banking industry more generally (Chaffee and Rapp, 2012).
We study these outcomes using difference-in-difference estimation that compares the evolution of the cost of deposits and liability structure within banks in states that remove and do not remove P2P investing restrictions. Estimates show that the entry of a P2P platform leads to an increase in the cost of deposits between 11% and 16%. We find larger responses when banks are subject to competition for funds with Lending Club compared to Prosper, consistent with Lending Club’s greater P2P market share. In essence, banks that experience larger reductions in the supply of deposits increase deposit rates to a greater extent. Furthermore, our estimates show differential treatment effects depending on banks’ geographical diversification and size. The increase in deposit costs is larger among small banks and those that operate branches in a limited number of states. This is consistent with banks using cross-state branch networks as internal capital markets to mitigate competition for funds with P2P lenders by sourcing deposits from regions where P2P lenders do not operate.
We also find that in the face of competition with P2P platforms, banks’ liability structure shifts towards greater reliance on non-deposit funding. Following an outflow of deposits, banks make up the funding shortfall by relying more heavily on non-deposit funds. Given these funding sources are typically more expensive than retail deposits, the net effect of P2P lenders on banks’ overall cost of debt is larger compared to the baseline increase in deposit costs. Specifically, while banks’ costs of deposits increase, they also rely more heavily on more expensive non-deposit funding.
Our contribution to the literature is twofold. First, we provide novel evidence on how the banking industry is affected by the rapid development of the Fintech sector. We document an unintended consequence of the growth in the Fintech sector: its impact on bank funding costs. Second, a novel outcome of our research is that by provoking an increase in non-deposits in banks’ funding mix, P2P platforms may undermine bank stability. For example, bank funding costs are integral to the transmission monetary policy, and banks’ funding costs matter for financial stability and macroprudential policy as they feed into assessments of the risks to the stability of the financial system. Our findings therefore have important policy ramifications.
The Fintech revolution has led regulators to question the risks and advantages of financial technologies, particularly with respect to consumer over indebtedness and bankruptcy. Our research demonstrates a hitherto neglected, unintended effect of the expanding Fintech sector. Specifically, P2P lenders trigger an increase in the cost of deposits and greater reliance on more expensive non-deposit funds. Prior research has shown reliance on non-deposit funding can undermine bank stability and speed up time to failure (Schaeck, 2008; Demirguc-Kunt and Huizinga, 2010). P2P lending may therefore have indirect consequences upon macroprudential policy.
Hisham Farag, University of Birmingham
Santosh Koirala, University of Birmingham
Danny McGowan, University of Birmingham