P2P companies can no longer pretend to be like banks

Lending to random Ramesh better give you more than just 9%

I tried to go here for a bad pun best not got into.

If you go to a bank and deposit some cash, you do it because you want to safeguard your money. The bank then takes this money which it’s supposed to safeguard, and lends it out to people and businesses who may be spending it on their high risk endeavours.¹

Sure, a bank’s business when described in this way sounds a bit bizarre. You gave the bank your money with the trust that it would be kept safe at all times! Not for it to be lent to do risky stuff! Yet, somehow in the grand scheme of things, we’ve all grown to accept that this is what banks do and it’s perfectly fine to deposit money into our bank accounts.

Let’s meddle with this idea a little. What if, when you deposit some money into your bank account, the bank sends you an email telling you exactly whom your money is going to be lent out to? You may have deposited ₹1 lakh, and the bank splits this into 10 chunks of ₹10,000 each and lends it out to 10 different people whose names you now know.

Seeing a random Ramesh getting a loan out of your deposit might make you nervous. You don’t want to know this! You don’t care who gets your money. All you care about is that your money is safe and that you’ll get a bit of an interest for your trouble.

Fortunately the first model is how banks operate. They don’t tell you about the investments (loans) that are being made with your money. In return, you get a guarantee of safety and liquidity. Your money will be safe and you can take it out whenever you like.

The second model is how peer-to-peer lending platforms operate. They take your money, you get an interest, but you also get the knowledge of who you’re lending to and what your borrower wants to do with that money.

The problem with model #2—as we’ve already observed—is that it’s not for the faint of heart. We’re all good with lending to an anonymous bunch of folks as long as we get our money back, but not to random Ramesh. The P2P lending platforms know this, so they did a bunch of things to make their loans look less like P2P and more like bank deposits.

Last month, RBI released a notification which pretty much puts an end to P2P lending platforms trying to look like banks. Here’s a report from Business Line:

In its latest action, the Reserve Bank of India (RBI) on August 16 disallowed P2P companies from offering investment products with features like tenure-linked assured minimum returns and liquidity options, which has led a few P2P companies to stop generating new business altogether, four industry sources told businessline.

RBI disallowing "tenure-linked assured minimum returns and liquidity options” is just code for RBI disallowing peer-to-peer lending platforms from offering “deposits”.

Two models

Here’s a model for how I would imagine a P2P lending company would work:

1. You’re in the mood to lend some money out so you sign up on the P2P lending company’s website and register as a lender.

2. Someone else in the mood to borrow some money signs up as a borrower.

3. The company matches the two of you based on how much you want to lend, how much the borrower wants to borrow, how much interest they’re willing to pay, etc.

4. The borrower (random Ramesh?) gets the money. If and when he repays the loan, you get your principal and interest. Of course, if he doesn’t repay, you lose money.

This is just my imagination. Here’s how things really worked:

1. You sign up as a lender because you’re adventurous and like living life on the edge.

2. But you also like fixed returns! So the P2P lending platform advertises a fixed 9% or 12% or whatever of fixed return to you.

3. You also like to be able to withdraw your money at any time, no matter if it’s actually lent out. So the P2P lending platform tells you you can withdraw at any time.

4. You lend, say, ₹1 lakh. The company takes this and divides it up across many, many borrowers getting maybe ₹1,000 each. If one of them defaults on their payment, that’s fine, the others might still pay.

5. But also, you can pull your money out! The platform would hope that you don’t, but if you do, it will replace your money with that of another lender just like you.

6. At some point in this process, the P2P company takes your “approval” about the borrowers who are getting your money. Because, well, the RBI requires it. While in our imagined P2P model, the borrowers were front-and-centre, in this model they might be an afterthought.

With its new notification, RBI has just converted the second model, which is what has been happening all this while, to the first (imagined) model which is essentially a matching service. P2P lending platforms can no longer advertise a fixed rate of return, and they will no longer be able to replace their lenders’ money with other lenders’ money.

There’s a couple of other things. From RBI’s notification:

An NBFC-P2P shall not provide or arrange any credit enhancement or credit guarantee. NBFC-P2P shall not assume any credit risk, either directly or indirectly, arising out of transactions carried out on its platform. In other words, entire loss of principal or interest or both, if any, in respect of funds lent by lenders to borrowers on the platform shall be borne by the lenders and adequate disclosures to this effect shall be made to lenders as part of fair practices code specified in para 12 of the MD.

When P2P lending platforms advertised a fixed return to lenders, it came with a benefit. They could promise a certain rate of return to their lenders, say, 9%, and charge their borrowers a much, much higher interest rate, say 18 or 20%. This spread was, in an ideal world, their profit. In the real world, the P2P platforms could use this spread to make sure that their lenders get their money back, with interest.

This one’s interesting too:

The funds transferred into the Lenders’ Escrow Account and Borrowers’ Escrow Account shall not remain in these Escrow Accounts for a period exceeding ‘T+1’ day, where ‘T’ is the date on which the funds are received in these Escrow Accounts.

Earlier, when a borrower repaid their loan, the platform could take that money and reinvest that into another loan. Or, you know, use that money to repay another lender who asked for their money back. Now RBI wants to ensure that the lender-to-borrower connection isn’t mixed up. If a borrower repays, the lender should get that money by the next day.

“The point of banking is to conceal risk”

One of Matt Levine’s many funny observations is this: the point of banking is to conceal risk. There probably couldn’t be a better way to describe what banks do. You put your money into a bank and aren’t worried about where it goes, and can access it whenever you like even though it’s technically lent out. Pretty magical.

If banks weren’t able to conceal risk, people wouldn’t put their money in them, there would be no lending, the economy wouldn’t function, etc. What Levine gets at is that banks play an important social function (the running of the economy) so the regulator sort of lets them get away with concealing risk. (Of course, it also sets a bunch of rules to reduce that risk.)

P2P lending platforms, unlike banks, don’t play an important social function. So RBI wants them to do the opposite—not conceal any risk at all. Lenders who sign up are going to want a lot more interest.²³

Cover Photo by Nataliya Vaitkevich/Pexels

1. This is not exactly correct, but it’s thematically correct, so we’ll stick to it.

2. The funny part here is that actual risk doesn’t go up. Platforms can still split the lenders’ money and lend it out to a thousand different borrowers. But perceived risk will go up, so fewer lenders will sign up, so there will be less money to lend, so the cost of borrowing that limited amount of money will go up, and hence the interest rate to borrow will go up.

3. Another consequence is that the NPAs (non performing assets) of these platforms will go up. Earlier, the promised interest to the lender was a lot lower than what the platform charged the borrower. So the bank could use that spread to cover any defaults and the lender could still get all their money back, because so less was promised to them in the first place. Now, in theory, lenders might make more money in terms of the interest, but if a borrower defaults, it might still become an NPA for the platform solely because there was no expectation-reducing promise in the first place. [Removing this because I’m not really sure if this is how NPAs are classified by P2P platforms]