Online peer-to-peer (P2P) lending is emerging as a provider of credit to individuals as well as small businesses, with the potential to benefit borrowers (by reducing the high cost of bank credit, credit card debt and payday loans) and lenders (by providing opportunities to earn higher yields).
A significant hurdle for investors, however, is the information asymmetry between the borrower and the lender. The lender does not know the borrower’s credibility as well as the reverse. Such information asymmetry can result in adverse selection.
Financial intermediaries have begun to replace individuals as the lenders, buying loans from originators such as the Lending Club, Prosper, Square and SoFi, and creating investment products such as closed-end “interval” funds that individual investors can use to access the market. These funds are not mutual funds, because they don’t provide daily liquidity. Instead, they provide for redemptions (with limits) at regular intervals (such as quarterly).
Reducing Asymmetric Information Risk
This type of financial intermediary can help reduce the asymmetric information risk by setting strong credit standards (such as requiring a high FICO score), performing extensive due diligence on the originators (to make sure their credit culture is strong), structuring repayments in ways that can improve performance (such as requiring that all loans be fully amortizing and that automatic ACH repayments are made, thereby eliminating the choice of which loans to pay off, as with credit card debt), and requiring the originator to buy back all loans that are shown to be fraudulent.
Additionally, they can enhance credit quality by requiring the use of social media to confirm information on the credit application. By improving transparency, they also facilitate the flow of capital to borrowers in a more efficient and dependable manner.
Riza Emekter, Yanbin Tu, Benjamas Jirasakuldech and Min Lu contribute to the literature with their 2015 study, “Evaluating Credit Risk and Loan Performance in Online Peer-to-Peer (P2P) Lending,” which appears in Applied Economics. They analyzed the data from the Lending Club, one of the largest providers of peer-to-peer loans. The database consisted of more than 61,000 loans, totaling more than $700 million, originated by the Lending Club in the period May 2007 to June 2012. Almost 70% of loans requested were related to credit card debt or debt consolidation. The next leading purpose for borrowing was to pay home mortgage debt or to remodel a home.
Following is a summary of the authors’ findings: