From the perspective of Lending Club’s shareholders and employees the company’s recent initial public offering (IPO) has been a resounding success. The danger though now is Lending Club’s success may carry seeds of peril for the nascent peer-to-peer (P2P) lending industry. Why? Greed.
That Lending Club’s IPO was a spectacular success is self-evident. The company’s shares priced 50% above the bottom end of the initial price range formulated at the start of its IPO road show. Those shares then rose a further 56% on its first day of trading as a public company. Lending Club currently has a market capitalization of a little over USD9bn. Not bad for a company that in mid-2012 had an implied valuation of USD570mn and as recently as May 2013, when Google Ventures bought in, was valued at USD1.55bn.
Given that Lending Club is both the world’s largest, in originated loan volume terms, online P2P marketplace lender and the first of its ilk to achieve a public listing, it is little wonder folk in the P2P industry are now in highly celebratory mood. Whilst some air-punching and back-slapping should be enjoyed by those who have toiled hard to build a new industry that has now had its first major stamp of public approval, it is also a time for all involved, including their customers, to become even more vigilant about industry practices and standards. Particularly, underwriting standards.
Charlie Munger, the long time investment partner of Warren Buffett, famously opined ‘Show me the incentive structure and I’ll show you the outcome’. Post Lending Club’s IPO success the danger is that the core incentive structure at the heart of the P2P industry may have taken a turn for the worse. Specifically, the riches prospectively on offer in the public market for those P2P companies that can demonstrate ‘strong growth’ in what is now a ‘hot industry’ have become, all of a sudden, very large. Given this the temptation to take a short cut to success has never been higher in the industry. The real danger is P2P lenders aspiring to be ‘the next Lending Club’, probably egged on by VC backers who have ticking fund clocks, will prioritize asset growth over asset quality. If this is the case it will be a tragic mistake. A strategy of ‘Damn the torpedoes. Full steam ahead’ may have worked for the American Civil War admiral David Farragut at the battle of Mobile Bay in 1864, but it is, I suggest, highly unlikely to produce an outcome of glorious victory in consumer and SME lending markets today.
I say ‘a tragic mistake’ because a collective dropping of industry underwriting standards is the surest way the P2P industry can destroy the genuine value it has brought to the High Street. The beauty at the centre of the P2P industry today is that it offers its borrower and lender customers alike an evidently better value proposition than the incumbents (banks, credit card companies etc) of financial services do. The High Street customer value creation currently supplied by the P2P industry is one of the principal reasons the industry has enjoyed, and deserves to enjoy, a supportive regulatory regime as well as strong government backing.
P2P lenders are classic disrupters bringing radically lower cost structures to an industry. The foundation of the new lower cost structure P2P lenders have brought to the finance industry is part tech-enabled business model innovation, part regulatory arbitrage and part underwriting competence. Take anyone of those factors away and the cost structure advantage enjoyed by P2P lenders evaporates and with it so does a very significant part of the superior customer value proposition they offer. Of those three factors, underwriting quality is the factor most in the hands of P2P lenders to self-control. It is also the factor that can be most easily manipulated to improve near term loan origination volumes.
Just because a risk is at large does not mean it will become manifest. But the probability of it occurring does rise. How might the P2P industry protect itself from the risk of a possible deleterious drop in underwriting practices by those chasing growth and riches at all cost? There is no infallible answer but I suggest 3 things could and should be done.
First, industry P2P industry bodies, like the P2P Finance Association in the UK, should demand rigorous underwriting standards from its Association members. The underwriting practices of applicant Association members should be carefully reviewed and required to meet an Association determined standard. Existing Association members whose practices fall short of those standards should be required to bring their standards up to par. Should a member fail to do so that member should be ejected from the Association. Members who are suspected of dropping underwriting standards of existing products, as opposed to say offering new, identified higher risk loan products, should be obliged to provide a full account of their practices to an Association level underwriting audit committee.
Second, industry regulators, such as the Financial Conduct Authority in the UK, should deepen further the level of scrutiny they employ on the underwriting practices and competences of those applying for P2P lending permissions.
Third, in sharp contrast to how the traditional finance industry operates, all employees in the P2P industry should be required by their respective companies to take an Association sanctioned oath. This oath should be renewed each year, and like its medical counter-part should seek to commit the sayer to both prioritizing the long term interests of the customer and maintaining the integrity of the industry. This may sound rather Boy-Scoutish to some. Good. The point is the Boy-Scouts have a decent track record of producing individuals of good character. Whereas arguably the biggest problem in the mainstream finance industry over the last 20 years has been the absence of enough people within it displaying good character. Posts hundreds of billions of dollars of banking industry related fines the take-away has got to be that the good character quotient in the finance industry needs to be helped to grow. The suggested oath for P2P lenders would act as a clear sign that they, the putative disruptors of finance, intend to hold themselves to a higher sense of public obligation than the incumbents of mainstream finance have in recent times.
What should the customers of the P2P industry do? In particular, what should the lender customers of the P2P industry do? 2 things. First, be aware of the underwriting dangers that lurk. These dangers lurk not because P2P lenders are generally incompetent at underwriting. Indeed the reverse is often the case. There is a growing body of evidence to suggest certain P2P lenders do and/or will better assess credit risk in a given loan category than the incumbent loan providers in those categories do. Rather the dangers lurk because there is now a strong temptation at large for P2P lenders to adopt a ‘damn the torpedoes’ growth strategy. That is not to say they will. But the chances that they might have risen thanks to Lending Club’s success. Second, place more value on the product offerings of the more tried and tested among today’s P2P lenders. In the US that might mean Lending Club or Sofi. In the UK it is likely to mean the likes of Zopa and LendInvest which have industry leading net charge-off rates.
The big truth in any industry and in any area of life is that ‘very good is very rare’. Underwriting is no different. It only becomes yet rarer still if incentive structures are not fully supportive of it. To protect against the risk of an erosion in the collective underwriting standards of the industry, and so to keep the P2P lending industry’s superior value proposition alive on the High Street, online marketplace providers and their customers alike should become even more vigilant and demanding in the wake of the Lending Club IPO. Their future depends on it.
21 March 2023
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