P2P lending: the real benefits and ways to mitigate riskVinay Mathews
The internet has changed many things around us. Almost nobody buys audio or video CDs today; we get them online or on Netflix at a fraction of the cost. When was the last time you met someone who sent his/her résumé through post? We all send it at no cost, through job portals/boards. We are all adopting a similar methodology to book a holiday, movie, air tickets, or e-books. Similarly, in future, we won’t be using brick-and-mortar financial institutions to borrow or deposit money. Instead, we will rely on cost-effective online peer-to-peer (P2P) lending companies.
P2P lending platforms have no branches. The idle money is used by retail lenders to lend to borrowers. This helps in lowering costs for borrowers and increasing returns for lenders. The platforms make money by charging fees to borrowers and lenders.
P2P lending is a good opportunity if you’re looking for an alternative way to invest your money. As a lender, the paybacks are amazing, with decent returns. So let me begin by listing a few of the benefits:
Benefit no. 1: you earn 16–22 percent returns
We invest to earn returns and P2P companies give you decent returns (yield). Lenders playing it safe make over 16 percent and those with appetite for little risk earn closer to 22 percent. It takes about 18 months and an investment of up to Rs 10 lakh across a diversified portfolio to stabilise at 16 percent to 22 percent. Choosing a level of risk is easy. Every borrower is rated for how risky they are. Your return will be the average interest rate of your borrowers minus the rate at which they default (don’t pay back their loans).
Benefit no. 2: asset class with returns more stable than stock market
The stock market may give you returns at par or greater than 20 percent over time. So what makes investing in P2P lending companies special? The answer is STABILITY. In 2008–09, the stock market had crashed, losing more than 55 percent of its value but globally, P2P loans didn’t stop and borrowers continued to pay lenders money. Also, if the borrowers don’t pay, there is legal recourse available, there are agreements. This would not be possible if you’d invested in, say, a listed bluechip company which went bankrupt. For an average investor, P2P lending is a good asset class of consumer credit. By diversifying your investment across 100 different borrowers, you will begin to mirror the overall default rate of the platform, gaining stability and consistency within your portfolio and enjoying the returns just like banks do.
Benefit no. 3: the return in itself is very exciting
Borrowers repay every month, which means there is a steady cash flow coming to you every month. Are there many investment opportunities that give you monthly returns upward of 16 percent, with the principal and interest coming back month on month, every month? There is none. Reinvesting this monthly inflow means an opportunity to earn even greater returns.
Benefit no. 4: enjoy the freedom
The money you invest helps bring positive change in people’s lives. People are able to come out of the credit card/debt trap, fathers are able to get their daughters married, sons are able to make their mothers healthier, businessmen are less stressed. A P2P investor can enjoy the freedom that it gives to people who were under pressure, due to lack of access to easy and cheaper credit. P2P lending companies are giving you the opportunity to invest in and help fellow Indians out.
While many investors continue to earn great returns on P2P platforms, a large section of the country has still not heard about or is skeptical about investing in them. While we have seen the appetite for risk with Indians changing in the last 10 years, I still believe, apart from trust, there is a huge leap of faith required from being interested in actually investing with your own money on a P2P lending platform.
P2P lending companies do a lot interventions and take significant measures to minimise risk for lenders. But the risk is supported by decent yield and you can’t get those returns without the risk. Let me quickly try to explain the risks involved and how to manage and mitigate them:
- Default risk and creditworthiness of the borrower over time: One of the basic risks of P2P lending is that investors/lenders may lose part or all of the principal due to loan defaults.
How to mitigate:
A few critical steps, if followed diligently by the P2P platform, can help minimise this risk for lenders. Traditional data like bank statements, salary slips, ITR etc. supported by digital data, online transaction data, and mobile and social data should be carefully evaluated and studied to understand the borrower’s ability, stability, and intention to repay the loan taken.
The CIBIL of the borrower is a must for the platform to be able to evaluate past performance. The identity verification process (physical or through technology) has to be done to eliminate fraudulent applications.
Risk mitigation should continue even after the lender and buyer reach an agreement. The platform should facilitate the signing of a legally-binding agreement as well as collection and holding of borrowers’ post-dated cheques which can be used by the lender to initiate criminal proceedings in case of default. This coupled with a proactive and disciplined collection process should take care of this risk.
Some companies talk about 100 percent lender principal protection programmes but to me, this is not something which is feasible or scalable. This is because under 4 percent default, the company will seize operations as they will not be able to make any money. The business model itself is flawed. Unless you are getting a written, stamped, and signed document, this one is just to keep you engaged.
- Concentration risk: Lack of a large and diversified borrower pool for lenders to diversify their investment across different yield types and risk grades. Exposure to a concentration of borrowers of the same type is risky. This concentration can be of city, risk/returns, loan purpose, gender, caste/community, tenure, loan amount, etc.
How to mitigate:
P2P lending platforms should allow lenders to diversify across many loans by factionalising an individual borrower. Diversification is a crucial step lenders must take to mitigate risk. As a lender, you need to check if the platform gives you a diversity of borrowers for investment. It’s always better to spread your investment across a minimum of 100 loans of different types and risk grades viz. city, risk/returns, loan purpose, gender, caste/community, tenure, loan amount, etc. Investing small amounts across a large number of diversified loans will likely keep default rate at a reasonable and consistent level, thereby increasing returns. Diversified lenders/investors have not lost money on P2P lending sites. At an aggregate level, it gives lenders a risk-adjusted return upward of 18 percent.
- Credit policy risk: Outdated credit policy and processes which are not tuned to your business needs and scale.
How to mitigate:
Check how strong the risk team is. Who runs the risk department? If required, please speak/write to the CRO. Ideally, the risk team should be of people with a strong track record in risk management and practice. The data science team within the organisation should be responsible and producing analytical work to improve the quality of the decision-making. In India today, not many P2P lending players publish data and statistics about loan purpose, returns, and default ratio on their website. However, serious, long-term players will, because they realise that it’s critical to do so to bring transparency in the system and build lender confidence.
- No insurance risk: If there is no insurance for the borrower and if he/she meets with some unforeseen situations like an accident, sickness, or death, the lender is exposed to a big risk.
How to mitigate:
Tie-ups with life insurance companies will help borrowers avail insurance to protect themselves from default in case of unforeseen situations like accidents, sickness, and death. The payment to the kin should happen on the conditions set out by the platform. A formal approval from the P2P lending company is required before the pay-out.
- Macro risk: Macro risks are beyond the control of the platform. These include an economic recession, policy change, political turmoil, natural disasters, and terrorist attacks, which may affect a borrower's ability to make loan repayments.
How to mitigate:
The agreement between the lender and the borrower is “I owe you” and one can rest assured that the lender has the right to collect what is due to him at any point in the future when say, the country is out of recession or overcomes the impact of a natural disaster. The P2P platform should keep in touch with the borrower and get regular updates on his/her status. Having said that, India’s story looks very positive for the next 10 years. The much-awaited regulatory framework expected to be announced by the RBI any time soon will help improve operational efficiency of P2P lending companies benefiting both the lenders and borrowers.
- Liquidity risk: If you are unable to sell your loans in order to convert them into cash, in case you need funds early.
How to mitigate:
Currently, no Indian P2P platform offers a secondary platform to trade your good/bad loans for a premium/discount. Also, the loan cannot be traded without the consent of the borrower and the platform. One option can be private placement of performing loans over six months to another lender with prior approval of borrower. Till the secondary platform comes up, it’s better to invest your spare money.
- Foreclosure and early repayment risk: A borrower repaying his or her loan before time and a lender not receiving the interest income which was estimated while investing.
How to mitigate:
Currently, there is no penalty for this. However, some P2P lending platforms charge a minimum of three months’ interest as penalty if the borrower decides to close in the first two months. Ideally, there has to be some flat fee even post three months.
The reason for discussing the associated risks and means of managing and mitigating them in such detail is to give P2P lending a perspective as an asset class especially over other similar investments like equities, MFs, and bonds. The average Indian may find stock trading or investing in SIP/MFs confusing. On the other hand, P2P investing is not just simple; it’s more revolutionary and exciting.
P2P lending is one of the most revolutionary and disruptive financial innovations of our times. Modern technology, lifestyle, and the way we earn, spend, and invest are the lifeline of P2P lending. It provides many left behind a chance towards financial inclusion. With borrowers well rated and mostly paying on time, with the promise of decent returns and the simplicity of asset class, with a conducive regulatory framework, and greater data-transparency in the system, P2P lending will become one of the most profitable investment classes in coming years.
(Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the views of YourStory.)