Peer-to-peer lending involves intermediary firms putting together borrowers and savers who are each looking to enjoy better rates of interest than they can find from, respectively, a loan or account on offer from a traditional bank. According to the Financial Times, the sector has grown from nothing to close to £400m in the UK in just six years so what could explain its burgeoning popularity?
For those doing the borrowing, the most likely answer would seem to be they are unable to find a loan anywhere else but what is the attraction for the individuals putting up the money? Might it have something to do with the present negative image of high-street banks, some sense of social or civic duty or perhaps the interest rates on offer of up to 15%?
Bearing in mind our day job here on The Value Perspective, let’s investigate that third possibility in more detail. After all, 15% is quite a rate of return so should we thinking about dabbling in a little peer-to-peer lending ourselves? The short answer is ‘not a chance’ – and not just because, if something looks too good to be true, there is a very good chance it is too good to be true.
Mind you, that is also a decent place to start the long answer and it would be fair to say the world is not so inefficient a place that people can enjoy 15% returns without some risks being involved. One that immediately springs to mind is anybody who has to pay 15% for a loan is likely to have been knocked back several times by one or more traditional banks, which will have had their reasons for doing so.
Another risk is that the intermediary firms tend not to lend money themselves, which at least raises the possibility they may be less diligent with their credit checks than if they had ‘skin in the game’. It also suggests their business models will often be based on gathering and packaging loans before selling them on – an area where financial companies hardly covered themselves in glory pre-credit crisis.
Indeed, one outcome of the credit crisis has been greater regulation to prevent banks from speculating but that only means if those who want to speculate cannot do so through a bank, they will find other ways. That in itself raises the interesting question of whether people putting up the money for peer-to-peer lending realise they are not investing, let alone putting cash on deposit – they are speculating.
Behavioural finance theory may offer some insight here because it could be some peer-to-peer lenders are making the mistake of ‘anchoring’ their perceptions on past experience rather than accepting things can and do change. Perhaps they are looking to boost their returns to – or beyond – pre-crisis interest rate levels while comforting themselves they are remaining within a quasi-banking environment.
However, there is a world of difference between the returns and risks related to peer-to-peer lending and the – albeit historically low – rates on offer from banks where your cash is at least protected by the financial services compensation scheme up to £85,000 per person per account. As ever, investors who do not make the right comparisons cannot hope properly to gauge the respective risks involved.