Peer to peer lending through the lens of disruption

I've begin to ask myself whether peer to peer lending is, in fact, a disruptive or incremental innovation. I can already imagine everyone out there reading this incredulously: of course peer to peer lending is disruptive!

But just because it is something banks aren't really doing much of at present does not make it disruptive.On the other hand, the theory behind disruption is well understood. It should be possible to see signs of peer-to-peer disrupting banks. Clayton Christensen's underpinnings to what follows will be obvious if you've read his books.

So what signs would one expect if p2p was beginning to disrupt traditional lending?

Firstly, it would start small, and grow big. It would start in segments the traditional part of the industry- banks – would not care much about. Loans, for example, to people that a bank wouldn't normally lend to. The loans that Prosper and Zopa are writing – would they be writing them today if customers could get a similar loan from a bank?

Secondly, the product needs to be good enough for the target market of people in that segment, but would under-perform for higher segment tiers. Because of this under performance, banks naturally dismiss p2p as an inconsequential threat to more highly profitable business. Bigger loans are more complicated. Mortgage, for example, requires all this stuff which a personal loan doesn't. Clearly, p2p under performs for complicated big products presently, although there are signs of this changing. Virgin Money in the US, for example, with their acquisition of Circle Lending, could conceivably crack the more complicated loans with a peer to peer model.

Thirdly, you'd expect to see banks ceding the low margin, uncomplicated loans to peer to peer, and move upmarket aggressively. For a peer to peer lender, such a market is attractive because of their low cost base and different business model. For a bank, however, margins are much thinner, and the upscale markets very much more attractive. The exit would be a natural, and justified move.

Here is the key question: are we seeing such behaviour presently in banks where a P2P player has entered the market? The answer is complicated by the present situation in financial markets. According to Zopa, they are doing great business at present, and even they put this down to the Crunch. Its by no means obvious, given what else is going on, that banks are exiting.

On the other hand, Gartner suggested a month or so ago that p2p could capture 10% of retail lending in the next year and a half. One way that would happen is if banks decided to leave very low margin unsecured loans on the table for peer to peer. It would be a classic example of flight from a disruptor.

My view is that if the Gartner forecast comes true – or actually, even close to true – p2p is disruptive, and is a very, very significant threat to the core business of banks (I realise I previously dismissed the Gartner forecast as ambitious). As a hypothetical exploration for a moment, let's explore what might happen if this came to pass.

Peer to peer, on an aggressive expansion programme, would naturally improve its product. This would make them good enough in other segments that banks had not yet vacated. There are already signs of this improvement happening. Zopa, for example,  launched deposit insurance, which will likely make them good enough to attract deposits from people who otherwise would have used a bank. There would still be a cost and business model advantage compared to banks, so banks would, again, have the choice to flee or fight. Disruption theory would suggest flight as the likely option. There would still be a more profitable segment for banks to focus on, so flight would make good commercial sense.

Now, that's all predicated on the idea that banks are already ceding low margin markets to P2P (because it is disruptive), and as I've said, that's by no means something that is certain right now. Let's consider the alternate case where, in fact,  P2P is incremental.

An incremental innovation introduces a minor variation on the core theme already offered by the incumbent. Such a variation would make it more likely or less expensive to get a loan (or make a deposit), but probably doesn't offer much that a bank wouldn't be able to if it put its mind to it. Likelihood is easily addressed by a bank through its lending criteria, and price is similarly easy to counter, especially if you have deep pockets. In any event, it does seem likely that any present price advantage in the P2P model comes as a result of premiums paid by a new entrant to get its foot in the door with customers.At this stage, I am not aware of any data that suggest that the social aspect of peer to peer is sufficiently motivating to consumers who want to conclude a financial transaction.

When P2P is conceptualised as incremental, entrants are fighting directly for customers of incumbent banks. In such a play, banks will definitely not cede low margin markets, and will counter with competitive products of their own. Family and friends lending, for example, would be such a response, where banks act as lending administrators for a fee, though not providing the funding themselves. That's the same model business model of most P2P players, but backed by the much larger resources of a bank.

In the case of an increment on traditional lending, I'd expect that banks will win the competitive battle. Either because they enter P2P themselves, or because of the competitive fatigue that new entrants will experience over time.

So let me state the key question differently: are P2P players writing loans to customers that wouldn't have acquired a loan previously? Or are they fighting to take share from banks by winning over the same customers? The former is disruptive, and the latter isn't. 

As this is such an important question, no matter which side of the debate you come down on, I'd welcome any thoughts.

8 Responses to“Peer to peer lending through the lens of disruption”

  1. May 27, 2008 at 6:03 pm #

    The state-of-nature for financial transactions is “p2p”: a group of free agents contracting between each other for cash flows conditional on certain risks. A standard bank loan is an edge case of that, although a very common one.
    Almost anyone alive today can take out a loan for far more than they could ever consume, at SOME PRICE. Access to credit isn’t an issue, the cost and the terms are. Even most of Grameen Bank’s borrowers could get finance from a moneylender, just not on terms that allowed them to be productive users of capital. (Grameen are a monolithic traditional bank in most ways – and that’s worked well for them.)
    So I would prefer to ask the questions: How would finance operate if we had globally accurate information and zero transaction costs? What real-world constraints have shaped our financial system? Which of these have been loosened by recent technology (thinking more of mobile phones & GPS, than facebook)? What can we do now that was previously too hard?
    (If a p2p player took over the entire mortgage market, surely that would be disruptive? Even if those people would have been able to get (inferior) mortgages before.)

  2. adampark
    May 27, 2008 at 9:50 pm #

    (If a p2p player took over the entire mortgage market, surely that would be disruptive? Even if those people would have been able to get (inferior) mortgages before.)
    Yes, it would be disruptive, but it seems that the cart is before the horse. The question is what would someone offer that is more attractive than a traditional mortgage provider to take over the entire market?

  3. May 28, 2008 at 8:34 pm #

    Or what could you offer the mortgage lender (whoever that might be) to drop the price of their money? There are two sides…
    (Clearer title to the asset and less applicant fraud?)

  4. May 29, 2008 at 8:26 am #

    These are good points, but I suspect that “taking over the entire mortgage market” would be a gradual thing. The key is that unserved consumers who otherwise would not get a mortgage would be able to as a result of the disruption. And we know where that has led us presently…

  5. May 29, 2008 at 12:27 pm #

    I sure think it is disruptive when concerning microfinance (MyC4.com, Kiva).
    Could potentially be disruptive overall , if the players can handle/lower the defaults (see Prosper, Boober).
    But even it is incremental- banks won’t take a piece of the pie, because if they enter it will be to late.
    And why would they enter now?
    One scenario could be a large bank acquiring a major p2p platform.
    Claus

  6. May 29, 2008 at 4:07 pm #

    I suspect most p2p platform would be happy to white/co-label their products through existing mainstream institutions. If I buy Nationwide Travel insurance, it’s not written by them. A lot of the UK’s store cards are run by GE. So it’s not unusual… Whether p2p is potential competitor or partner depends on how keen banks are to take credit risk, rather than do customer facing finance operations.
    @James – I’d partially disagree. I think it’s just as likely that the wealthier and more sophisticated borrowers will exit the mainstream first. It’s not being poor, it’s being different. But if it ever happens, I agree completely it will be a gradual shift. Finance takes a decades to re-orientate – people change slowly.

  7. Dave Morris
    June 4, 2008 at 12:31 am #

    James,
    P2P will both grow the market through extending credit to new segments, and take market share from existing players by lowering the cost of credit to existing segments.
    See: http://www.techcrunch.com/2008/06/02/greennote-offers-more-peer-to-peer-loans-to-tackle-the-college-funding-gap/, http://www.techcrunch.com/2008/03/19/fynanz-how-students-spell-peer-to-peer-loans/, and http://www.crunchbase.com/company/qifang
    Student banking is where it is focussed now because of the large need for unsecured credit, and because the social aspect *is* a motivating factor for lenders.
    Against social lending, banks will struggle to compete, because they suffer greater information asymmetries and cannot use loss of face or shame to enforce obligations.
    But in the case where lenders and borrowers are unknown to each other, I tend to agree that banks can compete if they “put their minds to it”. There is merely a legacy legacy cost structure to overcome first…
    Dave

  8. April 3, 2009 at 7:24 pm #

    Hi, you have a nice site, good Luck!.
    I am from Czech and also now teach English, please tell me right I wrote the following sentence: “One in the airline management believed that.”
    With love :-D, Bena.

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