With increasing difficulty in securing finance through traditional measures, SMEs have turned to new alternatives. By Prof Theo Lynn and Dr Pierangelo Rosati calculate the possibilities and the implications.
Small and medium enterprises (SMEs) are at the core of the Irish economy as well as of most economies worldwide. Despite the fact that SMEs employ the majority of the working force and their undoubted contribution to GDP growth, SMEs have historically faced a lack of external funding to boost their growth or to overcome temporary cash flow shortfalls.
Banks – local banks, in particular – have traditionally been the main and sometimes the only source of external capital for SMEs. However, increasing regulatory requirements have lowered the probability for SMEs to obtain access to bank financing.
‘P2P lending platforms act as intermediaries and provide additional services like risk assessment, payment transfers and portfolio management in exchange for a fee’
Peer-to-peer lending (or P2P lending) is not a new concept. Indeed, many entrepreneurs have the shared experience of borrowing or seeking investment from family and friends. Such loans and investments required little due diligence or risk assessment, and are largely determined by the strength and number of founder relationships and the financial capacity of individuals in these networks.
The widespread adoption of the internet facilitated the next generation of P2P lending. Online P2P lending platforms use the power of the crowd to connect small businesses in need of funding and potential lenders typically looking for profits. P2P platforms do not invest their own funds and do not provide protection for lenders; they act as intermediaries and provide additional services like risk assessment, payment transfers and portfolio management in exchange for a fee typically calculated on the basis of the outstanding capital.
The P2P lending landscape
Modern online P2P lending is taken to have started in 2005 when Zopa, a UK platform, originated its first loan. This was quickly followed in the US by companies such as LendingClub and Prosper.
Initial growth in US P2P lending was mostly driven by individuals seeking loans during the financial crisis when banks did not want to increase their exposure. In the UK, the market developed with a greater focus on loans to SMEs.
P2P lending is part of the wider universe of crowdfunding. This is a bigger market than many people expect. For example, a 2016 paper for the European Commission reported that crowdfunding expanded by 167pc in 2014 and reached $16.2bn. North America remains the largest market ($9.5bn), followed by Asia ($3.4bn) and Europe ($3.3bn). While there are no accurate figures on the Irish market, Orca Money reports that the UK P2P market had £9.6bn cumulative lending since 2010, £1bn of which was in Q1 2017. In 2016, Orca Money reported that the UK P2P market comprised 177,000 retail investors with consumer (46pc), business (35pc) and property (19pc) borrowers.
The P2P market is a large, growing market and should be interesting to investors, borrowers, entrepreneurs and policymakers in Ireland.
Online P2P lending arrived relatively late in Ireland, mostly due to greater regulatory uncertainty, the limited size of the market and the relatively poor conditions of the economy in the late 2000s. Even though the Irish P2P lending market has been growing over the last few years, it still accounts for less than 1pc of SME credit, with one platform, Linked Finance, accounting for more than 90pc of Irish P2P lending.
Institutional and professional investors v ‘the crowd’
Online P2P lending has become particularly popular among investors due to the low interest rates offered by central banks. However, it is well known in finance that higher returns come with higher risk.
P2P loans are mostly unsecured and, even though platforms pursue those borrowers who do not meet the repayment schedule, the full recovery of the capital invested is not guaranteed. As such, P2P lending is neither a saving investment nor a way to obtain constant payments since most of the loans tend to be repaid earlier than scheduled.
So far, P2P platforms have been very cautious about the loans they offer to investors, with most of them being classified as low-risk. This has resulted in low default rates and acceptable positive returns for investors. The potential for positive returns has attracted institutional and professional investors (eg investment banks, venture capitalist etc) into the game and created a disproportionate capital supply and demand. Such a trend is particularly visible in the US and UK, the two largest P2P markets, but it has recently emerged in smaller markets like Australia and New Zealand and is likely to occur, to a greater or lesser extent, in all regulated markets, including Ireland.
‘P2P lending is neither a saving investment nor a way to obtain constant payments since most of the loans tend to be repaid earlier than scheduled’
The participation of institutional and professional investors and the abundance of capital might create potential incentives for the platform to increase the risk of loans offered, or to favour institutional and professional investors over individuals over time. Institutional investors are particularly attractive for P2P platforms since they bring in more funds and are more likely to accept higher risk for higher profits.
This, ultimately, would translate into potential higher fee income for the platforms and may attract unwanted behaviour. What if junk loans are picked repeatedly by individual investors who can’t properly assess the risk of their investment and who can’t afford the loss? Such a trend, particularly if at a large scale, might look like déjà vu: a reliving of what happened right before the financial crisis.
But is this really happening?
The good news is, this doesn’t seem to be the case. A recent study we conducted in collaboration with Dr Ciarán Mac an Bhaird and Prof Mark Cummins at Dublin City University (DCU) actually shows that, not only do platforms not favour institutional and professional investors, but the more conservative investment strategy adopted by individual investors are actually paying off. ‘The crowd’ has obtained, so far, higher returns and faced lower losses than institutional and professional investors. Even more interesting is the fact that the larger the crowd, the better the financial performance.
Next steps in Ireland
Maybe we realised that, as James Surowiecki notes in The Wisdom of Crowds, “we’ve been programmed to be collectively smart” and that more ethical business practices are the key for more sustainable financial systems and for economic growth. Hopefully, we all learned the hard lesson and we are finally ready to exploit the benefits of the digital economy in a sustainable way.
The lack of a clear regulation has arguably prevented the growth of the Irish P2P lending market by discouraging both investors and small businesses to participate. A clear regulatory framework is necessary to ensure transparency and to increase investors’ confidence in P2P lending markets.
For example, the Financial Conduct Authority regulations, signed in 2014, were welcomed by both investors and platforms, since they build legitimacy around these new forms of investments and business models. The Irish Department of Finance is aware of the necessity for further discussion on this and launched a public consultation in April 2017 on the potential introduction of regulation of crowdfunding. This might represent the missing piece of the puzzle for the increasing adoption of P2P lending on this side of the Irish Sea.
Prof Theo Lynn and Dr Pierangelo Rosati are part of the Irish Centre for Cloud Computing and Commerce’s Finance Innovation Group, a research group comprising researchers with an interest in finance and financial technologies. The group is currently organising the 4th DCU Symposium on Capital Markets and Fintech, which will be held on Friday 8 December in DCU Business School.