Crowdfunding loans put new pressure on banking regulation

Crowdfunding loans put new pressure on banking regulation

Lending Club’s IPO in December 2014 drew so much interest because it’s crowdfunding model flips the traditional loan market on its head: that could create conflict with existing banking regulations.

Even fifteen years ago, the idea of peer-to-peer (p2p) lending on a large scale was little more than a pipe dream.

Because of that, the U.S. Securities and Exchange Commission’s (SEC) regulatory framework was not set up with p2p lending in mind. That did not stop start-ups like Prosper (founded in 2005) and Lending Club (founded in 2006) from adapting the power of p2p applications to consumer lending.

The p2p concept first flourished in illegal music downloading networks, but has since become the backbone of many of Silicon Valley’s most highly valued businesses, including Uber and Airbnb. By removing the centralized decision-making from transactions, these new businesses have the ability to charge customers less and generally be more flexible.

It can also allow borrowers to access funds that they would not have been able to secure from traditional banks. The popularity of the platform is plain to see: Lending Club originated over $1 billion in loans in the final quarter of 2014, up $700 million the prior year.

It also is what originally put p2p lending platforms in conflict with the SEC and state regulators, since the agencies and industry self-regulatory organizations rely on issuing financial institutions for compliance and registration with industry and legal standards.

Originally, p2p lending was a simple proposition: a borrower applies for a loan and the best offer from a lender wins the business. Now, this also came with a great deal of risk, especially since the debt was not registered with any regulators. The SEC put a stop to this in 2008, since debt of this type requires registration.

Legal hurdles mostly behind p2p lending

It took a fair amount of creativity, but the major p2p lending platforms have found ways to fulfill regulatory requirements while still maintaining the spirit of p2p. The loans are no longer strictly p2p – one person is not directly loaning money to another – but the system reasonably mimics it.

Until 2008, loans on Prosper and Lending Club directly connected creditors and borrowers, but the SEC stepped in due to the high default rates and the failure to register the debt securities.

Since then, the structure of these transactions has changed to comply with the SEC and lower the risk of creditors. They mostly offer unsecured notes now, which entitle the ’lender’ to payments that are tied to whether particular loans issued by Lending Club are paid. With these notes, creditors can invest in small portions of many loans and diversify their investment.

Propser still also allows creditors to pick out individual borrowers to fund, but in practice Prosper loans its own money to the borrower and sets up an entirely separate agreement with the ‘creditor.’

Remaining regulatory hurdles

For private p2p lending platforms (which Lending Club was until last December), even the new structure of lending is illegal in several states. The loans are under regulation of state laws, not SEC laws, when they are issued by private companies.

Now that Lending Club is a public company, that has the potential to change.

Debt issued by a company whose stock is traded on a national exchange falls under federal regulation instead of state regulation, as it had for Lending Club prior to its IPO. This has angered the state regulators that previously did not allow p2p lending. For now, Lending Club is acting conservatively and still only offers loans in 27 states.

Risks and opportunities

The exciting part of p2p lending, even if it is only allowed to be quasi-p2p in the US, is that it seems to connect borrowers and lenders without a bank meddling in the process. Just like other p2p services, customers get a service for less than in the traditional model.

In reality, of course, Lending Club and other platforms are more like traditional banks than they appear – albeit filling a different role in the financial system.

Peer-to-peer lending borrows from some entities and loans to others, making a profit on the fees – just like banks. Unlike banks, however, they take no risk on for themselves. If a borrower defaults, the platform is off the hook for paying back the creditor (at least under the Lending Club note model).

In the sense that the central role of banks in the economy is turning risky assets into less risky assets, p2p lending cannot replace banks. It certainly can and will fill a role that banks were not adequately fulfilling before, however.

The major risk the industry faces now is the patchwork of state laws regulating p2p lending – even in the case of Lending Club. The uncertainty over whether state regulators will prevent Lending Club from issuing notes, even though by all appearances it would be legal, has a chilling effect on the platform.

Other changes in regulation also have the prospect of changing or impeding the industry as well – especially as it grows in popularity and the perceived consumer protection risks associated with p2p grow.

In its essence – stripping out the complications of unstructured notes and federal pre-emption and the like – p2p lending is exactly the kind of opportunity that the internet was built to create. Despite the uncertainties caused by a regulatory system that was designed in a time before p2p lending was possible, the platform is an interesting glimpse into what financial services can be without technological barriers.

Categories: Finance, International

About Author

Alex Christensen

Alex is an Editor at Global Risk Insights, who also currently works in investment research. His work on political risk and economic policy has appeared in many forums, including Business Insider, Seeking Alpha, & The Emerging Market Investors Association. He holds a Master’s in Economics from the London School of Economics and BA from Washington University in St. Louis.