Ever since peer-to-peer (P2P) lending started to take off in 2011, there has been widespread confusion about what exactly it is and how it differs from other, more familiar types of lending, such as the mortgages, personal loans and credit cards that most of us get from our bank.
In some ways, P2P is nothing new. For centuries, organisations with money have been lending to businesses and individuals and charging them interest. Most people are used to the idea that if you want a loan you go to a bank, but in fact there are plenty of other organisations that offer loans without being banks.
Often, these “non-bank lenders” specialise in types of loans that most banks do not offer: short-term “bridging loans” secured against property or other types of assets are a classic example. The umbrella term for what these non-bank organisations do is “direct lending”, which simply means loans that do not come from a bank.
Looked at one way, P2P platforms are simply organisations that offer investors the opportunity to lend their money directly to borrowers – be they private individuals or businesses – and earn interest. Therefore, P2P is just another type of direct lending because the loans do not come from a bank but from one or more private lenders instead.
But looked at another way, P2P lending is very different from other types of direct lending; the crucial difference is in who shoulders the risk of losing money if a loan goes bad. To see what this means in practice, it’s important to understand the difference between P2P lending and balance sheet lending. Here’s what you need to know:
What do you mean by ‘balance sheet lending’?
It’s an odd phrase with a straightforward meaning: a balance sheet lender provides loans at its own risk. This means that if the borrower cannot repay, the lender could end up out of pocket unless it can recover the debt, for example by taking possession of assets that the borrower has pledged as security and selling them to raise the money that’s owed.
So a balance sheet lender uses its own money, then?
Not necessarily. The best-known balance sheet lenders of all are banks, and most of the money they lend doesn’t belong to them – it’s the money their customers deposit with them for safe-keeping. In effect, the bank is borrowing money from its savers and lending it to its borrowers. So you can see that a balance sheet lender doesn’t always use its own money. Some of it will belong to the bank; the rest will be borrowed from other sources. The important point is that a balance sheet lender is directly liable for any losses that result from its lending decisions. If my bank uses my savings to give a loan to someone who doesn’t pay it back, that loss won’t be taken off my bank balance. Instead, the bank will cover the loss from its own funds, which is also known as its balance sheet. Hence the phrase ‘balance sheet lender’.
I see. So the source of the money isn’t the point?
Exactly. The phrase ‘balance sheet lender’ is really just a way of showing who’s responsible for shouldering any losses.
How is that different from peer-to-peer lending?
P2P lending websites are like matchmaking services – they find borrowers on one side and link them with investors on the other side who want to lend their money and earn interest. The P2P lending website does not lend money itself; the loan contract is between the borrower and each investor. This means that if the borrower doesn’t pay the loan back, it’s the investor who risks ending up out of pocket, not the P2P lending website itself.
If a P2P lending site doesn’t lend money, what does it do?
It varies from one P2P lending site to another, but generally they will find borrowers, assess their creditworthiness and reject the ones they decide are too risky. Borrowers that are accepted will usually be put into different groups according to how risky the P2P lending site decides they are, and an interest rate will be set to reflect that risk – the safer they are believed to be, the lower the interest rate. Once a loan is agreed, the P2P lending site will collect interest and capital repayments and pass them on to the investor. If the borrower falls behind with its payments, the P2P lending platform will usually take charge of chasing the debt. To use the industry jargon, P2P lending sites are in the business of “origination” (finding borrowers and assessing their creditworthiness), “loan servicing” (monitoring the performance of loans and collecting and processing payments), and “recovery” (pursuing repayment of loans that have gone into default). These are all important services that benefit investors who use P2P lending websites – and services that they pay for through the fees charged by the website.
But this is not the same as lending money on the P2P lending sites' own accounts, right?
Right. P2P lending sites provide services that enable other people to lend. They do not lend themselves. That’s the crucial difference between a balance sheet lender and a P2P lending website.