One could argue that we are living in a period of renaissance when it comes to developing new financial technologies. Those new financial technologies, colloquially known as Fintech, include such radical ideas as Bitcoin and block chain technology, as well as more mainstream concepts that involve payments and lending. The fact is, these new technologies are changing the financial landscape. Fintech’s main benefit is essentially a better deal for all parties, whether that means lower fees or higher rates for savers or lower rates for borrowers. There is another key benefit in new Fintech technology which tends to get significantly less exposure.
Of course, I’m talking about the P2P lending model, which is Fintech that has enabled savers and lenders to come together. As with every new business model, especially when it comes to finance, there is tremendous interest but also a stark warning of the risks it poses for those who invest their savings. Yet, paradoxically, the P2P lending banking model may actually have the power to prevent the next financial crisis.
Watch on Forbes:
More than seven years have passed since the 2008 US sub-prime crisis, and the global banking system is still trying to recover. Yet, with US housing prices once again on the rise and with mortgage rates close to record lows, another credit bubble could be in the making, and this time, not just in the US. So far, efforts to prevent another crisis have focused putting in place tougher regulations. But there is one major flaw in the current banking system that has not been properly addressed but is, in fact, very well addressed by P2P lending.
Traditional Banks Vs P2P
Under the current system, bankers do not risk their own money; rather, the risk is entirely on their savers aka the bank’s depositors. Under extreme circumstances, the government may be required to foot the bill if and when things turn sour at the bank. As for the bankers themselves they have very little at stake; in fact, their willingness to take risks (with their depositors’ funds, of course) often leads to lucrative bonuses. Bankers at no time do they risk their own savings or pensions. And that’s the real problem; how can professionals be expected to take low risk on behalf of others when they have so much to gain and so little to lose? We can’t expect them to take the high road; indeed, the sub-prime crisis proves that.
So how exactly will P2P lending make a difference? It’s quite simple, actually. In P2P lending it is the individual who lends his own money and it is the individual who decides who to lend to and it is the individual who decides how much risk to take.
One must wonder what 2008 would have looked like if our banking system had been built primarily on P2P lending as opposed to the current banking system? Well, let’s examine a simple chart to illustrate. Below, we have a comparison of the Case-Shiller Housing Index which measures housing prices (black curve) compared to the fixed 30-year mortgage rate. Let me make two points here; first, it’s well recognized that 30-year mortgages have much lower interest rates than sub-prime mortgages, however, it is still a benchmark for the US mortgage market. Second, though it’s called the “sub-prime crisis” the fact is the entire US housing market was pretty bubbly back in 2008.
Moving on, what we see when looking at the chart is remarkably interesting. Housing prices rose substantially; in fact, much faster than mortgage rates. In other words, housing prices were rising but banks were not asking for higher interest rates. Now, one could reasonably argue that this is a factor of the Fed’s monetary policy and that would be true. (Also, the risk of lower rates was not rolled back to the savers as it is in P2P lending).
Now, let's imagine what would happen if those who lend were not the banks but rather, individuals. That individual lender (aka the saver) would be faced with a choice; buy a house or lend someone else money to buy a house. If housing prices rose quicker investors would require higher rates of returns on their P2P mortgages (not lower as would be the case under the current monetary system). And that could mean that housing prices would simply not have been able to surge into a bubble because the P2P mortgage market, led by individual investors, would have caused mortgages to become more expensive. Essentially, that would act as a balancing force.
Of course, for every upside there is downside and that is that the risk is moved from the institution to the individual saver/lender. And that is where the Fintech industry still has to achieve additional progress. An effective system would allow an investor to insure some of his investment against a default. Or perhaps there could be a system in place which would require some borrowers to put up assets as collateral—especially if we were to see P2P lending expand into P2P mortgages. And yet, despite all the challenges and the risks, the upside is clear—P2P lending is the only way in which credit will become more accountable, perhaps making P2P lending a banking system better designed to avert future financial bubbles.
