Can P2P Lending Reinvent Banking?

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Need to borrow a not-insubstantial sum of money? Some options that may spring to mind: the friends and family plan, maxing out credit cards, or the traditional bank.

Now, imagine you could whip out your smartphone, answer some simple questions on an app, offer basic bona fides, and get an answer within minutes. If the latter sounds appealing, that could explain why, over the past several years, peer-to-peer lending has swelled in popularity.

P2P lenders have leveraged low operating costs, minimal regulations, Big Data and technology streamlined for a mobile generation to mediate terms between everyday borrowers who want quick access to cash and the lender-next-door starved for yield. It's a fast-growing financial model, with global variations, that some have predicted could upend the traditional banking industry. Right now, however, it is attracting institutional investors, as well as big banks eager to learn how to become more agile.

These days, “marketplace lending" is a more fitting term for this evolving business. “The fastest growing marketplace platforms are not really peer-to-peer but institutional investors partnering with tech platforms to cherry-pick borrowers, often with offline marketing," says Smittipon Srethapramote, who covers the North American payments industry at Morgan Stanley.

In the US, marketplace loan origination has doubled every year since 2010, to $12 billion in 2014. Meanwhile, the trend is playing out globally, notably in Australia, China and the UK. All-told, such lending could command $150 billion to $490 billion globally by 2020.

That would still be but a sliver of total bank lending, yet traditional lenders are taking note. Whether they roll out their own offerings, upgrade existing platforms or invest in established marketplace lenders, “banks will be forced to provide a similar level of service and price, if they hope to compete and stay relevant to their customers," says Huw van Steenis, head of Morgan Stanley European financial services research.

So far, marketplace lenders have focused on unsecured consumer credit, with roughly 80% of loans used to consolidate debt, and small business loans—with an estimated $100 billion in unmet demand solely in the US. But don't be surprised to see these lenders make a play for the $1.2 trillion student loan market, auto loans and even mortgages. "It's still more theoretical than proven," says Srethapramote of a marketplace for mortgages, "but the value proposition makes sense to us."

The global financial crisis paved the way for innovators. Heavy losses forced banks to scale back on riskier consumer and small business lending, as increased regulatory oversight and capital requirements made these loans less attractive to banks. Years of historically low interest rates, meanwhile, whetted investor appetite for alternative sources of yield.

Meanwhile, Big Data and improved analytics made it possible for tech-driven platforms to identify borrowers and make quick lending decisions. Where traditional lenders have to follow laundry lists of requirements to vet applicants, marketplace lenders are using propriety algorithms to make snap judgments. “One of the driving factors behind the growth of online lenders is better customer satisfaction due to faster response times, quicker loan approval times, and faster funding," notes Srethapramote.

Marketplace lenders enjoy the advantages of the financial system, without its costs. They have no capital requirements, can leverage the existing payments infrastructure virtually for free, and have lower operating expenses, all of which allows them to offer borrowers lower rates—for a fee. "Banks are keen to learn how marketplace lenders are architecting their systems to utilize big data more efficiently," says Betsy Graseck, who covers US Large Cap Banks at Morgan Stanley.

Creating a tech platform that is as fast and nimble as the upstarts will take time. Traditional banks excel at originating loans and underwriting credit, but are slowed by the batch process and portfolio approach to their deposit and loan legacy systems, which are the backbone of the US and global payments system, and by liquidity and capital rules. "By far the biggest advantage for marketplace lenders has been the lack of capital and liquidity requirements relative to the incumbents," Graseck says.

For marketplace lenders, the regulatory environment remains a question mark, as financial rule-makers play catch-up with the latest technology. Another wildcard is how this model would fare in an economic downturn; it's yet to be tested in a meaningful way. Finally, any rise in interest rates could send investors to other asset classes, many of which provide more certainty, or curb borrowers' appetite for new credit.

The same trends that have put US marketplace lending on the map are playing out globally, though there are notable nuances.

In China, for example, marketplace lending operates both online and offline. It is also extremely fragmented, with more than 1,500 lending platforms, estimates Richard Xu, Morgan Stanley’s China financial sector analyst. These lenders aren't recognized as regular financial institutions, and don't have access to the China's central-bank credit reference database. Consequently, delinquency rates are high—along with interest rates, which are in the double digits.

Another market to watch: Australia, where household leverage is high but limited primarily to residential mortgages. Meanwhile, just four banks control 75% of the retail banking market. Recent changes in credit reporting, among other factors, bode well for innovators, says Richard Wiles, Morgan Stanley’s Australia banking analyst.

In Europe, the UK market is leading the way, accounting for 80% of European marketplace loans in 2014. Platforms are privy to in-depth credit information, similar to that of the US, but they can include demographic data in their analysis. Interestingly, the typical borrower is older than his US counterpart and, in many cases, has already been approved by a bank to borrow, but opts for the better rate and faster execution from marketplace lenders, van Steenis says.

Marketplace lenders may have started on the financial fringe. However, as they increasingly change the way borrowers and investors think about the lending process, institutional involvement and big bank interest could speed their journey into the mainstream.

That can only be good news for anyone who's in the market for a loan.

Morgan Stanley Research has written a Blue Paper, “Global Marketplace Lending: Disruptive Innovation in Financials" (May 19, 2015). Morgan Stanley and its affiliates do not engage in marketplace lending. Explore more Ideas and Research, or contact your Morgan Stanley representative for the full report. Find a Financial Advisor to discuss your investment goals and strategy.