P2P Lending – An opportunity for risk taking investors to diversify their portfolio

Peer to Peer lending, also known as P2P Lending, is an innovative financial platform which connects verified borrowers seeking unsecured personal loans with investors looking to earn higher returns on their investments. Verified borrowers are listed on the P2P lending platform, and Investors can see all the details about the borrowers before lending money to them. Investors have the option to lend small amounts to multiple borrowers to diversify their investments. This helps in diversifying the amount given as loan to multiple borrowers and reduce overall risk for investors.

Peer to Peer Lending is already a successful model for alternate financing across globe. In India, P2P Lending is gaining traction at very fast pace in the past 3 to 4 years and slowly becoming a very attractive investment option for risk taking investors.

Following picture depicts P2P lending. (Reference: i2ifunding)

How P2P Lending works?

·         Lenders have to register to use the platform. Some P2Ps charge a one-time registration fee while others earn their revenue based on how much is lent.

·         Borrowers too have to register. They are listed on these platforms under different risk categories, and the interest rates vary for each category. They are charged a registration fee and a processing fee too after they get a loan, which depends on the amount and term for which the loan is borrowed. They have to pay the agreed-upon interest on the loan.

·         The P2P platform matches lenders and borrowers based on a lender’s risk-taking ability and a borrower’s creditworthiness. This results in varying interest rates for borrowers, i.e., return for the lenders.

·         These platforms also use alternative credit scoring metrics, besides credit scores from credit bureaus.

P2P Lending Companies in India

Some prominent P2P Lending Companies in India are:

·         Lendbox

·         i2i Funding

·         Faircent

·         LoanTap

RBI Guidelines on P2P

The Reserve Bank of India (RBI), on October 4, issued directions for non-banking financial companies (NBFC) that operate peer-to-peer (P2P) lending platforms.

According to the directions, from now on no NBFC can start or carry on the business of a P2P lending platform without obtaining a Certificate of Registration. Every company seeking registration with the bank as an NBFC-P2P shall have a net owned funds of not less than Rs 20 million or such higher amount as the bank may specify. The existing P2P players which are listed above have been asked to apply for registration as NBFC-P2Ps within 3 months. These directions issued by RBI will be known as the Non-Banking Financial Company - Peer to Peer Lending Platform (Reserve Bank) Directions, 2017 

Based on these RBI guidelines, an NBFC-P2P can:

1.    Act as an intermediary providing an online marketplace or platform to participants involved in P2P lending. 

2.    Not raise deposits as defined by or under Section 45I(bb) of the Act or the Companies Act, 2013.

3.    Not lend on its own.

4.    Not hold, on its own balance sheet, funds received from lenders for lending, or funds received from borrowers for servicing loans.

5.    Not cross-sell products except for loan specific insurance products.

6.    Not permit international flow of funds.

An NBFC-P2P will be expected to:

1.    Perform due diligence of the participants.

2.    Undertake credit assessment and risk profiling of the borrowers and disclose the same to their prospective lenders.

3.    Undertake documentation of loan agreements and other related documents.

4.    Provide assistance in disbursement and repayments of loan amounts.

5.    Render services for recovery of loans originated on the platform.

Prudential norms for NBFC-P2P are as below:

1.    The aggregate exposure of a lender to all borrowers at any point of time, across all P2Ps, shall be subject to a cap of Rs 10 lakh. 

2.    The aggregate loans taken by a borrower at any point of time, across all P2Ps, shall be subject to a cap of Rs 10 lakh. 

3.    The exposure of a single lender to the same borrower, across all P2Ps, shall not exceed Rs 50,000. 

4.    The maturity of the loans shall not exceed 36 months.

What are the advantages of P2P platform for risk taking investors?

Major advantage for an investor is that, he/she can micromanage his investment by spreading it across multiple borrowers for multiple interest rates. Thus, instead of investing entire amount to be invested for a low interest rate of 12%, he/she can lend it to multiple borrowers at different interest rates such as, 12%, 14%, 18%, 22% or even higher depending on the credit rating of the borrower. Higher % return means higher risk of something going wrong with that investment but an investor can hedge high level of risk by investing something like 15-20% of their entire portfolio in high risk investments.

With interest rates on Bank Fixed Deposits as low as 6% to 6.75% in October 2017, and Debt funds also giving returns as moderate as 7% to 9% going forward, probably P2P lending is one of the few options available for risk taking investors to generate handsome returns on their investment. 

This platform is specifically useful for those investors who do not wish to invest in equity mutual funds or direct equity (stocks), due to their limited understanding of equity markets or want to diversify their portfolio across various asset classes like equity, fixed deposits, debt funds and P2P lending.

Risks involved in P2P lending
Though there are multiple advantages in lending money to borrowers using online P2P platforms, there are some inherent risks in this model which we should not ignore.

Borrower default: The biggest threat to the investor in case of P2P lending is the fear of borrower default. If the borrowers default on payment, the investors run the risk of losing their entire investment. Here, this risk can be mitigated to some extent by lending money to multiple borrowers and limiting the loan amount to single borrower to only Rs. 50,000. Also, if the credit evaluation team of P2P platform is highly efficient, it can come up with a pool of creditworthy borrowers.  Legally enforceable agreement goes further in securing the investor’s interest. Also, an investor can get his/her principal back up to 100% if the P2P platform has the Principal Protection Plan in place. A highly efficient credit evaluation team, complete legal assistance in case of any default and Principal Protection Plan are some of the most desirable features of a P2P platform.

P2P Platform goes out of business: Lenders often ask this question, what would happen to their money if the P2P platform provider failed. In some countries, it is mandatory for platform providers to have contingency arrangements to manage their loans in the event that they no longer existed. Since the contracts are directly between lenders and borrowers, the service provider would effectively manage the company’s loan book to maturity to ensure that payments from borrowers are received as scheduled and capital and interest payments are returned to lenders as expected. For this service, the back-up services provider would take a fee. Though this would slightly impact returns received, but lenders have increased confidence that their loan contracts are safe.

General Economic conditions can add to some stress: In some of the countries like US and Europe, where P2P lending practice is existing since pre-2008 days, it has been observed that, if there is stress in overall economy then the rate of defaulting the loan increases. If the overall economic conditions take much longer to normalize then this acts as a risk to investors which may have lent their money to more risky borrowers. P2P lending has worked quite well in good economic conditions and risk of default may go up in case of adverse economic scenarios.

If investors can select the P2P platform after substantial research, its past history, principle protection plans, and efficiency of its credit evaluation team then P2P lending platform can offer them an excellent opportunity to micro manage their investments. It has immense potential to generate handsome returns on their investments by diversifying their P2P portfolio across multiple borrowers.