What the govt can do to make P2P lending scalable and sustainable

P2P lending was gaining popularity and by 2016 there were about 30 such platforms. Post RBI intervention in late 2017 and subsequent regulatory requirements, the number shrunk to under 15. Faircent, i2i Lending and LenDenClub are a few examples of popular platforms in India.

While the business model is simple, it has some very unique challenges. Firstly, the lender is not in a position to assess the risks associated with the borrower, including any misrepresentation of information. Second, the intermediary has no skin in the game and takes no responsibility for outcomes. Third, the platform needs to attract both borrowers and lenders, therefore, doubling marketing activity. The business model adoption in its worst form has been seen in China where several P2P platforms have committed serious fraud, losing billions for small investors. In many instances, there were fake borrower profiles and a complete misrepresentation of information. P2P operators embezzled funds by not passing them on to the borrowers. Such practices have taken the sheen off what was an innovative way to invest and borrow money.

P2P lending can be made sustainable through effective regulation. Credit goes to the Reserve Bank of India for an intervention in this segment in 2017 and bringing in strict rules. The RBI is amongst the first regulators in the world to introduce supervision and regulation in the P2P segment. As part of the regulation, a new category of non-banking finance companies (NBFC) was defined called NBFC-P2P. Like other NBFCs, a minimum of Rs 2 crore of the net owned fund is required to qualify. Other rules required such platforms to not lend on their own, not to use any of the money from the lenders or borrowers, not to cross any unrelated product, conduct risk profiling of customers, undertake documentation of loan agreements and provide collections and recovery services. Additional prudential norms put a cap on total exposure of any one individual lender to Rs 10 lakh across all platforms, a cap on total loans of a borrower across all platforms limited to Rs 10 lakh, a maximum loan term of 36 months and exposure of one lender to one borrower to not exceed Rs 50,000.

The RBI has done the right thing by introducing regulation for this segment at a very early stage in the development of the industry. There are a number of additional steps that can be taken to make this industry commercially scalable and sustainable. Some of these are elaborated below.

Default guarantee on loans is a standard technique for most fintech lending players, wherein fintech platforms underwrite and process loan applications on behalf of lenders (banks and NBFCs). In order to build trust in their underwriting and processing, fintech platforms offer a default guarantee (often termed as first loss default guarantee or FLDG), which means first 'X' percent of the loss, if any, will be covered by the fintech platform. This establishes a clear skin in the game for the platform. Similarly, lenders of P2P platforms must have an option to take such guarantees from the platform in exchange for sharing some of their income to pass on as a reward to the platform for risk-sharing.

Co-lending is another way to share risk between the platform and the lender. In this, the platform would lend a certain proportion for each loan through its balance sheet. While the RBI rules prohibit P2P platforms from lending, the introduction of co-lending will create far better risk protection for lenders as the platform will have to share the risk and reward from each loan.

Disclosure and transparency rules must be further improved and require P2P platforms to clearly state their risk assessment and mitigation methodology. Underwriting criteria, information used and models applied must all be made transparent to the lender along with a regular update on portfolio performance.

Taking a cue from the Financial Conduct Authority (FCA), the UK regulator, an appropriateness test should be introduced for the lender. This test will work much like risk profiling done by banks prior to making mutual fund recommendations. Here a client’s knowledge and experience will be tested before they make any investments. Further to add, the Rs 10 lakh cap can be removed and instead the result of the appropriateness test should be used to determine how much exposure an individual can have in P2P lending. A sufficiently knowledgeable and high net worth individual should be able to invest higher amounts. This will also create a way to scale the P2P industry further while still protecting the interest of the lender.