What threat to banks from internet lenders?

Who needs banks?

Well for better or worse, we all do - because they perform that vital job of converting our savings into loans to businesses and households.

And without their ability to create credit in this way, we'd all be a lot poorer. As I mentioned the other day, they provide about four-fifths of our financing needs.

Unfortunately - and as we painfully experienced in 2007-8 - they perform this essential function in a manner fraught with risks, for two principal reasons:

  1. They borrow for short periods and lend for long periods, which means they're always at risk of going bust if all their creditors want their money back at once (which is what happened in the autumn of 2008
  2. They are conditioned to lend far too much in boom periods, as they did in 2004-7; and far too little in bust or anaemic conditions (where we are now)

By way of illustration, today's report on improving the supply of credit for businesses, commissioned by the Business Secretary Vince Cable, and prepared by Tim Breedon, the outgoing chief executive of Legal & General, points out that the total stock of lending to UK businesses has shrunk by a staggering £151bn since December 2008.

Breedon and his team also estimate that between now and the end of 2016, there may be a gap of between £84bn and £191bn in what British businesses will want to borrow and what the current financial system is able to supply.

I wrote a bit about Breedon's recommendations for closing this funding gap, earlier this week.

Breedon wants to make it easier for smaller businesses to raise money from investors rather than banks, and also to encourage cash-rich big companies to mitigate the borrowing needs of their smaller suppliers.

But what is also striking is that both he and the Bank of England's brainy financial stability director Andy Haldane have been waxing lyrical about the long-term potential of new-age internet-based lenders - what are known as peer-to-peer lenders - to significantly reduce our dependence on traditional banks.

In fact Haldane suggested in a speech earlier this week that our gigantic banks could go the way of the dinosaurs. Here's the relevant extract:

"Lending is the new frontier. Kiva is a developing world micro-finance organisation with a difference: it is based in San Francisco. Person-to-person financing is provided remotely using borrower information stored on Kiva's website.

"Credit assessment and tracking are done by Kiva's field partners. Each of these is ranked, eBay-style, using information on their historical default and delinquency rates. This disintermediated market has so far avoided both banana skins and lemons. Kiva has a 99% repayment rate."

"The model may be set to spread into advanced economies. Commercial peer-to-peer lending, using the web as a conduit, is an emerging business."

"For example, in the UK companies such as Zopa, Funding Circle and Crowdcube are developing this model. At present, these companies are tiny. But so, a decade and a half ago, was Google."

"If eBay can solve the lemons problem in the second-hand sales market, it can be done in the market for loans. With open access to borrower information, held centrally and virtually, there is no reason why end-savers and end-investors cannot connect directly."

"The banking middle men may in time become the surplus links in the chain. Where music and publishing have led, finance could follow. An information web, linked by a common language, makes that disintermediated model of finance a more realistic possibility."

What these peer-to-peer lenders do is directly match people and companies who have surplus cash with people and companies looking to borrow.

If you place your money with a peer-to-peer lender like Zopa, you are not lending to Zopa, in the way that you are lending to Barclays if you put your money on deposit with Barclays. You are actually lending to the individuals who have registered with Zopa.

Here's what matters: when those borrowers can't pay up, it is you as the lender who takes the loss, not Zopa. And what's more you commit to lend for a certain length of time - and you can only get your money back quickly if someone else is prepared to buy your loans from you.

The important point is that businesses like Zopa and Funding Circle do everything that banks do, except that all the credit risk (the risk that the borrower can't repay) and all the liquidity risk (the risk that you as lender won't be able to get your cash when you need it) is with the lender - not with Zopa or Funding Circle.

Now you may think that you would be out of your mind to take on all those risks. You may say hooray for banks that are happy to insure you against credit and liquidity risk.

But there is quite a big cost of being insured by the banks against those risks. If you are prepared to take those risks, you in effect extract the hidden insurance premium you pay to the banks. Or to put it another way, you get a massively higher interest rate.

Also, although those risks are real, Zopa and Funding Circle are not lending your money to just anyone. They're not throwing your money away.

They have access to all the credit assessment data used by the banks, and make credit checks on your behalf on all those requesting loans from them. Which means that in normal economic conditions, the losses you should face on loans made through them would be pretty small.

Now from a public policy point of view, what the Zopas and Funding Circles do seems pretty attractive. They provide new sources of finance for businesses and households.

But perhaps more importantly - and at the risk of repeating myself - they make the risks of lending much more transparent to the actual providers of credit, which (just to remind you) would be you and me.

That doesn't mean booms and busts can be avoided: we're still likely to be prone to lend too much in the good times and too little when the outlook is darker. But maybe there would be a reduced danger of extremes in the credit cycle, because there should be less illusion about where the risks of lending actually reside and therefore better pricing of credit.

But if it is in the interests of any government to help the growth of these businesses, is that best done by the authorities standing well back and allowing them to develop free of regulation, or would it better if they were subject to some official minimum standards of conduct.

Here's a very interesting thing. Zopa, Funding Circle and their ilk are regulated by the Office of Fair Trading as lenders or credit providers. But the much more sensitive part of what they do, which is take money from people, is wholly unregulated.

The following statement from Zopa's website is instructive:

"Currently we are not regulated by the FSA as none of our activity warrants regulation. Zopa's business as a lending and borrowing exchange is quite new and does not fall under any of the existing regulatory categories, and as a result the FSA would need an act of parliament to create a new one. We were closely monitored by the FSA whilst we performed activity that required regulation (the selling of insurance)."

Now interestingly Zopa told the Treasury minister Mark Hoban that it believes the long-term growth of the industry would benefit from a degree of additional regulation: not so many rules, that lenders would have the false comfort that the money they lend is sheltered from all risk; but just enough to prevent total cowboys entering the industry and giving it a terrible name before it has had a chance to prove what it can do.

Intriguingly the Treasury has made clear it does not think additional regulation is sensible. Which some would say is courageous, given the rate at which the industry is growing.

Zopa, for example, expects to lend £100m this year, up from £60m in 2011. And if it continues to grow at that rate, it will be lending half a billion pounds within three or four years. So it would not need many Zopas to be created for the amount of money that's being borrowed and lent almost free from any serious regulatory oversight to be really quite substantial.

What does history say happens when institutions spring up offering to pay you a whopping return on your money outside of the scrutiny of watchdogs? I think you know the answer - and it's not terribly pretty.