Microcredits and peer-to-peer lending as financing tools for start-ups in Germany

Table of Contents

LIST OF ABBREVIATIONS

LIST OF FIGURES

LIST OF TABLES

1 INTRODUCTION
1.1 Relevance of the Topic
1.2 Objectives and Structure of the Thesis

2 FUNDAMENTALS OF MICROCREDITS
2.1 Definition of Microcredits
2.2 Characteristics of Microcredits
2.2.1 Socio-Political Intentions
2.2.2 Credit Period and Redemption
2.2.3 Credit Risks and Collaterals
2.2.4 Developmental Types of the Supply of Microcredits
2.2.4.1 Upgrading
2.2.4.2 Downscaling
2.2.4.3 Greenfieldbanking
2.2.4.4 Linkage Banking
2.2.5 German History of Microcredits

3 FUNDAMENTALS OF PEER-TO-PEER LENDING
3.1 Definition of Peer-to-Peer Lending
3.2 Characteristics of P2P Lending
3.3 Models of P2P Lending
3.3.1 Direct and Indirect Lending
3.3.2 Secured and Unsecured Lending
3.3.3 Prior Relationship Lending
3.4 Exemplary P2P Lending Process

4 PARALLELS OF P2P LENDING AND MICROCREDITS

5 RELEVANT THEORIES OF ECONOMICS CONCERNING MICROCREDITS AND P2P LENDING
5.1 Law of Diminishing Marginal Returns
5.2 Transaction Cost Theory
5.3 Principal Agent Theory
5.3.1 Problems of the Principal-Agent-Relationship
5.3.1.1 Adverse Selection
5.3.1.2 Hold-Up Problem
5.3.1.3 Moral Hazard
5.3.2 Approach for Problems of the Principal-Agent-Relationship
5.3.2.1 Screening
5.3.2.2 Signaling
5.3.2.3 Monitoring
5.3.3 Summary of Findings for the Principal Agent Theory

6 FRAMEWORK FOR MICROCREDITS AND P2P LENDING IN GERMANY
6.1 Economic Factors and Labour Market
6.2 Current Start-Up Demeanour in Germany
6.2.1 Formations of Companies in Numbers and Structural Features
6.2.2 Characteristics of Start-Up Financing
6.3 Alternatives of Financing
6.4 Loan Programmes
6.4.1 Start-Up Grant of the Federal Employment Agency
6.4.2 Support for Recipients of Unemployment Benefit II - “Einstiegsgeld”
6.4.3 KfW Start-Up Loan
6.5 Legal Framework for Microcredits and P2P Lending Platforms
6.5.1 General Regulations for Microcredits
6.5.2 Legal Framework for P2P Lending

7 SUPPLY OF MICROCREDITS AND P2P IN GERMANY
7.1 Microcredit Supply
7.1.1 The “Mikrokreditfonds Deutschland” and Microfinance Institutions
7.1.2 The “Deutsche Mikrofinanz Institut”
7.1.3 The GLS-Bank
7.1.4 Summary of Loan Disbursement
7.2 P2P Lending Suppliers
7.2.1 Smava
7.2.2 Auxmoney
7.2.3 Online P2P Microcredit Model

8 DEMAND OF MICROCREDITS AND P2P LENDING IN GERMANY
8.1 Potential Volume of Demand
8.2 Borrower Characteristics
8.2.1 Start-Ups of Women
8.2.2 Start-Ups of Immigrants
8.2.3 Start-Ups out of Unemployment
8.3 Investors Characteristics

9. EVALUATION OF START-UP FINANCING THROUGH MICROCREDITS AND P2P LENDING PLATFORMS
9.1 Impact Assessment of the “Mikrokreditfonds Deutschland”
9.1.1 Evaluation of the Preferential Treatment of Target Groups
9.1.2 Evaluation of the “Mikrokreditfonds Deutschland”
9.1.2.1 The Expedience of Founders
9.1.2.2 The Expedience of Microfinance Institutions
9.1.2.3 The Expedience of the DMI
9.1.2.4 The Expedience of the GLS Bank
9.1.2.5 The Expedience of the “Mikrokreditfonds Deutschland”
9.2 Evaluation of the P2P Granting System

10 CONCLUSION AND OUTLOOK

LIST OF LITERATURE

List of Abbreviations

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List of Figures

Figure 1: Financial need of start-ups

Figure 2: Traditional credit granting process

Figure 3: Peer-to-peer lending process

Figure 4: Marginal return for production factor capital

Figure 5: Use of external financial resources by start-ups

Figure 6: Financing alternatives

Figure 7: Microcredit funds programme in Germany

Figure 8: External borrowing requirement amounts

List of Tables

Table 1: KDF-indicator

Table 2: Predicted and historical payment rates of loan pools as per 02.07.2011

Table 3: Overview of conditions of microcredit and p2p lending models

Table 4: Microcredit conditions

Table 5: Overview of conditions of Smava and Auxmoney

Table 6: Kiva statistics

Table 7: Conditions of the “Mikrokreditfonds Deutschland”

1 Introduction

How much money would you lend to someone who is a complete stranger to you? How much would you lend to this stranger, if he explains that he will use your money for a promising new business project? And how much would you lend to the same person and his promising project, if experts would support him to realise it?

If the amount of money you would consider to lend to this person increases with each question, you are very likely in good company of most other people, trying to receive as much return as possible on their investments. However, things appear quite different walking the miles in the shoes of the stranger who is in need of money. Already Benjamin Franklin^[1] said:

"If you would know the value of money, go and try to borrow some "^[2].

Especially in 2008, with the start of the financial crises, this real life experience had to be made by lots of small and medium sized enterprises as well as self-employed persons and business start-ups. Since then, media reports continually about the hesitant credit granting of banks and a pressurised situation of the financing situation in Germany^[3]. Even now, three years after the credit crunch it can be seen that investment activity as well as the volume of business loans still remain on a low level^[4]. Simultaneously, consumers’ faith in banks decreased significantly during the crisis. Therefor, a strong tendency towards an exploitation of alternatives in order to supplement traditional sources of finance will retain^[5]. Such alternatives can be found in online peer-to-peer lending platforms, which are Internet portals that mediate loans funded by private investors to borrowers. Another alternative, especially for start-up businesses, is represented in form of microcredits, which are loans that usually do not exceed a volume of 25 thousand EUR. The main objective of the microcredit concepts is to provide destitute populations with access to capital but also to stimulate the mobilization of savings^[6]. In this context, the Grameen Bank model, established by nobelist Muhammad Yunus in the early eighties, has been a state of the art microcredit concept, which accomplished various achievements regarding the fight against poverty in rural areas of Bangladesh^[7]. Nowadays it is largely acknowledged that microfinance is an important driver to reduce social exclusion in both developing and developed countries. Even though both sectors have been growing rapidly over the past years the vast majority of the so-called “unbankables” are still underserved. Banks argue that lending to the specific segment of small and micro enterprises, let alone unemployed people without any collateral, is considered risky and cost intensive, because they are confronted with unacceptably high risks of default and low margins, which hardly cover their transaction costs nor give them a promising rate on return^[8].

Hereupon, both alternative financing models, microcredit and p2p lending, opened huge possibilities to support so-called “unbankables” on their way out of poverty, unemployment and social exclusion. How they work, what impact they have on the German start-up endeavour and which kind of obstacles still remain that they need to overcome will be investigated in the paper at hand.

1.1 Relevance of the Topic

Self-employment has become a buzzword in European labour market policy. In 2010, the number of German business start-ups has risen up to 936 thousand, which represents an increase of 8% compared to the previous year. As to see in figure one below, significant 66% of these business start-ups were in need of financial support^[9]. If an average requiring amount of 8 thousand EUR^[10] can be assumed, the total loan requirement of start-ups in Germany would sum up to 1,361 billion Euro^[11].

At the same time, Germany’s largest government bank, the “KfW-Mittelstandsbank”, henceforth KfW - which uses commercial banks as a distribution channel for its products and describes itself as the major supplier of start-up finance to small and micro-enterprises - reports, that in 2009 less than 7 thousand loans with a total amount of 130 million EUR were granted in this credit segment. These figures indicate that only approximately 1.05% of all start-ups in Germany finance the starting phase of their business with a subsidized loan from the KfW.

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Based on: Hagen et al. (2011), p.46.

Figure 1: Financial need of start-ups.

Throughout the last years, the German press has been crowded with articles about founders which had great and innovative ideas, being keen of realising them but failing in doing so because their credit requirements are not met by their own banks^[12].

Combining the before mentioned information, it seems that German start-up businesses are excluded from the loan market, just as small entrepreneurs in developing countries. However, it is of vital importance to support the entrance to the financial market for founders with promising business ideas in order to endorse the growth of the whole economy.

1.2 Objectives and Structure of the Thesis

The thesis at hand pursues manifold objectives. Following the introduction the second and third part addresses fundamentals of microcredit and the peer-to-peer lending models. Part four traces parallels between those two financing methods.

Afterwards, chapter five provides the necessary theoretical background from an economic point of view. General conditions of the German market for start-ups in terms of economical background, labour market, loan programmes and legal requirements will be examined in chapter six. An overview of microcredit and peer-to-peer lending supply as possibility for start-up financing in Germany will be provided in the seventh chapter. Followed by the examination of the demand side and therewith borrowers and investors, in chapter eight. Building on that, chapter nine will provide an evaluation of each market actor and its expedience. Finally, in chapter ten, recommendations will be given in order to improve the microcredit sector and usage of online peer-to-peer platforms as start-up financing tools in Germany. Hence, the thesis shall arouse interest from both academic and practical point of view but also of everyone who would like to gain extensive knowledge about the possibilities of start-up financing through microcredits and peer-to-peer lending in Germany.

2 Fundamentals of Microcredits 2.1 Definition of Microcredits

Microcredits became a prominent topic at the beginning of the 1980s as a tool to alleviate poverty in emerging countries while in Western Europe, a few organisations pioneered with microcredit models in the early 1990s. However, the majority of organisations, which are still active at present, began lending in the last and present decade.

Besides micro insurances and saving accounts, microcredits are playing a substantial role in the concept of microfinance. In economic science, the term microcredit is used very widely and often after its main use depending on regions, maximum amount of credit, target groups, allocation and intention. Furthermore, the characteristics of a microcredit can vary even from case to case which complicates to bear a consistent definition. This, in its turn, leads to confusion and misapprehension in the scientific view of the same.

In order to avoid such misunderstandings two different definitions will be introduced and used inside this paper. In chapters 2.2, 2.3 and 2.4, the term microcredit is used in a global sense due to the consideration of developments and characteristics in diverse countries using different frameworks. For that purpose the definition of the Microcredit Summit Campaign in 2011 suits best:

„Microcredit is the extension of small loans to the very poor. This allows them to pursue entrepreneurial projects that generate extra income, thus helping them to better provide for themselves and their families “^[13].

The reason why this definition cannot be used for every country in general will be explained in the following example. The expression “very poor people” here, is used as of the definition of the World Bank. Thus, the target group of microcredit programmes would be those 1,4 billion people that are living from less than 1,25 US Dollar per day^[14].

For German microcredit lenders this definition of poverty does not apply, since already the standard rate of the so-called “Arbeitslosengeld II” - can be translated as “unemployment benefit II” - which is the basic financial security given by the German government to unemployed people, sums up to 364 EUR per month^[15]. Besides, poverty in Europe is not defined in absolute but relative terms. According to Eurostat^[16], which is the statistical office of the European Union, the group of people living in relative income poverty are individuals living in households where equivalent income is below the threshold of 60% of the national equivalent median disposable income after social transfer^[17].

To further investigate in the currently existent microcredit programmes in Germany, as in chapter 6, 7, 8, 9 and 10, the more specific definition of the European Commission for microcredits shall be applied. It reads as follows:

“Microcredit is the extension of very small loans, also micro-loans, to social economy enterprises, to employees who wish to become self-employed, to people working in the informal economy and the unemployed and others living in poverty who are not considered bankable”^[18].

The typical micro-loan volume does not exceed 25 thousand EUR, while the average micro-credit provided by microfinance institutions, henceforth MFIs, in Europe sums up to approximately 7,700 EUR^[19]. Since traditionally, banks have not considered poor people to be a viable market, MFIs, which are organizations that provide financial services to the so-called “unbankables”, are trying to fill this gap. The also very broad definition for MFIs includes a wide range of providers that vary in their legal structure, mission, and methodology. They can be regarded as co-operations, governmental organisations, projects, registered bank institutions and non-governmental organisations^[20]. In chapter 7.1.1 of this paper MFIs, their working methods plus their role in the German microcredit market will be introduced in detail.

In Western Europe, in contrast to developing countries, it stands out that the objective of microcredits is not mainly the fight against poverty but more the social inclusion through the creation or expansion of income and job generating measures and the support of micro-enterprises, whose principal need is financing of initial investment or working capital^[21].

2.2 Characteristics of Microcredits

As described in the definition earlier target groups, quality, intentions and coherences by granting microcredits vary from region to region. Nevertheless, similarities of microcredit programmes in their central aspects and general frameworks remain and will be described in the following.

2.2.1 Socio-Political Intentions

The idea behind the encouragement of self-employment is to have next to economical effects also positive impact on socio-political issues. Especially enforcing the social position of women is a main goal of many microfinance programmes, which is the reason for the high percentage of female participants in the same. In global comparison of different microcredit programs, it stands out that this percentage is extremely high in developing countries while, at the same time, the participation of men and women in developed countries is roughly equal^[22]. One reason for the high percentage of women using microcredits is that they are often starting a business in supplying services or in trading small amounts of goods. Therefor, they can use the conditions of microcredits better than for example agricultural or producing entrepreneurs that usually need long- or medium-term investments. Specific reasons why the participation of women in Western Europe is comparatively low will be investigated in detail in chapter 8.2.1.

2.2.2 Credit Period and Redemption

Microcredits are usually contracted to existing small enterprises or start-ups for financing working capital or long-term assets such as machinery and equipment in order to cover their short- and medium-term need for payments. Thereby, it is typical that short-term credits with relatively low amounts, in case of punctual repayment, are followed by long-term credits and higher investments. At the one hand, these follow-up credits allow lenders a much easier financing of their company’s growth, on the other hand they are very lucrative for credit institutions due to the overall lower handling expenses and a lower probability of default. As a result the interest rate of those follow­up credits are lower as well.

Microcredits are mainly redeemed through annuity payments, whereat the payment periods differ in monthly rates in developed countries and weekly rates in developing countries^[23]. As an exception microcredits for agricultural production can be named, where repayments are made on an annual basis^[24].

2.2.3 Credit Risks and Collaterals

Conventional methods like the check-up of the lender’s economic situation, its previous payment moral in dealing with other institutions and review of the business plan or credit application are the rule in order to evaluate credit risk. Additionally, judging the personality of the lender plays a very important role when evaluating his credit­worthiness. Last but not least, missing collaterals are the main reason why traditional institutions are not approving loans to such applicants.

Microfinance institutions are using alternative methods to safeguard credits. In developed countries it is accepted to use guarantors of credits and it is even possible to waive collaterals at all, while in developing countries so-called group credits have been established over the years. The strategy of such group credits is joint liability of borrowers. Group members control each other and peer pressure uses moral and other linkages between borrowers to ensure participation and repayment in microcredit programmes to reduce credit default.^[25]

2.2.4 Developmental Types of the Supply of Microcredits

Depending on economic, cultural and structural circumstances in a country, the supply of microcredits can develop in manifold ways. In general four main developments can be distinguished^[26].

2.2.4.1 Upgrading

“Upgrading” describes the development of a non-governmental organisation, henceforth NGO, or self-help group, henceforth SHG, into a professionally managed microfinance institution of the formal credit sector adjusted to all legal regulations as well as customs within the industry norms and manners. Their structures and economic sustainability are developed until they reach the status of a microfinance bank with all formal legal regulations. In doing so, the scope of financial activities widens up and gives new opportunities for the collateralisation of capital. However, only a very limited number of NGOs and SHGs are in the position to walk this resource-intensive extra mile. For that reason this development can be seen increasingly in countries where entrance barriers into the formal credit sector are comparatively low as in Middle and South America as well as in Africa.^[27]

2.2.4.2 Downscaling

Compared to “Upgrading” the development goes into the opposite direction in “Downscaling”^[28]. Commercial banks adopt the concept of microcredits as a new department or a new product category in their product portfolio in order to service target groups, which before, could not meet entrance requirements for their standard products. Simultaneously, existing local networks and tailored financing instruments such as local funds, additional training and mentoring measures, are used by the banks to expand the new microcredit clientele. “Downscaling” has a huge potential due to the possibility of using the existing infrastructure of the formal credit sector and already existing public awareness of banks as such. Though, only a very small proportion of traditional banks are willing to tap into this segment due to generating comparatively poor revenue. The introduction of this new category allegorises a risk for business better to be avoided for banks. Therefor, this step is only taken if the pressure of the market and therewith the need to reach new target groups is high enough to do so. Famous for Downscaling are microcredit banks such as the “Bank for Agriculture and Agricultural Cooperatives“ in Thailand and the “National Bank for Agriculture and Rural Development“ in India.^[29]

2.2.4.3 Greenfieldbanking

The start-up of a commercial, specialised and for-profit MFI within the formal credit sector is called “Greenfieldbanking”. Requirements for such an undertaking are quite high because extensive investments in order to develop a corporate structure and training of appropriate employees have to be considered. Typically, these MFIs are formed with the participation of private equity by financially strong institutions and management support from consulting companies. The success predominantly relies on entry barriers, the network of already existing MFIs and the demand for microcredits. Particularly in Middle and Eastern Europe those models were increasingly put into practise because a lack of supply for appropriate financing possibilities for micro, small and medium sized enterprises remained, even though, the demand increased steadily.^[30]

2.2.4.4 Linkage Banking

As the name implies, Linkage Banking describes the relationship between formal financial institutions with existing NGOs and SHGs. While financial institutions provide the necessary capital, NGOs and SHGs contribute mentoring, consulting and procurement measures. In order to secure capital backing so-called credit guarantee funds for granting loans are implemented as a rule. In a broader sense this can also include refinancing of local microcredit institutions by national and international financial institutions. Usually the extensive knowledge of those intermediaries in local conditions is used as an advantage of information, which is also in favour of the participating financial institutions due to reduced credit risks implied. This model is very successfully reaching out to poor ethnic groups that are locally rooted mainly in rural areas. Up to now, this concept has covered the demand for microcredits especially in Southeast Asia. Nowadays it more and more finds its way in Western developed countries including Germany.^[31]

2.2.5 German History of Microcredits

The roots of microcredits and credits in general in their most primitive forms date back many millenniums^[32]. In order to limit the frame of this paper only an overview of the period dating back until the 18th century will be provided. Back then, the ban of interest implemented by the Roman Catholic Church was slowly rescinded by worldly law. This was followed by a fast paced development of the credit market, as it is known today. In Germany the supply of microcredits was revolutionised by two main actors in the 19th century. Franz Hermann Schulze and Friedrich Wilhelm Raiffeisen developed and founded independently of each other the first credit unions^[33]. After establishing a friendly society against famine in 1846, in his hometown Delitzsch, Schulze constantly carried on with his social engagement^[34]. Using his experience from various charitable projects he founded an association to support the financing of local craftsmen in 1850. In the following years Schulze improved the concept by giving more responsibility through solidary liability to creditworthy participants so that they could get a chance to become more independent from external investors^[35].

In 1846, only 400 kilometres away in Weyersbusch, Raiffeisen as well founded an association to fight famine. Wealthy inhabitants of surrounding communes pre-financed the poor to purchase food in order to be fit for work^[36]. With subsequent foundations he gave people the possibility to even save money and to accumulate their capital^[37].

Schulze and Raiffeisen exchanged their experience a couple of times with each other. Therefor, both organisations are comparable archetypes of contemporary credit unions. They are conform in characteristics such as the encouragement of self-help and personal responsibility, equity financing through membership and obligation of deposits as well as in reducing risk and gaining stability through implementing reserve fund and operating local. Those principles still shape business models of contemporary credit unions in Germany as for example the “Volks- und Raiffeisenbanken” or the “GLS Gemeinschaftbank eG” and serve as role model for numerous microfinance institutions.^[38]

3 Fundamentals of Peer-to-Peer Lending

3.1 Definition of Peer-to-Peer Lending

Peer-to-peer lending, henceforth p2p lending, is an often online-based form of transaction where borrowers place requests for loans while private lenders fund these by direct lending, meaning without the intermediation of a traditional financial institution like a bank. These online platforms are also known as person-to-person lending, peer- to-peer investing or social lending and operate mainly for profit. However, there are non-profit organisations, referred to as person-to-person charities or as crowd-funding projects, which connect donors and recipients of donations in almost the exact same way.^[39]

The rise of the Internet as the enabling technology behind those platforms gave these crowd-sourced business models the opportunity to gain ground. Recruiting platforms bring together employees and employers, auction portals connect sellers and buyers and in the same manner p2p lending platforms link borrowers with lenders like an eBay for loans^[40]. The pioneer of p2p online lending platforms has been “Zopa”, founded in 2005 in the United Kingdom^[41]. Since that day, more than 40 online lending websites started mainly in the United States of America and Continental Europe. At present, the total volume of p2p credits mediated by the biggest websites in the United States of America and Europe - Prosper, Lendingclub, Zopa, Smava and Auxmoney - approximately amounts to 600 million EUR^[42]. Compared to the volume of the traditional consumer credit market, p2p lending is still a niche product. Nevertheless, its occurrence raises significant attention of the general public, financial professionals and academics.

3.2 Characteristics of P2P Lending

The two major characteristics of p2p platforms are reliance of existing social networks and disintermediation^[43].

Many p2p lending sites use already existing online communities and pre-existing relationships between groups of people in order to reduce the default rate of loans because they assume that borrowers are more likely to repay to members of their own community than to a stranger^[44]. The associated risk of loans is minimized either by the support of one another within a group or, as appears in some cases, through forms of social peer pressure. P2p lending platforms either act as intermediaries for friends and family to support in consulting and calculation of repayment terms, or link anonymous borrowers and lenders adapted from similarities in their geographic, educational and professional background or through an already given social network.

While figure two shows the credit granting of the traditional banking system, figure three shows how traditional financial institutions such as commercial banks are excluded as intermediaries from the supply chain of a credit transaction not at last to lower costs for servicing clients.

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Figure 2: Traditional credit granting with a bank. Own creation of author.

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Figure 3: Peer-to-peer banking process. Own creation of author.

Besides, the reduction of transaction costs, motivations to circumvent traditional intermediaries are, that borrowers have the chance to present their loan project in detail, providing information directly to lenders. This extra information would usually not be taken into account of banks with their standardized decision processes. Due to the online traceability of all bids the transparency of the overall process seems higher which creates a trustworthy and most notably fair feeling for investors. Furthermore, the loans on such platforms are advertised to have a higher return on investment for lenders and to get them at lower costs by borrowers.

3.3 Models of P2P Lending

Various models of p2p lending services have developed based on different arrangements of the following criteria.

3.3.1 Direct and Indirect Lending

In “direct lending” a loan is provided to a borrower based on the credit worthiness of the same. The risk lies completely on the shoulder of the lender if the borrower defaults on the loan.^[45]

“Indirect lending” tries to reduce this risk for lenders by mediating small amounts into a large number of loans. Money is mediated to several borrowers with similar credit ratings. Therefor, the risk of capital and interest for the lenders are the defaults within a certain peer where the money is invested in. This, in turn, reduces risk to a great extent because the effect of one defaulter that does not repay is made unimportant comparing to the on-time repayments by the vast majority of borrowers. This model works almost analogous to the traditional bank model and it does not allow lenders to select specific borrowers by themselves.^[46]

3.3.2 Secured and Unsecured Lending

In the secured lending model a lender gives money to a borrower against the strength of collaterals given by the borrower or a so-called pledged property. While in the unsecured lending model the credit rating of the borrower is the basis for the lending process and calculation. The loan is not secured against the borrower’s assets and thelender runs the risk of the capital and interest in case of failure on the part of the borrower. The interest rates applicable to these different forms may vary depending on the lender and the borrower.^[47]

3.3.3 Prior Relationship Lending

P2p lending models refer to lenders and borrowers, which usually are completely strangers to another. The system of the platforms makes it possible to connect both groups with each other. In addition, the marketplace process may include other intermediaries who bundle and resell loans in some cases, but the loans are ultimately sold to individuals or pools.

The opposite of this “marketplace lending” is the lending of money between friends and family members. This model has its focus on formalizing and servicing a personal loan and lenders can charge below market rates to assist the borrower.

A special instance of this kind of model is community lending^[48] in microfinance whereby a loan is lend to a specific individual. The lending contract is defined to hold the borrower's social peer either directly liable for the repayment of the loan, like a co­signing procedure, or indirectly accountable, whereby the whole social peer has to face further consequences, such as mitigated access to credit or higher future interest rates, if one of the peer’s member fails to repay a debt^[49].

3.4 Exemplary P2P Lending Process

In the following a short summary of the concrete functionalities of online borrowing and lending processes will be provided. For the purposes of this paper, only the processes of Smava, which has been the first German lending website will be described. Every p2p lending website operates in a slightly different way, but since the basic mechanisms are similar to each other, this explanation should be a broadly applicable introduction for most of them.

In 2005 Smava was founded by three experienced Internet-entrepreneurs and launched in 2007^[50]. As an online marketplace for loans the company closely works together with the “Bank für Investments und Wertpapiere”, henceforth biw, which is a traditional commercial bank that is specialized in the technical handling of banking services^[51]. From a legal point of view the biw hands out loans to borrowers and divests these without extra charges to investors. Thus, neither the borrowers nor the lenders need a banking licence because none of them is doing bank transactions regularly according to article 1 German Banking Act. During the conception phase of the platform, Smava worked closely together with the Federal Financial Supervisory Authority in order to correctly obey financial legislation and avoid hassle with supervision ex ante. All information of borrowers and lenders underlie the German banking secrecy. The investment of lenders, which remains in a biw account until the credit is finally approved, is secured through a deposit guarantee fund^[52].

The market functions in the following way: People that want to borrow or invest on the platform have to enlist themselves and prove their identity. Full aged residents of Germany are allowed to invest their capital on the platform. Borrowing is allowed to private persons that have to fulfil several requirements. Applicants have to be at least full aged and only borrowers whose individual financial burden does not exceed 67% are authorised to borrow on the platform.^[53] '" This financial burden is revealed through the so-called "Kapital di enstfähigkeits-Indikatof. henceforth KDF-indicator, which describes the ability of a borrower to repay the instalments from its net income. All borrowers' monthly payments and outstanding debts, including Smava credits, are put in ratio with the monthly disposable income of the borrower^[54]. The earnings and savings of other household members are not taken into account. Depending on the individual ratio, borrowers are rated on a scale from one to four depending on their calculated KDF-indicator, as it can be seen in table one.

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Based on: Smava^[55]. Table 1: KDF-indicator.

In addition, Smava solely accepts candidates with “SCHUF А-rating” scores ranging from “A” to “H”^[56]. This rating of the German national credit bureau, henceforth SCHUFA, measures borrowers’ solvency on a scale from “A” as the best to “M”, as the worst score^[57]. These ratings shall help to estimate the probability of loan defaults. Moreover, all candidates have to let their identity being verified by the “PostIdent” procedure, which means that a German Post officer has to look at the documents provided by the applicant and confirm them^[58]. However, investors as well as borrowers use the platform not under their real name but use pseudonyms.

The online procedure starts after a borrower placed its credit request including the period term, the amount of money he would like to borrow and the interest rate he is willing to pay. Additionally, he can upload personal data and a detailed description of his project. However, the platform sets limits for the credit period, 36 or 60 months, and for the credit volume, 1 thousand up to 50 thousand EUR for borrowers. Lenders can place their investments of minimum 250 EUR up to 100 thousand EUR for either 36 or 60 months, while all orders within this range must be multiples of 250. If the investor sends its order, he virtually is signing an obligatory contract.^[59]

What distinguishes Smava from other p2p lending platforms is that no auction for the credits takes place. Investors cannot bid for credit parts or propose their investment for a lower interest rate^[60].

Every project is published on the platform for 14 days. If the project is not financed for more than 25% after these days have passed, the project is cancelled and lenders that already have invested into the project get their money back. However, the borrower is free to place his project again with adjusted credit conditions or extended set of information he is willing to provide on the platform. If a project is financed successfully the credit amount is usually transferred within 48 hours to the borrowers banking account. The fee the borrower has to pay depends on the credit period and volume, while the fee for investors solely depends on the credit amount.^[61] The procured loans are not collateralised but the borrowers are obligated to repay these instalment credits and interest on a monthly basis. In order to avoid a total loss for the investor in case of credit default, two instruments are used on the platform. One instrument is the selling of the claim to outstanding debt to a collecting agency. Therewith, on average 15% to 20% of invested money can be collected. The second instrument is provided in form of loan pools, which serve as a risk-sharing tool. Investors are divided into groups depending on how much and how long they want to invest their capital. Since there are 8 rating groups, “A” until “H” and 2 credit periods, 36 or 60 months, available, there exist 16 pools all together.^[62] The monthly repayments excluding the interest rate of the borrowers are collected in the respective pools. If a project of a pool defaults the amount is subtracted from the whole collected pool repayments and the remaining money is split among the pools investors, proportionally to their investment amounts. Subsequently, all investors including the ones having invested into the failed project receive a portion of the money.

On Smava an estimated forecast of the average repayment rate for all of the different pools is made available, an example is provided in table two below^[63].

illustration not visible in this excerpt

Based on: Smava^[64].

Table 2: Predicted and historical payment rates of pools as per 02.07.2011.

This instrument guarantees that investors are not losing 100% of their investment. However, it also reduces their profits. Another risk that investors have to face is that borrowers are allowed for an early redemption of their credit projects. Therewith, investors loose a share of their actually expected interest return. Since borrowers do not have to pay a redemption fee, investors do not get compensated for their associated loss. Another risk can be found in delayed repayments, because they tie up investors’ capital in order to reinvest it into new projects.

[...]

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^[1] American politician, author and natural scientist, (1706-1790).

^[2] Cf. http://www.famousquotesandauthors.com/topics/money_quotes.html, Accessed 28.06.2011.

^[3] Cf. Rossen (2010), p. 74.

^[4] Cf. Abberger (2011), p. 4.

^[5] ibid.

^[6] Cf. Khandker (2005), p. 1.

^[7] Cf. Santiso (2005), p. 503.

^[8] Cf. http://www.kfw.de/kfw/en/KfW_Group/Press/Latest_News/PressArchiv/2011/20110615_50985.jsp, Accessed: 30.06.2011.

^[9] Cf. Hagen et al. (2011), p. 6.

^[10] Cf. Hagen et al. (2011), p. 6. and p. 45.

^[11] 8,000€ . 936,000 . (66% . 34% . 81%) = 1,361,048,800.00€.

^[12] Cf. Evers (2002), p. 35 ff.

^[13] Cf. http://www.microcreditsummit.org/about/what_is_microcredit/, Accessed: 16.04.2010.

^[14] Cf. http://www.economist.com/node/12010733, Accessed:04.07.2011.

^[15] Cf. http://www.arbeitsagentur.de/Navigation/zentral/Buerger/Arbeitslos/Grundsicherung/Alg-II- Sozialgeld/Alg-II-Sozialgeld-Nav.html#d1.1, Accessed: 28.06.2011.

^[16] Cf. http://epp.eurostat.ec.europa.eu/portal/page/portal/about_eurostat/corporate/introduction, Accessed 29.06.2011.

^[17] Cf. http://epp.eurostat.ec.europa.eu/statistics_explained/index.php/Glossary:At-riskofpoverty_ threshold, Accessed: 16.04.2011.

^[18] European Commission (2007), p. 14.

^[19] Cf. European Commission (2007), p. 14.

^[20] Cf. Lapenu et al. (2001), p. 22.

^[21] Cf. Carboni et. al. (2010), p. 388.

^[22] Cf. Underwood (2006), p.13.

^[23] Cf. Evers (2001), p. 158.

^[24] Cf. Churchill (1999), p. 33 ff.

^[25] Cf. http://www.grameen-info.org/index.php?option=com_content&task=view&id=43&Itemid=93, Accessed: 30.06.2011.

^[26] Cf. GTZ (2004), p.5 and Schäfer (2008), p. 30.

^[27] Cf. GTZ (2004), p. 5 and Schäfer (2008), p. 30.

^[28] Cf. Schäfer (2008), p. 30.

^[29] ibid.

^[30] Cf. Schäfer (2008), p. 30.

^[31] ibid.

^[32] Cf. Homer (2005), p. 17.

^[33] Cf. Bonus (1994), p. 28 ff. and Faust (1977), p. 17 ff.

^[34] Cf. Schaaf (2000), p. 7.

^[35] Cf. Koch (1991), p. 80 ff.

^[36] Cf. Koch (1991), p. 106 ff.

^[37] Cf. Koch (1991), p. 115 ff.

^[38] ibid.

^[39] Cf. Barasinska (2011), p. 5 ff.

^[40] Cf. Liebetrau (2006), p. 54.

^[41] Cf. http://uk.zopa.com/ZopaWeb/public/help/help-faqs-interested.html, Accessed: 30.06.2011.

^[42] Cf. Barasinska (2011), p. 4.

^[43] Cf. http://www.networkcultures.org/weblog/archives/2005/03/, Accessed: 04.07.2011.

^[44] Cf. Wydick, et al. (1999), p. 5.

^[45] Cf. Signoriello (1991), p. 35.

^[46] ibid.

^[47] Cf. Signoriello (1991), p. 35.

^[48] Cf. Ledgerwood (2000), p. 138.

^[49] ibid.

^[50] Cf. https://www.smava.de/48+Management.html, Accessed: 03.07.2011.

^[51] Cf. http://www.biw-bank.de/index.php?id=idee_der_biw, Accessed: 03.07.2011.

^[52] Cf. http://www.biw-bank.de/index.php?id=145#c670, Accessed: 02.05.2011.

^[53] Cf. http://www.smava.de/1617+Indikator-fuer-die-Kapitaldienstfaehigkeit.html, Accessed: 01.07.2011.

^[54] Cf. Barasinska (2011), p. 5.

^[55] Cf. http://www.smava.de/1617+Indikator-fuer-die-Kapitaldienstfaehigkeit.html, Accessed: 01.07.2011.

^[56] Cf. http://www.smava.de/747+Bonitaet.html, Accessed: 01.07.2011.

^[57] Cf. ibid.

^[58] Cf. http://www.deutschepost. de/dpag?tab= 1 &skin=hi&check=yes&lang=de_EN&xmlF ile=link 1017199_1009833, Accessed: 01.07.2011.

^[59] Cf. http://www.smava.de/1616+Preis--und-Leistungsverzeichnis.html, Accessed: 27.06.2011.

^[60] Cf. Barasinska (2011), p. 6 ff.

^[61] Cf. http://www.smava.de/1616+Preis--und-Leistungsverzeichnis.html, Accessed: 27.06.2011.

^[62] Cf. http://www.smava.de/3480+Sicherheit-Ihres-Geldes.html, Accessed: 03.07.2011.

^[63] Cf. Barasinska (2011), p. 6 ff.

^[64] http://www.smava.de/3126+Performance-der-Anlegerpools.html?interestsDuration=36, Accessed: 02.07.2011 and http://www. smava. de/3126+Performance-der-Anlegerpools.html?interestsDuration=60, Accessed: 02.07.2011.