Loading...

Disintermediated finance peer-to-peer lending and payday loans

Term Paper (Advanced seminar) 2016 20 Pages

Economics - Finance

Excerpt

Table of Contents

1. Introduction

2. Online peer to peer lending
2.1 Introduction to the Market and the Author’s Intention
2.2 The System of Prosper
2.3 Data and empirical Results
2.4 Result’s Implications

3. Payday Loans
3.1 Definition of Payday Loans and how the Industry works
3.2 Payday lenders: Heroes or Villains?
3.3 Review of the Author’s Findings

List of Figures
Figure 1: Outstanding volume of global peer to peer lending market
Figure 2: Hierarchy of Friends
Figure 3: Probability of Funding
Figure 4: Lender effects on foreclosures after disasters
Figure 5: Effect of payday lending on crime after a disaster

1. Introduction

In the following paper, I want to give an insight in two financial markets, the online peer to peer lending market and the payday loan market. Both are examples for disintermediated finance. Disintermediation means to withdraw funds from intermediary financial institutions, such as banks and savings/loan associations, in order to invest them directly. Simply put, in disintermediated finance one gets rid of the middleman or intermediary.

This paper is organized as follows. At first Chapter 2 will look into the online peer to peer market of Prosper.com. Therefore, I will analyse a paper of the authors Lin, Prabhala, and Viswanathan (2013) called “Judging borrowers by the company they keep: Friendship networks and information asymmetry in online peer-to-peer lending”.1 In Section 2.1 I will start with an introduction to the market and the author’s intention. Section 2.2 will explain the system of the online platform Prosper.com. The following section will outline the empirical results of the authors, in order to express the result’s implication in the last section of chapter 2. Chapter 3 will continue with payday loans. The first section 3.1 gives an introduction into payday loans and explains how the industry of payday loans works. The second section 3.2 will analyse one specific paper of Adrian Morse (2011) called “Payday lenders: Heroes or Villains?”.2 The last section 3.3 will give a summary of the author’s findings and question them critically.

2. Online peer to peer lending

2.1 Introduction to the Market and the Author’s Intention

Peer to peer lending, the process of direct loan provision by lender to borrower via internet platforms, has received great attention over last years. The reasons for this are its rapid growth and the large amount of new services. This growth stems largely from the emergence of the internet, but also from the ongoing innovation by start-up companies and increasing financial regulation of traditional banks.

The peer to peer lending disintermediates nearly all major banking functions. With regard to this, Andrew G. Haldane, Executive Director for Financial Stability at the Bank of England, demands for a continuation of the disintermediation: “Commercial peer-to-peer lending, using the web as a conduit, is an emerging business. [...] 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 middlemen may in time become the surplus links in the chain.”3

The peer to peer lending market has surpassed the 1 billion Euro of outstanding loans volume and is still growing. Figure 1 shows the growth of the outstanding volume of the global peer to peer lending market. Since its inception in 2005 by a UK start-up called Zopa the industry has experienced rapid growth. At the end of 2006, the outstanding loan volume was approximately 29 million. This volume has risen to approximately 1.1 billion at the end of 2011. The compound annual growth rate for this time is more than 100%.4

Figure 1: Outstanding volume of global peer to peer lending market

Abbildung in dieser Leseprobe nicht enthalten

Source: Moenninghoff, Sebastian C., and Axel Wieandt. "The future of peer-to-peer finance." Page 8

Many peer to peer lending services launched from 2005 to today. In Germany two big provider are Smava (launched in 2007) and Auxmoney (launched in 2007). In the US the market leader of peer to peer lending is Prosper (launched in 2006).

The most prominent concern about the emerging online peer to peer lending is that borrowers will become more anonymous and this will worsen the problem of adverse selection. Borrowers on these online lending sites have better information about their own solvency than lenders. Without the intermediary of a bank, investors lack the mechanism of complex risk assessment which is normally provided by the banks.

In 2013 the authors Lin, Prabhala, and Viswanathan published a paper called “Judging borrowers by the company they keep: Friendship networks and information asymmetry in online peer-to-peer lending”. In this paper they analysed the online peer to peer lending site Prosper.com. They raised the question whether the mechanism of creating friendship ties on Prosper can be a valid signal of a borrower’s creditworthiness. The hypothesis is that a borrower with friends who are successful lenders on Prosper have a better chance of funding their loan than borrowers with bad or no friends (for example friends on Prosper.com who have defaulted a loan in the past). They also checked if good friends will lower a borrower’s interest rate on a loan and whether these borrowers are less likely to default a loan.

The following chapter will represent and analyse the findings of the paper by Lin, M., N.R. Prabhala and S. Viswanathan. At first section 2.2 will contain general information about Prosper and explain its system. After that section 2.3 will show the data and empirical result of the authors. Finally section 2.4 will present the implications of these results and tries to answer the questions raised in the beginning.

2.2 The System of Prosper

The paper “Judging Borrowers by the Company They Keep: Friendship Networks and Information Asymmetry in Online Peer to Peer Lending” by Lin, M., N.R. Prabhala and S. Viswanathan analyses the online peer to peer lending site Prosper.com. The authors try to find a link between the online friendships of borrowers and the probability of successful funding, lower interest rates on funded loans and lower ex post default rates. The hypothesis is that online friendships of borrowers act as a signal of credit quality and this signal mitigates adverse selection.

The institutional background behind Prosper is rather simple. At first users of Prosper.com have to create an account by entering an email address, which is verified by the website. To engage in transactions users have to give additional information to the website. If a user wants a loan funded he has to reside in the US, have a valid bank account number, a minimum Fico credit score5 of 520, a valid social security number and a valid driver’s license and address. All these details about the user are verified by Prosper. For privacy protection, these details about the user are never publicly revealed. Users are identified via names chosen when signing up.

If a user has given all the required information, he/she can make an online listing, which indicates the loan amount and the maximum interest rate. Additionally the listing includes information about the number of credit inquiries in the last six month and a letter credit grade from high quality AA to low quality HR, which is a similar version of the borrower’s FICO score. The borrower can also add a text description and images, but these information are optional and not verified by the website. An important fact for the analysis of the authors is that the listing shows information about the friendship data, but without personal information.

On the other side users on Prosper can bid and fund the listings of the borrowers. Therefore, a user has to transfer sufficient funds to their noninterest Prosper account. An individual lender has to specify the minimum interest rate he/she desires and can bid the minimum amount of $50 or higher. Even if the lenders minimum rate is lower, the ongoing interest rate for the fund is the borrower’s asking rate. If the loan has been funded to 100% the auction will be closed if it is of closed format. The borrower can also set the auction to an open format, which means that the auction remains open up to seven days even if amount and rate criteria are met. In this auction format, the lenders can bid down the interest rate.

The lenders bid can win or be outbid, but the lender has the option to place a second bid to rejoin the auction. Regardless whether the format is closed or open, if a loan is not fully funded at the end of the auction, the funding has failed and no money will be transferred. In the site policy of Prosper.com it says that no partial funding is allowed. If a loan was successfully funded, the loan will go to the Prosper staff for further review. If the staff approves the loan, the money will be collected from the auction winners and transferred to the borrower’s account. The fee of Prosper can be up to 2% of the loan amount.

Funded loans via Prosper have a fixed maturity of 36 months. The monthly repayments are automatically collected from the borrower’s bank account and distributed to the lenders Prosper accounts. If the repayments are not paid, the status of the loan can change from “late” to “one month late” right up to “two months late”. After the status has changed to “two months late”, the loan will be sent to a collection agency. Late repayments are sent to credit report agencies and can affect the borrower’s credit score. If a loan defaults the borrower is cannot borrow on Prosper.com again.

Users of Prosper.com can form friendships similar to social network sites like Facebook etc. To form a friendship, a user has to insert the friends email address and send a request. Afterwards the other user can accept or decline the friendship request. So for establishing a friendship on Prosper the user have to have some offline connection and information about each other (such as the users email address). Without a friendship users are identified via their self-given usernames. After a friendship is formed, both ends know the real name behind the username. The implication by the authors is that friends of borrowers who default their loan can link the defaulter to their real name, which creates social stigma costs to the defaulters with friends. For the authors analysis it is important that the friendship ties are clearly visible on members profile pages. The friendship information is displayed in listings, which makes this information to one of the most prominent pieces of information besides the credit- and the listing data about the borrower. If a lender bids on a friends listing it is visible for other potential bidders via an icon next to the user name. A potential bidder can access additional information about the friend by clicking on his profile.

2.3 Data and empirical Results

To examine the friendships on Prosper, the authors divided the different friendship types into a hierarchy of friends. Figure 2 shows the six levels of friends. The author’s hypothesis is that friendships increase the probability of a successful listing and lower the default rate as well as the interest rate as you go down the hierarchy of friends.

[...]


1 Lin, Mingfeng, Nagpurnanand R. Prabhala, and Siva Viswanathan. "Judging borrowers by the company they keep: friendship networks and information asymmetry in online peer-to-peer lending." Management Science 59.1 (2013): 17-35.

2 Morse, Adair. "Payday lenders: Heroes or villains?." Journal of Financial Economics 102.1 (2011): 28- 44.

3 Robert Peston (2012): What threat to banks from internet lenders?, [http://www.bbc.com/news/business-17400491] retrieved on 29.05.2016.

4 Moenninghoff, Sebastian C., and Axel Wieandt. "The future of peer-to-peer finance." Zeitschrift für betriebswirtschaftliche Forschung (2013): 466-487.

5 The FICO score is a credit score and part of the credit report that lenders use to assess an applicant’s credit risk.

Details

Pages
20
Year
2016
ISBN (eBook)
9783668763524
ISBN (Book)
9783668763531
File size
1.2 MB
Language
English
Catalog Number
v432918
Institution / College
University of Marburg – Accounting & Finance
Grade
1,7
Tags
peer-to-peer lending payday loans P2P peer to peer crowdfunding Disintermediated finance financial markets

Author

Share

Previous

Title: Disintermediated finance peer-to-peer lending and payday loans