Why P2P lending might cause trouble – Sara Hsu

With large companies like Tencent, Alibaba and Baidu entering the financial industry, P2P lending has become a major issue in China, as common bank loans are hard to get. But there are huge risks involved, writes financial analyst Sara Hsu in The Diplomat, as the new ventures lack essential transparency.

Sara Hsu:

A large risk has been presented by the business model that some P2P firms follow. Businesses that use the model set forth by Yixin Company in 2006 apply a type of lending called debt assignment, in which the platform itself lends money to borrowers before finding investors to channel their funds into these loans. Under this model, the investors may end up lending to several borrowers, or several investors may lend to one borrower. In some cases, loans are pooled and the debt is transferred to investors.

This type of model is not clearly legal and may make it easier to commit financial fraud, since the use of the funds is very opaque. Since the original relationship between borrower and lender is obscured by this mode, there is additional responsibility on the shoulders of the P2P lending company to ensure that the borrower is creditworthy. Credit risk is compounded in cases where the principal has been guaranteed, and P2P lenders may rapidly face a crisis of liquidity or solvency when borrowers become delinquent.

Although not all P2P lending platforms are Ponzi schemes, attracting funds to cover liquidity shortages may be an all-too attractive option for some of these companies. Under the current system of regulation, P2P companies do not face the same restrictions that banks face, since they are not a registered financial firm type. This, coupled with a lack of sufficient financial information and lending expertise has created a weak institutional structure in these firms that, if not doomed to failure, will certainly constitute a challenge to success going forward. Regulatory measures that have aimed to curb worst practices of P2P lending companies, including requiring such firms to deposit client funds in third party accounts, are insufficient. Further regulations are expected this year.

While the P2P lending model works well when there is sufficient information, in China’s financial environment this model faces real barriers to healthy expansion. The alternative to P2P lending platforms, until there is improvement in loan expansion by banks to smaller borrowers, is to return to traditional informal financial methods in which parties know each other and both have “skin” in the game.