Rogue bankers may have done more for good corporate governance than specialists in that field could achieve in a lifetime. Designing incentive schemes to align bankers' interests with those of shareholders has not worked – bonus is almost an evil word these days. Neither, as former taoiseach John Bruton recently observed, has excessive regulation.
Last week, the UK’s Commission on Banking called for stronger criminal sanctions to be imposed on those running its largest banks – on top of the heavy regulation they currently face.
There is a simpler solution: Impose losses directly on those who make reckless lending decisions.
Under the current system, bankers can walk away from flawed loans, leaving shareholders and the taxpayer out of pocket. Thanks to internet technology, and the current state of dysfunctional banks, a new industry has mushroomed known as peer-to-peer lending (P2P).
In essence, if you are a small firm or individual looking for a loan, there are internet sites that can match you to people who have spare cash that they wish to invest. The investor makes the decision to lend and then he or she suffers if the borrower defaults. This leads to improve corporate governance.
The British government has recognised its potential. As in Ireland, attempts to revive lending to small and medium-sized enterprises (SMEs) through conventional banking has failed. So now it has allocated £20 million (€23.5 million) to a P2P firm.
It says: "We set up the Business Finance Partnership to invest £1.2 billion in increasing lending to [SMEs] from sources other than banks. This money is being matched with at least an equal amount from private sector investors and will be invested on fully commercial terms."
Andrew Haldane, the Bank of England's executive director for financial stability, also sees its potential. "At present, these companies are tiny. But so, a decade and a half ago, was Google, " he has said.
According to LinkedFinance, a new Irish P2P company, €40 billion was lent to small businesses last year, well below demand. At the same time, people have about €90 billion on deposit earning low rates of interest. Clearly opportunities exist.
New player
LinkedFinance, which has the backing of Enterprise Ireland and Senator Feargal Quinn, started operating last March. To date, it has advanced €412,000 over 12 loans, according to its founder Peter O'Mahony. O'Mahony says that, under the conventional banking system, savers get at most 2 per cent while borrowers are charged about 10 per cent: that's a gap he hopes to close.
The service charges an upfront fee to successful borrowers of 2.5 per cent and 1.2 per cent per annum to investors. The total charge between borrower and investor spread out over a typical three-year loan equates to about 2.1 per cent. That’s a substantial reduction on the eight percentage point gap, though you still need to factor in the interest rate sought by the investors and the risk of bad debts.
The shortage of loan financing in the Irish market is well known. So poor are the conventional banks at making good loan decisions, the Government has set up a Credit Review Office. Its recent annual report, published two weeks ago, expressed “concerns on the small number of active banks and other lenders currently supplying new credit to the SME market”.
Refinancing debt could prove difficult. The Economic and Social Research Institute recently warned at a small business forum that failure to deliver a banking system that is fit for purpose within six years, poses one of the biggest risks for Ireland's economic system.
Risks
While P2P lending certainly has its attractions, it is a relatively new industry, and it may be too risky for some. It is generally unregulated, which means that fraudsters may see potential.
On some websites, there is too little information to determine the risk of bad debts. Also, companies may be anxious to maximise fees, making loans appear attractive by underplaying their risk.
In Britain, one company, Funding Circle, advances loans of £5,000 to £1 million. The borrower must be a limited company or partnership with at least two years' published accounts.
Once approved, investors can bid the amount they wish to lend and the rate they will charge. Individual bids are then pooled and, if the total exceeds the borrowing requirements, the bidders with the highest lending rate are removed. Investors currently earn an average of 6.2 per cent. P2P lending has growth potential even if traditional banks become fully functional once again – though there is little sign of that in the short term. However, the headache of bad debts will always remain.
Those firms that provide detailed data about their borrowers, allowing the investor to make his own decision rather than relying on non-transparent credit assessment models are likely to escape the credit scandals that may close down some of their competitors.
Quakle, a UK company, closed after incurring bad debts of close to 100 per cent despite being regulated by the Financial Services Authority. Lenders to these companies are not entitled to the compensation that ordinary bank customers with deposits of below €100,000 can expect. It appears that it used internet chat sites to determine the credit risk of its customers.
For the Government, P2P lending could be part of a solution that helps prop up the small business sector. A solution that avoids bureaucratic regulation and reduces the white collar crime associated with banking these days must be welcome.
For more on Haldane's views see:
http://www.bankofengland.co.uk/ publications/Documents/speeches/2012/ speech552.pdf
Cormac Butler is the author of Accounting for Financial Instruments and has led training seminars for bank regulators and investors on financial risk. He has traded equities and options.
