research

WINNERS AND LOSERS OF MARKETPLACE LENDING

A TFI Research Challenge project by Sudheer Chava and Nikhil Paradkar
Posted on March 28, 2018

The research project "Winners and Losers of Marketplace Lending: Evidence from Borrower Credit Dynamics" is one of the eight projects selected last year for the TFI Research Challenge.

Marketplace lending (MPL) platforms offer online direct contact between individual borrowers and individual lenders – without intermediaries. In this report, Dr Sudheer Chava and Nikhil Paradkar use data from approximately 1 million MPL borrowers to analyse both the benefits and drawbacks of these emerging platforms for consumer loans.

Summary

The advent of peer-to-peer (P2P) financed loans through marketplace lending (MPL) platforms since the mid-2000s presents a new financial technology-driven competitive challenge for traditional banks in the lending domain. Relative to individual lenders, banks have traditionally enjoyed economies of scale in information gathering, borrower monitoring, and transaction costs.

An abundant amount of theoretical and empirical research suggests that the lending market would break down in the absence of traditional banks. This traditional paradigm has been increasingly challenged by MPLs focused on connecting individual borrowers to individual investors looking to earn higher returns through the use of credit bureau-generated reports on these prospective borrowers. MPLs have also focused on using alternative data and statistics techniques to offer alternative, possibly lower, interest rates than banks. In effect, MPL platforms look to provide more favorable borrowing alternatives and, more broadly, to cut out the “middle man” in lending transactions. Over the last decade, numerous variants of MPLs have gained larger market shares in specific niches of the credit market, such as consumer credit, student loans, or startups.

In our research, we focus on MPLs specializing in the consumer credit space. Our interest in the consumer credit space rests on the bullish prospects of MPLs in this domain as reported by industry leaders in the United States. In a February 2015 report, Goldman Sachs estimates that more than 31% of the $843 billion unsecured personal lending market is prone to disruption by MPLs. PwC, in an equally optimistic February 2015 report of their own, estimates the MPL market to reach $150 billion by 2025. Indeed, MPLs in the consumer credit space have experienced strong growth in the last decade. Between 2007 and 2017, Lending Club and Prosper, two dominant MPLs in the consumer credit space in the United States, have disbursed over $35 billion, with approximately $6 billion disbursed in 2017 alone.


“What are the characteristics of individuals engaging with MPL platforms, and how they compare with the average American resident?”

As a first step, we attempt to understand the characteristics of individuals engaging with MPL platforms, and how they compare with the average American resident. Making use of rich credit bureau data, we analyze approximately one million MPL borrowers in the month immediately before they received their loan, and compare them to a 5% random sample of the U.S. population. Our findings suggest that MPL borrowers are more financially constrained relative to the average American adult. MPL borrowers are found to have twice as many credit cards, and over twice the average credit card debt relative to the national average. Most tellingly, the percentage of the total credit available to them that they were currently using – known as their credit utilization ratio – was 69%. This is more than twice the national average of 30%. This aspect of being financially constrained is perhaps best captured through credit scores, with MPL borrowers having credit scores that average 20 points below the national average.

Consistent with the aspect of being financially constrained, the vast majority of MPL borrowers state “debt consolidation” as the primary reason for requesting MPL funds. The idea is, thus, to use these funds to pay down expensive debt, replacing it with monthly amortized payments of relatively cheaper MPL debt. The reasons provided by borrowers are non-verifiable, however, since MPL platforms have no mechanism in place to ensure that borrowed funds are used in manners consistent with the reasons stated on the applications. In this sense, MPL platforms simply serve as brokers. That is, they serve to match borrowers to prospective lenders through the reduction of information asymmetries between the two parties, and nothing more. Moreover, given the unsecured nature of MPL loans, the entire risk of strategic reason misreporting on MPL loan applications, and possible borrower delinquency, is borne by the lending party. Finally, from the borrowers’ perspective, if MPL funds are used to consolidate debt, it’s not empirically certain which debt they consolidate. While MPL funds are cheaper than credit cards (unsecured credit cards charge rates of approximately 20% relative to average MPL rates of 15-17%), these funds are more expensive than auto debt, for example. Thus, analyzing whether MPL funds are efficiently used is also an important question.  

Our findings suggest that strategic reason misreporting is not a significant concern on MPL platforms – MPL borrowers use borrowed peer-financed funds to consolidate debt. Moreover, they appear to consolidate the most expensive debt they face – credit cards. We find no evidence of inefficient consolidation of relatively inexpensive debt, such as auto, mortgage, or student loans.

We find that the consolidation activity induced by MPL funds have effects on other credit profile characteristics of borrowers. In the quarter after receiving their loan, we find evidence that borrowers enjoy lower credit card utilization ratios, higher credit scores, and even higher credit limits on existing credit cards issued by their current bank creditors. Thus, our findings suggest that, at least in the short term, MPL funds definitely alleviate financial constraints on MPL borrowers.  

What about the long-term however? Here, our results suggest that MPL borrowers revert to consuming credit cards following the short-term consolidation phase. In fact, within three quarters of taking out the loan, MPL borrowers have nearly as much credit card debt as they did pre-loan. This trend is reflected in trends of increasing credit utilization, declining credit scores, and higher default rates on credit cards in the period of time following MPL-induced debt consolidation. We do not, however, find evidence of increasing defaults on the MPL loan itself. Overall, our findings suggest that while MPL funds help in alleviating financial constraints in the immediate term, the long-term benefits of MPL loans depend exclusively on the actions of individuals following the initial consolidation phase.

In our final set of results, we classify MPL borrowers as subprime, near-prime, or prime depending on their credit score in the month immediately prior to MPL loan origination, and conduct our analysis described above separately for these three credit segments. The subprime, near-prime, and prime segment account for approximately, 23%, 50%, and 27% of our sample, respectively. Our findings suggest that subprime borrowers are quicker to revert to consuming on credit cards following the short-lived MPL-induced consolidation phase. Moreover, the subprime segment experiences the largest expansion in credit limits on credit cards from their existing bank creditors, and default at significantly higher rates on credit cards a year down the line. The near-prime and prime segments enjoy better financial situations in the period of time following MPL loan origination.

Overall, our research suggests that MPL funds unequivocally improve the financial situation of borrowers in the short-term. MPL funds do not reduce aggregate indebtedness, however. They simply substitute for a more expensive debt. It is important, therefore, that MPL borrowers carefully consider their credit card consumption activities in the months after they take out the MPL loan and pay off their debts. Any increase in credit card consumption will strictly increase the aggregate indebtedness of the borrowing individual, who is also tasked with paying down the MPL loan. Another implication regarding MPL loans is that banks should be prudent with regards to making limit extension decisions on single snapshots of borrower quality, which can be at odds with their historical patterns. 

Dr Sudheer Chava is Alton M. Costley Chair and Professor of Finance at Scheller College of Business at Georgia Tech, US. E-mail: sudheer.chava@scheller.gatech.edu
Nikhil Paradkar is a PhD candidate in Finance at Scheller College of Business at Georgia Tech, US. E-mail: ikhil.paradkar@scheller.gatech.edu