ichthyoid

At the beginning of this series, I talked about the two primary functions of a traditional bank: storage and lending. So far, we’ve mostly talked about how we want to store and cement the value we earn through assets which increase in value above inflation over the long term. By collateralizing our assets, we can make use of them multiple times, allowing us to basically function like a traditional bank, except without the morally and legally questionable things they are currently allowed to do.

And so, we’ve come to the topic of lending. Lending is perhaps the most important, and yet also riskiest, part of the banking cycle. It’s exactly as it sounds: taking the money that we have through collateralization, letting another party borrow it, which they return back to us at interest. This interest rate needs to exceed the rate at which we are borrowing from our own assets, so as to increase the money that we have.

But to whom do we lend? Banks and financial institutions, being the major holders of our societies’ money, are at an advantage since they are far better known for their lending services. Almost all major borrowing events, from cars and real estate to big business loans, primarily go through banks. This locks out individuals from being able to determine where their money is going and how it is being used, putting that responsibility instead in the hands of bankers and financial institutions who don’t care much about whether we keep or lose the money we've stored with them.

A Tentative Solution: P2P Lending

However, over the past few decades, peer-to-peer (P2P) lending has become increasingly popular. Rather than relying on banks to tell us what our credit is, many people and many businesses are beginning to go through third-party services which have their own ratings for credit to obtain loans for their needs. More importantly, the average person can be an investor in these services by lending these people or businesses money and allow it to go to work for them.

There are a plethora of these services. Just a random search on Google will yield companies like Lending Club, Prosper, Sofi, and Upstart, all of which have varying reviews. What’s great about this is that we don’t have to pick just one service for our lending functions. Instead, we can spread out the money we’ve obtained from our assets to see which services are better for our own purposes.

Each of these services offer basically the same things, with some nominal differences in the way they deal with borrowers. Some are more difficult to sign up for as borrowers, others have differing rates offered to different people. Most importantly, these services give us investors choices of who we want to lend to. Furthermore, we can divvy up our money invested to different pools, so our money isn’t contingent on a single party paying us back. For example, if I put $1000 into a P2P service, I can divide that into sets of $25 dollars and loan that out to 40 different people. Theoretically, and especially when I use multiple services, I’ve divested my risk this way.

The Great Caveat

This all sounds too easy and too good to be true. And it almost is. Because there is one massive caveat to almost all P2P lending––you are not guaranteed any of the interest returns on loans. At any point in time, any of those borrowers can just default on the loan they received and decide not to pay any of their lenders back. Because these companies are not backed by a government or central authority, they have very little power or ability to force another person to pay back their loan. And since many of these borrowers already have very low credit from traditional banks and financial institutions, it can be quite likely that they may not have the means to pay back what they borrowed. In fact, this is becoming an increasingly common scenario.

There are a few ways to get around this caveat. First, rather than chasing the advertised higher rates of interest, it’s usually better to go for lower yields that would probably be more secure. Many who use P2P lending services are already lowly rated by banks, and so even a AAA rated customer is probably around a B rated client normally. Second, rather than allowing the automation of these services determine who you’re lending to, it’s much better to determine the clients for yourself. It may seem slower, but in terms of security, personally vetting client usually is less risky. Third, as given before, it’s better to diversify your investments as much as possible, so even if a few people default, it won’t necessarily bankrupt your entire portfolio.

Of course, this doesn’t rid us of all risk that we’ve taken on. After all, if we have somehow poorly chosen all our borrowers, and a majority of people we loan to decide to default on their loans, there is basically nothing we can do about it. In being our own bank, we need to assess whether this kind of risk would be worth it for us in the long run.

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