Internet-based micro-lending, also known as peer-to-peer lending, has opened the doors to many borrowers and lenders seeking nontraditional means to capital. Borrowers with less than stellar credit scores can obtain loans that they could not obtain from banks. Lenders can be personally involved in the process and can choose to partake in riskier, yet potentially higher yielding loans. Overall, these independent lending organizations provide alternatives to banks and are relatively unregulated by government – essentially a libertarian’s dream. Unfortunately, many such organizations have faced problems with litigation, expanding regulation, fraudulent borrowers, and a lack of repeat lenders.
One of the prominent online lending organizations in the United States, Prosper.com, has received promising media attention (for example: here and here) and increasing amounts of loans. The growth of Prosper.com has also spurred the attention of the government, specifically that of the Security and Exchange Commission (SEC). In November 2008 the SEC found the organization in violation with the Securities Act of 1933 and issued a cease and desist. In response, Prosper.com registered with the SEC in July of 2009. Litigation also plagues the company with lenders suing over supposed past state and federal securities violations. Additionally, repeat lenders are growing dissatisfied with risk reduction mechanisms and management actions regarding fraudulent borrowers. Fred93, a lender and blogger, discusses Prosper.com’s problems and concludes:
Prosper borrowers are “different”. While most of them are very nice people, like the couple I met in Long Beach, a substantial fraction of Prosper’s borrowers are hardened deadbeats, attracted by the sweet odor of naivete. Prosper lenders cannot succeed without better mechanisms to protect against against these zombies.
As Fred93 says, “It was such a wonderful concept. It seems such a shame.” What has gone wrong in the micro-lending industry? Is it just bad management and a lack of substantial risk reduction mechanisms? The answers lie more in the institutional makeup of lending.
SEC regulation has stopped lending and fueled litigation despite transparent reporting of risks by Prosper.com and other organizations. The more time and effort spent by management on legal compliance takes away from improving and innovating their company structure. In an environment like this, the companies most likely to succeeded are big, old banks with strict credit rules and lending structures not the small, internet-based organizations. In addition, the recent financial crisis has led to an ever changing and expanding regulatory regime, which hinders entrepreneurial efforts to bring about more variety and flexibility to the credit market. Still, I am hopeful. More efforts by small, internet-based organizations may have the ability to highlight the benefits of micro-lending and help to change the lending environment.
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