Before there were banks, people simply lent and borrowed among their peers. Lender and borrower often were personally acquainted, and the desire to maintain good social standing provided strong incentive to repay debts.

But as commerce evolved, intermediaries sprouted up. Banks brought new scale and diversification to the lending game. By pooling capital, they were able to make larger loans and take bigger risks. And since the loans were spread out over a diverse group of borrowers, the occasional default made little impact on their overall balance sheet.

In recent months, the weaknesses in this model have become painfully apparent. Its complex web of interdependencies is difficult to regulate, and community loyalty is no longer part of the client relationship. These days, a tractor loan to a farmer in Idaho might end up in the debt portfolio of a hedge fund in Singapore.

The solution may be a return to the basics, albeit with a high-tech twist. Writing in the January 2009 issue of Harvard Business Review, former Harvard professor John Sviokla says a modern version of peer-topeer (P2P) lending will emerge as one of the most important financial services innovations of the next decade.

How it works
Potential borrowers visit a P2P lending website and apply for a loan, indicating how much they need and how they plan to use it. Investors browse the site and choose loans they wish to fund in whole or in part.

There are more than thirty such sites in operation, and Lendingclub.com is one of the most popular, where it’s not unusual to find more than a hundred investors chipping in to give someone a $5,000 credit card consolidation loan.

Lending Club even augments conventional credit scoring with proprietary tools that allow them to analyze a borrower’s reputation within other online communities such as eBay and Facebook.

The P2P model helps investors diversify their lending like a traditional bank, except with far lower overhead and a much better idea of who they’re lending to. Meanwhile, borrowers get a sweet deal. Lendingclub.com offers fixed rate loans starting at 7.88% interest, whereas the bank rate for personal loans in the U.S. is 13% on average.

Sviokla ultimately envisions a convergence of P2P with traditional lending. He sees banks and other investors giving the most successful P2P lenders additional capital to grant more and bigger loans. He also predicts that every major bank will have its own P2P lending network within the next five years.

Our view
If P2P lending helps information and credit flow efficiently between lenders and borrowers, we believe it’s a good thing. After all, getting capital to where it is needed is the core purpose of capital markets. //