Peer-to-Peer Lending and What Financial Institutions Can Learn

Coauthored by: Laura Pringle, Lynn Pringle, & Miles Pringle

May 2014

Introduction

The strategic alliance announced on May 6, 2014, by LendingClub and Union Bank, N.A., San Francisco, California highlights opportunities for others to explore expanding lending opportunities.  Legal and business issues can be inhibiting to those opportunities unless the issues are properly considered and addressed.  While these opportunities have not long been available, the timing is now appropriate for financial institutions to embrace this lending model.           

Background Developments

As access to the internet took off in the mid-1990’s, and businesses began using the logistics the internet provides, many scholars, economists and bankers have speculated regarding the impact the internet would have on lending and the role it would play.  Some changes to traditional banking activities have come by way of e-banking that allow people to access their accounts and move funds without ever stepping foot in a bank.  Currently, mobile banking is allowing people to send images of checks to financial institutions. However, another concept, “person-to-person” or “peer-to-peer” lending (referred to as “P2P”), appears to be more revolutionary than even these other developments from evolving technologies.

Several companies have attempted to use the internet to pave a new course in lending. P2P lending, however, appears to be proving itself superior to other internet lending models.  Since 2001, at least fourteen companies have offered P2P lending platforms, seven of which were reported to be still operating as of May 2011.[i]  P2P allows individuals and companies access to the lending side of finance that was previously unavailable to them at any significant level, especially access to consumers.  This access has the potential to provide earnings to these new lenders and the platform providers in the process.

Two companies have emerged as for-profit P2P industry leaders: the LendingClub Corporation (“LendingClub”), and Proper Funding, LLC (a wholly-owned subsidiary of Prosper Marketplace, Inc, referred to as “Prosper”), both based in San Francisco.  In 2012, LendingClub reported funding $720 million in loans, and has loftier ambitions, i.e. LendingClub plans to lend $2 billion in 2013 after receiving a $125 million investment from Google.[ii]  Prosper, the older but smaller of the two platforms, reported originating $50 million in loans during the first four months of 2013, up 20% from 2012.[iii]

This aggressive expansion by P2P lenders is not inherently bad news for traditional lenders, in part, because P2P lending offers a learning opportunity.  P2P lending is almost exclusively limited to consumer debt, and specifically targets the payment of already accumulated credit card debt (which makes up over 75% of LendingClub’s loans).[iv]  From 2007 to January 2013, LendingClub originated $1.25 billion in loans, and during that same time Prosper originated $447 million.[v]  It is important to note here that, according to the Board of Governors of the Federal Reserve System (the “Fed”), the United States’ outstanding consumer credit is approximately $2.839 trillion, $856.5 billion of which is made up of credit card debt (roughly 30%).[vi]

Opportunities for Financial Institutions and Regulatory Considerations

It appears that refinancing credit card debt has been an effective way to develop P2P lending and earnings as credit cards bear some of the highest interest rates. Investors with capital have used the platforms provided by LendingClub and Prosper to obtain returns on their investment that far exceed typical savings rates, and there may be large room for growth if competition does not increase.

Most outstanding consumer credit is still held by traditional lenders (depository institutions and the federal government hold $2.03 trillion, which does not include mortgages).[vii]  P2P lenders recognize this fact and are looking for ways to expand beyond credit card refinancing.  Renaud Laplanche, the CEO and Founder of LendingClub, stated that LendingClub is exploring ways of expanding its lending into student loans, small business loans up to $250,000, and eventually mortgages and home-equity lines of credit (“HELOC”).[viii]

This desire for expansion may be startling for officers, board members and owners of traditional financial institutions because it begs the question, how can LendingClub and Prosper meet all the Regulation Z, RESPA, and other requirements necessary to extend consumer loans including mortgages and HELOCs.  The short answer is: they do not have to.

Neither LendingClub nor Prosper actually fund loans directly to borrowers through their platforms. Instead, the loans are extended by WebBank, a Utah-Chartered Industrial Bank, Member FDIC.[ix]  Both companies’ lending processes begin with investors (or lenders) agreeing to fund a specific loan.  Then WebBank originates and funds the loan for the borrower and sells the note thru the lending platform.  The borrower is then obligated to make monthly payments to the lending platform, which pays the investor after subtracting a 1% servicing fee.

Therefore, it is through WebBank that LendingClub and Prosper comply with state and federal lending statutes and regulations.[x]  WebBank’s primary federal regulator is the FDIC, and it has the authority to “indirectly” oversee both companies’ compliance.  According to a Government Accountability Office (“GAO”) report issued in July 2011, “Officials from the FDIC and UDFI said that they could take enforcement action against a bank or refer the companies operating platforms to law enforcement agencies if they identified problems in a bank’s relationship with the companies, or found evidence that the companies had violated federal or state laws.”  See Endnote I, infra, for citation of GAO report.

LendingClub and Prosper themselves are regulated by the Securities and Exchange Commission (the “SEC”) in order to protect the lenders/investors that purchase notes on the platforms.  Both companies have registered with the SEC and regularly post information for investors, along with detailed information about the companies themselves.  In addition, LendingClub and Prosper are regulated by state agencies where their respective lenders are located.  Because not all states have allowed the one or both of the companies to offer investments within the state, neither company allows investors to purchase notes in all fifty states. 

Of course, the Consumer Financial Protection Bureau (“CFPB”) may assume jurisdiction over non-depository financial institutions as well, e.g., the CFPB may determine that a nonbank is “engaging, or [has] engaged, in conduct that poses risks to consumers with regard to the offering or provision of consumer financial products or services,”[xi] and, therefore, falls under the CFPB’s supervision.

Future of the Regulatory Framework and Related Issues

The GAO was specifically tasked with reviewing the current regulatory framework and recommending if changes were necessary.  The GAO did not offer a firm recommendation, but instead provided two alternatives: 1.) Keep the status quo, or 2.) Consolidate all regulatory duties into one agency.  As Congress does not appear eager to consolidate regulatory authority into one agency, the status quo is anticipated for the foreseeable future.

WebBank appears to have benefited significantly from this arrangement.  It appears not to have risked its own funds, limits the time and expense of originating loans, does not run the risk of concentrations, and receives fees for the services it provides.  As a result WebBank has gained a source of income from its relationship to P2P lenders.  Under these circumstances, it becomes apparent how LendingClub and Prosper would be able to offer mortgages and HELOCs to investors: by severing the servicing obligation from the underlying indebtedness.  Thus, WebBank or another servicer could service the loans for a fee, and the investor could be owed the payments.  It should be informative to compare this business model to the strategic alliance between Union Bank and LendingClub.

Although this could work in theory, there are several practical reasons that would keep LendingClub and Prosper from more vigorously exploring real estate loans currently.  First, home mortgage interest rates continue to be very low, especially compared to credit cards.  The average conventional mortgage rate has been 4.07%, compared with 12%-18% for most major credit cards.[xii]  P2P lending platforms can both offer a large return on credit card debt for investors and better rates to consumers.  The opposite is true with mortgages and HELOCS, because there is no gap available.  Also, mortgage terms may prove to be too restrictive for consumers who often need to refinance loans or extend maturity dates.  Large investors may seek better opportunities for their money, and smaller investors may be unable to fund and/or maintain large investments such as mortgages.

Another practical consideration is that LendingClub and Prosper had been unwilling to secure loans with collateral.  Both companies had limited the maximum amount of each loan; for example, LendingClub would only extend personal loans up to $35,000.  As investors put more money at risk, for example $250,000 for business loans, prudent investors will demand some type of security as well as other assurances.  Case in point, hedge funds and other private equity groups typically require preferred stock or some other interest or collateral for providing its investment in companies.  These are practical issues that traditional financial institutions have long solved.

Before moving onto the lessons for traditional financial institutions, the myth the P2P loans are being funded by “persons” or “peers” should be debunked as a misnomer.  Many of the “investors” that fund loans through LendingClub and Prosper are large institutions and professional investors.  As the CEO of LendingClub stated, “We haven’t used the term ‘peer-to-peer’ for the past three years, just like Facebook doesn’t call itself a social network.”[xiii]  Investors interested in funding loans through these platforms have created larger pools of capital, some as large as $100 million.[xiv]

Benjamin Franklin has been quoted as saying, “Tell me and I forget, teach me and I may remember, involve me and I learn”.  For traditional financial institutions P2P lending is both a new competitor and an excellent test balloon from which to learn.  First of all, banks and other lenders may get involved themselves as there is clearly a strong market for credit card refinancing.  Traditional lenders can develop products to help their customers refinance credit card debt and advertise those products so customers are aware of its benefits.  There also may be a strong market for other types of small consumer loans for lenders to pursue, and institutions may purchase notes on LendingClub or Prosper – provided an institution is permitted by law to do so.

A second way to get involved in the services that P2P lenders offer is to develop and expand an institution’s own internet services, which could include on-line funding to consumers.  Any institution contemplating such services should maintain its underwriting standards and comply with all regulations, such as Regulation Z; along with all other requirements, such as its Customer Identification Program.  Most financial institutions will need to contract with outside vendors to develop a lending platform.  The contract should include provisions outlining privacy standards, indemnification for breaches, and other Gramm-Leach-Bliley and Dodd-Frank considerations.

Financial institutions that offer on-line funding may initially limit lending to smaller consumer loans.  Safety and soundness standards will dictate that collateral be secured and other assurances be made with larger loans.  Also, an institution should avoid concentrations and risking Fair Credit Reporting Act and other consumer credit protections.  If implemented correctly and conservatively, an on-line funding program may directly increase a financial institution’s loan portfolio.  At the very least, it will demonstrate an institution’s ability to keep up with the times.

Moving forward, it can be expected that more on-line lending platforms will form to compete with the established platforms.  If approached, traditional lenders may consider partnering with new platforms to gain a source of revenue as illustrated by the Union Bank announcement.  Obviously, the terms of the relationship will need to be carefully negotiated and documented.  

The question has been raised as to whether some institutions may be able to establish financial subsidiaries that are online P2P lenders.  An institution would need to meet the requirements necessary to form a financial subsidiary, and the particulars of creating and gaining the necessary regulatory approval will depend on the charter type of a financial institution.  For example, it may make sense for one institution to operate a financial holding company, where another may seek to establish a financial subsidiary.  In addition to statutory and regulatory constraints, the need to demonstrate the ability to plan strategically and address other issues may limit or delay regulatory approvals.  Also, some state laws may not allow state chartered financial institutions or their subsidiaries to engage in activities similar to P2P lenders.

With all of the above caveats, there is a basis for believing that financial subsidiaries may engage in activities similar to LendingClub and Prosper.  Pursuant to 12 C.F.R. § 5.39(e)(1), a national bank’s financial subsidiary may engage in (i) Lending, exchanging, transferring, investing for others, or safeguarding money or securities;… (iv) Issuing or selling instruments representing interests in pools of assets permissible for a bank to hold directly;… and (v) Underwriting, dealing in, or making a market in securities.  While this provision does not apply to all financial institutions, any interested institution should obtain legal advice on whether it meets the criteria to form such an entity.

Conclusion

In sum, financial institutions should take the time to learn as much from on-line peer-to-peer lenders as possible with the assistance of their legal counsel. Understanding this business model can assist development of financial institutions’ own business operations and open opportunities for carefully enhancing loan growth.

[i] United States Government Accountability Office (“GAO”). Report to Congressional Committees. “PERSON-TO-PERSON LENDING: New regulatory Challenges Could Emerge as the Industry Grows” Published July 2011 as GAO-11-613. Accessible at http://www.gao.gov/products/GAO-11-613 (accessed July 8, 2013).

[ii] Kaufman, Wendy. “Peers Find Less Pressure Borrowing From Each Other.”, National Public Radio, All Tech Considered, published March 10, 2013. http://www.npr.org/blogs/alltechconsidered/2013/05/10/182651552/peers-find-less-pressure-borrowing-from-each-other (accessed June 10th, 2013).

[iii] Mecia, Tony. “Peer-to-Peer Loans Catch on for Credit Card Debt Consolidation”.  Foxbusiness.com, published June 24, 2013. http://www.foxbusiness.com/personal-finance/2013/06/05/peer-to-peer-loans-catch-on-for-credit-card-debt-consolidation/ (accessed July 8, 2013).

[iv] Shankland, Stephen. “With rising revenues, Lending Club CEO plans expansion (Q&A)”. www.cnet.com. Published June 7, 2013, http://news.cnet.com/8301-1023_3-57588175-93/with-rising-revenues-lending-club-ceo-plans-expansion-q-a/ (accessed June 10, 2013).

[v] Levy, Ari. “Banks’ Pain is Startup’s Gain.” Published January 22, 2013 by Bloomberg.com. Accessible at http://go.bloomberg.com/tech-deals/2013-01-22-banks-pain-is-startups-gain/ (accessed July 10, 2013).

[vi] Board of Governors of the Federal Reserve System. “FEDERAL RESERVE Statistical release: G. 19 Consumer Credit”.  Published July 8, 2013. Accessible athttp://www.federalreserve.gov/releases/g19/Current/g19.pdf (Accessed July 10, 2013).

[vii] Id.

[viii] Shankland, Stephen. See note supra iv.

[ix] GAO, see note I supra, at page 32

[x] Id, at page 34.

[xi] 12 U.S.C. §5514(c); 12 C.F.R. §1091 et al.

[xii] Board of Governors of the Federal Reserve System. “FEDERAL RESERVE Statistical release: H.15 (519) Selected Interest Rates”.  Published July 8, 2013. Accessiblehttp://www.federalreserve.gov/releases/h15/current/h15.pdf (Accessed July 10, 2013). 

[xiii] The Economist. “Crowdfunding in America End of the Peer Show: Peer-to-Peer Lending Needs a New Nam.”, published June 1st, 2013, http://www.economist.com/news/finance-and-economics/21578670-peer-peer-lending-needs-new-name-end-peer-show (accessed June 10, 2013).

[xiv] Id.

©PRINGLE® 2014

This Article was also published at Wolters Kluwer’s Compliance Headquarters™ website: www.complianceheadquarters.com