Caveat Emptor Banking: Peer-To-Peer Lending Challenges Too-Big-To-Fail Status Quo

Imagine a financial institution that the government cannot deem too big to fail, requires no deposit insurance, can never be subject to a run, needs no lender-of-last-resort support by a central bank, cannot become overleveraged, suffers no maturity mismatches between assets and liabilities, is immune to interest rate manipulation, can never subject the rest of us to systemic risk, offers quick approval of unsecured personal and business loans at market rates, and provides yield-hungry investors with a way to build individualized debt portfolios based on risk models of their own choosing.

It’s called peer-to-peer lending, the latest innovation shaking up the financial industry. It will be interesting to see how long it lasts before Washington’s out-of-control regulatory regime attempts to crush it—and what happens afterward if they do.

In terms of regulation, companies like Prosper Marketplace and Lending Club have more in common with online dating sites than with banks. By serving as middlemen matching willing lenders with eager borrowers, peer-to-peer banks avoid many of the liquidity risks faced by fractional reserve banks today.

Those risks got much worse as a result of the 2007/2008 bank bailouts, which led to the enshrinement of Too Big to Fail (TBTF) banking policy in the Dodd-Frank financial regulation legislation. This essentially provides a guarantee of eternal life to a handful of well-connected banks in return for their submitting to a thicket of complex and ambiguous regulations designed by lawmakers and bureaucrats whose campaigns they lavishly funded. All of this to make sure a debacle “never happens again,” a refrain we hear after every banking crisis. The biggest banks can absorb the compliance costs of regulation more easily than smaller community banks, leading to a vicious cycle of more regulation in turn leading to even bigger banks.

Peer-to-peer banking (sometimes called shadow lending by its detractors) gets around all that. The process is simple. Borrowers apply online for loans of up to $35,000. Loan officers then run a vetting process that includes credit history checks, employment verification, and an analysis of the borrower’s debts and assets. An interest rate is then assigned based on the judged riskiness of the loan—an admittedly inexact science similar to bond rating and insurance underwriting. But the peer-to-peer operator never makes the call to put depositors’ money at risk.

Instead, investors are invited to individually sign up for whatever portion they would like of a particular loan. A loan is “approved” when enough investors sign up. If a particular loan at a particular interest rate doesn’t attract investors, it’s back to the drawing board. Smart investors can build their own portfolios, signing up for small amounts of multiple loans with staggered maturities to diversify their risk, while letting their own experience act as their guide. (“OK Mabel, no more restaurants; let’s stick to food trucks!”) Most importantly, investors know they can’t simply demand their cash back whenever they want it. Hence, there is never a maturity mismatch between assets and liabilities, nor can there be a run when a bank’s leveraged proprietary trading bets go bad.

Peer-to-peer lending services build their reputations by accurately assigning interest rates to loans that reflect the actual risk of default while minimizing the fees they take on each transaction. If the assigned interest rates overcompensate for the actual default rate, then lenders get a great deal. If the opposite is the case, then borrowers get a great deal. In the end, competition sorts out where lenders and borrowers decide to take their business, with the market providing checks and balances because both are needed to make the system work.

Just as importantly, if either party goes crying to Washington, they’re likely to meet the response, “You knew what you were getting into.” And the lack of either implicit or explicit taxpayer-backed deposit guarantees means Uncle Sam never has to bail them out. So taxpayers will never be on the hook to cover the heads-I-win, tails-you-lose excesses of overcompensated bank executives, which is what happens whenever Too Big to Fail banks go bad (four times at last count for Citigroup).

Free marketers should celebrate before nanny-state demagogues try to do to peer-to-peer banks what they’ve done to payday lenders, which today face an array of state-level price controls, imposed at the urging of federal bureaucrats. This has led to a tightening of nonbank credit and a skyrocketing of bounced check and late payment fees.

“It’s not fair!” they proclaim. “How can we protect borrowers from paying too-high interest rates and lenders from losses they can’t afford? How do we prevent drug dealers and money launderers from utilizing the system? How can we impose racial and geographic quotas to ensure equal access to loans regardless of potential borrowers’ credit histories or arrest records? And most of all, how can we extract campaign donations from bank executives who haven’t bought in to the cycle of boom, bust, and bailout that keeps us at the center of the nation’s financial system?”

The size of the peer-to-peer banking business is still small. Whether it gets a chance to grow or is snuffed out in its infancy will depend on how long it is before headline-grubbing politicians start peddling the next solution in search of a problem.