A P2P lending platform works as an intermediary providing loans through an online platform.
The recently released RBI notification announcing regulations for peer-to-peer lending (P2P) platforms will be instrumental in boosting the growth of small business sector in India.
This timely notification stated that all P2P lending platforms will be treated as non-banking financial companies (NBFCs) with minimum capital requirements and regular disclosures to RBI.
While this means that the P2P lenders will gain more accountability in the system, it also signals RBI’s acknowledgement of the growing need for alternative lenders to complement the role of traditional banks.
A healthy and booming small business sector is crucial for any country's growth. India is home to over 5 crore Micro, Small and Medium-sized enterprises (MSMEs), which contributed 33% of India’s manufacturing output and 30% of India’s GDP, while employing 12 crore people. These astounding figures emphasise the vital contribution of MSMEs to India’s future.
Timely and sufficient availability of finances is crucial for the growth of these small businesses. Often enough, these businesses turn away new sales orders due to inadequate working capital.
Unsurprisingly, this sector is facing a huge capital shortage of Rs. 32 trillion, according to an estimate by International Finance Corporation. Financial Institutions such as banks contribute only a meagre 2 percent of the required finances. As a result, the business owners have to depend on their own funds or family and friends for a major remaining chunk.
Over the last few years, the government has taken multiple steps to boost bank credit to the small business sector. Despite all those efforts, the shortage in available credit still prevails.
One of the biggest challenges faced by banks is the soaring mountain of bad debt on their balance sheets. Even though recapitalisation measures will provide some respite to public sector banks by increasing their capital base, the loan quality would remain an issue.
In this current scenario, it seems highly unlikely that banks would be willing to increase their exposure to small businesses considerably. Banks perceive these businesses riskier as they find it extremely difficult to evaluate their financial standing due to lack of proper books and accounts and the resulting information asymmetry.
On top of this, these borrowers seek unsecured loans as they don’t have sufficient collateral in most cases.
What makes matters worse is the range of operational challenges faced by the banks. The traditional loan underwriting process is completely manual and requires a lot of documentation, making it extremely inefficient.
Today, it could easily take up to a few months to just get a small loan approved. This makes the overall process quite daunting and cumbersome for borrowers as well.
Additionally, banks find it seemingly impossible to reach such a large and scattered audience using their existing brick-and-mortar infrastructure. Given the small ticket-size of these loans and existing set of operational difficulties, banks find it unprofitable to lend to this sector.
Amidst all the haze, P2P lending is emerging as the silver line for small businesses and banks.
A P2P lending platform works as an intermediary providing loans through an online platform. Since these platforms don’t necessitate the brick-and-mortar infrastructure as required by traditional banks, they are easily scalable.
With increasing internet penetration, these lenders could reach small businesses located in any nook and corner of the country and offer to fulfil their funding requirements.
P2P lending platforms are using technology and non-traditional data sources such as social media to reinvent the frameworks to assess the financial standing of the borrowers.
For example, the number and quality of reviews that a travel operator has on TripAdvisor could be an indicator of how well the business is doing and could help determine the willingness of these platforms to lend money to the operator.
As P2P lending sector develops, the establishment of India digital stack will be instrumental to its rapid growth. The stack has made it possible for borrowers to authenticate themselves using the Aadhaar infrastructure without being physically present.
They can also select the loan offers and e-sign the documents from the comfort of their homes. The introduction of GST will ensure that all the sales and purchase transactions performed by businesses are logged that could eventually be used for credit evaluation by the P2P platforms.
The entire loan approval process including disbursements of funds could potentially be handled within as quickly as
quickly as a few hours. By increasing efficiency and using better credit assessment tools, the P2P lenders should also be able to drive down the costs and offer cheaper loans to borrowers compared to those provided by banks.
At present, there are more than 30 specialised P2P lending platforms in India. The biggest of these has already disbursed loans to the tune of Rs. 1,000 crores and hope to achieve a target of Rs. 5,000 crores over the next two years.
As these P2P lenders create a roadmap for the future, regulatory certainty would be crucial for the overall ecosystem. With RBI issuing guidelines around how it intends to regulate these platforms, investors will get more comfortable betting their money on them.
It is also an acknowledgement from RBI that there is a growing need for these alternative lenders in extending credit to the traditionally under-banked sector.
However, even with all these glorious possibilities, the whole ecosystem would still have to overcome several challenges. One of the biggest challenges has been to create awareness about this new funding opportunity amongst the borrowers and investors.
Since P2P lending is still at a nascent stage in India, both borrowers and investors seem to be testing waters. They are looking for assurance that they are treated fairly and look towards the regulators to develop accountability around the whole framework.
Another big challenge faced by P2P lenders is lack of easy access to funding. Because they don’t accept deposits, they currently rely on loans from banks and other NBFCs or VC investment for their own funding. But this source of funding could itself prove to be a limiting factor. Looking at the west, the P2P lenders in the U.S./U.K. have established diversified channels of funding.
They leverage retail investors, and institutional investors such as asset managers, hedge funds, pension funds, insurance companies etc. to fund these loans.
While retail investors offer stable funding, the institutional investors have a strong appetite and capacity to fund these loans. The investors, in turn, look to benefit from the potentially lucrative and stable returns.
The diversified sources of funding enable P2P lenders to develop scale and expand their reach. They actively tap the capital markets to sell these loans to investors and raise money to ensure regular and uniform flow of funds in the ecosystem. Currently in India, the capital markets are pretty much non-existent for P2P lenders.
As the regulations evolve and P2P loans become an established asset class with predictable performance, more investors will flock to these assets, creating a ripple effect to enable further innovation in the ecosystem.
In summary, P2P lenders have an opportunity to disrupt small business lending, but it would require a disciplined execution and persistent dialogue with regulators to make it happen.The author is currently working in San Francisco at LendingClub, the largest P2P lender in the United States, as Senior Director