What is P2P lending and why has RBI decided to regulate it?

Borrowers are either individuals or small businesses. But unlike a traditional savings account, one can lose money if the borrower defaults.

Regulation in India

Till April 2016, there were around 30 start-up P2P lending companies in India. Although nascent in India and not significant in value yet, the potential benefits that P2P lending promises to various stakeholders (to the borrowers, lenders, agencies etc.) and its associated risks to the financial system are too important to be ignored, according to RBI.

Global cumulative lending through P2P platforms at the end of Q4 of 2015, had reached 4.4 billion GBP (approximately Rs 38,300 crore) from 2.2 million GBP (about Rs 19 crore) in 2012.

At present, it is partially or fully regulated in Australia, Argentina, Canada (Ontario), New Zealand, United Kingdom, France, Germany, Italy and USA while it is banned in Israel and Japan. China has the largest P2P market in the world, with hundreds of platforms offering diverse services, but the sector is not regulated currently.

How does it work?

Firstly, decide on how much you wish to lend, and for how long. The investors’ funds could be tied up for up to 5 years, so it’s important to be comfortable with this timescale. Remember, you are lending to those wishing to borrow, and 1-5 year loans are the norm.

Some companies offer the option to withdraw your funds during the loan term. There may be a cost for doing this and you'll have to wait until another lender comes in to replace you, but it is there should you need it. Ideally though, you want to avoid doing this, as you’ll lose out on the great rate of return.

Operation model in India

P2P lending platforms are largely tech companies registered under the Companies Act. Once the borrowers and lenders register themselves on the website, due diligence is carried out by the platform and those found acceptable are allowed to participate in lending/borrowing activity.

The companies often follow a reverse auction model in which the lenders bid for a borrower’s loan proposal and the borrower has the freedom to either accept or reject the offer.

Some platforms provide several additional services like credit assessment, recovery etc. In most cases, the platform moderates the interaction between the borrower and the lender.

Documentation and checks

P2P platforms leverage metrics such as credit scores and social media activity to link borrowers and lenders at favourable interest rates. At present, such platforms have very low regulatory restrictions because they merely act as intermediaries between borrower, lender, and partner bank.

The documentation for the lending and borrowing arrangement is facilitated by the P2P platform. The lender transfers money from his/her bank account to borrower’s bank account. The platform facilitates collection of post-dated cheques from the borrower in the name of the lender as a proxy for repayment of the loan.

The P2P forum, in general, also helps in the recovery process and as part of this, follows up for repayments and if need be, employs recovery agents too.

The regulatory concerns in such cases would relate to KYC (know-your-customer) and recovery practices. Since all payments are through bank accounts, the KYC exercise can be deemed to have been carried out by the banks concerned. Though these platforms claim to follow soft recovery practices, the possibility of use of coercive methods cannot be ruled out.