How Does Peer-to-Peer Lending Fare in a Recession?
There are already signs of recession even before the pandemic hit. The notion of economy plummeting has been around since around last year, and Covid-19 exacerbates this.
In the worst scenario of economic downturns due to the global crisis, we may enter a condition called Insolvency Crisis or Doomloop where companies or individuals will not have enough money to pay down their debt, creating negative feedback loop. This is the condition where banks, individuals, or institutions choose to holding their money instead of spending it, causing the deflation in a broader sense. Central bank will then penalize banks for holding on to all of the excess cash, and it’s supposed to encourage the banks to lend more money to customers. Accordingly, other financial institutions will lower their interest rate to be able to compete with the banks, including the P2P Lending.
Despite the more loosely access from banks to lend the money, the criteria for eligible borrowers are still tight (good credit score, collaterals, etc). As an alternative, P2P Lending is a choice for customers borrowing the money in the times of crisis due to the absence of collaterals and the more loose credit criteria. In some cases of consumer loans, P2P lending is used for debt consolidation.
To prove whether P2P can survive the recession storm, we will look back to the last recession period in 2008–2010. Around the same period P2P lending started to come into existence. Despite customer loans were hurting, investment in P2P yielded positive results, the same way its asset class counterpart, credit card, experienced positive return when it served the prime borrowers (customers with good credit score).
For lenders, it is relatively safe to put their money into P2P Lending because most of its loans are low-grade loans with low default rates. There is, however, a caveat for the unsecured loans: in a recession, loan defaults will be increasing, and the absence of collaterals may backfire for lenders. This can be balanced by tightening the selection process for loan application. Another approach that was taken by lenders to minimize the risk of unsecured loans when funding in P2P was to opting for productive loans (income-generating loans) compared to consumer loans. The nature of productive loans is that there are yields from business activity as a substitute of collaterals, making it more compelling and safer for lenders to chip in their money.
Final Words
The trend of consumer loans during recession is that they are likely declining in the beginning, as the customers would want to spend less. This causes banks and other financial institutions will have excess cash, and in turn will lower the interest rate for customers. At some point when the financial meltdown got worse and we fell onto the Doomloop, central bank may have to regulate the cash flowing, so that the money will be distributed more to the consumers. At this time, customers will start to borrow again and banks may have to stricken their loans approval process. This is where P2P lending can become the choice for borrowers to go.
History showing that P2P Lending performed well during the last recession despite being in their infancy stage, and the nature of its business indicate this industry will be here to stay.
