Impacts of Social Lending on Financial Services Industry - Essay Example

Social lending has been disruptive to financial services for the last ten years in the United Kingdom. Characterized by direct borrower-to-lender association and contractual obligations between the two, social lending platform provides a mere adjudication and intermediation. One of the key functions of financial institutions is to mitigate problems associated with adverse selection. Overtime, lenders obtain adequate private information about their potential borrowers (Fama, 2013). The lender is capable of selecting a loan customer who bares the lowest rate of defaults from publicly available information and the private information altogether. Therefore, lower average defaults help in the reduction of the lending costs. In social lending groups, the group leader is the final arbiter of the person that should receive a loan. The group leader may on some occasions require an individual to provide additional private information beyond the normal requirements, thus, forming an analogous form of information collection compared to the role played by financial institutions intermediaries in mitigating the effects of adverse selection.

However, in social lending, groups are not monopolistic because of the wider membership composition. Therefore, some group leaders may be more devoted in the collection of more private information of the borrowers than others may. It is for this reason that the necessity for group categorization to reveal their participation in monitoring and screening effort is paramount. Public lenders have high chances of emerging winners than private lenders in the bidding auction due to the steep competition in the market between the two. Since public lenders have reduced chances of facing adverse selection from the borrowers, the interest rates are likely to go down (Hauswald and Marquez, 2010). In addition, the presence of stiff competition associated with online auction may lead to a lack of sharing of borrower's surplus between the investors, which may result in a reduction in the costs of lending due to a decline in the default risk. This is possible because the risk is usually passed to the borrower in the form of relatively lower interest rates (Boot and Thakor, 2012).

Another key function of intermediaries in financial institutions is to mitigate moral hazard, which may arise because of irresponsible acts by the borrower upon receiving the loan proceeds. It is the role of financial intermediary to monitor the borrower to ensure that no prohibited contractual activities are taking place. In social lending, there is no effective monitoring mechanisms to ensure the borrower abides by the contractual agreement. Instead, the emphasis is laid on expulsion and shame to pressure group members to comply (Williams, 2011). Effective social punishment is based on the social relationships between the members of a group. The presence of market competition impacts adversely on the financial relationships, which in turn decrease credit costs as it is perceived that social connections help in improving repayment rates (Woolcock, 2012). In the event that a borrower defaults payment, he or she may only be subjected to social sanction punishment. The social sanctions may cause lenders to charge higher interest rates without increasing defaulting risks.

Zopa Social lending platform

Zopa is the world's first social lending service in the United Kingdom that was launched in 2005 (Ashta, 2010). Gaining much support from the award-winning experience from customers, Zopa platform connects borrowers and lenders directly. Its tremendous growth in the recent past is attributed to friendly competitive lending rates and returns, adjudication model and a seamless process of origin. It has since become the first United Kingdom's social lending platform and in 2014, Zopa achieved approximate default rate of 0.38%, which is much lower than the other financial institutions. The evolution of Zopa is because the traditional institutions were not offering quality financial services to the customers, evidenced through high-interest rates charged to borrowers, weak returns to investors, poor customer experience, and inefficient intermediaries. Further, the emergence of eBay created a good foundation for the formation of an online platform that enhances the connection between the borrowers and lenders (Ashta 2010).

Social lending has shown a tremendous growth and has become a main mainstream service in the financial sector. A prediction by financial analysts shows that the United Kingdom expects a total of about £4.3 billion loans originating from social lending and that Zopa is expected to have lent its second billion before 2016 elapses. Social lending is also expected to receive massive tax treatment in the form of inclusion returns on individual savings allowances and Innovative Finance ISA by the end of April 2016 (Information Resources Management Association, 2012). Apart from the tax treatment being favourable to social lenders, it will also boost the confidence of the social lending industry from the government, thereby helping in the creation of awareness of the industry. Projection shows that in the next five years, social lending will take up a majority lending with Zopa having around 40-50 percent of the unsecured personal loans in the financial market in the United Kingdom. However, the banking halls are not likely to be displaced since most banks have recognized the value added to the financial sector by the online lending firms, and are willing to enter into partnership agreements with these firms, for example, the existing partnership between Zopa and Metro Bank (Ashta, 2010).

The prevailing favourable economic conditions play a major role in the nourishment of the social lending in the financial sector. The improved consumer credit quality and a strong demand for economic and credit from borrowers have contributed to the growth of social lending. Therefore, the fundamental errors committed by the existing financial sectors have largely contributed to continued disruptions in the lending industry by the social lending platform. Firstly, failure of putting the customers at the core of their decision-making process and second, banks have focused on becoming everything to everyone (Kuratko, 2008). On the other hand, Zopa focuses on funding circle or consumer loans and business loans that create a better and more efficient solution, than those offered by banks. In addition, Zopa offers a superlative financial lending customer experience that is different from what is offered by banks, thus, offering a better agile technological platform for disruption of the financial markets.

However, there exist some challenges to social lending technology, as they keep up with the disrupting pressure. Being an online-only platform, Zopa has to keep up with the dynamical technological advancement in order to achieve best user experience and develop this business of social lending further (Ashta, 2010). This calls for the creation of a reliable and secure platform with enough room for improvement and innovation. In addition, more investment in hiring expert developers and recruitment of new CTO means that a lot of finances are needed. Moreover, Zopa is a relatively young initiative in the industry, and for it to tackle the challenges that come with social lending well, a number of proprietary technologies have to be developed, and more collaboration with well-established firms be enhanced.

In conclusion, this paper has outlined the history, basics, and impacts of social lending to the financial service industry. Social lending provides a platform in which the risk profiles and processes of lending are transparent to both lenders and borrowers. A borrower who feels underserved by the existing financial institutions such as banks can have easy access to loans offered by lenders. In addition, the diverse risk appetites of lenders are well met, thus the whole process helps in the reduction in the costs of the transaction. However, social lending is susceptible to moral hazards in which borrowers may default loan repayment that may result into losses, which may eventually lead to the collapse of businesses, especially for smaller investors. This also means that there is a limited guarantee on business investments. Social lending companies like Zopa are likely to replace all the personal finance functions of retail banks in the United Kingdom today because they have customer’s interest at heart. Zopa offers friendly competitive lending rates and returns, adjudication model, and directly connects borrowers to lenders, which has made it a popular initiative despite being relatively young.

Reference List

Ashta, A., 2010., Advanced Technologies for Microfinance: Solutions and Challenges. Hershey, PA: Idea Group Inc (IGI).

Boot, A.W., and Thakor, A.V., 2012. Can relationship banking survive competition? Journal of Finance, 55(12) pp. 679-713.

Brau, J., and Woller, G. 2009. Microfinance: A comprehensive review of the existing literature’, Journal of Enterprise Financials. Business Ventures, 13(2) , pp.1-26.

Fama, E. F., 2013. What’s different about banks?’ Journal of Monetary Economics, 15(10), pp. 29-39.

Gorsky, M., 2012. The growth and distribution of English friendly societies in the early nineteenth century. Economic History Review, 51, pp.489-511.

Hauswald, R., Marquez, R., 2010. Competition and Strategic Information Acquisition in Credit Markets. Review of Financial Studies, 19, pp.967-1000.

Hollis, A., and Sweetman, A., 2011. The life-cycle of a microfinance institution: The Irish loan funds. Journal of Economics, 46(4), pp. 291-311.

Information Resources Management Association (IRM)., 2012. E-Marketing: Concepts, Methodologies, Tools, and Applications: Concepts, Methodologies, Tools, and Applications. Hershey, PA: IGI Global.

Jaffee, D.M., and Russell, T., 2011. Imperfect information, uncertainty and credit rationing’, Quarterly Journal of Economics, 90(13), pp. 651-666.

Kuratko, F. D., 2008. Entrepreneurship: Theory, Process, and Practice. Mason, OH: South-Western Cengage Learning.

Potter, H.C., 2010. Savings and loan associations and the consumer interest. American Journal of Economic Sociology, 13(4), pp. 191-203.

Santos, J.A., and Winton, A., 2011. Bank loans, bonds and information monopolies across the business cycle. Journal of Finance, 63(10), pp.1315-1359.

Schenone, C., 2010. Lending relationships and information rents: do banks exploit their information advantages? Review Financial Studies, 30, pp.1151-1199.

Stiglitz, J. E., and Weiss, A., 2012. Credit rationing in markets with imperfect information. American Economic Review, 71, pp. 393-410.

Williams, T., 2011. Requiem for microcredit? The demise of a romantic ideal. Banking Finance Law Review, 19, pp.145-198.

Woolcock, M., 2012. Microenterprise and social capital: A framework for theory, research, and policy. Journal of Socio-Economics, 30(6), pp.193-198.