Should Your Friend Be Your Banker? Digital Models Test the Waters

Lending to and borrowing from family or friends can either be easy, or terribly complicated. On one hand, when lending to those in your own social network, you often know your customer better than any financial institution knows them. On the other hand, once you do decide to give friends or family a loan, the decision isn’t just made on your view of their credit worthiness, it may also be based on subjective factors - for example, a sense of obligation or a need to avoid conflict. Following up for repayments may be even more precarious, as memories of lending agreements differ, interest rates are not taken seriously, or personal history colors the transaction - ‘remember when I helped you with your house move?’ 

As a result of these factors, people may become more hesitant to lend, which is particularly unfortunate for the underbanked. For them, family and friends could represent a promising source of reasonably priced finance, as compared with financial institutions which either won’t lend or lend at exorbitant rates with delayed processes to make up for the asymmetry of information.

Technology is changing this equation. With the advent of smartphones, combined with a rapid increase in engagement with online social networks, new digital platforms are emerging that make it easier to lend and save within a broader social network. These models rely on a person-to-person approach and utilize innovative new forms of information (including your social networks) to enable lending decisions.

A recent study by CGAP identified three Person to Person (P2P) business models that could be applicable to underbanked populations in developing countries and help them move up the financial ladder:

1. Digitizing social credit
2. Group savings
3. For-profit P2P credit marketplaces

Digitizing social credit

Online platforms such as Lendfriend and Lending Karma help mitigate the social complications of credit transactions with friends and family. Specifically, they digitize them and allow you to make them legally binding. The interest rate and repayment schedule is entered online by the borrower and proposed to a lender, and parties can choose to add collateral. Then, a digital promissory note is signed. Repayments are made as per the decided schedule, often through Paypal.

Although most of these deployments operate in the USA, there is potential for these services in developing countries where informal credit transactions with friends and family are large in volume.

Group savings

Rotating Savings and Credit Associations (ROSCAs) enable members to meet their own financial goals through a pot of savings received by each member on a rotating basis. Platforms such as eMoneyPool in the USA have digitized this well-known and traditionally informal model to add security and convenience, as well as broaden members’ reach beyond existing social networks. Testament to the potential of the business model, eMoneyPool has ensured a 99% repayment rate for over $760,000 worth of funds transacted since late 2012. Digitization allows transparent accounting, and creates additional pressure through convenient P2P electronic communication facilities and automated reminders for timely payments. It enables payments online or through mobile money, eliminates the need for proximity of group members and allows you to expand your ROSCA beyond your direct networks (as Puddle does, in the USA). Chama Pesa in Kenya is providing a similar service using cell phones and M-PESA.  

For-profit P2P credit marketplaces

When borrowing from and lending to individuals in your social network is too complicated, borrowing and lending from the broader market may be a better option. For-profit P2P credit platforms are enabling people to do just that. These open market P2P credit platforms are growing fast. Since 2010-11, they have emerged across Latin America and Asia to try and replicate the success of the Lending Clubs and Zopas of the developed world. They facilitate affordable, unsecured, small-size loans between individuals, and sometimes between individuals and financial institutions. By eliminating banks from the transaction, borrowers are able to access loans for which they would otherwise be ineligible, or charged prohibitively high interest rates. On some platforms, interest rates are decided through lenders bidding for borrowers (i-lend and Faircent in India, Afluenta in Latin America), whereas others have prescribed interest rates based on borrower risk profiles (e.g. Kubo Financiero in Mexico).

Borrowers using for-profit P2P credit platforms are often repeat borrowers, developing a credit history over time. This allows them to access increasingly cheaper loans on P2P platforms. In addition, platforms like Afluenta are already developing mobile applications and anticipate the bulk of their users to be accessing their platform via mobile in the future. 

Volumes are growing: Lending Club, set up in 2007, has processed over $6 billion worth of loans since its founding in 2007. Latin America could offer a unique opportunity for the growth of these platforms as personal loan interest rates can be very high. For example, banks in Chile sometimes charge over 50% interest rate for small personal loans, and in Argentina, the effective financial cost of a personal loan can cross 65% annually when added fees and administrative expenses are accounted for. P2P platforms like Afluenta may offer refreshing competition in this sector by charging closer to 35-40% APR on small personal loans.

Some players are still refining risk algorithms to figure out how to lend intelligently on these platforms. These businesses are developing credit scoring techniques by supplementing credit bureau and other personal data with information from online footprints such as social media use, credit card activity and online browsing history. Even though in these cases customers are not borrowing from friends, how they behave within your social networks, for example, is forming part of the lending decision.

In some countries, regulators may be skeptical of their legality and try to constrain their operation, such as in Chile. Greater penetration of these models into developing country markets remain unproven, but the building blocks of online social networking, electronic payments as well as smartphone and mobile data proliferation point to significant potential.

The three categories of P2P business models described above may offer powerful new benefits to poor unbanked populations, as long as potential risks such as data privacy and consent considerations are also identified and appropriately addressed. And exciting as these early trends are, there could be an even larger inclusion play on the horizon: massive social networking companies such as Facebook, Weibo and Twitter are experimenting with payments. If this came to pass, a financial service provider would conceivably exist that knows who your friends are, your day-to-day movements, details of previous electronic transactions, and who you have lent to or loaned from. This information is richer than what most traditional banks have when opening an account. Today’s P2P platforms can feasibly collect all this information described above. That is a compelling set of digital data on which to form a meaningful banking relationship at a fraction of the cost of alternative models today.