Head in the sand

Social networking sites like Facebook, MySpace and Bebo have exploded in popularity over the last eighteen months, with users quickly acquiring hundreds of online friends – but are they be prepared to
lend them money? Duncan Jefferies examines the threat posed to traditional retail banks by peer-to-peer lending websites and asks if banks are blind to a looming rival?

Social lending companies allow people to both lend and borrow money to each other via a web-based platform. They aim
to offer better rates by cutting out the middle-man – namely, traditional banks. Just how aware are High Street institutions
of these new rivals?

The number of such websites has more than doubled in a year with serious venture capital investment now going into firms,
such as Zopa, Prosper, and Lending Club. Virgin USA’s recent acquisition of CircleLending, has further highlighted the potential
of this fledgling industry.

Gartner is predicting that by 2010, social banking platforms will have captured 10 per cent of the available worldwide market for retail lending and financial planning. However, as David Furlonger, managing vice president at Gartner, also admits the business these sites are currently taking away from traditional financial institutions is relatively insignificant. “The volumes that are going through these sites at the moment are nothing compared to the overall volume of bank lending in the retail space,” he says. “But
that shouldn’t detract from its potential, or the fact that it might grow dramatically quickly.”

So is social lending a proven business model? “These sites, no matter how comparatively embryonic they are, have proved that
they can actually work,” says Furlonger. “There are obviously people out there who are prepared to lend, and there are people
out there who are prepared to borrow.”

Zopa claim consumers enjoy interacting with social lending websites and taking advantage of their low rates, but that there is still
a way to go before the market reaches maturity. “What hasn’t been proven yet is whether or not businesses such as ourselves
can scale to the state where we become profitable entities [that can challenge traditional banks],” says Giles Andrews, managing director and co-founder of Zopa. “I certainly believe though that we are very much heading in the right direction and it’s only really
a question of time before we are able to prove our bona fides.”

Several social lending companies have formed alliances with mainstream financial services providers. When money is transferred into Zopa, for instance, it is put into a segregated Royal Bank of Scotland account and held there until it is passed on to the borrower. All interest paid on the money held in this account is given to the lender and it does not form part of Zopa’s assets,
which means that in the unlikely event of Zopa going out of business, the lender’s money is safe.

However, any internet-based business clearly faces more security risks than your average High Street bank. “A lot of these sites are fairly new and may still be finding their feet with regards to legislation,” says Graham Cluley, senior technology consultant at the vendor, Sophos. “Obviously with these companies being globally accessible, some may be operating in a manner in one country that isn’t considered safe, or perhaps even legal, in another.”

Cluley believes extra caution must be exercised by consumers when using online financial services. “Even if people don’t list their full identity on these sites, they may leave enough clues for a criminal to identify them by,” he says. “Offering money, or even asking for it, could put you at risk as you may appear to be a good target for scams.”

Although most social lending sites provide security controls and guidance for lenders, there is nothing to stop people disregarding these, which could prove a costly mistake. “An insurance company, should you try to make a claim for identity theft, may well say that you acted irresponsibly if you haven’t followed the guidelines provided,” says Cluley. “It’s the equivalent of having house insurance and leaving all the windows and doors open and putting a sign in your front yard saying, ‘I’m on holiday for two weeks.’”

To counteract these concerns Prosper claims it operates a com-prehensive ID theft guarantee. “We’ve been pretty successful
in stopping it and, when we have caught it in a few cases, prosecuting the criminals responsible,” says Chris Larsen, CEO and
co-founder of Prosper. “The identity checks that a borrower or lender goes through with us are pretty similar to what you would expect from an online bank,” he adds.

High-street banks have established reputations and any person dealing with them can be pretty sure their money and personal details are safe and secure (Northern Rock customers aside perhaps). “Love them or hate them, people generally trust the banks not to disappear or lose their money,” says Zopa’s Andrews. “They might pinch a few extra fees or profiteer in some way, but people know they will still be around.”

Operating model and regulation
To reduce risk, Zopa lenders only lend small chunks to individual borrowers. For example, someone lending £500 or more would have their money spread across at least 50 different people. Contracts between borrowers and lenders are also legally binding
and all borrowers are subject to identity and credit checks. “CallCredit provide us with data, as do Equifax and Experian,” explains Andrews. “We also provide information on our customers’ behaviour to the credit reference agencies in the same way that traditional banks do. So if someone defaults at Zopa, it has the same implications for their credit rating as it would if they did it to Barclays bank.”

Zopa is regulated by the Financial Services Authority and Office of Fair Trading in the UK. Its bad debt numbers have so far been much lower than expected – less than 0.1 per cent across the whole portfolio of loans written since the company launched three years ago. Admittedly this is on a much smaller customer base but the default ratio is still better than most banks.

“We worked hard to get regulated in the UK, and it took us over a year to get regulated in the US,” says Andrews. “One of the things that prevents us from launching a new Zopa in every country around the world is that the regulations in each one are completely different. You have to tailor the business model accordingly, hence why we have a different business model in the US to the UK.”

Since the credit crunch last summer personal loan rates have gone up, potentially creating a favourable economic climate for social lending sites. “The credit crunch is a big opportunity for social lending,” claims Prosper’s Larsen. “Even people with great credit can’t get loans these days. I think social lending sites are now considered a viable, safe place to get a better deal from.”

How to respond
Gartner advises banks against trying to replicate their own social lending platforms, suggesting that they instead identify opportunities for partnerships and provide capabilities, such as transaction processing and risk management, that are often lacking in social lending companies. “The last thing they should do is set up their own platform because it is almost diametrically opposed to the idea behind social networks,” says Gartner’s Furlonger. “The last thing people using a social network want is some kind of big brother corporate entity imposing their will on it.”

Banks should also be using business intelligence and customer analysis tools in order to monitor changes and developments in
the social lending market. “They have to make some decisions around the value proposition - are these sites going after the kind of customers that the banks actually want and can make money from? I don’t think they’ve really asked themselves that question yet,” Furlonger adds.

According to Zopa’s Andrews, the banks and other traditional financial institutions are well aware of social lending networks and their implications. “They’re probably doing the right thing commercially, which is to ignore us for now,” he says “I’ve heard of some high level discussions taking place among traditional players, but I don’t know what they’re planning to do long-term in terms of any response. Some people say, ‘Why don’t banks launch social lending businesses themselves?’ But I just don’t think that they can.”

More social lending companies will undoubtedly be launched over the coming months. “It wouldn’t surprise me to see more well known companies come into the market as it grows and gets increased traction,” says Prosper’s Larsen. “We think because it’s such a new market that’s actually good for us because it legitimises the industry.”

Those already in existence are working to develop the core fundamentals of their business – security, trust, brand recognition, depth of book, and efficiency of process. “The honeymoon period is over,” says Gartner’s Furlonger. “The hard work of building
the business after the hype of being a new phenomenon needs to happen now.”

It is yet to be seen just how many social lending websites the market can actually support, but consolidations and clear winners
are likely to emerge as time goes on. “It’s only got to the first stage at the moment,” says Prosper’s Larsen. “The next stage is really about taking it mainstream, making it the place where you go both as a borrower and as somebody who wants to make a return before you go to a traditional bank.” It will be interesting to see if Gartner’s prediction of a 10 per cent market share for social lending companies by 2010 comes true. Watch this space.