umarsaeed

Being a Bank

In Financial, Fresh on March 4, 2014 at 4:31 PM

Banking is the best business in the world. People give you money, trusting you to keep it safe. In exchange, you pay them a tiny amount of interest. You then have the right to lend a portion of that same money and charge a higher interest rate, keeping the difference as profit.

This scheme is the backbone of every economy in the world, which means the government is often willing to backstop the scheme and take risk away from the banks. Because of this, some people consider the business of banking as guaranteed profit. However, if you actually try starting a local bank/trust you’ll quickly learn about some significant barriers to entry – the first one being that you need a lot of capital.

That is all changing right before our eyes with something called peer-to-peer (P2P) banking. Ultimately, it is a service that allows people with savings to lend to people who need a loan without involving the traditional banks. By lending your money to others through such a service, you can collect more interest on your deposits while the borrower still receives a competitive rate of interest.

P2P banks operate fairly similar to traditional banks, but they are structurally much leaner. Your investment will often be carved up, then pooled together with others and spread across several different loans. By mixing and matching, P2P banks are spreading the risk of default across several loans so that one unlucky investor does not lose his/her entire investment because of one bad apple. This risk is pooled and shared. As the premise of P2P banks is to match lenders with borrowers, they have the chance to match the duration of the investment with the duration of the loan. In other words, much like a GIC certificate you can’t simply withdraw your funds on demand (without consequences). This ensures P2P banking stability. It prevents a run on the bank that would likely collapse such organizations if investors demanded their money at once.

Currently, P2P banks offer interest rates around 4%-5% to lenders. This is an extremely good rate of return, assuming that the risks of P2P banking are similar to traditional banking. If we were to compare P2P loan for five years (4.9%) to a GIC offered by a traditional bank (less than 3%), there is a substantial disparity in the interest earned. Why?

When you deposit your money at a traditional or chartered bank, your deposit is guaranteed by the federal government up to $100,000. That means the bank pays for deposit insurance and passes that cost to you by paying you less interest on your money. There is no such guarantee with P2P banks. However, many of them have a “reserve” fund, which acts like self-insurance. They set aside rainy day money because they know that someday in the future they will need to absorb a bad loan on behalf of all investors. Having such a mechanism is key to a successful banking operation and should comfort investors. This does not explain the disparity between what the GIC pays versus what the P2P loan investment pays.

One potential explanation for why P2P loans pay such high interest rates is that your money is being lent to non-creditworthy people. Perhaps these borrowers have already extended their credit and you’re their last ditch attempt at making things right with their other creditors. Before investing your money with a P2P bank, it’s important to understand how they assess creditworthiness. Some P2P banks do target higher risk borrowers because they charge much higher rates of interest. However, the P2P banks have access to the same system of credit as the big banks that allow them to make similar judgments about borrowers. Here, we should recall why the banking business is so great in the first place.

There are always bad apples in the basket. That fact alone has never precluded a bank from being profitable. Provided the losses from these bad apples are shared across the profits of all the good apples, it’s really just a predictable cost of doing business. For the most part, P2P banks have boasted a good track record for collecting its loans from its borrowers and protecting their client investments. However, this is still a relatively new concept with a limited track record. It would be nice to see how the P2P banks perform during tougher times.

Nevertheless, this is an extremely intriguing proposition to unsophisticated investors. The P2P market is growing fast but remains tiny in the grand scheme of things. As it grows, it will force traditional banks to be more competitive with their interest rates in order to keep your savings. This idea has picked up steam in the U.K. and the U.S. but Canada has no comparable P2P service to match lenders with borrowers. It’s an appealing proposition to invest in something where you actually know where your money is and what it’s being used for. The risk and returns of your investment are known and its a proven business. Why invest in stock markets when you can be a bank?

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