How to Reduce Risk in Peer-To-Peer Lending

CUHK research reveals the tactic used by default lenders in Chinese online lending platforms

By Jaymee Ng, Principal Writer, China Business Knowledge @ CUHK

Peer-To-Peer (P2P) lending emerged in China in 2007. The micro financing method enabling borrowers to connect with individual lenders directly originated in the U.K. Since 2007, China’s P2P lending industry has soared rapidly and peaked at 2,804.8 million RMB in 2017, thanks to the relatively lax regulations. However, in mid-2018 since the Chinese government tightened the credit market and vowed to curb the lending risks through its national P2P rectification campaign, the P2P industry started crumbling with many platforms reporting high default rates. Some of the collapsed platforms which didn’t provide clear information of either the lenders or the borrowers were likely nothing but Ponzi schemes.

According to Home of Online Lending, a platform which complies the data of Chinese online lending platforms, 5,245 platforms have suspended their businesses or reported to be in ‘trouble’ as of the end of November 2018. Angry P2P lending investors have taken to the streets after some platform owners allegedly ran away with their money. The banking regulator issued a warning to savers that they should be prepared to lose all their money in high-yield products.

Despite the ongoing crisis, some 1,181 platforms are still operating in the country.  Yet, industry experts expect many more to be forced out when Chinese officials issue licenses to platforms that meet their strict criteria next year. It is estimated that no more than 200 companies would still be operating in three years.

While China continues to clamp down on scams and financial risks from these platforms, some consumers, especially small businesses, continue to rely on them. How can consumers protect themselves from fraud? Are there any signs given out by poor-quality borrowers? A recent research by Prof. Maggie Hu from The Chinese University of Hong Kong (CUHK) Business School has revealed some answers.

“We find strong evidence that poor-quality borrowers obtain more certificates to boost their credit profiles and improve their funding success rate,” says Prof. Maggie Hu, Assistant Professor of Real Estate and Finance at CUHK Business School.

The Study

In the study entitled “Adverse Selection and Credit Certificates: Evidence from a P2P Platform”, Prof. Hu and her collaborators studied the role of certification in ensuring investment efficiency using the data from Renrendai, one of the largest and earliest P2P lending platforms in China.

Using a web crawler programme, they gathered a sample of 799,852 loan listings on the platform from October 2010 to January 2016. The team then divided the entire sample into three groups based on the number of certificates, the average funding probability and interest premium of each group.

Important Certificates Boost Credit Grades

Certification is essential for borrowers to apply for loans on P2P platforms. Since the procedures are all carried out online, lenders tend to choose borrowers based on their certificates. Theoretically, certification should help investors make better judgements in deciding whom to fund.

“Lenders often remain attracted by higher certificates despite lower interest return ex-ante and higher default ex-post, which results in distorted capital allocation and investment inefficiency,” she says.

On Renrendai, there are 21 types of certificates in total and 12 of them are considered important, including identity card and income information, occupation, car and property ownership proofs, etc. Borrowers can also provide other proofs that are not regarded as important such as marital status, education and social media accounts. The platform categorizes all borrowers into seven different credit grades (AA, A, B, C, D, E and HR). According to the study, one additional important certificate can increase funding odds by 88.3 percent.

If a borrower wants to improve his credit grade, he needs to provide more certificates. To increase the number of certificates, he only needs to upload certain document proofs online for verification, which is relatively easy to do.

“Most lenders on P2P platforms are inexperienced retail investors who tend to regard certificates as positive signs for quality due to conventional wisdom. Therefore, they are more willing to invest in borrowers who display a higher number of certificates.”

Prof. Maggie Hu

More Certificates, Better Credits?

So one may assume the more certificates, the better the credit. However, the study reveals that loans with more certificates in fact have a higher hazard of delinquency.

In general, an additional certificate will increase the default probability by 7.8 percent and an additional important certificate will increase the odds by 22.6 percent. The effect is particularly strong among borrowers with low credit grades.

“In this group, an additional certificate and important certificate will increase the default probability by 180 percent and 174 percent respectively,” says Prof. Hu.

Certificates on this platform are unable to serve their proper signalling role, as they fail to distinguish the good from the bad, resulting in losses of both lenders and high-quality borrowers.

“This leads to platform inefficiency; specifically, lenders take more risks without being compensated and high-quality borrowers experience an exaggerated low funding probability,” Prof. Hu warns.

Not only do certificates fail to serve as an accurate signal in the RRD platform, they also significantly distort credit allocation. So why can’t lenders identify bad investments? Why does this distorted credit profile phenomenon exist?

“First, most lenders on P2P platforms are inexperienced retail investors who tend to regard certificates as positive signs for quality due to conventional wisdom. Therefore, they are more willing to invest in borrowers who display a higher number of certificates,” Prof. Hu says.

“Second, high-quality borrowers often display sufficient credit profile only and do not actively seek to upload more certificates to attract lenders because they are not be as desperate as low-quality borrowers for the loans,” she adds.

For low-quality borrowers, the benefits of having more certificates significantly outweigh the troubles of obtaining more certificates. It is natural for them to keep getting more certificates until they can successfully secure the loan. The situation is even more severe for those who intend to default from the start.

“Since these people have never planned to repay the loans, they are more likely to do anything just to boost their funding success rate,” she says.

Certificates Are No Guarantee

As for investors, if they decide to stay in the game, they should bear in mind a common saying: If something is too good to be true, it probably isn’t true.

“There is no guarantee that certificates are always associated with positive attributes and favourable outcomes. If signal observers are not sophisticated enough to recognize this nuance, and simply interpret certificates as a positive sign based on cognitive simplification, we will observe similar equilibria in other contexts where low-quality individuals are selected and favoured by means of mimicking high-quality individuals,” says Prof. Hu.

She also warns that borrowers need to be cautious when obtaining the certificates, even if they seem costless. The personal information provided at the early stage of a loan application will turn into a nightmare in the debt collection stage. “Yet, many borrowers have little consideration of how the information they have supplied could be used by debt collectors without realising it. This myopia behaviour of borrowers also contributes to the inflated credit profile phenomenon,” she says.