Peer-to-peer lending currently accounts for a tiny fraction of the total loanbook, but this could begin to change as the number of available platforms multiplies.

Demand for alternatives to bank lending

With banks charging an average of 18% for borrowing through overdrafts or credit cards, it's no surprise that consumers are looking around for cheaper sources of finance. At the same time savers are earning a pathetic return, and in some cases are prepared to take more risk to improve income. Could peer-to-peer (P2P) lending be a mutually beneficial solution?

Possibly, but it has to be approached with caution as P2P lending is not regulated and there's no guarantee you'll get your money back. From the borrower’s point of view P2P could be a good source of finance for small projects or to carry a person over a difficult patch. But the interest rates may not be much lower than you would find at a commercial bank. The advantage is that personal lenders may consider a loan of only a few hundred pounds where a bank would not be interested.

Zopa

P2P lending originated in the US, where it is an estimated to be worth $1 billion, with loan volume in 2012 expected to triple as banks continue to tighten their policies. Zopa is the highest profile P2P lender in the UK and has been around since 2005.  

To reduce the risk to lenders Zopa checks potential borrowers’ credit files and puts them into risk categories. Lenders decide how much they want to lend, at what rate and to which category of risk.  

To keep risks manageable Zopa will only lend small amounts to individual borrowers – so this isn’t really a replacement for a bank loan. A lender offering £500 or more would have their money spread across at least 50 borrowers, who enter into legally binding contracts with their lenders. If repayments are missed, a collections agency uses the same recovery process as the high street banks. Zopa’s cut is a £130 transaction fee and a 1% annual servicing fee to lenders. 

However, Zopa is unregulated and lenders have no comeback if a borrower defaults, other than taking the borrower to court. This is not likely to be practicable since if borrowers were financially sound they probably wouldn’t be borrowing in this way in the first place. Zopa says the average return on loans over the past 12 months has been 6.5% net of charges, but not bad debts.

Other portals

FundingCircle.com is an online portal where investors can make loans directly to small businesses in sums as small as £20 to spread the risk. The average return is around 8.4%, according to the firm. The problem is getting your money back, as these loans may not have a fixed term. Loans can, however, be sold to other investors to realise your cash. 

Another website that puts wealthier investors and small businesses in touch is ThinCats.com. Lenders set their interest rates and make their investment decisions. Borrowers can get loans between £50,000 and £1 million at fixed rates of 7-15% for six months to five years. All ThinCats loans are backed by debentures or personal guarantees to a similar standard that a bank require. The minimum investment is £1,000.  

Developments in the US

P2P websites in the US such as Wikiloan.com admit that the majority of their potential borrowers would not pass conventional credit checks. ‘More than 85% of users applying for peer-to-peer loans are not credit worthy,’ says Marco Garibaldi, chief executive of Wikiloan.com.   

P2P lending is growing fast with many different models. Lendingclub.com, for example, lends mostly to those who are a good credit risk and would qualify for a bank loan anyway. Prosper.com brings together creditworthy borrowers with individual and institutional investors. Its results for September 2011 showed a 367% year-on-year increase in loans. 

Much of this growth is driven by the banks’ clampdown on riskier lending, and some is idealistically motivated. Prosper makes no secret of its support for the Occupy Wall Street demonstration, which seeks to break the hold of banks over the US administration.  

An end to the banks' stranglehold?

Converts believe technology will mean that P2P lending could eventually break the stranglehold that the banks have over consumers. Others say online retail services companies – such as Amazon, eBay, PayPal, Facebook, Twitter, Google and others that are already trusted brands – will provide all the front-of-house customer services and banks will simply handle the money transmission and products. The advantage of this is that online retailers do not have legacy computer systems that need to be replaced, and there could be a real incentive for the banks to partner with these brands.

At the moment there is no real competition for traditional bank borrowing, but that will almost certainly change. However, half the UK population has an overdraft, which means they can neither take their account elsewhere nor borrow cheaply, so the banks have us over a barrel. They will be around for a long time yet – however much we dislike them.