Lenders and borrowers are circumventing banks

On the Money
From the August 4, 2006 print edition

Commercial banks play an important role in the financial system and the economy.

Although it may not always appear this way, banks don’t create money. They simply allocate funds from savers to borrowers, and reward themselves for this matchmaking effort by loaning the money they receive from savers at interest rates higher than they pay to the savers (the spread), and charging fees for their connection services.

A quick glance at The Wall Street Journal reveals that as a saver, you’ll receive about 5 percent on a one-year savings deposit. On the other hand, as a borrower, you get to pay 13 percent on an average credit card. The 8 percent difference is commercial banking’s matchmaking fee.

Banks also provide specialized financial services, mostly information about both savings and borrowing opportunities. They key word is “information.”

We’ve been living in the Information Age for awhile now. Electronic devices, high-speed telecommunication lines and the Internet have made Alvin Toffler’s “Future Shock” a reality. A simple search on the phrase “borrow money” yields 6.1 million Web site references.

Even in the face of this overwhelming information, a new form of banking has emerged, called “peer-to-peer banking.” It removes most of the middleman from the process of linking savers to borrowers.

One example is a United Kingdom company called Zopa, which is an acronym for Zone of Possible Agreement. In banking, the “ZOPA” is the overlap between one person’s bottom line for what they’re prepared to receive and another person’s top line for the most they’re prepared to give.

Formed in March 2005, Zopa’s service is open to any U.K. resident over 18 who passes a credit check. Rather than participate in “the spread,” Zopa takes a 1 percent commission from every borrower’s loan.

Since the site’s debut in March 2005, more than 23,400 people have joined. “Some people hate their banks and want to borrow from real people,” CEO Richard Duvall says. Zopa expects to begin operations in California before year-end.

Another example is “Prosper,” which calls itself “America’s first people-to-people lending marketplace.” It was created to make consumer lending more financially and socially rewarding for everyone.

It operates similarly to eBay. Instead of listing and bidding on items, people list and bid on loans using Prosper’s online auction platform.

People who want to lend set the minimum interest rate they’re willing to earn and bid in increments of $50 to $25,000 on loan listings they select. Borrowers create loan listings for up to $25,000 and set the maximum rate they’re willing to pay.

Then the auction begins as lenders bid down the interest rate. Prosper then takes the bids with the lowest rates and combines them into one simple loan. It also handles all loan-administration tasks, including loan repayment and collections on behalf of the matched borrower and lenders.

Prosper generates revenue by collecting a one-time 1 percent fee on funded loans from borrowers, and assessing a 0.5 percent annual loan servicing fee on lenders.

These companies hope that by eliminating the middleman — namely banks — individual lenders earn a higher rate of interest and borrowers get a lower rate than typically would be available from traditional financial institutions.

Users of these sites may have non-financial personal reasons for becoming involved. “I am fascinated by the concept, [and] hate big corporate banks …” writes one Zopa user.

The fervently capitalistic appear to be better represented on Prosper, which offers lenders a wider range of risk and return. Interest rates for loans funded through Prosper range from 7.32 percent (low-risk) to 24.04 percent (high-risk) — not too far from the rate charged by credit card companies.

Zopa, on the other hand, offers less risk and less return, claiming an average gross return of 7 percent. It reduces risk by automatically spreading lenders’ money across 50 borrowers. On Prosper, lenders can form groups, but they have to manage the process themselves.

Another — perhaps even more important — aspect of peer-to-peer banking is sociological. The personal preferences of individuals are far more exposed in the peer-to-peer environment, leading some to call the practice “social financing.”

The value of social financing as a stable investment vehicle remains unproven. But the ability of specialty-oriented groups to offer discount loans to members of their respective communities has obvious advantages over the impersonal, institutional lending practiced by banks. Specialty-directed lending gives groups the financial muscle to advance their goals.

Prosper, for example, hosts a group called Christian Opportunities, which says it’s “dedicated to helping borrowers and lenders of any denomination invest in their future.” There’s also the more cult-oriented Apple User Group, which bills itself as “a lending group for those wishing to purchase either a Macintosh or Apple iPod.”

© C. Stephen Guyer for American City Business Journals Inc. All rights reserved.