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Peer-to-Peer Lending: An empirical study of the requirements for a trusted online peer-to-peer lending platform in the Netherlands. This thesis focuses on three areas within the online p2p -lending services:
1) The need of trust in financial services;
2) The importance of peer-production structures in p2p-lending; and
3) The need of new government imposed banking regulations for p2p-lending.
This study explores patterns of trust and identifies variables that contribute to trust or decrease the level of trust in financial services. It aims to identify causal relations among the identified variables that contribute to a tangible and measurable equation for trust in p2p-lending.
Peer-to-Peer Lending: An empirical study of the requirements for a trusted online peer-to-peer lending platform in the Netherlands. This thesis focuses on three areas within the online p2p -lending services:
1) The need of trust in financial services;
2) The importance of peer-production structures in p2p-lending; and
3) The need of new government imposed banking regulations for p2p-lending.
This study explores patterns of trust and identifies variables that contribute to trust or decrease the level of trust in financial services. It aims to identify causal relations among the identified variables that contribute to a tangible and measurable equation for trust in p2p-lending.
Copyright:
Attribution Non-Commercial (BY-NC)
Verfügbare Formate
Als PDF herunterladen oder online auf Scribd lesen
Peer-to-Peer Lending: An empirical study of the requirements for a trusted online peer-to-peer lending platform in the Netherlands. This thesis focuses on three areas within the online p2p -lending services:
1) The need of trust in financial services;
2) The importance of peer-production structures in p2p-lending; and
3) The need of new government imposed banking regulations for p2p-lending.
This study explores patterns of trust and identifies variables that contribute to trust or decrease the level of trust in financial services. It aims to identify causal relations among the identified variables that contribute to a tangible and measurable equation for trust in p2p-lending.
Copyright:
Attribution Non-Commercial (BY-NC)
Verfügbare Formate
Als PDF herunterladen oder online auf Scribd lesen
An empirical study of the requirements for a trusted online
peer-to-peer lending platform in the Netherlands
Student name: Syb Groeneveld Course: Thesis Executive MBA in International Business at MSM Student number: 26693 Title: Peer-to-Peer Lending Supervisor: Prof. Dr. Weixin Huang Date: 08 August 2011
This paper was submitted in partial fulfillment of the requirements for the Master of Business Administration (MBA) degree at the Maastricht School of Management (MSM), Maastricht, the Netherlands, August 2011.
Copyright, Syb Groeneveld, Amsterdam, 2011
This publication is licensed under a Creative Commons Attribution - Non Commercial 3.0 Netherlands License You are free to share, to copy, distribute, adapt and transmit the work under the following conditions:
Attribution: Correct mentioning of the author (Syb Groeneveld) Non commercial: You may not use this work for commercial purposes.
For more information please visit: www.creativecommons.nl
- i -
The best time to plant a tree is twenty years ago. The second best time is today. [Chinese proverb]
In the summer of 2005, I attended a summer school on Internet Law and the Future of the Internet at Harvards Berkman centre for Internet and society. I was invited to attend after I co-founded Creative Commons in the Netherlands: a license system for copyrighted material. At Harvard, I followed classes from some of the most acknowledged professors on Internet related subjects including Lawrence Lessig, William Fisher, Yochai Benkler, Jonathan Zittrain, Charles Nesson and John Palfrey. It was an elevating experience that introduced me to conceptual models that explain how Internet fundamentally alters our society. It taught me how computer codes determine new laws, how free speech relates to the infrastructure of the Internet, how the networked economy defines new production modes and how all these aspects influence the future of the media. Im still building on that knowledge.
Four years later, I started my MBA study at MSM. At that time, I was still living in Moscow. The lecture weeks in Maastricht were a nice and often inspiring break from day-to-day business in Russia. The diverse group of classmates made it fun to discuss life, politics and business in a relaxing atmosphere where we agreed to disagree most of the time.
I am grateful to (former) MSM staff and faculty members Aad van Mourik, Bruce Schneider, Ellen Narinx, Frank de Langen, Frdrique Franssen, Jean Verhardt and of course my supervisor Weixin Huang for their contributions to make this study meaningful and at times even entertaining.
Since July I have spend many long days in the Openbare Bibliotheek Amsterdam. An amazingly beautiful building that shaped the right conditions for me to set the framework for this research. The ten days in the South of France at Eva and Gert-Jans house Lou Mouli san Farino gave me the right surroundings to finish this work.
But none of this would have been possible without the understanding, the support and the love of my wife Tanja and our two children Ilan and Luca.
Thank you all!
Syb Groeneveld St Jean de Barrou, France, 08 August 2011
ps: You can contact the author of this study for any questions or comments via syb@sybski.ru
- iv - ABSTRACT Peer-to-peer lending (p2p-lending) platforms facilitate financial transactions (lending and borrowing) between individuals without the intermediation of a traditional financial institution. It is an unsecured decentralist financial service. P2p-lending platforms offer lenders the potential to earn higher returns than conventional banks and may offer borrowers broader access to credit. Although researched on a case-by-case basis by Herzenstein (2008), Freedman (2008) and Berger (2009) little has been written until now about the fundamental shift p2p-lending causes in terms of regulation, trust and user centred financial services .
This thesis therefore focuses on three areas within the online p2p -lending services: 1) The need of trust in financial services; 2) The importance of peer-production structures in p2p-lending; and 3) The need of new government imposed banking regulations for p2p-lending. This study explores patterns of trust and identifies variables that contribute to trust or decrease the level of trust in financial services. It aims to identify causal relations among the identified variables that contribute to a tangible and measurable equation for trust in p2p-lending.
This framework is tested via qualitative research and empirical observation and the collection of data via a comparative case-study analysis of two leading p2p-lending platforms (Zopa and Prosper) and a quantitative Internet mediated survey of 102 respondents. The major research question: What are the regulatory and the market requirements to co-create a trusted online peer-to-peer lending platform for consumer credit in the Netherlands? is derived from the conclusions to seven minor research questions. Based on a trust model that encompasses four dimensions (reliability, openness, competence and concern) eight variables are identified that can be measured on a scale of 1 to 10. This results in the following ROCC trust equation for p2p-lending: The study concludes that: 1) The minimum acceptable level of trust in a p2p-lending platform in the ROCC formula should at least be a score of 48. 2) Despite the credit, operational and legal risks associated with p2p-lending, the government should only play a moderate role to regulate and control the sector. 3) There is a trend discernible where users of financial services slip away from a blind trust in the financial sector to a dangerous low level of trust. P2p-lending contributes to more user oriented services that can create smart trust. 4) A break-even point for a p2p-lending platform in the Netherlands is possible at 11.000 transactions per year. This means such a platform is feasible and viable at a minimum market share of 1,25%. 5) A p2p-lending organisation model should be based on a triangle structure that places the p2p- lending provider in the middle and is built on three pillars: users, values & trust and tools. Keywords: p2p-lending, trust, peer-production, regulation, financial sector,
TRUST = (R1+R2) + (O1+O2) + (C1+C2+C3+C4)/8
- v - LIST OF FIGURES Figure 1: Research design of the thesis (Source: Author) ................................................................................ 7! Figure 2: Model of financial markets (Source: Allen & Maddaloni, 2008).......................................................... 9! Figure 3: A new strategy model for banking institutions (Source: King, 2010)................................................ 11! Figure 4: P2p-lending: how it works (Source: GAO, 2011) ............................................................................. 16! Figure 5: From product driven to user driven business (Source: Vervoorn, 2007).......................................... 21! Figure 6: From bank to service provider and p2p-lending (Source: Innopay, 2010) ....................................... 22! Figure 7: Directional change in communication (Source: Bauwens, 2006)..................................................... 23! Figure 8: Speed, Trust and Costs (Source: Covey, 2006) .............................................................................. 24! Figure 9: Trust business formula (Source: Covey, 2006, p. 20)...................................................................... 24! Figure 10: CRIOS trust equation (Source: Deloitte, 2010) .............................................................................. 25! Figure 11: Smart trust matrix (Source: Covey, 2006)...................................................................................... 26! Figure 12: Defining customer trust elements in Belgium (Source: Deloitte, 2010).......................................... 26! Figure 13: Evolution of client-advisor relationship (Source: Maister et al. 2000) ............................................ 27! Figure 14: Positioning regulation, peer production and trust (Source: Author) ............................................... 29! Figure 15: Origin of the respondents (n=77) ................................................................................................... 34! Figure 16: Final scores Facebook campaign (Source: Author) ....................................................................... 36! Figure 17: Details initial Facebook campaign (Source: Author) ...................................................................... 36! Figure 18: Paid interest rate for consumer credit (n=31)................................................................................. 37! Figure 19: Level of education and income (n=81) ........................................................................................... 38! Figure 20: Level of service and trust in provider consumer credit (n=31) ....................................................... 38! Figure 21: Level of trust and service in provider saving accounts (n=84) ....................................................... 39! Figure 22: Level of trust in the financial sector in general (n=82) ................................................................... 39! Figure 23: Indicators that contribute to the level of trust (n=77) ...................................................................... 42! Figure 24: Indicators that contribute to a decrease in trust (n=77).................................................................. 43! Figure 25: Interest in p2p-lending (n=82) ........................................................................................................ 44! Figure 26: Reasons to use p2p-lending (n=41) ............................................................................................... 45! Figure 27: Perceived risk and the need of trust in p2p-lending (n=77) ........................................................... 46! Figure 28: Is there a need for government regulation in p2p-lending? (n=77) ................................................ 47! Figure 29: Bad debt levels at Zopa (Source: Zopa, 2011) .............................................................................. 49! Figure 30: Total amount requested per Zopa risk category (Source: Ljay, 2011) ........................................... 52! Figure 31: Overview listings at Prosper (Source: Prosper, 2011) ................................................................... 52! Figure 32: Specifics per offering (Source: Prosper, 2011) .............................................................................. 53! Figure 33: The triangle structure for a p2p-lending platform (Source: Author)................................................ 59! Figure 34: Version 2 Smart trust index (Source: Covey, 2006)....................................................................... 61! Figure 35: The new ROCC trust equation (Source: Author)............................................................................ 63!
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LIST OF TABLES Table 1: Comparing rates between traditional banks and p2p-lending (Source: Author).................................. 3! Table 2: Rates for consumer credit in the Netherlands (Source: Independer and author 2011)..................... 17! Table 3: P2p-lending platform basics (Source: Author)................................................................................... 48! Table 4: Prosper rating and closing fee (Source: Prosper, 2011) ................................................................... 49! Table 5: Loans at Prosper (Source: Prosper, 2011)........................................................................................ 49!
- 1 - CHAPTER 1. INTRODUCTION In 2010, the IMF calculated that the global financial crisis of 2008 had a cost of trillions of US$ and caused millions of people to lose their jobs and homes worldwide. It was the worst recession since the Great Depression of the 1930s. Three years later, Europe is still in the middle of a struggle to save the euro after euro zone member states (Greece and in al probability Portugal, Spain, Italy and Ireland) broke the rules to control their budget deficits.
While writing this chapter, officials from the Group of Seven industrial countries (G7) issued a joint statement saying. "We are committed to addressing the tensions stemming from the current challenges on our fiscal deficits, debt and growth." The statement came after the group held an emergency conference call to discuss the debt crisis in Europe and market prospects following the announcement of the first-ever downgrade of the credit rating of the US government by Standard & Poors. (Huffington Post, 2011)
It is an understatement to say that the financial sector is in turmoil. Many people are losing trust in financial institutions due to the non-transparency of information, the high rewards for banking managers and the billions of investments various governments had to make to save the international financial system. It is this type of crisis that usually opens the door for new, unexpected and disruptive interventions in a system. Necessity is the mother of innovation (or invention) is an often-repeated proverb by politicians and businessmen to introduce new ideas. 1.1. Peer-to-peer lending This thesis describes in length the possibilities of a new financial phenomenon called peer-to-peer lending (p2p-lending). I first heard of p2p-lending in 2006 when I was advising some major social and cultural funds in the Netherlands to improve their cooperation structures. A new platform called Zopa had just started operations in the UK. It was a kind of market place where ordinary people that needed a loan could apply for financing. They would introduce themselves at the platform (income, age, residence) and explain why they needed the loan. People that had savings could then underwrite the proposal and with a bit of luck a deal was made. I explained to the Dutch funds that this kind of decentralised collaboration structures could also apply to their business. They could pool financial and human resources to more effectively service their customers. And the customers would probably like the service much more than the more distant way of communicating that was common practice for these funds. At that time the proposal did not make it yet. Five years later this type of organisational and production structure only has developed marginally in the Netherlands. Ill explain why. Peer-to-peer lending platforms facilitate financial transactions (lending and borrowing) between individuals without the intermediation of a traditional financial institution. It is an unsecured decentralist financial service. P2p- lending platforms offer lenders the potential to earn higher returns than established banks and may offer borrowers broader access to credit. It has some familiarity with the old principle of a credit union. In the Netherlands there used to exist the Boerenleenbank (now Rabobank) where farmers pooled their savings to lend it to other farmers.
- 2 - P2p-lending comes with a number of operational and credit risks. Individual lenders face the risk of losing their principal and the interest on their investments as the loans are unsecured and lenders may not have the expertise to predict and screen the risks of their transactions. Borrowers face the risks of typical consumer lending, such as unfair lending and collection practices.
However, the main difference between p2p and conventional lending is the formers ability to utilize social networks. Platforms encourage borrowers and lenders to collaborate and to share knowledge and information. The p2p-lender provider helps this process by providing digital community tools such as an online forum, Facebook groups, Twitter updates and most importantly by providing quantitative and qualitative data about the transactions and activities on the platform.
Since 2005, p2p lending is spreading internationally. This happens at a time when IT innovations and the Internet allow banks to compete on a global scale and while other players are preparing to enter the market. Companies like Google and Paypal hold banking licenses issued by the Central Bank of the Netherlands for digital banking services and consumer credit since 2007 (DNB, 2011). This indicates that Internet companies aim to start financial services in due time to extend their core activities and that they are willing to compete for market share with traditional retail banks. P2p-lending platforms entered this market place already and challenge the incumbents with competitive interest rates.
When I started my MBA at MSM in 2009, this disintermediation of the banking sector was an incentive for me to look into the financial market once more and more specifically to analyse the current developments in p2p- lending. This thesis discusses a number of p2p-platforms and links their business incentives to a key variable in the financial sector: trust.
It analyses the opportunities set by the globally networked information society for this new and disruptive financial service and it conducts an in-depth analysis of variables that influence trust in financial services in general.It researches the necessity of the variable trust for p2p-lending.
It is important to state at this stage that p2p-lending is a for-profit activity. This distinguishes it from crowd- funding platforms or micro-financing initiatives that are currently in wide spread use. These relatively new forms of financial services can be divided in three categories: 1. P2p lending marketplaces like Zopa.com, Prosper.com and PPDAI.com where users are primarily active due to economic motives. Borrowers use it to consolidate or pay off debts or seek alternate sources of credit, while lenders seek attractive returns; 2. At social micro-financing lending services like Kiva.org and Grameen.com participants are driven by social motives and charitable interests in the first place; and 3. At Crowd-funding platforms, donations, memberships or the pre-ordering of products are pooled, but none of the contributors get a future stake or monetary reward. Initiatives like Kickstarter.com in the US and Voordekunst.nl in the Netherlands are examples of such initiatives.
- 3 - This thesis only deals with the first category: p2p-lending.
The business model of p2p-lending is quite straightforward: the platform asks a nominal fee of around !100 per transaction or a percentage of the loan amount to cover its costs. Based on numbers from various p2p- lending platforms, the table below indicates that p2p-lending customers potentially can save a considerable amount of money when compared to trustworthy other credit providers in the Netherlands (in this case OHRA and ABN-AMRO). The table shows that the average lender customer (CBS, 2011) that concludes a loan of !10.000 in 60 instalments can save more than !1.000 at a p2p-lending platform. This amount can vary depending on his/her credit risk profile and the associated interest rate.
Table 1: Comparing rates between traditional banks and p2p-lending (Source: Author)
Main sum of loan (B profile) !10.000,00 Period of loan in years 5 Loan provider p2p-lending OHRA ABN-AMRO Annual interest rate 7,0% 9,0% 11,0% Monthly instalment !197,00 !205,88 !214,85 Total payment in 5 years !11.819,94 !12.352,99 !12.890,85 Total paid interest !1.819,94 !2.352,99 !2.890,85 % Interest of total main sum 18,2% 23,5% 28,9% 1.2. Problem definition The author has a deep-rooted and longstanding interest in p2p structures. Since 2001 he worked on a number of projects 1 that research the consequences of the global networked economy. P2p-lending is a model that could fundamentally transform the financial sector. The idea that customers move away from traditional banks and opt for a more tailor-made system in which borrower and lender meet in a social online network is challenging and promising. However, such a system has a plethora of pitfalls that require a thorough analysis. First of all, there is an absolute need for trust within such a peer-production structure. But how is trust organised between only loosely affiliated users of a p2p-lending platform? Secondly, any kind of financial agreement requires a regulatory framework to conclude transactions and contracts. The financial sector has an extensive regulatory history and a great number of controlling mechanisms. How does p2p- lending fit in that framework? Thirdly, the system of p2p-lending is based on the online pooling of financial resources. How do users of the p2p-lending service minimise their risk exposures and how do they collaborate and communicate online between each other and with the p2p-lending provider?
1 In 2001 the author initiated the Digital Pioneer fund for innovative civil society media on the Internet. In this capacity he approved for financing more than 100 innovative Internet projects. In 2004 he was co-founder of the Dutch version of the Creative Commons licenses that create a legal and technical infrastructure that maximizes digital creativity, sharing, and innovation. He also advised the European Commission on various p2p related issues and projects. He is now responsible for new media at the Dutch Mediafund.
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These issues will be thoroughly discussed in five separate parts of the literature review. The first part concentrates on an introduction to the financial sector. It will discuss how the sector shifted from a domestic government-led system to a global market regulated system where transnational corporations, empowered by advancements in information technology, compete on a global scale. It pictures how banks should become Bank 2.0 organisations as described by Brett King (2010), which entails a move away from the traditional distribution channel strategy with hundreds of bank branches to a total customer orientated distribution system. This paragraph is followed by an overview of the developments in international banking regulations. It explains how the financial sector and governments have tried to come to international agreements via the Basel Accords to reduce the risk for a financial system fall-out. It researches if these regulations indeed support the global networked information society, or that it primarily supports the transnational corporations. After concluding these financial industry specific topics the chapter continues with an explanation on the new phenomenon of online p2p-lending. Recently both the Dutch and the American regulating authorities issued recommendations about p2p-lending (GAO, 2011, DNB & AFM, 2011). Based on these reports and studies from Hulme (2006), Freedman (2009) and King (2010) the characteristics of p2p-lending are defined and possible regulatory interventions portrayed. 1.3. Research objectives The primary objectives of this research relate to the problems and the theories identified in the literature review. This study explores patterns of trust and identifies variables that contribute to trust or decrease the level of trust in financial services. It researches the possibilities and the necessity of peer-production structures in p2p-lending platforms. It aims to identify causal relations among the identified variables that contribute to a tangible and measurable equation for trust in p2p-lending. A final objective for the research is to empirically demonstrate the pro and con arguments for p2p-lending services and to develop a conceptual model how to employ a p2p-lending platform. 1.4. Conceptual and theoretical framework This study is based on the premise that trust is the most important variable for the new financial service phenomenon of p2p-lending. The research therefore focuses on the problem what variables influence trust in financial services. Based on available data from Deloitte (2010), Covey (2006), GAO (2011), Berger (2009) and Freedman (2008), eight variables are defined to measure trust in financial services and related to the four dimensions of Aneil Mishra (1996) reliable, open, competent, and, concerned and the Deloitte (2010) trust equation: TRUST = (Credibility + Reliability + Intimacy + Openness)/ Self interest The intent is to come to a new tangible and measurable trust equation for the p2p-lending business.
To measure the importance of peer-production structures of co-creation and information sharing in the decentralised model of p2p-lending, the comparative case study model as defined by Yin (2003) is used. To define the need of new government imposed banking regulations to regulate and/or control p2p-lending, the case study and the literature review are used. This framework is tested via qualitative research and empirical observation and the collection of data via a comparative case-study analysis and a quantitative Internet
- 5 - mediated survey. To construct validity, the outcomes of this data are interpreted to answer the major and minor research questions as formulated in the next section. 1.4.1. Assumptions 1. The selected case studies exemplify the p2p-lending business; 2. Lessons from international p2p-lending cases are applicable to the Dutch market; 3. The selected sample size of the survey is large enough to come to generalised data analysis; 4. The selected group of respondents of the survey result in trustworthy outcomes for the described objectives. 1.4.2. Limitations 1. The research is limited to people older than 15 and people living in the Netherlands; 2. People invited for the survey show a bias in the age category 32-44, education level and income vis- -vis the total Dutch population as survey respondents primarily came from the authors personal network. 3. In addition, the building of the ROCC trust equation in this study as well as the answering of the major and minor research questions will be based on the quantitative and qualitative data gathered. Other standardized statistical methods such as regression, the uncertainty coefficient or t-test are not used to validate the findings. 1.5. Research questions My research will focus on the major research question: What are the regulatory and the market requirements to co-create a trusted online peer-to-peer lending platform for consumer credit in the Netherlands? To answer this question, seven minor research questions were formulated to contribute in answering the main question: 1. What are the intrinsic reasons for participants to use a p2p lending platform? 2. How do customers define Trust in financial service providers (including p2p-lending) and what variables contribute to the level of trust? 3. Should the government regulate peer-to-peer lending? 4. How does the model of peer production relate to p2p-lending? 5. What are the loopholes in current banking regulations vis--vis p2p-lending? 6. What would an organisation model for p2p lending in the Dutch retail banking sector look like? 7. Is a viable economic model available for p2p-lending and what does it look like?
The approach of this thesis to examining p2p-lending platforms makes a number of important contributions to the available research in the financial sector. First, this is one of the first studies that describes the historical context of regulatory frameworks to explain the importance of trust for the rise of online p2p- lending services in a global networked information society. Second, the thesis develops a model, based on the work of Stephen Covey
(2006) and Mishra (2000), to measure trust. This model is empirically examined via a quantitative Internet mediated survey. The more than 100 respondents give a clear insight in how people in the Netherlands perceive trust in their financial service provider. Third, the study defines a number
- 6 - of pre-requisites necessary for any p2p-lending platform in the Netherlands to succeed. My interpretation of the acquired data yields to new knowledge and insights about the requirements for a trusted p2p-lending service.
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1.6. Structure of the research
The theoretical and conceptual framework (Chapter 3) incorporate the concepts of the literature review. This results in a number of minor research questions (MRQ) and one major research question Literature Review (Chapter 2) consists of four p2p-lending related dimensions: 1. Financial sector, 2. Regulation, 3. Peer-production and 4.Trust
The research method results in data outcome and the first interpretation of the emperical data in Chapter 4. This contributes to the answering of the minor and major research questions in Chapter 5. Case Study Analysis MRQ: 2, 3, 6 and 7 Desk research MRQ: 1, 3, 4, 5 and 7 Survey MRQ: 1, 2, 3, 4 Conclusions, Recommendations and future work (Chapter 5) - Answering of all minor and major research questions (conclusions) - Recommendations for p2p-lending activities in the Netherlands - Necessities of further research Figure 1: Research design of the thesis (Source: Author)
- 8 - CHAPTER 2. LITERATURE REVIEW Since the 1970s the financial sector witnessed a rise of non-banking institutions, deregulation and liberalisation of financial services and the internationalisation of banks that move away from their domestic focus. (Dicken, 2007)
However, the fundamental core of the system is unchanged. The function of the financial system as a whole remains the pooling of financial resources among those with surplus funds to be lent out to those who choose to be in deficit.
The massive disruption in the banking sector in 2008 caused a global financial crisis and resulted in a decreased trust in the financial (regulatory) system. Since then, many stakeholders put pressure to improve transparency and to reduce system risk in the financial sector. And, it led many scholars and practitioners to consider the current financial system as a mammoth that cannot adapt to the fast changing and global networked economy.
The subject of research, p2p-lending, incorporates a number of subjects that need to be discussed to grasp the complete picture of this financial service. It includes the use of new information technology, the online pooling of financial resources, the co-creating role of users, the importance of the customer behaviour variable trust and a rudimentary different regulatory system. This literature review is therefore divided in a number of central topics. 1. An introduction to the financial sector; 2. An overview of the history and current developments in banking regulations; 3. Explanation of the new phenomenon of online p2p-lending; 4. The application of the customer variable trust in financial services; and 5. The importance of commons based peer production (co-creating users). 2.1. Introduction to the financial sector The financial services sector is at the core of todays globalized networked economy. One of the most important catalytic events for the development of the financial sector was the rise of the US economy in the 19 th century. Railroad and heavy industry companies caused a huge demand for capital and the wide extension of the railroad network allowed money transactions over large geographical distances. (Philippon,
2008) The continuing growth of the sector came to an abrupt stop on Black Friday (1929) when a crash at the New York Stock Exchange caused a worldwide decline of the economy. Only after the Second World War the financial sector recovered completely. It started to grow continuously and became more and more (inter)connected on a global scale, only to be slowed down by the economic crises in 2000 and 2008. ! A widely accepted definition of this financial globalization is the (ongoing) integration of domestic financial systems of individual countries with the global financial markets and institutions. (Das, 2006) The acknowledgement of this development and the potential disruptive forces involved (1929!) led to the creation of the Bretton Woods system of monetary management, which established the rules for commercial and financial relations among the world's major industrial states in the mid 20th century. The Bretton Woods
- 9 - system was the first example of a fully negotiated monetary order intended to govern monetary relations among independent nation-states. 2
Figure 2 gives an overview of the functioning of this financial system including the key actors in the system. The graph illustrates the market-led international monetary system of today. (Dicken, 2007) In the past two decennia small banking companies, especially in the US, started to diversify their product portfolio from activities belonging to a traditional bank to those of an integrated investment bank (e. g. Citigroup). This went together with numerous mergers and acquisitions, which led to major concentrations in the financial sector. Asian Banking companies grew tremendously before the whole Japanese economy broke down in 1997. After the meltdown of the financial sector in Japan, the dot-com bubble burst in the early 2000s led to another period of cooling down the world economy. But soon after this crisis the rise of international banking companies like Morgan Stanley and Citigroup took of for real. They grew with double-digit rates and published record profits from year to year. At the peek of their success story in 2006 the percentage of the financial sector on the GDP in the US was 8%. (Philippon, 2008)
These growth rates were partly made possible due to a major trend in society in general and the financial sector in particular: the role of technology and the Internet. Information Technology (IT) has become the fundament of the financial industry. Information is both the process (risks, returns on investment, exchange rates) and the product (how to deal with the process) of financial services. IT can add value to information and it is therefore not surprising that all major financial institutions invest huge sums in IT infrastructure. Global information technology spending by financial institutions is expected to reach more than !300 billion in 2011. (CELENT, 2009)
What is the rationale for all these investments? In summary, information technology developments and the rise of the Internet have: - Vastly increased productivity in financial services, because IT allows a follow the sun 24 hour trading day.
2 See for more info on history of Bretton Woods: http://en.wikipedia.org/wiki/Bretton_Woods_system
Figure 2: Model of financial markets (Source: Allen & Maddaloni, 2008)
- 10 - - Altered the patterns of relationships within financial institutions and also between financial firms and their clients. These developments lead to the trend for more securitization of transactions and the introduction of new products. - Increased the velocity of turnover of investments, as it is now possible to transfer funds electronically. - Shocks occurring in one part of the world now spread instantaneously around the globe. IT enabled financial institutions to increase loan activities and to respond immediately to fluctuations in the market.
So what role does IT play in addressing the needs of the financial industry in the current financial crisis? In a post-crisis climate of increased competition, financial institutions did recognize the necessity to operate with superior technology and connectivity options for long-term sustainability (competitiveness). The presented figures on IT investment suggest that the financial industry is building on a new IT infrastructure to better manage their risk, to comply with new regulatory reforms imposed by government and multilateral institutions and to keep up with competitors and the growing demand from customers. Strangely enough, new products in the financial sector are primarily developed to manage the institutes exposure to risk. The derivates market for example, aims to enable participants to manage their exposure to the risk of movements in interest rate, equities and currencies.
Until now, financial institutes seem to only marginally respond to the increasing role of Internet in society at large and the fact that we witness a transformation of product innovation in the financial sector that comes from bottom-up, that is the customer. The recent rises of Internet based initiatives like crowd funding (mass of people finance business initiatives), p2p-lending (disintermediated borrowing and lending) and mobile banking (payments via Twitter or Facebook) illustrate the constant development of new currency and banking technology. These technologies have the disruptive potential to rapidly alter the current financial sector playing field. There is a huge possibility for new products to compete on the payment market by cutting transaction costs and cut out the traditional middle-man (bank).
- 11 - After the government led financial system of Bretton Woods and a period of financial deregulation the financial sector seems to move into the direction of a major overhaul again. At its basis is a trend of decentralisation that will cause a new wave of product innovations, while the traditional relationship between banks and its customers is weakening. The time that consumers trust banks to take care of all their financial concerns appears to be ending due to the credit crunch and the process of globalization that caused a decrease of the consumer trust in financial service providers. This allows innovative companies with a large consumer user-base that have already established a trust relationship with their consumers (like PayPal, Facebook, Amazon and Google), to create a niche market. This entails a move away from the traditional distribution channel strategy of banks to a total customer orientated channel as pictured. Next to the major effects this development will have on the banking sector as such, it has much wider implications. One major point to consider here is the shift from the traditional distribution of new product offerings in retail banking through the branch network of a bank to a system where the new customer led strategy products will be offered, positioned and co-created via multiple channels. The current regulatory framework is insufficient for these new developments. The next section will address this issue. 2.2. Bank regulations In the market-led financial system, there is not one single entity that oversees and regulates the international financial system. Until recently, financial markets were closely supervised at a national level because of concerns over the vulnerability of the financial system. There existed two major types of regulation: (Dicken, 2010) - Governing the relationship between different financial activities of banks and securities houses; - Regulations governing the entry of firms into the domestic financial sector. Governments often imposed a restricted governmental regime that limited the influence of foreign entities.
FROM A DISTRIBUTION/BRANCH LED STRATEGY >>>>>>> TO CUSTOMER LED/DERIVED STRATEGY Customer Self service Contact centre
www ATM Branch Mobile Branch Alternate channels Customer Figure 3: A new strategy model for banking institutions (Source: King, 2010)
- 12 - In the 1980s an aggressive pressure for deregulation emerged. Transnational Corporations (TNCs) explored the possibilities to escape strict regimes to the maximum and profit from the possibility to operate outside the national regulatory boundaries. The emergence of the Eurodollars can be marked as the starting point. Huge reserves of dollars were held outside the USA by for example China and were not under any US political control.
The US allowed the establishment of international banking facilities (IBFs) in 1981. These IBFs created onshore offshore centres for foreign customers and allowed banks to develop all kinds of new financial services. In 1986, in what is referred to as the Big Bang, the UK removed the existing barriers between banks and securities and allowed the entry of foreign firms to the Stock exchange. This was followed by similar developments in France and Germany. The accelerating deregulation of the financial services clearly indicated the pace of globalization. The differences in regulation per country led to an enormous increase in international financial trade dynamics (e.g. the securitized mortgages). Hence, financial TNCs made strategic choices where to locate their head office or how to arrange monetary flows in order to optimize competitive and comparative advantages. This development illustrated that the internationalization of financial services and the deregulation of financial services are virtually two sides of the same coin: deregulation is necessary to facilitate further internationalization
This deregulation trend came to an unanticipated stop with the 2008 financial crisis. A crisis triggered by a liquidity shortfall in the US banking system after US house prices began their steep decline in the fall of 2006. As a result securities backed with subprime mortgages, which were widely held by financial firms, lost most of their value and caused a large decline in the capital of many banks and US government sponsored enterprises 3 . The strong interconnectedness between all banking and insurance companies turned out to be one of the reasons for this credit crunch. To share the risk, financial corporations started developing products to sell the risk or parts of their investments. Banking corporations, as well as insurance companies, bought these products because of the expected high revenues, but this led to a vast network of cross-investments, which was like a vicious circle. The development of these very complicated and risky products in the last 15 years was instrumental to the crisis.
The financial crisis spread from the US to the whole world, from developed countries to emerging market economies. It also hit the real economy and resulted in a sharp decline of the global stock market and an increasingly volatile and uncertain international financial market. The bail out of banks by national governments was daily news and in many countries the housing market suffered heavily with price drops of over 50%. This current crisis is considered by some economists to be the worst financial crisis since the 1930s. (Reuters, 2009) 4
3 It is not in the scope of this research to extensively discuss the financial crisis. See for example http://en.wikipedia.org/wiki/Subprime_mortgage_crisis for more detailed information on the crisis. 4 Economists include Nouriel Roubini (New York University), Kenneth Rogoff (Harvard University) and Nariman Behravesh (IHS Global Insight).
- 13 - 2.2.1. The need for new regulations The causes of the 2008 financial crisis have made one question top priority in the international financial regulatory landscape: What specific new regulations will be most effective in improving the financial sector's future behaviour? Global governance structures and institutions are responsible for the establishment of these new rules.
Many authors 5 have focused on one or more of the following regulating issues to be taken: - Mortgage lending: Mortgage lending financed with money borrowed from banks should be included on the banks' balance sheets. - Cross border burden sharing: although the financial sector is heavily globalised, it proved difficult internationally to come to an agreement how to tackle the crisis. Some authors argue that countries commit in advance to some particular scheme of burden sharing for the treatment and resolution of cross-border failure in the financial sector. - Securitization: All lenders who pool and securitize loans should be required to retain at least 10% to 20% of the value of each securitized pool on their own books to ensure the loans are sound. - All persons or firms who enter financial derivative transactions should be required to register the nature and size of those derivatives with a centralized derivative exchange run either by the nation in which they operate or by an international agency. - Money market operators: contra-cyclical control mechanisms, instruments that allow the monetary authorities to do something about fluctuations in liquidity conditions. These watchdogs should only be paid by the buyers of rated securities (not the originators) through a fee added onto security prices. The next paragraph will discuss how the so-called Basel proposals deal with the above proposed regulations. 2.2.2. Basel II and III Especially since the 2008 financial crisis but also before, bank regulations are under discussion for revision. The scholar Goodhart (2008, p. 356) argues The problem of how to handle cross-border financial failures in a world of national fiscal and legal competences is understood, but not resolved. This statement stresses the importance of bank regulations that take the global networked economy into account. It also relates to the new Basel proposals to tighten standards for hybrid capital.
It started in 1988 by the Basel Committee on Banking Supervision that consists of a group of central bankers and regulators. The aim of the Committee was to establish international convergence of capital measurement and capital standards by requiring a minimal capital requirement for banks. Basel I primarily focused on credit risk. Assets of banks were classified and grouped in five categories according to credit risk The Basel I framework has been progressively introduced by the G-10 countries, but is now widely viewed as outmoded due to the disintermediation of the financial sector, the development of enormous financial
5 See for example, Anthony Downs, New Rules for the Financial Industry and The regulatory response to the financial crisis, by C.A.E. Goodhart.
- 14 - conglomerates and the innovation in complex financial services. In addition, many countries adopted the rules with their own interpretation. (Barfield, 2007) In June 2004, the Basel II Accord was published and caused a paradigm shift in the banking sector. It created an international standard on the amount of capital banks need to set aside. It shifted from a capital measurement system to a complex capital adequacy framework. The idea was that this system would protect the international financial system from multiple bank collapses via rigorous risk and capital management requirements. The objective was to ensure that capital allocation would be more risk sensitive. One of the mechanisms to do so was by separating operational risk from credit risk, and quantifying both. Another objective of Basel II attempted to align economic and regulatory capital more closely in order to reduce the scope for regulatory arbitrage.
Basel II largely left the question of how to actually define bank capital untouched. Is it predominant Tier 1 capital of common stock and disclosed reserves/retained earnings? Basel II allowed the largest banks to use internal models to calculate the risks of their assets to determine the capital charges against them. In fact they could establish their own Tier 1 capital ratio (ratio of a bank's core equity capital to its total risk-weighted assets) within Basel II. (Zapodeano et al., 2009) Possibly that was one of the variables that contributed to the widespread financial crisis. These weaknesses in Basil II were instrumental for the call for Basel III, which should give a direct answer to the deficiencies in the financial regulations as revealed by the financial crisis.
The Basel III Accord tackles the system risk of "too big to fail" banks. All major G-20 financial centres committed to adopt the Basel III Capital Framework by 2012 (full implementation scheduled for 2019). The Basel III objectives are quite clear. It wants to strengthen global capital and liquidity regulations and bank leverage with the goal of promoting a more resilient banking sector. The objective of the Basel Committee's reform package is to improve the banking sector's ability to absorb shocks arising from financial and economic stress, whatever the source, thus reducing the risk of spill over from the financial sector to the real economy. (Slovik et al., 2011)
Basel III is of course a response to the 2008 global financial crisis and not a true proactive regulatory intervention. Will it work? Let me explain why I think Basel III is not enough. Firstly, the language of the Accord is too much based to accommodate many different cultures and the varying structural models of countries (and regions). It therefore needs to be in line with complex existing regulation and policy. This is what I call the Brussels disease where countries interpret Basel Accords in the most convenient manner to satisfy corporate banking demand. The Basel Accord responds too late to changing circumstances in legal, market and technical respect. The IMF stated in July 2010: The current euro area crisis results from fiscally unsustainable policies in some countries, delayed repair of the financial system, insufficient progress in establishing the discipline and flexibility needed for a smooth functioning of monetary union, and deficient governance of the euro area.
Secondly, Regulators in most jurisdictions around the world plan to implement the new Accord with widely varying timelines and with the use of varying methodologies. Moreover, the Basel Committee has loosened
- 15 - several of its initial regulations, as exemplified below. In July 2010, the Basel Committee agreed to continue allowing some assets, including banks minority stakes in other financial firms to count in part as capital. (Business monitor, 2010) This reversed its initial stance to ban their use all together. It also expanded the definition of what counts as liquid assets and gave banks until 2019 (!) to comply with the new leverage ratio designed to rein in risk taking. This attitude of the Basel Committee illustrates once more that banks and regulators are lukewarm defenders of the old order. The July 2010 adaptations are first and foremost a response to the wish list of the financial sector itself and show that the Accords do not necessarily entail what is best for the globally networked information economy.
It can only be concluded that regulators and governments play a decisive role in supporting the market- based financial incumbents of the twentieth-century system so far. By keeping the old mechanisms in place and by maintaining the lack of transparency. This strategy has negative consequences for new product innovation in the financial sector that come from new actors in the emerging networked information economy. The Basel II Accord separates credit risk from operational risk and as such, there needs to be a separation between the manufacturing of the product and the distribution. Many banks already segment their product per distribution channel, but banks rarely start their design process of new services from a multiple channel approach. This is the market niche p2p-lending platform are diving in to and the central topic of the next paragraph. 2.3. Pioneers in the unsecured online p2p lending market British Zopa.com
and American Prosper.com pioneered peer-to-peer lending for the unsecured consumer market in 2005.
(Berger et al., 2009) In p2p lending one borrows money from a source other than a bank. Borrowers post the amount (up to ! 25.000) they want to borrow and the interest they are willing to pay online. Lenders can get a rate of return of 5% to sometimes 20% while borrowers pay (depending on their risk profile) 7.5% and more. For borrowers, rejected by their banks or scared away by the bankruptcy of lending institutions, these low-cost p2p-lending platforms can be an attractive alternative. 2.3.1. Characteristics of p2p-lending Let us look at some more specifics and characteristics of the p2p-lending service for most platforms: - The provider gives a service to the lenders by giving them a platform where they can subscribe to loans of categorised borrowers according to a risk profile. - The platform authenticates the identity of each borrower and lender and extracts the borrowers credit history, and posts credit grades in the borrowers listing. - The provider realises a contract between a group of lenders and a borrower. - The platform plays an intermediary role when entering into financial transactions between (a pool of) lenders and borrower and is responsible for the contractual basis of the transaction, the execution, the collection of interest or dividends for the lenders and in the case of a loan repayment default the hiring of a collecting agency. - Borrowers repay monthly by direct debit. If any repayments are missed, a collections agency uses the same recovery process that other banks use. - A loan that is more than four months behind has defaulted.
- 16 - - The p2p-lender informs customers on expected bad debt and actual default levels per borrower category. - Many platforms encourage borrowers and lenders to form online groups and establish social network (Facebook, Twitter, MySpace) relationships with other members. It allows members to give endorsements for a specific listing. - P2p lending providers ask a nominal fee per contract of ! 100 to ! 150 or a percentage of the loan amount to be paid by the borrower. Lenders of some platforms pay an annual servicing fee of around 1%.
The Dodd- Frank Wall Street Reform and Consumer Protection Act directed GAO to conduct a study of p2p- lending. GAO published this report on p2p-lending in July 2011 and addressed among other things how the major person-to-person lending platforms operate and how lenders and borrowers use them. Figure 4 illustrates how the described characteristics are operated on a p2p-lending platform.
Figure 4: P2p-lending: how it works (Source: GAO, 2011)
According to the authors Hulme (2006), Freedman (2009) and King (2010), these characteristics effectively mean that the online p2p lending market replaces the bank as the intermediary and enables decentralised unsecured online transactions between borrowers and lenders.
In Kings already mentioned Bank 2.0: How customer behaviour and technology will change the future of financial services, a view of the future of retail banking is presented and linked to changing customer behaviour. Customers are changing, according to King, because of the psychology of self-actualisation and technology innovation and adaptation. (2010, p. 41) P2p-lending is an outcome of this changing customer behaviour and so far p2p-lending platforms fulfil an increasing demand and now serve more than 4.000.000 users worldwide (Zopa, Prosper & Ppdai, 2011) although their outreach has been limited to a few countries (including China, Japan, UK and USA).
- 17 - 2.3.2. P2p-lending market in the Netherlands Current market size in the Netherlands for consumer credit contracts is 3.500.000. On average these contracts have a maturity of 4 years, which means that approximately 875.000 new contracts are concluded on a yearly basis. (CBS, 2011)
The table shows the lowest rates available in the Netherlands consumer credit market. The table was obtained from the leading benchmarking website in the Netherlands (www.independer.nl) on 01 July 2011, with the following coordinates: - Gender: male - Age: 35 - Income: !40.000 - Required sum: ! 10.000 - Nr. of instalments: 60 - Repayment: max ! 200 per month - Job: temporary - Household: living together one kid - No BKR registration: BKR is the Dutch Central Credit Information System, where each persons credit history is registered.
The mentioned interest rates of these seven providers are the bottom line. If the borrower has a BKR registration, other loans, less income or wants to repay a lower amount, the charged interest rate will increase. None of these seven consumer credit providers is a p2p-lending platform.
The first Dutch p2p-lending platform to emerge on the market was Booper. It started operations in 2007 and it had a total of !1,4 million in outstanding loans after a few months in operation. The Dutch Authority for Financial Markets (AFM) then decided to temporarily suspend Boopers activities because it operated without a banking license. After analysing Boopers business model vis--vis the regulatory framework, the AFM decided Booper could continue under the condition that a lender can invest a maximum sum of ! 40.000 divided over a maximum of 100 loans (maximum ! 400 per loan). However, The Dutch government implemented new regulation in November 2007 that levelled the rules for private loans with the regulation of consumer credits in the commercial market. (Rijksoverheid, 2007) The business model for Booper turned out to be unsuccessful within this new framework and the company went bankrupt in 2009. Many lenders lost the larger part of the money they provided to loans on the platforms. 6 It was only at the start of 2011 that three new p2p-lending platforms started in the Dutch market: http://mkbcrowdfunding.symbid.nl,
6 The Dutch p2p-investment association still tries to recover some of these investments. See http://www.pivn.nl/ for more details. Table 2: Rates for consumer credit in the Netherlands (Source: Independer and author 2011)
- 18 - www.geldvoorelkaar.nl and www.crowdaboutnow.nl All platforms only have a limited reach so far in terms of users and the number of transactions. However, the start of these platforms reintroduced the topic of p2p- regulation in the Netherlands. The next section will discuss the issue of regulation in more detail. 2.3.3. Regulation of p2p-lending The unsecured online p2p lending market is a relatively young part of the financial service industry. Such an unsecured loan is issued and supported only by the borrower's creditworthiness, rather than a collateral loan in which assets have been pledged as security on the value of the loan. (Freedman et al., 2010) This also means that the lenders that provide the money to the borrowers on a p2p-lending platform take a higher risk than putting their savings at a traditional bank. In the Netherlands, savings up to ! 100.000 are guaranteed by the central bank in case of default of the bank. Such assurance is absent in p2p-lending and lenders of a p2p-platform have a high credit-risk.
To increase trust at the lenders side these platforms try to be as transparent as possible in their information about borrowers, their risk profile and expected bad debt. This is one of the reasons why the AFM and the Dutch Central Bank (AFM & DNB, 2011) published an open letter to inform the public about the legal risks of p2p-lending in May 2011. The main conclusions and recommendations made in this letter were: - DNB and AFM point out that under Article 3:5 of the Act on Financial Supervision it is prohibited to attract repayable loans outside the personal circle, to obtain such loans, with the exception of professional market players. This may, depending on the method of organising and structuring occur in p2p-lending if the platform for example keeps the invested money in escrow for too long. This prohibition is intended to prevent individuals or companies other than banks to attract funds from the general public. The reasoning is that other actors than banks generally lack the safety mechanisms to ensure a responsible and trustworthy handling of the funds - Additionally, DNB and AFM note to any p2p-lending platform that it is forbidden to be active as a bank in the Netherlands unless they have a banking license. A company wishing to engage in banking activities in the Netherlands may apply for a banking license. - Thirdly, depending on the design and the structure of the p2p-lending platform, it may be subject to legal provisions and restrictions that the AFM supervises. This may mean that the p2p-lending providers need to be authorized by the AFM for: (1) Offering investment properties; (2) The provision of credit; (3) Mediating in credit, insurance or financial products (4) Providing investment services or perform investment activities; or (5) That certain transparency should be provided in any offering via a prospectus.
Although the letter seems to indicate that both AFM and DNB have legal grounds to limit the operations of p2p-lending in the Netherlands, a closer analysis of the text implies that p2p-lending platforms can design and structure their operations in such a way that they can comply with the aforementioned rules without having a banking license. However, p2p-lending is a new phenomenon for loans and savings and the
- 19 - assessment of these type of activities by government institutions is uncovered territory. It could for example well mean the tax-authorities interpret the activities on the platform as entirely different (e.g. income tax or entrepreneurial activities) in the coming years, making the business model for both the platform and its users less attractive. The legal risk of p2p-lending is still difficult to judge at this stage.
In the US, p2p-lending platforms like Prosper and Lending Club lobbied for new regulations. In December 2009 the House of Representatives approved to set up a new regulatory agency: the Consumer Financial Protection Bureau (CFPB) which now deals with p2p-lending platforms. (King, 2010, p. 235) This, by Congress established, organisation has as its central mission to make markets for consumer financial products and services work for all Americans, whether they are applying for a mortgage, choosing among credit cards, or using any number of other consumer financial products. The CFPB acts to protect consumers by carrying out Federal consumer financial laws. In the GAO report of July 2011, the agency identified two principal options for regulating p2p- lending that differ primarily in their approach to lender protection: (1) continuing with the current federal system that is protecting lenders through securities regulators and borrowers mainly through financial services regulators, or (2) consolidating borrower and lender protection under a single federal regulator, such as the CFPB. Remarkably the report does not make a recommendation as to which regulatory system would be best. There seems to be a reluctance to shift to a new regulatory regime at this stage and about its potential benefits. This might also be caused by the possibility that new regulatory challenges could emerge as the industry continues to evolve and grow.
As mentioned, p2p-platforms operate with unsecured loans. How risky are these services? Recent figures on Bad debt from the p2p-lending platform Zopa illustrate that the realised bad debt within the Zopa platform in the last twelve months was 0,14%. (Zopa, 2011) Since inception of the platform the actual default levels have always been lower than the expected bad debt. However, these figures should not be taken at face value as they were provided by the Zopa platform and could not be checked on the criteria used to qualify a loan or borrower as being in default. Actual loan default and loss rates may be different than expected, because the platforms have limited historical loan performance data, and their credit rating systems may not accurately predict how loans will perform. (GAO, 2011) Another point of interest from a lender perspective is that individual lenders on p2p-lending platforms are by definition less professional than financial institutions. They may not have the expertise to qualify associated risks in advance and during the monitoring phase after a contract has been signed. This means that the operational risk at p2p-lending is perceived higher than a standard savings account at a traditional bank.
The described credit, operational and legal risk seems to justify a regulatory role for the government in p2p- lending. Others however argue that such intervention from the government would stop this innovation in the banking industry. Banks have the choice to either try to reinforce traditional mechanisms and behaviours or to transform their operations and services to a more user oriented model. King refers in this respect to value innovation, which means that banks should create superior customer value with a view of gaining a competitive advantage. In the dynamic Internet based landscape continuous improvement of the customer experience is required. This includes the servicing of the customers, offering of value propositions and
- 20 - collaborating with the customers. (King, 2010, p. 51) This observation is also a central thought of what is called peer-production. 2.4. Peer production In the Wealth of Networks, Yochai Benkler describes the rise of effective, large-scale cooperative efforts as peer production in a global networked information economy. This rise is the consequence of Internet as a communications medium that expands its reach by decentralizing the capital structure of production and distribution of information, culture, and knowledge. This networked information economy, according to Benkler, allows for the emergence of a more critical and self-reflective culture. It builds on the assumption that the increased capabilities of individuals (via the Internet) are the core driving force behind the networked information economy and leads to new (peer) production structures. Benkler links this trend with the rise of individual and cooperative private action and the relative decrease in dominance of market-based and proprietary action. (Benkler, 2006, p. 17)
Open source software is such a cooperative private action. It is an approach to software development that is based on shared effort on a non-proprietary model. Programmers contribute their knowledge and software code in a collaborative software development project. The source code and certain other rights (normally reserved for copyright holders) are provided under a software license that permits users to study, change, improve and at times also to distribute the software. 7 Open Source software has become a driving force for successful companies like IBM. John E. Kelly III, Senior Vice President, Technology & Intellectual Property at IBM, stated in 2005: Open source software and standards developed among universities, government and the IT industry form the basis for genuine collaborative innovation. This collaboration will lead to greater commercialization throughout the IT industry. Because of that, it is imperative that these principles guide our efforts to collectively improve current intellectual property practices. (Computerweekly, 2005)
Another example of collaborative innovation is Wikipedia, an encyclopaedia that emerges on the web out of the coordinated but entirely independent actions of millions of users. It is the worlds largest and most cited collaborative encyclopaedia and is licensed under Creative Commons. The Creative Commons license gives everyone from individual creators to large companies and institutions a simple, standardized way to grant copyright permissions to their creative work. This way the pool of content from Wikipedia can be copied, distributed, edited, remixed, and built upon within the boundaries of copyright law. 8 Furthermore peer-to-peer file-sharing networks like Napster, Kazaa and Pirate Bay are examples of highly efficient large-scale collaboration data networks among loosely affiliated users.
The three examples suggest that the networked environment makes a new modality of organizing production possible: radically decentralized, collaborative, and based on sharing resources and outputs among widely distributed, loosely connected individuals who cooperate with each other without relying on either market
7 At http://sourceforge.net/ a number of high quality examples of open source software (Linux, Moodle, Open Office, Compiere) can be found. 8 More information on the Creative Commons license is available at http://creativecommons.org/licenses/
- 21 - signals or managerial commands. This is what Benkler calls commons- based peer production. (Benkler, 2006, p. 60) Commons in this respect, refers to a particular institutional form of structuring the rights to access, use, and control resources.
This thought is clearly depicted in Figure 5, where the move from product driven business to customer driven business innovation is shown. The key assumption is that the user adds value in the co-creation process that is designed to facilitate exactly this type of participation.
What we are seeing now is the emergence of effective collective action practices. They are decentralized and do not rely on a managerial structure for coordination. Ubiquitous networked storage and connectivity have made it easy for individuals to create and exchange information, knowledge, and culture in patterns of social reciprocity, redistribution and sharing. Benkler continues that this networked environment provides a platform for new mechanisms. At the simplest level, social production in general and peer production in particular present new sources of competition to incumbents that produce information goods for which there are now socially produced substitutes. (Benkler, 2006, p. 122) Another study that points in that direction comes from Baldwin and Von Hippel (2009) who have extensively researched the paradigm shift from producer innovation to user and open collaborative innovation. Their work has shown how the model of user innovation has been integrated into the business model of innovative firms.
This observation is important for the financial sector where, as we concluded earlier in this chapter, IT has become a fundamental characteristic of the industry. Basic material capital requirements of information production that used to create high (financial) entrance barriers in finance have dissolved for the larger part. Internet communities and individuals can easily generate trustworthy and high-quality information in finance. The Netherlands is one of the countries with the highest number of broadband Internet connections and scores a top ten in the world when it comes to the use of Internet related services and social networks. The countrys broadband penetration in early 2006 is the highest in Europe. Much of this achievement is due the governments progressive Broadband Expert Group (BEG), which has promoted the broadband economy. 9
9 More figures on the use of Internet in the Netherlands can be found at http://www.internetworldstats.com/eu/nl.htm Product driven User driven Figure 5: From product driven to user driven business (Source: Vervoorn, 2007)
- 22 - This offers a unique opportunity for new peer production structures. In principle, new p2p-services for digital networks can be offered without the necessity of large capital investments.
Peer-production in the financial sector offers unique first mover advantages as depicted in Figure 6 that explains how the market transforms from banks as trusted party in a central market place to a decentral market place where other (financial) service providers deliver and create new services. There is, of course, nothing new about entrants with new business models putting slow incumbents (in the financial sector) out of business. More fundamental is the change in the relationships of the financial service provider to its users. Understanding the opportunities of peer production is a prerequisite for any financial institute, if they want to benefit from the new developments. A strategy that is built on a mutually reinforcing relationship should be the starting point if the sector wants to profit from peer-production.
Benkler mentions how businesses like IBM and eBay use peer production as a critical component of its business ecology: The peer reviewed system of creating trustworthiness, without which person-to-person transactions among individual strangers at a distance would be impossible, have to structure their relationship to the peer-production processes that they co-exist with in a helpful and non-threatening way. Here, the critical and difficult point for business managers to accept is that bringing the peer-production community into the newly semi-porous boundary of the firm, taking those who used to be customers and turning them into participants in a process of coproduction, changes the relationship of the firms managers and its users.
(Benkler, 2006, p. 137) Michel Bauwens (2006)goes even further in The Political Economy of Peer Production, where he argues that the p2p phenomenon is an emerging alternative to capitalist society. He presents a strong case of interdependence between the two production systems, as peer production only covers a section of production and peer producers are dependent on the income provided by the market. On the other side, the market economies will become more dependent on p2p production via distributed networks of information processing and production.
In addition the concept of peer production changes the way companies should view their relationship and communication strategy in terms of marketing. Peer production causes a major directional change, depicted Figure 6: From bank to service provider and p2p-lending (Source: Innopay, 2010)
- 23 - in Figure 7 from a corporate elite push strategy (pushing the product through the distribution channel) to a bottom-up approach integrating both push and pull strategies to shorten the difference between customer demand and service supply. The important point Benkler is making in this respect, is that companies must learn to think from a community perspective (not a customer perspective) and work on a relationship of trust with their users. Incorporating the value of what users deem important is essential in the new business model. Creating trust and increasing service level with this community is central in defining the new interaction with the users. This next paragraph will therefore look at a few dominant theories of trust and link these models to the research on p2p-lending.
2.5. Trust In 1996 Aneil Mishra designed a model of trust that addresses four dimensions of both individual and organizational trust. These dimensions create a perception of trust based on one partys willingness to be vulnerable to another party based on the belief that the latter party is: 1. Competent: trust can only be created if one party has confidence in the knowledge, skills and abilities of the other party. 2. Concerned: the demonstration of interest and care in the well-being of others. 3. Open: stakeholders must trust industry leaders to be open and honest about strategy, intent and purpose. 4. Reliable: consistency of words and actions. From a company perspective, the first two dimensions seem to be primarily related to human behaviour and human resources, while the latter two relate to corporate operations and corporate strategy. (Mishra, 1996) Ten years after Mishras article was published, this framework was further built upon in Stephen Coveys influential book The Speed of Trust. (Covey, 2006) The book presents a road map to establish trust on every level (personal, relational, organisational, market and at the level of society) from an inside-out approach.
Figure 7: Directional change in communication (Source: Bauwens, 2006)
- 24 - He brings trust from an intangible and unquantifiable variable to an indispensable factor that is both tangible and quantifiable. (King, 2006, p. 13) When trust in a company is in a downward slope, speed in the in any organisational process slows down and costs increase. On the other hand, when trust increases, the speed of the process will gear up and the production and operational costs decrease.
Covey claims that trust, regardless of its status as high or low, is the hidden variable in the formula for organisational success. Figure 9 below states the traditional business formula and afterwards includes the trust variable (T).
Trust, when high, can function as a performance multiplier, but when low, it can function as a performance decreaser, even if strategy and execution are in good order. According to a poll in 2003, 39% of individuals said they would increase their business with a company specifically because of trust, while 83% stated that they were more likely to give a company they trust the benefit of the doubt. (2006, p. 266) These figures support Coveys formula and it will be interesting to see how financial service providers can incorporate this formula in their business strategy.
In July 2010 Deloitte Belgium published a troubling report on the suffering of financial institutions from a lack of trust and satisfaction. It concluded that Overall, there is a deeper distrust between the public and the financial services industry. The public has experienced an imbalance, where the industry holds the lions share of power and is able to make decisions and take risks in ways that have a tremendous impact on its stakeholders. More profound attempts are needed to rebuild the image of the financial industry. These efforts should be focused on rebuilding real trust.
(Deloitte, 2010, p. 5) Low trust causes friction and creates costs for organisations as it slows down projects, interaction between people, product innovation and the decision- STRATEGY X EXECUTION = RESULTS (S X E = R)
(S * E)T = R
Figure 9: Trust business formula (Source: Covey, 2006, p. 20) TRUST = SPEED COST TRUST = SPEED COST Figure 8: Speed, Trust and Costs (Source: Covey, 2006)
- 25 - making progress. The study uses five dimensions to measure trust, which can be combined into a trust equation:
T = C+R+I+O S Where: 1. Credibility (I believe what my bank is telling me) 2. Reliability (my bank is conforming to facts) 3. Intimacy (my bank is close to my needs and concerns) 4. Openness (my bank has a simple and transparent communication) 5. Self-interest (my bank acts to my best interest)
The equation is based on the work of Maister, Green,and Galford (2000, p. 69) in their book The Trusted Advisor. These authors argue that winning trust requires that you do well on four dimensions (in the clients eyes) and come to the following equation: T =C + R + I/S
The basic assertion of the authors is that It's probably fair to say that leading professional services firms have made (or are attempting to make) the adjustment to an approach that recognizes just how little content mastery matters if the client does not trust us. We would venture to say that truly great professional service firms haven't just made the adjustment to that approach; they are built upon it." (Maister, 2000, p. 41) The theory of their formula is built on the clients perspective. The Deloitte study added the openness variable to the formula.
The Deloitte research then introduced a 5-point scale for use among 2000 customers of Belgium banks with ratings from 1 to 5 (1 = completely disagree, 2 = rather disagree, 3 = neither agree/nor disagree, 4 = rather agree, 5 = completely agree). Based on this formula where trust is the sum of credibility, reliability, intimacy and openness divided by self-interest, the general level of trust in the financial sector in Belgium scores 5.5 on a maximum of 20. It concludes that the industry is suffering from a lack of customer trust as 1 out of every 3 customers does not trust banks in general, and only 12% of customers confirm that they definitely trust the banking industry. (Deloitte, 2010, p. 9) TRUST = (Credibility + Reliability + Intimacy + Openness)/ Self interest T=C+R+I+O/S
- 26 - But if we look closer to the figures presented, the scores seem to indicate that on the level of credibility, reliability, intimacy and openness all banks on average score above 3,5. This score indicates that the customers rather agree that banks deliver what they promise, listen to their clients and communicate in the clients interest. It is mainly on the question whether banks act in the self-interest of the client that most customers tend to disagree. The straightforward conclusion of this formula would then be that if banks increase the level to act in the self-interest of customers, the trust level in the financial sector would increase. If we relate the outcomes of the study to the four dimensions of Mishra, it would mean that Belgium banks do not score well on the dimensions of open and reliable. That seems to be more fitting to the conclusions the Deloitte report makes that there is a deep distrust between the public and the financial services industry than the used trust equation merits. It seems that the outcomes of the trust equation do not correspond with the overall Deloitte conclusions. The question is then of course if the trust equation can be altered to better reflect trust and its applicability. Figure 12: Defining customer trust elements in Belgium (Source: Deloitte, 2010) Figure 11: Smart trust matrix (Source: Covey, 2006)
- 27 -
A possible adaptation of the equation could come from one of the models Covey introduces: the Smart Trust Matrix. (Covey, 2006, p. 268) In this matrix he juxtaposes Propensity to trust (tendency that people/companies are worthy of trust) and the Level of analysis (ability of the mind to evaluate and consider implications and possibilities). The Deloitte study suggests that the propensity to trust in financial service providers is decreasing. It however does not relate this with the level of analysis customers make in the services they choose. In the book The Trusted Advisor, Figure 13 was presented that illustrates how one evolves from a subject matter to a trusted advisor. (Maister et al., 2000)
Also the theory of peer-production suggests that the customers of information services (including financial) transform into informed users that a company needs to interact with. In the theoretical framework section, the possibility to include the depth of personal relationship (trust) and level of analysis (information supply) in the trust equation will be further researched. 2.6. Summary Massive disruption in the banking sector in 2008 caused a global financial crisis. The crisis coincides with the rise of new financial phenomenon p2p-lending. This literature review presented the following findings: - A decrease of trust of customers in the financial (regulatory) system; - Stakeholders put pressure on financial institutions to improve transparency; - Increase in political pressure to the financial sector to reduce system risk; - Too little adaptation in the financial sector to IT investments and product innovation in the fast changing and global networked economy; - The rise of decentralised, user oriented and user driven business; - The increasing importance of commons based peer-production in todays society; - The association of p2p-lending with credit, operational and legal risk; - A lack of strategy in the financial sectors to regain trust of the user (not the consumer) of financial services; - The lack of a convincing trust equation to measure trust in the financial sector.
The findings of this literature review allow us to design a theoretical and conceptual framework for the researched p2p-lending phenomenon.
Figure 13: Evolution of client-advisor relationship (Source: Maister et al. 2000)
- 28 - CHAPTER 3. RESEARCH METHODOLOGY AND CONCEPTUAL FRAMEWORK This chapter is a top-down design that reflects the outcomes from the previous chapter. The conceptual framework for this thesis processes and synthesises the ideas and the information from the literature sources and presents them in a logical and coherent way. 3.1. Problem Statement Since 2005 a plethora of new p2p-lending initiatives started. Most of them are based in the UK and the USA. The market for p2p-lending in the Netherlands, which has a long tradition of innovative financial services, is underdeveloped. Although p2p-lending platforms now have millions of users worldwide, the regulatory system for this kind of financial services is still immature. The business model of traditional banks is based on the profit margin between the interest they pay savers and the interest they receive from borrowers. For borrowers with a good credit history this profit margin is between 2 and 3%, while the profit margin for less credible borrowers can increase to 12% or more depending on the risk the bank has in this loan. (NRC, 2007) P2p-lending is reducing this profit margin. Borrowers use p2p-lending as an alternative source of credit. Interest rates may be lower than those on traditional loans or credit cards. As of March 31, 2011, the annual percentage rate for a 3-year loan was as low as 6,3% for p2p-lending at the USA based provider Prosper while the average annual percentage rate for credit cards around that time was 14,7%. (GAO, 2011, p. 9)
The concept of p2p-lending, as explained in the previous chapter, challenges customers of traditional banks to become users of a decentralised system for loans and savings. It offers lenders the opportunity to increase the return on their investment, while it offers borrowers the opportunity to lower the cost of their loan. Apart from financial incentives, the concept of p2p-lending relates to a shift in customer behaviour. From being a passive customer focusing on specific products, people become active users and co-create products, services and knowledge with other users. Within such peer-production structure there is a great need of trust. Based on Coveys claim that trust is the hidden variable in the formula for organisational success, this research states that for the new financial service phenomenon of p2p-lending, trust is the dependent variable. This research focuses on the problem what variables influence trust in financial services and how a p2p-lending platform in the Netherlands can increase trust through organisational design, company policy, values and peer production structures. 3.2. Research Objectives The primary objectives of this research are: 1. Exploring patterns of trust and to identify variables that contribute to trust or cause a decrease in the level of trust in financial services; 2. Research the possibility for and the necessity of peer-production structures in p2p-lending platforms; 3. Identify causal relations among the identified trust variables that contribute to a tangible and measurable equation for trust in p2p-lending; 4. To empirically demonstrate the pro and con arguments for p2p-lending services; and 5. To develop a conceptual model how a p2p-lending platform should be organised.
- 29 - 3.3. Theoretical Framework Although researched on a case-by-case basis by Herzenstein (2008), Freedman (2008) and Berger (2009) little has been written about the paradigm shift p2p-lending causes in terms of regulation, trust and user centred peer-to-peer structures.
The overlapping part of the three depicted services defines the area of research where p2p-lending is operating. The figure indicates that in p2p-lending trust and peer-production are strongly correlated and banking regulations are a more external factor in defining p2p-lending.
This thesis will therefore focus on three areas within the online p2p -lending services: 1) The need of trust in financial services; 2) The importance of peer-production structures of co-creation and information sharing in the decentralised model of p2p-lending; and 3) The need of new government imposed banking regulations to regulate and/or control this new financial service.
Ad 1) As trust is central in the research, specific variables are defined to measure trust in financial services. Based on the available knowledge as expressed in the literature review, 10 eight variables were defined and related to the four dimensions of Aneil Mishra (reliable, open, competent, and, concerned) and the Deloitte (2010) trust equation: TRUST = (Credibility + Reliability + Intimacy + Openness)/ Self interest.
10 The variables were selected from the Deloitte (2010), Covey (2006), GAO (2011), Berger (2009) and Freedman (2008) studies. Banking regulations
Peer Production
Trust Figure 14: Positioning regulation, peer production and trust (Source: Author) Reliable: 1. User: The level of regulation and control by the government. 2. Provider: Focus on customer value or shareholder value. Open: 3. User: Access to information and knowledge. 4. Provider: Bi-directional communication strategy (cooperation structures between users and between users and provider) to realise a higher level of analysis. Competent: 5. User: The level of fulfilment of the values of the financial service provider. 6. Provider: The level of bad debt. Concerned: 7. User: The level of service experienced by a customer from its provider. 8. Provider: The number of contacts and the depth of personal relationship with users.
- 30 - The intent is to come to a new tangible and measurable trust equation for the p2p-lending business. The eight variables include one variable from the financial service provider perspective and one variable from the user perspective. In the research, To acquire data, the online survey will gather data on the defined variables for p2p-lending.
Ad 2) To measure the importance of peer-production structures of co-creation and information sharing in the decentralised model of p2p-lending, the comparative case study model as defined by Yin (2003) is used combined with the literature from Benkler (2006) and others to analyse if p2p-lending can be classified as a user driven peer-production structure.
Ad 3) To define the need of new government imposed banking regulations to regulate and/or control p2p- lending, the case study and the literature review will compare different regulatory regimes in order to recommend a regulatory p2p-lending model for the Netherlands. 3.4. Research questions My research will focus on the major research question: 3.4.1. Minor research questions (MRQ): 1. What are the intrinsic reasons for participants to use a p2p lending platform? 2. How do customers define Trust in financial service providers (including p2p-lending) and what variables contribute to the level of trust? 3. Should the government regulate peer-to-peer lending? 4. How does the model of peer production relate to p2p-lending? 5. What are the loopholes in current banking regulations vis--vis p2p-lending? 6. What would an organisation model for p2p lending in the Dutch retail banking sector look like? 7. Is a viable economic model available for p2p-lending and what does it look like? 3.5. Research Design and Methodology As the previous chapter clarified, literature is used to help identify theories and ideas to develop a conceptual framework for this thesis. This framework is tested via qualitative research and empirical observation and the collection of data via a comparative case-study analysis and a quantitative Internet mediated survey. To construct validity, the outcomes of this data are interpreted to answer the major and minor research questions.
What are the regulatory and the market requirements to co-create a trusted online peer-to-peer lending platform for consumer credit in the Netherlands?
- 31 - 3.5.1. Case study analysis Building on the literature study, various p2p-lending platforms will be evaluated in a multiple (comparative) case study analysis. The case study, like other research strategies, is a way of investigating an empirical topic by following a set of pre-specified procedures. It comprises an all-encompassing method that covers the logic of design, data collection techniques and specified approaches to data analysis. (Yin, 2003, pp. 13 17) This research investigates the p2p-lending phenomenon within its real-life context via multiple case studies and searches for quantitative evidence and builds on the benefits from the prior development of theoretical propositions. This case study has the following research design components: (Yin, 2003, pp. 21- 29) - Question: The case study is meant to analyse a number of well known best-in-class practices for p2p- lending. Empirical evidence is collected for the following research question: How and why do existing peer-to-peer lending projects integrate trust in their business operations. - Units of analysis: Based in extensive research of p2p-lending platform carried out in 2010 and 2011, two p2p-platforms were selected for further analysis based on number of users, geography, number of years in operation and the availability of research data. i. ZOPA.com (United Kingdom in operation since 2005); ii. Prosper.com (USA in operation since 2005); - Propositions: The research question is based on the following propositions that help focus in the case study research: a) Trust is fundamental for p2p-lending; b) p2p lending platforms focus on financial benefits; c) Using p2p-platforms leads to more interaction between users of the platform. - In the analysis a logical linking between the available data and the formulated propositions is made to explain certain phenomena: - Proposition (a) is linked to the measures the p2p-lending platform has taken to increase trust. - Proposition (b) is linked to the business model of the platform. - Proposition (c) is linked to the interaction design and the information provided to the lender and the borrower. This data collection tactic incorporates multiple Internet based sources of evidence to construct validity of the data. 3.5.2. Quantitative Internet mediated survey In July 2011 a quantitative Internet mediated survey was designed and posted on SurveyMonkey.com. The survey is used for exploratory and descriptive research to suggest possible reasons for particular relationships between the variables formulated in the major and minor research questions, and to produce models of these relationships. (Saunders, Lewis & Thornhill, 2009, p. 144) The survey focuses in particular on: - What kind of users are interested in p2p lending? - How do customers define Trust in financial service providers and what variables contribute to the
- 32 - level of trust? - What are the reasons for participants to use a p2p lending platform? - Should the government regulate peer-to-peer lending?
The survey allows that we move to the explorative research via the survey, in addition to the case study, which is based on propositions. Three types of questions are asked in the survey: - Opinion variables are included to measure how respondents feel about p2p lending and their level of trust in financial service providers. - Behavioural variables in the survey help to measure what respondents financial behaviour was in the past, how they operate now or will do in the future; - Attribute variables are used to collect characteristics of the respondents including gender, income, age, education and Internet skills.
The design was checked on content validity to ensure that the questions asked, provide adequate coverage of the investigative questions. The survey focuses on minor research questions 1 to 5 as formulated in the previous paragraph of this chapter. Linking some questions of customer behaviour to secondary data certifies the predictive validity of the survey. And finally, the construct validity was tested to ensure the questions of the survey measure the presence of the constructs as formulated in the five minor research questions. (Saunders et al., 2009, pp. 373-399) The questionnaire was pilot tested by several persons, among whom an external survey data expert to test the face validity of the survey.
Surveys of the general population that rely only on the Internet can be subject to significant biases resulting from under-coverage and non-response. In general people with low incomes, basic education or with an age older than 60 make less use of the Internet. Literature (Saunders et al., 2009, PeoplePulse, 2011) indicates that large invitation lists are associated with lower response rates for quantitative Internet mediated surveys. As the topic of this research is quite complex and technical in nature, it was important that the sampled population had some familiarity and knowledge to the issue of savings, loans and social networks in order to create conditions for a high response rate. An additional feature of the research that could limit response was the personal information asked for in the survey such as income, amount of loans and savings. These topics are considered as very personal in the Netherlands and could severely reduce the number of people willing to respond. It was therefore important to use an invitation list that was focused on the target group.
Respondents were gathered in a two-stage process from a total of 1600 people from the authors contact database on his computer, his Facebook account and his LinkedIn network. People were selected with the following characteristics: - Older than 15; - People with a clear link to the Netherlands; - People with good Internet skills that are member of at least one social network.
The following number of people was approached via a direct invitation to take part in the survey:
- 33 - 1 st via Facebook (selection of n=260), 2 nd LinkedIn invitation (n=189), 3 rd e-mail invitation (n= 60)
This brought the total primary research group at n=509. This group received a direct link to the survey that was posted at http://www.surveymonkey.com/s/T5HVSSJ. The exact questions of the survey are included in the appendix. The survey was available for answering between 13 July and 24 July 2011. A reminder was sent in the second week.
The 509 invitees were also invited to forward the invitation to other people they expected to be interested in the topic. The survey was promoted via a sponsored Facebook advertisement campaign from July 15 till 20 July 2011. 11 The prognosis was that in total 1000 persons would receive the invitation. The expected response rate was set at 16% (n=160). 3.6. Explanation of the data analysis This methodology of data analysis examines the contextual conditions of p2p-lending. The methodology has a deductive approach as it leads to gaining understanding of the dependent variable trust in financial services based on the gathering of qualitative data and the generalisation of this data based on a small sample size. This is possible because the analysis is based on a close understanding of the research context. At the same time, the research includes deductive approaches as it gathers quantitative data and links theory to the acquired data. The research methodology should lead to new understanding of the variable trust in financial services. The next chapter will interpret and assess the gathered data and information in light of the presented conceptual framework.
11 The author created an advertisement account on his Facebook profile and accepted to pay a price of !0,59 for each person that clicked on the advertisement with a maximum of !40 per day.
- 34 - CHAPTER 4. FINDINGS AND DISCUSSION This chapter presents the results of the survey and the case study analysis. It relates the outcomes to the literature to interpret, support and validate the findings. The results help benchmarking this study vis--vis the findings from other studies and literatures. 4.1. Response rate of the survey The presented results of the quantitative survey are based on the responses of n=102 individuals. The survey was conducted between 11 and 24 July 2011. The aim of this research is to measure customer trust in the banking industry in order to obtain a better understanding of: - How customers value the level of trust and services of their financial service providers (including banks); - What important variables are for measuring trust; - How people think of p2p-lending; - Segmentation of responses based on gender, education, age, income and geography.
Eleven respondents only answered the first question of the questionnaire and then left the survey. After the closing of the survey, these respondents were deleted from the total records to prevent a bias in the total results. This number of eleven is considered acceptable as the topic under research and the questions asked contain explicit information on respondents income, loans and savings. A subject that many people, especially in the Netherlands, consider as private information that they are not willing to share. With this Figure 15: Origin of the respondents (n=77)
- 35 - filter, the total number of respondents to the survey is 91. Of these respondents 83.5% (n=77) completed all questions of the survey.
The respondents that answered the questions were invited via Facebook (260 people invited, number of respondents 38, response rate = 15%), LinkedIn (189 people invited, number of respondents 16, response rate = 8,5%) and via e-mail (60 people invited, number of respondents 12, response rate = 20%).
Next to this direct invitation strategy two actions were initiated to attract people to the survey from outside the authors network: 1. Friends of friends: people that were being pinpointed to the survey by friends of friends via Twitter, Facebook, LinkedIn or e-mail, resulted in a response of 11. 2. A Facebook campaign that was initiated on July 15. In first instance, people were selected via the Facebook segmentation tool that allows defining the target group based on their Facebook profile information. The following parameters were defined: o Living in the Netherlands; o 15 years and older; o Interest in social networking (this means they include this tag in their Facebook profile).
- 36 - Facebook computed the target audience to consist of 10.647 Facebook profiles. An advertisement was uploaded to Facebook to appear on the profile page if this group accessed their account. After two days it appeared that the advertisement (as shown in the overview above) was published at 259 profiles but none of these people clicked on the advertisement to access the survey. It was therefore decided to broaden the scope of the target group and not to filter on the interest social networking anymore. This resulted in a total target group of 4.503.620 profiles (above 15 years old and living in the Netherlands). In the remaining period of the campaign the adjusted advertisement appeared on more than 700.000 individual profiles. Only 184 persons clicked on the advertisement to access the survey. None of these people completed the survey.
This outcome of this response rate is considerable lower than was expected at the start of the survey. It was expected that the multiplier effect of friends that forwarded the survey invitation and the Facebook advertisement would double the number of respondents. The prognosis was that in total 1000 persons would receive the invitation. The expected response rate was set at 16% (n=160) Figure 17: Details initial Facebook campaign (Source: Author) Figure 16: Final scores Facebook campaign (Source: Author)
- 37 -
This leads to the following observations for this survey: - Focused targeting of respondents from your personal network represented 85% of the total respondents. - Indirect targeting via people in your network contributed for 15% extra response; - Limited-focused targeting via Facebook advertisement did not significantly increase the response rate. - The respondents (n=102) represent a focused target group from the Netherlands (63 respondents are from the Netherlands, 14 from other countries) of 15 years and older and with online social network skills. 4.2. Characteristics of the respondents Of the respondents, 66% is male and 34% female. All respondents conduct their regular bank affairs (payments and savings) via the Internet and 93% have a savings account (48% more than !20.000) for which more than 70% receive less than 3% interest. Of this group, 59% has been with their bank for more than 10 years. Only 41% have some form of consumer credit and for most of them (65%) the amount of consumer credit is smaller than ! 2000. It is striking to notice (See Figure 18) that 32% of the respondents (10 people) do not know what interest rate they pay for this consumer credit, while 38% say they pay more than 8% interest per year. The survey segmented respondents in the following age categories: - Silent generation (age 65-75), n=2 - Baby boomers (age 45-64), n=11 - Generation X (age 32-44), n=55 - Generation Y (age 15-31), n=9
The largest group of respondents is Generation X. Most respondents in this group have been active on the Internet for more than 10 years (93%) and are on average member of 3,3 social networks. In comparison: only 75% of the baby boomers have been active on the Internet for more than 10 years, and on average they are member of 2,9 social networks. From Generation Y 55% has been active on the Internet for more than 10 years and on average they are member of 2,4 social networks. Figure 18: Paid interest rate for consumer credit (n=31)
- 38 - Figure 19 represent the level of education and the household income of the respondents. The figures show that 80% of the respondents have at least a master degree (in comparison, 25% of the population has a bachelor degree or higher in the Netherlands). The pie chart indicates that 59% of the respondents have a household income of ! 60.000 and higher, while the average gross household income is ! 55.000 in the Netherlands. These results indicate that on average the respondents are disproportionally high educated and have a disproportional high income. 12
The survey results show in Figure 20 that 31 of the 91 respondents have a consumer credit. For their level of trust in their financial service provider, seven respondents give a score of 5 or lower (23%) while 24 evaluate
12 The average figures of population are based on Dutch central statistics organisation (CBS) and the data were gathered from: http://statline.cbs.nl/StatWeb/publication/?VW=T&DM=SLNL&PA=70843ned&D1=a&HD=110707- 0647&HDR=G1,G2,T&STB=G3
Figure 20: Level of service and trust in provider consumer credit (n=31) Figure 19: Level of education and income (n=81)
- 39 - this trust level with a 6 or higher (77%). Of the same group, 11 respondents evaluate the level of service with a 5 or lower (35%) and 20 with a 6 or higher (65%).
If we look at the same trust and service variables for saving accounts in Figure 21, the scores are more or less similar. Only 13 respondents (n=82) evaluate trust with a 5 or lower (this is 16%) while 33 respondents evaluate the service level (n=84) with a score of 5 or lower (39%).
Furthermore, the survey showed that of the people with a high income (above ! 60.000) 55% valued their trust above 8 or higher. Based on these figures, the level of trust is evaluated with a higher score than the level of service. Actually, the financial service providers can, despite the financial crisis, still count on an acceptable level (between 77% and 84%) of trust among their customers. This high score is surprisingly high and higher than expected, based on the outcome of for example the Deloitte study (2010, p. 9) in Belgium in which one out of every three customers does not trust banks in general.
The survey also measured (Figure 22) what the level of trust in the financial sector in general is. The scores on this question turned out to be quite different. More than 41% evaluate this level as low or very low while almost Figure 21: Level of trust and service in provider saving accounts (n=84) Figure 22: Level of trust in the financial sector in general (n=82)
- 40 - 48% gives a score of neutral. Only 11% has high or very high trust in the financial sector in general. That is exceptionally low if you consider, as one respondent noted, that: Trust is the most important fuel for any (money related) business.
Almost 60 respondents eagerly put some additional comments to this question, which are summarised in the paragraph below. A wide spread voice was echoed in the comments about the dishonesty in corporate practice of the financial sector: I believe the money is save, but banks slowly lower the interest you get on your savings account step by step every year, and they expect that their customers do not notice this practice, or get used to lower interest rates. Misleading their customers is 'corporate policy' in the finance world. Other critique reflected the idea that the companies interest is not necessarily the same as the customers interest. The financial sector is not very transparent. It is based on high profit margins, a high bonus culture, a focus on shareholder value and a lack of intrinsic need to reorganise their business. The financial sector is not suffering from this financial crisis as much as other sectors.
Some of the respondents linked the perceived behaviour of the financial sector with a decreasing trust: I tend to trust them in the sense of 'my money is in save hands'. On the other hand, thinking about what these guys and girls did with the money that led to the financial and euro crisis, that is not really worth my trust. I don't trust the financial sector in the sense that the institutions are honest and open to their customers. But it is up to me to take the responsibility for my own savings and loans and keep myself informed and make balanced decisions. Other respondents complained about the lack of information they get from their financial service provider: It is very unclear what the financial institutions actually do with my savings. I receive an interest rate of 1.6 % whereas I know that the returns for these institutions are much higher. The least they could do is offer me a good interest rate. Besides this their products are not transparent and complex.
Other respondents put it more mildly and stated: The sector is in a feeble state, but are making effort to clean up the current state of affairs. In my opinion they manoeuvred themselves in the heart of the product and service chain instead of supporting this chain. This brought them profit opportunities too hard to resist and it resulted that they make too much money for the added value they provide. This last comment can be interpreted as a call for new market entrants that focus more on the user of the financial system and add more value to the service it offers.
Some respondents argued that high-risk ventures with high short-term profits will continue to dominate banking in general. Competition levels in banking are demanding high profit margins. The sector is short- term profit driven and incentives at various organisational levels do not reward long-term stability. Moreover, financial regulators have difficulty attracting the best and brightest experts, which can keep up with the for- profit financial services industry. Final factor is that politicians from the Reagan and Thatcher era onward eliminated rules and relaxed the Tier-1 capitalisation ratios. This removed the stability of the sector and dampened its buffers. This last comment seems to suggest that the financial sector is in a kind of systemic circle that is difficult to change and that without controlling regulations, most banks will probably revert to
- 41 - their 'old ways' of taking high risk to ensure large short-term profits. For some respondents it was an eye opener that rules and regulations for the financial industry need to remain controlled and verified to avoid, for example, a new economic downturn due to the current euro crisis. Although the Euro as currency is currently weak with the crisis in Greece, Ireland and Spain, and now in Italy (the 3rd biggest economy in the EU), I am confident that politicians will continue to support the financial sector once it is in trouble. They simply have to.
Based on the survey, it seems that people have a higher trust in their own financial provider than the sector in general. This large divergence in assessing the individual provider from the system at large, is most probably a consequence of the financial crisis of 2008, the current Euro crisis or the fact that the savings at their own financial provider are secured by the Dutch central bank, while the financial sector in itself does not have such guarantees. It is safe to conclude that there is only a thin line between trusting your financial service provider and distrusting the financial sector. Moreover, we can conclude that trust and reliability are key-characteristics for the financial service providers, but ultimately they are perceived to be working for profit margins and shareholder value and as companies that may not have the interests of the customer let alone the larger common good as their first priority. This conclusion is of great importance for defining the strategy of any financial service provider. The next paragraph will elaborate on this issue.
- 42 -
4.3. What are important variables for measuring trust in financial services? Respondents answered two questions to indicate how they measure their level of trust in a financial service provider. Per respondent a maximum of three indicators that increase trust and three indicators that decrease trust could be given. Figure 23 indicates that almost 70% of the customers define trust based on the level of service and the contact they have with their financial service provider. Second best (65%) is the track-record of the financial service provider and thirdly the involvement of the government in the regulation of the sector. Respondents specified some other indicators which are important to them but which were not mentioned in the list including: - Business philosophy regarding how the financial sector should operate and how products relate to that; - Focus on sustainability; - Ethical investments, especially the fairness level of an institution to customers and workforce; - Background and track record of the top management; - History of the financial institute as being risk-taking or conservative. But also is it a cooperative (therefore more true to the original goal of a bank as an utility) or a commercial entity?
Figure 23: Indicators that contribute to the level of trust (n=77)
- 43 - The indicators that contribute in a decrease of trust are listed in Figure 24. The lack of transparency in information provided by the financial service provider contributes most in a decreasing trust according to 83% of the respondents. The two other main indicators are the disproportional management bonus and reward systems (62%) in the financial sector and the current financial crisis (48%). Respondents added one indicator as a decreasing trust factor, not mentioned in the initial options: shareholder focus in the corporate strategy.
Both figures present an interesting view on how financial service providers can increase the trust level of their clients themselves at relative low costs: a better communicative and qualitative information strategy would be very important as well as a transparent reward system for management. It is therefore striking to see the figures on the level of contact financial service providers have with their customers. Almost 70% of the respondents indicate to have a maximum of two contacts per year with their financial service provider. Figure 24: Indicators that contribute to a decrease in trust (n=77)
- 44 -
4.4. What is the propensity to start using the p2p-lending mechanism? This category of the survey researched the propensity of the respondents to start using a p2p-lending service. In the introduction to the questions the basic ideas and mechanisms behind the service were explained in plain language.
Figure 25 shows that of the respondents, 52% is interested in p2p-lending as a lender (43 persons). Of these 43 respondents, 15 would also be interested as a borrower. Of the respondents 48% indicated that they are not interested in the system at this time. Many people gave additional feedback to this question and explained their reason of choice. Most of them (16 persons) argued that they would need more information about the associated risks in order to make an informed decision. As one of the respondents wrote: Unless there is some form of institutionalised system of checks for this sort of lending, I would be hesitant to lend or borrow. I'd be worried about the risk of the borrower not being able to pay back the money (principal as well as interest). Many mentioned trust-issues, i.e. they would need quite some convincing and proven track records before they would be tempted to engage in a p2p-lending scheme, as it is unknown what the exact risks are as both a lender and as a borrower: I would hesitate to believe any risk profile data, because when enough data is gathered high-risk profiles might appear as low risk profiles. Some of the potential lenders added that they would also be interested to invest in small business ventures as this would help small business to get access to capital, which they otherwise would not have. Figure 25: Interest in p2p-lending (n=82)
- 45 - A number of comments also stressed that they were not interested at all in spending time on borrowing money to others and the associated tasks: It depends too much on personal involvement and commitment, while others see this point as a positive point: It is interesting to be more involved with banking matters. It turns banking from boring into a game or sport with real other people.
After this question, respondents that answered YES were asked why they would use a p2p-lending service. Almost 64% answered that they would choose for p2p-lending because it gives More interest payment for the lender and less for the borrower compared to traditional banks. In addition, 56% answered that: I like the do-it-your-self culture of peer-to-peer lending without intervention of any institution and 44% highlighted the reason Because the interest payments of a borrower go to real people and not to a bankers' bonus. These answers indicate that the competitive interest rates, the peer-production feeling and the reward schemes of p2p-lending are competitive advantages vis--vis traditional banks.
Figure 26: Reasons to use p2p-lending (n=41)
- 46 - The survey continued then by explaining to the respondents how p2p-lending platforms check and assess the risk profile of each borrower. In addition, the given information clarified that a p2p-lending contract is between the borrower and the lender and that the p2p-platform is not part of the contract. As this system of saving and lending is quite different from traditional banking, participants were questioned about their perception of risk from a borrower and from a lender perspective, as well as the need of trust in this system. The outcome (Figure 27) shows that 72% of the respondents agree that the need of trust from a lenders perspective is high or very high. From a borrowers perspective, the same categories amount to only 43%, indicating that the issue of trust is perceived as bigger for lenders than for borrowers. The same conclusions can be drawn from the perception of risk in p2p-lending. For lenders this is assumed high or very high by 47% while for borrowers this is only perceived as high or very high by 21% of the respondents (n=77).
The final question posed on p2p in the survey related to the role of the government. Information provided with the question described that the government sets specific regulation for traditional banks to control the sector and to protect the customer and that it is more difficult for the government to regulate p2p-lending as the platforms provide a service and are not banks in themselves.
Figure 27: Perceived risk and the need of trust in p2p-lending (n=77)
- 47 - Of the 77 people that answered the question Should the government introduce specific p2p lending regulation for the consumer credit market?, 64% said yes (Figure 28). As some respondents explained: The government should take care that the mechanism will be and will stay transparent and they should control that the money is used the way it is stated. Some institutionalised regulation would boost the confidence in p2p-lending. Others are more sceptical about a governments role: I don't think the government would be the logical regulator, but some regulation seems imperative as legal agreements with financial consequences should somehow be monitored by the government to increase the security for the lenders in p2p-lending. Others dont see a role for the government at all: Why is this a task for the government. The government probably should not do this for consumer savings either; financial service providers should insure this by themselves. A proper insurance construct, to be paid from the transactions would be more appropriate. This should be an opt-in clause for p2p-users. P2p lending is just another platform where net lenders (SSU) meet net borrowers (DSU). If a consumer wants to have protection, he has to choose the traditional way of saving or borrowing at a traditional bank. If p2p wants to provide consumer protection, it has to generate money to do so. This means borrowing will be more expensive.
Providing the volume of money involved, p2p-lending does not influence general monetary policies or society and therefore it can be argued that regulation is not necessary, as one respondent did. It looks like a good idea to have this regulated by the market itself instead of governmental influence and guarantees. So far governments haven't been able to regulate traditional banks very well either. Due to the large interests in the financial sector, the power of the government is limited. The p2p-lending system is too young and still in development. To introduce a system of regulation would mean institutionalisation and that would kill the innovative impulse. In the end, the system has a self-regulating mechanism for the moment: trust is the key- factor and this factor can only be upheld if the p2p platform functions transparent, careful and has an innate controlling mechanism.
As these comments again and again show the importance of trust, it will be interesting to see how two market leaders, UK based Zopa and USA based Prosper have positioned themselves in the market. Figure 28: Is there a need for government regulation in p2p-lending? (n=77)
- 48 - 4.5. Multiple case study analysis This multiple case study analysis is meant to analyse a number of well known best-in-class practices for p2p- lending on top of the literature review and the survey data. Empirical data was collected on the Internet in the period 01 July 2011 till 01 August 2011. Primary focus for the case study was the following research question: How and why do existing peer-to-peer lending projects integrate trust in their business operations. Based on the number of users, the geography, the number of years in operation and the availability of research data, ZOPA.com and Prosper.com were selected. In addition, two platforms started operations in the Netherlands in 2011: http://www.geldvoorelkaar.nl and www.crowdaboutnow.nl. Unfortunately, the lack of data and activity on both platforms at this time, has prevented to fully analyse these two projects as part of this research. The same is true for the Chinese platform www.ppdai.com.
The first step in the case analysis is a simple overview of the platform basics and the tagline the company uses.
UK based Zopa (Zone of Possible Agreement) started operations in 2005. Currently it has more than 600.000 members with an average age of 44 that can get loans up to 15.000 GPB.
Mission: Zopa's interest rates aren't squeezed by middlemen (the banks) because there are no middlemen - that's the Zopa idea. www.prosper.com
US based Prosper started in 2005 and in July 2011 has 1.100.000 members that can borrow up to USD 25.000. So far, it has $248.000.000 in personal loans funded.
Mission: Peer-to-Peer Lending Means Everyone Prospers
A second step in the case analysis is to research the business model of the various platforms to validate that the respective p2p-lending platforms operate for financial benefits.
- 49 - Zopa earns money by charging borrowers a 100.00 transaction fee and lenders a 1% annual servicing fee. If a borrower defaults on part of their loan, the lender is not charged a 1% annual servicing fee for that part. In the last twelve months, the total lent amounted to more than ! 60.000.000 with an actual default level of 0,14% (Zopa, 2011)
Prosper fees only result from obtaining a loan as a borrower or having your loan serviced as a lender. The closing fee is a percentage of the amount borrowed and varies by Prosper Rating (which has the same principles as the Zopa rating):
Table 4: Prosper rating and closing fee (Source: Prosper, 2011)
The closing fee is taken directly from the loan before the loan proceeds are transferred to the borrowers account. For example, if someone has a Prosper Rating of A or B and takes a loan for $5,000, he will be charged a $150.00 closing fee. The actual interest returns by rating are listed in Table 5. It clarifies that the actual return rate is 10,6% on average. It also illustrates that the loss rate increases from 2% for A ratings to 11,4% for HR (highest risk) rate. When it comes to p2p-lending it seems that such principal losses (charge-offs/loss rate) are part of the game. With strong underwriting and collections management prosper tries to minimise these Prosper Rating Closing Fee AA: 0.50% A, B 3.0% C-HR: 4.5% Table 5: Loans at Prosper (Source: Prosper, 2011) Figure 29: Bad debt levels at Zopa (Source: Zopa, 2011)
- 50 - risks (also via higher interest rates for higher risk debtors), but some losses are still likely. The annual servicing fee is 1%. For example, on a $5,000 loan with a 10% interest rate, the servicing fee, based on the daily principal balance, would be $80.70 over a full 3-year length. Since July 2009, Prosper investors have averaged annual returns of 10.6%. In this calculation Prosper does not include loans that have originated in the last 10 months so that they are not seasoned enough to show true default rates. (Prosper, 2011, Facebook, 2011)
In summary, the findings imply that the researched platforms operate from financial benefits. They compete on the return rate of the investments and try to limit bad debt via a number of measures. Although much more information is available from these platforms as from ordinary banks, the case study research has not found specific actions from these platforms to measure trust of its users.
A third step in the case study is to compare regulatory regimes. Zopa has received credit licenses from the Office of Fair Trading. Zopa is not authorised and regulated by the Financial Services Authority as none of Zopas activities warrants regulation. Zopa's business as a lending and borrowing exchange does not fall under any of the existing regulatory categories, and as a result the financial service authorities would need an act of parliament to create a new one. Zopa was closely monitored by the authorities whilst it performed activity that required regulation (the selling of insurance).
(Zopa, 2011)
Up to March 2011 Prosper and LendingClub (both US based) have made a total of about 63,000 loans, totalling approximately $475 million. (GAO, 2011) Investing and loan servicing activities on the Prosper marketplace are subject to state and federal regulation. Loans originated through the Prosper marketplace are made by WebBank, a Utah-chartered Industrial Bank, which is regulated by the Utah Department of Financial Institutions and the Federal Deposit Insurance Corporation (FDIC).
Prosper is subject to examination, supervision, and potential regulatory investigations and enforcement actions by state agencies that regulate consumer credit, trade, and commerce; and federal agencies, such as the Federal Reserve Board and the Federal Trade Commission, that administer the federal consumer protection laws, trade, and commerce. Prosper and the loans originated through the Prosper marketplace must comply with applicable state and federal lending laws such as the federal Consumer Credit Protection Act, Fair Debt Collection Practices Act, and Electronic Fund Transfer Act. (Prosper, 2011)
In summary, it seems that Prosper and Zopa have different strategies and company policies when it comes to regulation. Zopa is choosing for a company policy, an operational structure and activities that limit the involvement of the government to a bare minimum. Prosper, in contrast, chooses to clarify to its users that the government is controlling and regulating their business. This may not be surprising considering that the legal risks in the USA for any business type are considered high and that companies therefore ensure that they obey any federal regulation.
- 51 - As a fourth step in the case analysis I looked at measures of the p2p-platform in relation to minimise risk and increase trust. To minimise risk and to increase trust, Zopa has the following policy in place. Everyone that wants to borrow is credit-checked and risk-assessed by credit agency Equifax. People that dont meet the requirements cannot borrow at Zopa. People who pass the check, are put into four categories of different risk profile that all have their own interest rate. Lenders are encouraged to diversify risk by spreading money across a range of borrowers with different risk profiles. When a person lends more than ! 500,=, the money is spread across at least 50 borrowers in order to reduce the risk if a lender defaults. A collection agency pursuits missed payments of any borrower on each lenders behalf. In the event of a total business failure of the company Zopa, the loan agreements still stand, because Zopa is not a party to any loan contracts. Zopa provides information (including market data and expected levels of bad debt) to help lenders choose their terms. Any money that has been transferred into Zopa and is not lend out is held in a segregated bank account at Royal Bank of Scotland. So if Zopa did go out of business, that money would be returned to the lenders. (Zopa, 2011)
Prosper lenders generally provide capital in relatively small amounts for borrowers who are typically seeking fairly small, unsecured loans for consumer purposes, such as consolidating debts, paying for home repairs, or financing personal, household, or family purchases or, to a lesser extent, for business purposes. Lenders can invest in many loans and may fund an entire loan request or only a fraction of each loan request. As of March 31, 2011, Prosper lenders invested on average about $3,700. To borrow or lend money, each participant must register as a member and provide basic information to determine their eligibility as a borrower or lender. Each borrower must complete a loan application that is reviewed to determine creditworthiness. (GAO, 2011, p. 10) Prosper posts approved loan requests, including loan amounts, interest rates, and assigned letter grades on Prosper.com for lenders to review and choose to fund. Lenders do not make loans directly to borrowers. Rather, lenders purchase payment-dependent notes that correspond to the selected borrower loans. Once lenders choose which loans to fund, WebBank approves, originates, funds, and disburses the loan proceeds to the corresponding borrowers.
In summary, as with any source of credit, borrowers on p2p-lending platforms face risks such as unclear or misleading lending terms, discriminatory credit decisions or unfair servicing or collection practices. According to the GAO report, regulators, researchers, and consumer advocacy organizations generally characterized these risks as similar to the risks borrowers faced in obtaining consumer loans from banks or other institutions, but () generally agreed that the major for-profit, person-to-person lending platforms currently offer loans with fairly straightforward terms (e.g., fixed-rate, fully amortizing loans). (GAO, 2011, p. 31) Both platforms choose to minimize risks of both lenders and borrowers via the described measures. In all probability the effective use of these measures contributes to an increased level of trust in the financial service provider, although this is difficult to measure directly from the available data. To research the peer-production potential of the p2p lending platforms and thus the level of interaction between the users, the case study will finally look at the interaction design of the website, the use of social networks and the communication between users.
- 52 - Zopa is linked to a number of tools that are provided by Zopa or used by its users. It has on open API (application programming interface) 13 system that allows users to track data and information from Zopa and use it for their own analysis. In this way, content that is created in one place can be dynamically posted and updated in multiple locations on the web. The graph presented is from one of the users who publishes market data from Zopa on his website at http://www.ljay.org.uk/zopa/summ ary.html Another user created a webpage at http://www.p2pmoney.co.uk/compare/borrow.htm where one can compare rates of different p2p-lending providers. Apart from these applications, community members discuss most issues via the Zopa forum http://talk.zopa.com/index.php?act=idx that has 3000 members and more than 90.000 postings. Via the Facebook Zopa group (http://www.facebook.com/ZopaUK), more than 1200 Zopa users discuss various issues among each other and with Zopa staff (also via http://twitter.com/#!/zopa with more than 1750 followers).
If you browse the listings of Prosper you see a wide variety of loans in different rating categories and amounts depicted in Figure 31. If you zoom in to a specific loan you get more specific information. (Prosper, 2011)
As a potential lender, you can estimate the
13 In general, the practice of publishing APIs has allowed web communities to create an open architecture for sharing content and data between communities and applications. Figure 30: Total amount requested per Zopa risk category (Source: Ljay, 2011) Figure 31: Overview listings at Prosper (Source: Prosper, 2011)
- 53 - return (based on the effective yield minus the estimated losses) and get detailed information on the borrower. If one is interested, he enters the amount he is willing to invest in the offer. This way of communication is rich in detail and increases the information level of each lender.
Experiences are shared via the 2500 members of Prosper at its Facebook page http://www.facebook.com/prosperloans and 3300 via its followers at Twitter (http://twitter.com/#!/prosperloans/). It however does not have the great information source Zopa members created in the forum and via the API access.
In summary, both platforms use a number of tools to share information and to create social and cultural ties between the users. However, the level of interaction and the sharing of personal information is not comparable to the information people share on Facebook for example. The advantages of peer-production on the platforms are primarily used for better access to information and increased communication with users. Again, an increase in trust is expected from this use but is impossible to measure as long as no (research) data is available on the perception of trust and risk at both platforms.
Key characteristics of both networks include that although they present the platform as motivated from a contribution to the common good and to be organised from a customer driven perspective, both platforms operate from a financial benefit model. The term trust is not used in the communication strategy of the two platforms but credit and operational risk-management include checking and assessing potential customers.. These measures to increase the perception of trust are supported by interaction design that focuses on community tools and information and knowledge sharing. An interesting observation is that Zopa chooses for a very transparent information and community structure while limiting external regulation as much as possible. Prosper is less transparent in the provision of information but seem to organise their model more towards a monitoring and controlling role of external regulators.
Figure 32: Specifics per offering (Source: Prosper, 2011)
- 54 - Unfortunately, it proved impossible to check the self-regulatory system from the user-perspective or to validate the data presented by the p2p-lending platforms. Lets now move to the final chapter of this thesis where the major and the minor research questions will be answered.
- 55 - CHAPTER 5. CONCLUSIONS, RECOMMENDATIONS AND FUTURE WORK This chapter contains a set of logical conclusions and recommendations for implementation of those conclusions. 5.1. Conclusions to the minor research questions
1. What are the intrinsic reasons for participants to use a p2p lending platform? According to the GAO report individuals participate as lenders in p2p-lending platforms as an alternative to traditional savings that pay low interest rates. Borrowers use p2p-lending as an alternative source of credit as p2p-lending loans may be lower than those at a traditional bank. (GAO, 2011, p. 9) Of the respondents of the survey, a small majority of 52% is interested to participate in p2p-lending. The survey results show that almost 64% respondents would choose for p2p-lending because it gives more interest payment for the lender and less for the borrower compared to traditional banks. In addition, 56% answered that the decentralist system of p2p-lending is a decisive factor to use it. The third important intrinsic reason to use p2p-lending is also related to this decentralist system. People are interested in the system because they are trading (lending or borrowing) from person to person instead of a third party that organises the trade and takes a high profit margin for that service (44%).
The outcomes of the survey show that the financial motive is of greatest importance to choose for p2p- lending, but that the peer-production structure (decentralized, collaborative, and based on sharing resources and outputs among widely distributed, loosely connected individuals who cooperate with each other) is considered important as well. This last claim is supported by the fact that many members of the Zopa platform co-create, share and use different software tools, information and knowledge among users, moving well beyond the involvement expected from an average customer seeking a financial service.
2. How do customers define Trust in financial service providers (including p2p-lending) and what variables contribute to the level of trust? The literature review offered us Mishras (2000) concept of trust based on one partys willingness to be vulnerable to another party based on the belief that the latter party is competent, concerned, open and reliable. Coveys business formula states that strategy multiplied by execution and trust gives result and the Deloitte study (2010) claimed that trust could be defined by the equation: TRUST = (Credibility + Reliability + Intimacy + Openness)/ Self interest
In the theoretical framework we identified eight variables that could contribute to trust in p2p-lending and which were processed in the survey to validate their role to the trust variable.
The survey respondents had to answer five questions on trust in financial service providers. Based on the accumulated answers of these questions the following variables were considered the most important contributors to their trust in the financial service provider: 1. Transparency in information provided by the financial service provider (83% of the respondents);
- 56 - 2. The level of service and the extent of contact with their financial service provider (70%); 3. The history of the service provider and its brand image (65%); 4. The involvement of the government in the regulation and controlling of the provider (62%); 5. The bonus and reward systems of management of the financial service provider (62%) 6. The current condition of the financial sector in general due to the financial crisis of 2008 and the current euro crisis (48%); 7. The competitiveness of the service provider (30%); 8. Business philosophy and ethics regarding how the financial sector should operate and how products relate to that (14%).
The survey also measured how service providers score on specific variables. Asked about the level of trust in their own financial service provider 20% of the respondents defined their level of trust to be 5 or lower while 80% evaluated this trust level with a 6 or higher. Of all respondents, 37% considered the general level of service from their own financial service provider to be a score of 5 or lower. On the question what the level of trust in the financial sector in general is, the scores turned out to be quite different. More than 41% of the respondents evaluated this level as low or very low while almost 48% gave a score of neutral. Only 11% had high or very high trust in the financial sector in general. That is exceptionally low compared to the level of trust respondents said to have in their own financial service provider. These scores are in line with the findings of the Deloitte study
(2010, p. 9) in Belgium in which one out of every three customers did not trust banks in general. I believe this divergence should be explained from the widely shared idea that the general interest of financial service providers is not necessarily equal to the customers interest. Yet, even with a maximum of two contacts per year with their financial service provider (indicated by 70% of the customers), the service of individual financial providers is perceived as adequate to the extend of what can be expected.
In general the data presented supports the conclusion that people have a higher trust in their own financial provider than the sector in general. More boldly, I would conclude that there is only a thin dividing line between trusting your financial service provider and distrusting the financial sector. Transparency, service level, the track record of the provider and regulation are key-characteristics for the financial service providers and instrumental to the trust of customers to financial service providers. In the current climate of international financial instability and the challenge of traditional market by innovative new initiatives, this outcome illustrates that an interactive communication strategy and a qualitative transparent information strategy are essential contributors for any financial service company to invest in.
3. Should the government regulate peer-to-peer lending? In the first half of 2011 both the Dutch regulating authorities for the financial sector (DNB and AFM) as well as the American regulator GAO published their stance on p2p-lending. This illustrates that p2p-lending has in its six years of existence grown into a financial service that is high on the agenda of regulators. Literature confirms that unsecured p2p-lending causes high credit risks for lenders, on top of their exposure to an operational risk as many of them lack the knowledge to adequately monitor their transactions. At this stage, the legal risk of p2p-lending is difficult to assess as government authorities have not yet developed a
- 57 - definition on how to categorise this new form of services. The Dutch tax-authorities for example have yet to present a clearly defined policy about how to deal with the gains and losses associated with p2p-lending.
The survey asked respondents if they think the government should introduce specific regulation for p2p- lending consumer credits and 64% answered this question with yes. The main reasons stated in favour of government involvement include a role for the regulating bodies to monitor that the mechanisms of the p2p- lending marketplace will be and will stay transparent and to control that the invested money from lenders is used the way it is stated. The government should somehow monitor legal agreements with financial consequences. Such institutionalised regulation would also boost the confidence in p2p-lending. On the other hand one can very well argue that a proper insurance construct to insure the credit risk would be more appropriate. If a consumer wants to have more protection, he or she has the possibility to turn to more conventional ways of saving or borrowing at a traditional bank. In addition, p2p-lending does not influence general monetary policies or large groups in society and therefore it can be argued that regulation is not immediately necessary.
The described importance in p2p-lending of user-interaction and trust are difficult to combine with systems of limiting regulation and severe monitoring. With the development of the new services in mind, it would be undesirable to create a full regulatory system. On the contrary, trust is a key-factor and this factor can only be upheld if the p2p-lending platform takes responsibility to function in a transparent, careful way with its own innate controlling mechanism. At this stage governments should not aim to regulate p2p-lending but instead should provide a comprehensive framework for p2p-lending. Some recommendations for such framework are included at the end of this chapter.
4. How does the model of peer production relate to p2p-lending? Peer production structures created new non-contract based innovative services and products like Wikipedia, Open Office, Creative Commons licenses and open access based scientific publications. The question if peer-production can also enable contract-based cooperation strategies in the financial sector is as of yet difficult to answer. The case study analysis showed that both Zopa and Prosper use community tools to involve users in the co-creation of linked services to p2p-lending that give the users better access to information and knowledge to reduce both their credit and their operational risk. These tools create new lines of interaction between users and between users and the p2p-lending platform. This clearly is a move away from the conventional one-way distribution channel strategy of banks towards a user-orientated channel as pictured by King (2010) in his book Bank 2.0. We see that users are changing because of the psychology of self-actualisation and technology innovation and adaptation. This changing behaviour includes the wish for personal involvement and commitment that is necessary in p2p-lending. The service of p2p-lending then bridges a growing loyalty gap between users and the service providers. In their day to day business, traditional banks have almost no contact with their customers, while customers become better informed and are part of numerous social networks. P2p-lending exactly offers the possibility to be more involved with banking matters. It turns banking from a boring but necessary aspect of life into a community activity with real other people.
- 58 -
However, the information on Zopa and Prosper indicate that these platforms first and foremost operate from a financial perspective. They compete on the return rate of the investments and try to limit bad debt via a number of measures. This does not have to be a contradiction, but it does illustrate that p2p-lending as a mechanism still is in a development phase, where its main benefits are financial and not necessarily focused on peer-production issues and trust.
5. What are the loopholes in current banking regulations vis--vis p2p-lending? The financial crisis of 2008 showed that current international banking regulations fall short of their goal to prevent major fallouts. Several measures should be taken to address these shortfalls. But more regulation would also mean more control by the government of the financial sector to repair several weaknesses that were identified during the credit crunch. At financial industry level, companies need to regulate and standardise the way money borrowed from banks is included on the banks' balance sheets as well as agree on what percentage of the value of each securitized pool is retained in their own books. In addition, the financial sector should focus less on short-term profits, and abandon the larger part of its bonus system. At national level, authorities should require that all persons or firms who enter financial derivative transactions register the nature and size of those derivatives. Strong national institutions with experts with a deep analytical understanding of financial services are a must to avoid a future crisis. The crisis showed that rating companies and several governmental institutions proved not to be able to understand the more difficult financial products. A final measure to take would be to allow the national monetary authorities to act on fluctuations in liquidity conditions in the financial market. In general, the banking corporations should start acting more responsible.
In the meantime, public opinion is steadily changing towards a negative sentiment after billions of tax funds were invested to end the financial crisis and to save corporations managed with irresponsible (risk and money wise) behaviour. This could accelerate the process of disintermediation towards Internet and social network based banking such as p2p-lending.
- 59 - 6. What would an organisation model for p2p lending in the Dutch retail banking sector look like? In his book Bank 2.0, King (2010, p. 81) mentions that the branches of Dutch retail bankers ING and Rabobank witnessed 90% less visitors in the last three years. That observation coincides with the outcome of the survey, which indicate that most customers have contact with their financial service provider less than two times a year .This underpins the idea that the old branch model for banking is outdated. Any p2p-lending organisation should start with a model that puts the user in the centre. As Benkler (2006, p. 51) argues innovation and information production comes from a mixture of non-market sources (government and individuals) and market actors, whose business models do not depend on the regulatory framework of intellectual property. This implies that conventional banks are not in a position to initiate p2p-lending. And they probably wont, as King explains Banks probably are reluctant to invest heavily in p2p-lending because it would ruin their model and destroys profit margin. (King, 2010, p. 326) But, if the service as such works for customers because of its effectiveness and cost-efficiency, it will prevail in the end as the advantages of the product will win over the traditional banking model. A complete new generation (born after 1980) grew up as digital natives. For them the variable trust is no longer automatically related to traditional banking brands or consumer credit products as we still witness today. This generation knows almost instinctively that network applications or platforms need to be built on participation of the users.
Based on these findings, a p2p-lending organisation model should then be based on a triangle structure as depicted in Figure 33 that places the p2p-lending provider in the middle and is built on three pillars: users, values & trust and tools. The organisation itself can be rather flat and small. For example the Zopa organisation consists of 23 multidisciplinary professionals in total.
Interaction between the three pillars facilitates user input for co-creation and peer production of community tools and the formulation of value and trust standards in collaboration with the platform. Such a structure allows for a transparent information, communication and service strategy. Apart from the p2p-lending platform, an official users organisation should be initiated with the task to advise the management of the platform on pro-bono basis on relevant issues such as transparency, reduction of credit risk, research and Figure 33: The triangle structure for a p2p-lending platform (Source: Author)
- 60 - development projects and communication strategies. This organisation monitors that the rules and values of the platform are obeyed.
7. Is a viable economic model available for p2p-lending and what does it look like? Segmentation and customer intelligence through customer analytics capability will be the key for success of any p2p-lending platform. Understanding the users, their behaviour, their online habits and the way they use the various media (from games to news to services) is the only way to go forward and to work on push-pull based strategies in p2p-lending. As stated, the market for consumer credit in the Netherlands is approximately 875.000 contracts per year. The author (Groeneveld, 2011) of this research wrote a business plan for p2p-lending. This business model is based on a number of rules that include:
The research for the business plan showed that a break-even point for a p2p-lending platform in the Netherlands is possible at 11.000 transactions per year. This means the platform is feasible and viable at a minimum market share of 1,25%. 5.2. Conclusion to the major research question This paragraph will answer the major research question: What are the regulatory and the market requirements to co-create a trusted online peer-to-peer lending platform for consumer credit in the Netherlands? Based on the partial answers of the minor research questions and the outcomes of the case analysis, survey and literature review, this paragraph utilizes the theoretical framework and discusses the various components of this question. 5.2.1. Target group for p2p-lending This empirical research indicates a transition from a market-based product driven culture to a more personal fulfilment and user driven culture. This transition is manifest in p2p-lending. The main change in p2p-lending 1. Each borrower is assessed and officially credit risked at an A, B, C or D profile. Interest rates vary accordingly: a. A: min: 7.4% max 8.6% b. B: min: 8.7% max 9.8% c. C: min: 9.9% max 12.4% d. D: min: 12.5% max 18.8%
2. Lenders can invest a maximum sum of ! 40.000 divided over a maximum of 100 loans (maximum ! 400 per loan) and define their lending portfolio in one of the following three possibilities: a. Progressive: (30%-D, 40%-C, 20%-B and 10%-A) b. Neutral: (10%-D, 20%-C, 35%-B and 35%-A) c. Defensive: (20%-C, 30%-B and 50%-A)
3. Lenders only invest a maximum of 5% to a loan and have a lending limit of ! 400 per borrower.
4. Borrowers enter into legally binding contracts with their lenders.
5. Borrowers repay monthly by direct debit. If any repayments are missed, a collections agency uses the same recovery process that other banks in the Netherlands use and after three non-payments the borrower is registered at the national credit authority in the Netherlands.
6. The platform earns money by charging borrowers a !100,= transaction fee.
7. Lenders have no costs to pay for the p2p-lending services other than a ! 2,= payment per successful transaction to the user organisation. This organisation of chosen platform members has specific advisory and monitoring tasks to the platform.
- 61 - compared to traditional banking is the informed online (social) interaction and collaboration between users (both borrower and lender) and between users and the p2p-lending provider. This leads to an effective organisation structure that benefits the interest revenues for lenders and limits the interest costs of borrowers as long as the credit and operational risks are properly managed. The discourse of generation X and Y (roughly age 15 to 44) identify easily with innovative Internet based practices and peer-production structures. This is the primary target group for p2p-lending. 5.2.2. Market requirements Financial institutions, the incumbents of the industrial information economy, experience new market entrants as a possible threat as it is changing their business model. For traditional banks it is difficult to change their one-directional relationship with their customers to a bi-directional communication strategy. P2p-lending is creating new sources of inputs, and new tastes and opportunities for outputs. In general, p2p-lending clients are active and productive users instead of passive consumers. This change of closer integration of users into the process of banking is irreversible under the continuing technological developments and changing psychology of users. 5.2.3. Moving trust Based on the conclusions of this research, Figure 34 positions traditional banking customers in the first quadrant with a high propensity to trust in their financial service provider without the necessity to analyse all information of the financial products from their provider. This positioning, resulted in the buying of financial products (consumer credits, pension arrangements, life insurance policies and mortgages) that were not necessarily in the best interest of the costumer but rather contributed to considerable revenue streams of the financial service provider. This position is called Blind Trust.
General trust in this financial system with these financial products is decreasing. This means many customers of traditional banks slip to the area marked with a 2. A position with a lower trust level combined with a low level of analysis of the risks and the opportunities of their financial services. This position will result in a further decrease of trust in the financial service provider. Customers remain passive and will not be capable to make informed decisions about their financial matters.
In p2p-lending, customers become users. If they decide to choose for p2p-lending they have an inherent high propensity to trust. As user (borrower or lender) of p2p-lending they have access to information of the financial services and a pool of resources of community members to share knowledge and to come to informed decisions. These users positioned in quadrant 3: Smart Trust. In this quadrant decisions are Blind trust No Trust Dis- trust Smart Trust 1 1 3 1 2 1 Figure 34: Version 2 Smart trust index (Source: Covey, 2006)
- 62 - based on judgement both on the side of the financial service provider (the p2p-lending platform) as well as the user side. In conclusion, the p2p-lending provider and the users value each other as a resource for knowledge and information and build on a trusted relationship. 5.2.4. Regulatory requirements The described interaction and trust elements in p2p-lending are difficult to combine with limiting government regulations and severe monitoring mechanisms. Trust within a p2p-lending platform is built upon transparent and full information provision, online interactions with a number of community tool create innate controlling mechanism between users and between users and the provider. Although unsecured p2p-lending causes high credit risks for lenders and exposes users (that lack the knowledge to adequately monitor their transactions) to a number of operational risk. However, for any user it is a voluntary choice to use or not use p2p-lending as there is always the choice to stick with a traditional bank and their financial services. The allocation of financial services in the market itself is sufficient and therefore, there is no market failure
Government involvement should therefore be limited to soft monitoring of the p2p-lending marketplace as will be explained in the next paragraph. Government should certainly not impose the necessity for p2p-lending to acquire a banking license as the requirements of such a license would limit the possibilities of a viable p2p- lending model as it increases costs, increases external control mechanisms and increases the requirements for any transaction made on the platform.
P2p-lending platforms from their side should create proper insurance constructs to reduce the credit risk of lenders. The governments role is to promote this by designing a comprehensive framework for a more trustworthy p2p-lending environment. 5.2.5. A trusted online peer-to-peer lending platform In the theoretical framework eight variables were defined to measure trust and to come to a tangible trust equation for the p2p-lending business These eight variables were divided in four dimensions (reliable, open, competent and concerned) and included per dimension one variable from the perspective of the p2p-lending provider and one variable from the user perspective.
- 63 - The research results indicate that most of the eight variables indeed influence the variable trust in p2p- lending. The figure below lists all eight.
This leaves the question if and how we can measure these eight variables into a trust equation. All eight variables can be measured on a scale of 1 to 10 (1 being the lowest score and 10 the highest). Data gathering for the variables from a user perspective can be obtained via a survey among the users. Data on the p2p-lending provider can be obtained via observation techniques and company information. The maximum score for trust is 80. This results in the following ROCC trust equation:
If the minimum acceptable score per variable would be a score of 6, the minimum acceptable level of trust in a p2p-lending platform should be at least a score of 48. The target score of any platform should be at least 56 without any ROCC variable score under 6. 5.3. Recommendations This study concluded that, despite the credit, operational and legal risks associated with p2p-lending, the government should only play a moderate role to regulate and control the sector. The financial sector is in a deep trust crisis and p2p-lending can stimulate the transition in financial services to a more user-oriented structure. Based on the findings of the research, the following recommendations are made for the Dutch government agency AFM and for any p2p-lending platform:
TRUST = (R1+R2) + (O1+O2) + (C1+C2+C3+C4)/8
Figure 35: The new ROCC trust equation (Source: Author) Reliable: 1. User: The level of regulation and control by the government (R1) 2. Provider: Focus on customer value instead of shareholder value (R2) Open: 3. User: Transparency and access to information and knowledge to be provided by the p2p-lending provider (O1) 4. Provider: Bi-directional communication strategy (cooperation structures between users and between users and provider) to realise a higher level of analysis (O2) Competent: 5. User: Fulfilment of the values of the p2p-lending platform (C1) 6. Provider: The level of bad debt (C2) Concerned: 7. User: The level of service (C3) 8. Provider: The number of contacts and the depth of personal relationship with users (C4)
- 64 - - P2p-lending platforms do not need a banking license; - P2p-lending stays outside the traditional banking regulations such as Basel II and III; - P2p-lending platforms can facilitate financial transactions up to ! 25.000; - A detailed, standardised and open-source based real-time monitoring system for financial transactions on p2p-lending platforms is developed; - Each p2p-lending platform finances an independent user organisation for its members that among other things: o Monitors the score of the platform on the ROCC trust equation; o Operates as an ombudsman for platform related disputes; o Advises management on a voluntary basis. - Each p2p-lending platform creates a proper insurance construct that lenders can use as an opt-in clause to a p2p-lending transaction. 5.4. Future Work The assumptions and limitations as put forward at the end of chapter 3 indicate that the current research is biased. The survey has insufficient data to be representative for the total population or to be representative to users of p2p-lending platforms. This research is preliminary. To further research this subject more data gathering is necessary. This should be done in close collaboration with the new p2p-lending platforms that started in the Netherlands. The obvious party to take the initiative for this research would be the Dutch Authority for Financial Markets (AFM).
Further research on the ROCC trust equation, based on the eight variables, would be invaluable in assessing the viability and prospects for success of p2p-services. A government assigned organisation in collaboration with the users of the platform and the p2p-lending provider should carry out this research. The research results have to be publicly available and are to be published on a yearly basis.
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- 68 - APPENDIX: QUESTIONS OF THE SURVEY 14
14 The data output of the survey including all the textual comments of the 102 respondents is available upon request via syb@sybski.ru as a PDF file.
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Page 6 Peer-to-peer lending: a survey to research a new financial phenomenom Peer-to-peer lending: a survey to research a new financial phenomenom Peer-to-peer lending: a survey to research a new financial phenomenom Peer-to-peer lending: a survey to research a new financial phenomenom 15. What would be your reasons to use a peer-to-peer lending system instead of saving or borrowing your money at a traditional bank like NG, Rabobank or ABN-AMRO? You can choose a maximum of three reasons from the list below.
16. Everyone who wants to borrow on a peer-to-peer lending platform is identity- checked, credit-checked and risk-assessed. To diversify any risk, the lender's money is spread across a number of borrowers.
f you for example lend 1000 or more, your money is spread across at least 50 borrowers. The P2P platform only receives a fixed fee after completing a successful transaction and arranging of the contract between the borrower and the lenders. This means that the P2P platform is not part of the contract.
At the largest P2P lending platform {ZOPA in the UK} less than 1% of the borrowers did not meet their obligations. f necessary, a collections agency will be responsible for collecting missed payments on the lender's behalf. This system of saving and lending is quite different than putting away your money at a traditional bank. What do you think about the following elements of this system?
Very high High Normal Low Very low Your perceived risk as a lender *' *' *' *' *' Your perceived risk as a borrower *' *' *' *' *' The need of trust as a lender *' *' *' *' *' The need of trust as a borrower *' *' *' *' *' More interest payment for the lender and less for the borrower compared to traditional banks.
M|. like the 'do-it-your-self' culture of peer-to-peer lending without intervention of any institution.
M|. Peer-to-peer lending system provides more feeling and linkage between lender and borrower.
M|. Because the interest payments of a borrower go to real people and not to a bankers' bonus.
M|. Because traditional banks do not accept my request for a consumer credit.