Matching Borrowers and Lenders and Learning Why Banks Exist
Peer to peer lending platforms connect borrowers directly with lenders, cutting out the bank. The model promised better rates for both sides and discovered the hard way why banks bear risk and hold capital.
Cutting Out the Bank
Peer to peer lending platforms connect borrowers directly with lenders, letting people who want to borrow get money from people who want to lend, without a bank in the middle. The promise was better rates for both sides, since removing the bank margin could give borrowers lower rates and lenders higher returns, sharing the value the bank would have taken.
The model attracted enthusiasm as a way to disintermediate banks, using technology to match borrowers and lenders directly and cut out the institution that traditionally sits between them. But peer to peer lending learned the hard way why banks bear risk and hold capital, discovering that someone must still bear the credit risk when borrowers default, and that matching borrowers and lenders is only part of what banks do. The evolution of the model reflects the lesson that removing the bank does not remove the fundamental functions of lending, particularly bearing the risk of default.
Removing the bank looked like removing a middleman taking a cut. It turned out the bank was also absorbing the losses when borrowers do not pay. Someone still has to, and figuring out who was the model's hard lesson.
The Original Promise
The original peer to peer model promised to benefit both sides by removing the bank and sharing the value.
| Party | Promised benefit |
|---|---|
| Borrowers | Lower rates than a bank |
| Lenders | Higher returns than a deposit |
| Platform | A fee for matching, not bearing risk |
By matching borrowers and lenders directly, the platform could give borrowers lower rates and lenders higher returns than a bank, since the bank margin was removed, and the platform would earn a fee for the matching rather than bearing risk or holding capital like a bank. This promised a more efficient system where the value the bank captured was shared between borrowers and lenders, with the platform as a lean intermediary just matching the two sides. The appeal was genuine, offering better terms by removing the bank, and the model attracted borrowers, lenders, and investment on the promise of disintermediating banks with technology.
The Hard Lesson About Risk
The hard lesson was that someone must bear the credit risk when borrowers default, which is much of what banks do, and the peer to peer model had to figure out who bears it. In the original model, the lenders bore the risk of the borrowers they lent to defaulting, but individual lenders were poorly equipped to assess and bear credit risk, and when defaults came, they took losses they had not fully understood.
The platforms learned that assessing credit risk, diversifying it, and bearing it are core functions that banks perform, and that simply matching borrowers and lenders left the lenders exposed to risk they could not manage well. When economic conditions worsened and defaults rose, the losses fell on lenders who had been promised returns without fully grasping the risk, revealing that the promised higher returns came with the risk of default that banks normally bear and manage. This lesson, that bearing and managing credit risk is central to lending and cannot simply be passed to individual lenders, forced the model to evolve, since the original promise of just matching borrowers and lenders ignored the fundamental function of bearing the credit risk that makes lending work.
The Evolution Toward Banks
In response, peer to peer lending evolved in ways that moved it closer to traditional lending, recognizing the need to manage credit risk properly. The lenders on many platforms shifted from individuals to institutional investors better equipped to assess and bear credit risk, changing the model from matching individuals to channeling institutional money to borrowers. Platforms took on more of the functions of banks, assessing credit, managing risk, and in some cases bearing it, becoming more like lenders than pure matchmakers.
Many peer to peer platforms became, in effect, lending businesses or worked with banks, rather than the pure disintermediation the model originally promised, reflecting the lesson that the functions of lending, credit assessment, risk management, and bearing risk, must be performed by someone equipped to do them. The evolution toward institutional lenders and more bank like platforms shows that removing the bank did not remove the need for its functions, which had to be reconstituted in the new model. Peer to peer lending demonstrated both the potential of technology to improve lending and the hard reality that the fundamental functions of banks, particularly bearing and managing credit risk, cannot simply be eliminated, which is why the model evolved toward a form that performs those functions rather than the pure matching it originally promised.
The Bottom Line
Peer to peer lending platforms connected borrowers directly with lenders, promising better rates for both by removing the bank and sharing the value the bank would have taken, with the platform earning a fee for matching rather than bearing risk. But the model learned the hard way that someone must bear the credit risk when borrowers default, which is much of what banks do, and individual lenders were poorly equipped to assess and bear that risk, taking losses they had not fully understood when defaults rose. Peer to peer lending evolved toward institutional lenders and more bank like platforms that assess and manage credit risk, reflecting the lesson that removing the bank did not remove the need for its functions, particularly bearing and managing credit risk, which had to be reconstituted rather than eliminated.