Do peer-to-peer lending sites like Prosper and Lending Club work?

The search for better economic policy.
June 30 2009 12:18 PM

It's Like eBay Meets Match.com

Does peer-to-peer lending work?

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What does all of this suggest for the future of peer-to-peer lending? Small-scale lenders have shown themselves to be savvy in their lending decisions. They are affected to some extent by human miscalculation and bias, but then again, so are bank loan officers. Employees of big banks are human beings, too, and may be similarly seduced by beauty or vulnerable to racism. Add the entertainment value of finding and following your own loan "investment portfolio," and the peer-to-peer movement seems likely to be more than a passing fad. (Though it's unlikely that individual lenders will ever have the means or sophistication to work out the terms of a million-dollar Park Avenue penthouse mortgage or a billion-dollar loan for Chrysler.)

Yet before we celebrate the end of banking as we know it, it's important to remember that the Web sites connecting borrowers to lenders are middlemen themselves. And this presents an additional layer of risk for those making loans through these sites. In fact, if you visit the Web sites of Prosper, you'll find that it's currently shuttered to new lending, pending regulatory approval from the Securities and Exchange Commission. (Lending Club, another leading site, just completed a similar "quiet period.") Among other things, regulators are concerned with what will happen to lenders' investments if a site goes bankrupt. If, say, Citibank went belly up tomorrow, depositors' savings would be insured up to $250,000 by the FDIC. Not so for those choosing to invest their savings through a peer-to-peer network. There is the possibility lenders may face delayed repayment if they get repaid at all (though both Prosper and Lending Club now have backup plans in case they go under). So once again, it raises the concern of businesses taking risks with other people's money. And given the lessons of the past few years, the SEC is probably wise to make sure this latest round of financial innovation doesn't end up as the financial crisis of the future.

Ray Fisman is a professor of economics at the Columbia Business School and co-author of The Org: The Underlying Logic of the Office. Follow him on Twitter.