3 June 2019

Adam Smith and the trouble with peer-to-peer lending


One cynical – but useful – view of modern technology is that it allows us to play through the scams and mistakes of the last few millennia at warp speed. Bitcoin and associated cryptos have gone through every fraud that anyone’s been able to come up with since Ur of the Chaldees invented the idea of monetary exchange. The grand idea of peer-to-peer lending is suffering at least in part from a similar process. And the lesson is that the essence of banking isn’t in making it easier to lend, it’s in being able to find those useful to lend to.

The idea at the heart of peer-to-peer lending is great. The thing the internet has enabled us all to do is disintermediate. We don’t have to gain our classified ads along with the local newspaper any more, we get them on Ebay and Gumtree. Buying car insurance doesn’t require a visit to an office – and thus isn’t limited to the choice of those who have invested in a chain of offices. Why not bring that same force to lending and match up willing lenders with willing borrowers online instead of having to use an expensive retail branch network?

There’s nothing wrong with the idea at all, except except to think the intermediation is the difficult bit of banking. In fact, it’s the easy bit. It’s finding people who might pay it back which is the hard part. Peer-to-peer platform Lendy is finding this out the hard way, as others may do too. According to The Times:

A week before the collapse of Lendy, the chief executive of Barclays business banking gave a warning of what might be in store for peer-to-peer lending.

Platforms linking ordinary investors and business borrowers were exposing people to poor-quality debts, Ian Rand, 49, said. There were, he added, “a lot of people that banks wouldn’t lend to who went to Wonga instead. That didn’t work out too well for them or for Wonga. I am nervous that we could be going down the same path with business lending.”

It’s not the platform that’s the problem, it’s who applies to borrow from the platform. The Times again:

By November last year about 60 per cent of its loan book had fallen behind on repayments. 

Ouch. One loan was quite a doozy:

The debt was secured against a farm in Somerset, the director of which was a twice former bankrupt with a string of failed companies behind him who had been accused in parliament of using ‘fraudulent valuations’ in a farm lending scandal.

And one final little point:

Gross annual returns — before any losses and tax — were 12 per cent.

This is what Adam Smith was talking about when, way back in 1776:

He further observed that if the legal maximum was ‘so high as eight or ten per cent’ then the ‘greater part of the money which was to be lent, would be lent to prodigals and projectors, who alone would be willing to give this high interest’, adding that ‘Sober people, who will give for the use of money no more than a part of what they are likely to make by the use of it, would not venture into the competition’.

To take that out of the Georgian prose, anyone willing to pay 12 per cent interest is the very person you don’t want to be lending money to. A projector there being not something to show a film but an archaism for somewhere between a fraud and a fantasist about his likely success.

This is not to say that we shouldn’t try out these new technologies on these old ways of doing things. Nor is it to say that regulation should be in place to ensure conformance to the conventional wisdom. For that identification of why the old way works can be wrong too. It isn’t true that a two year training in The Knowledge is necessary to be able to drive a cab for example, contrary to what we all long thought.

But our new experiments reveal, once again, what is the difficult part of an activity. Sometimes our new and spiffy arrangements will solve that old problem, rather more often it won’t. But the only way we’ve got of finding out is to continue with the experiments and see.

Thus markets, that continual experimentation which is the free market, is the only way we’ve got of testing these new technologies to see whether they do indeed solve problems we’d like to solve or not. This does mean that those who lent – rather than those who borrowed perhaps – through Lendy are collateral damage in the ongoing advance of our civilisation but then that’s just how it works. The vast majority of business adventures fail, that’s how we find those few that work.

That Adam Smith can be said to have predicted this particular oopsie is true. But that makes him perceptive about the problem to be solved which is to identify and only lend to the creditworthy. Not correct about the inadvisability of the method of banking being employed. Peer-to-peer lending which managed that lending to those who might pay it back might well still be a useful disintermediation around the costs of branch networks and banks. For it is important for us to identify why an experiment failed as well as noting it – that’s how we learn.

To put it another way, Lendy may be a disaster. But it’s exactly the implosion of those failures that teaches us what not to do. It would be far worse to restrict the experimentation so that we never did learn about those few things that do work.

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Tim Worstall works for the Continental Telegraph and the Adam Smith Institute.