Danger in the shadows
The controversial concept of ‘liquidity mismatching’ has divided the industry and grabbed the attention of the regulator. At what point does maturity transformation turn a P2P lender into an online bank?
When does a platform stop being peer-to-peer and start becoming a bank? This is one of the questions that the Financial Conduct Authority (FCA) has been wrestling with since it began regulating the P2P sector. While the sector is rooted in the idea of one investor being matched with one borrower, the reality is that it has drifted somewhat away from that classic model. As well as facilitating ‘peer-to-peer’ loans, most UK-based platforms offer access to secondary markets and segmented loans, while some have even started to move into the complex world of securitisation. But the most controversial development in the P2P sector is maturity transformation – the mis-matching trend which threatens to undermine the core purpose of P2P lending and channel the ethos of the banking world instead.
In short, maturity transformation (or ‘liquidity mismatching’) pairs short-term loans with long-term investments in an effort to maintain high borrower volumes. However, this leaves the initial investment sitting on the platform’s balance sheet once the loan term is up. In the best case scenario, the investor’s money (and interest) is being held in a secure place, free from the risk of default. In the worst case scenario, the platform fails and the investment is lost forever, despite the fact that the initial loan was paid back in full.
And even in that best case scenario, there is another risk – that by essentially accepting cash ‘deposits’ from so-called investors, the platforms are taking on the role of the banks, without any of the regulation.
In the banking world, maturity transformation tends to happen in the reverse, where long-term loans are as commonplace as short-term deposits (or ‘investments’).
“The majority of bank deposits are made up of short-term easy access accounts, whilst the majority of bank lending is longer-term, such as mortgages,” explains David de Koning, director of communications at Funding Circle. “This is a key difference between banks and platforms and is why we are regulated differently.”
Indeed, maturity transformation is one of the most closely-monitored trends in the banking industry, and opinions are split in terms of its viability. In an October speech at the LendIt Europe conference, former Financial Services Authority chairman Lord Turner described the practice as “dangerous” when used by banks.
“[It is] dangerous because in aggregate banks they don’t just take existing money and lend it on, they create credit, money and purchasing power which didn’t previously exist.”
However, he then added that “there’s a good argument that without maturity transformation – which makes it possible for people to fund long-term investments while holding short-term financial assets – it would be more difficult to generate the credit and investment needed within our economy.”
The appeal of maturity transformation is obvious. It offers an easy way to keep volumes up, and it allows platforms to maintain their reputation for speedy transactions.
“Whilst we as a platform do not carry out maturity transformation, it does play a beneficial role for banking customers,” says De Koning. “For example, mortgage lending allows consumers to own their own homes. Banks are well placed to perform this function as they are deposit-taking institutions and are regulated accordingly.”
This is the key difference between maturity transformation in banks and maturity transformation in the P2P sector. Regulation on issues such as capital adequacy will dictate whether or not maturity transformation is allowed to happen among P2P lenders in any form and platforms will be watching with interest as the FCA mulls its next course of action.
P2P lenders currently have much lower capital requirements than banks. According to the FCA, the minimum level is currently £20,000, but this is set to rise to £50,000 or a percentage of loaned funds from 1 April 2017. In addition, each platform must have a resolution plan to ensure that loan repayments will continue to be collected and the loan will be managed until maturity, even if the platform ceases to exist. However, according to some critics, these capital adequacy rules leave too much room for interpretation.
“During the financial crisis, most of the bank failures were down to liquidity rules,” says Jay Tikam, managing director of P2P advisory firm Vedanvi. “The minute the customers start to smell a rat, everyone withdraws. No matter how much capital adequacy is on their books, the banks will go under.”
He predicts that the same thing could happen in the P2P sector if maturity transformation is allowed to continue without proper regulation.
Tikam’s background includes a stint at the regulator’s office in South Africa where he helped to implement Basel II among the country’s banks. One of the key objectives of Basel II was tackling maturity transformation and banks were strictly forbidden from ‘matching’ short term investments (or deposits) against long-term loans. As it happened, before Basel II could be fully enforced, the financial crisis hit.
Today, capital adequacy requirements, the upcoming implementation of Basel III and government guarantees such as the FSCS scheme mean that it would be extremely unlikely for a similar situation to unfold in the banking world. But the same thing cannot be said for the P2P sector.
In Tikam’s view, some P2P platforms are “acting like banks, but without the same liquidity buffers” and he predicts that a maturity transformation crisis “will absolutely happen”.
“They are on interim permissions,” he says. “Some of them are doing P2P but they’re also doing six other things so they will need to apply for six other licenses.
“Their core competency is that they can approve a loan within two weeks. If it takes any longer it will impact their business model.”
Complex capital adequacy regulations would certainly have an impact on the day-to-day operations of P2P lenders, particularly if they are already engaging in some form of liquidity mis-matching.
In fact, speaking exclusively to Peer-to-Peer Finance News, Lord Turner has warned that maturity transformation could have a negative impact on the P2P sector.
“A lot of people think when you say P2P that it means individuals choose their loans and that’s not what they’re doing,” he said. “Once you understand it, a lot of them are clear what they’re doing. They’re doing good credit analysis, they’re dividing it into tiers, they’re offering that to investors.
“I think what will worry regulators is if the thing becomes more complex over time. If people start taking more of these packages of loans, turn them into credit securities, sell them down to people who don’t really understand what they are, or sell them into things like SIVs (structured investment vehicles).
“That’s concerning. Now I don’t think that’s happening to any significant stage at the moment, but it probably will because what we know is that these financial systems continually mutate and continually evolve and the process of searching for new ways of profit will create new risks.”
In the end, the burden should not be on the regulator to minimise the threat of maturity transformation. It is down to the platforms themselves to anticipate any liquidity issues, communicate risk to their investors and to do everything in their power to ensure that default rates stay as low as possible while offering the best possible returns. After all, isn’t that the whole point of P2P lending?