P2P Lending and Screening Incentives - UCL...

IntroductionAdvantages

Adverse Selection, Trust and ReputationThe Model

Welfare AnalysisConclusions

P2P Lending and Screening Incentives

Dairo Estrada & Paula ZamoraThe Second International Workshop P2P Financial Systems 2016

September 6, 2016





Overview

1 Introduction

2 Advantages

3 Adverse Selection, Trust and Reputation

4 The ModelPerfect ScreeningImperfect ScreeningFinancial Inclusion and Welfare

5 Welfare Analysis

6 Conclusions





Composition of Crowdfunding by category

Source: Company Data, Morgan Stanley Research estimates





Peer to peer Lending Process

Source: Aveni(2015)





Loan Distribution Originated by P2P platform

Source: Company Data, Morgan Stanley Research estimates





Advantages of P2P Platforms

Have broader access to information (Big Data)

Lower costs compared to the intermediation operations of banks

Improve financial inclusion

Quick adjustment to new market conditions (technology, new instruments)





Costs and Interest Spreads for Banks and Lending Club

Costs in Basis Points

Sources: Aveni (2015) and Lendit 2013





Information Role

The agility of the system, customer satisfaction, the success of the platform andits growth depend directly on the number of agents willing to participate in themarket on both sides.

The challenges:1 Build a solid performance history to generate credibility.2 Maintain users’ confidence in the system.

Importance of the screening process: platforms are highly interested in enforcingstrict lender and borrower requirements to guarantee quality in the transactions,increase reputation and guard against misbehavior and fraud.





Perfect ScreeningImperfect ScreeningFinancial Inclusion and Welfare

The Model

A model with screening activities

Agents receive a pool of loan applications and decide the amount of them to bescreened (k) in order to grant loans.

The agents cannot identify directly the type of project without screening, butthey know the share of good (low-risk) projects in the economy, [λ ∈ (0, 1)].

The bank’s optimal number of loans granted is small relative to market demand.

Two questions:1 How do the economic outlook, the screening costs and the quality of screening affect

the incentives of the bank and the platform to screen potential borrowers?2 What is the resulting impact on loan supply in the market?






Monopoly Case

Timing of the Bank’s problem with Perfect Screening






Monopoly Case

The profit function:

ΠpsBank (k) = kλπL − rL− k2z (1)

L = kλ is the amount of loans that the bank grants

The optimal amount of loans granted by the bank is:

LpsM =λ2πL − rλ2

2z(2)






Monopoly Case

Amount of loan applications screened by the bank






Duopoly Case

A bank and a platform are active in the credit market and they randomly andindependently choose which loan applications to assess. Hence, we can find fourgroups of loan applications:






Sequence of decisions in a Duopoly lending industry with Perfect Screening






Duopoly Case

The profit function for agent i is:

Πpsi (ki , kj ) = kikj

λ

2πL + ki (1− kj )λπ

L − rLi − k2i zi (3)

zA > zB

The number of loan applications that agent i decides to finance is:

Lpsi = kikjλ

2+ ki (1− kj )λ (4)






Duopoly Case

The optimal values of kA and kB expressed through the exogenous parameters are:

kpsA =

λ2

2(r − πL)2 + 2λ(r − πL)zBλ2

4(r − πL)2 − 4zAzB

(5)

kpsB =

λ2

2(r − πL)2 + 2λ(r − πL)zAλ2

4(r − πL)2 − 4zAzB

(6)






Duopoly Case

Screening and Economic Outlook

0 0.1 0.2 0.3 0.4 0.5 0.6 0.7

Economic Outlook ( λ )

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1S

cree

nin

g (

K)

ZBank

=0.09, ZPlatform

=0.03, r=0.03, πL=0.2

KMonopoly

ps

KBank

ps

KPlatform

ps






Monopoly Case

Screening is costly (z > 0) and imperfect, β ∈ [0, 1]. The risk that the bank orthe platform approves unqualified loan applications rises as β increases.

Mistakenly approved bad projects have an strictly negative expected revenue forthe agent.






The profit function for the bank is then as follows:

ΠisBank (k) = k[λπL + (1− λ)βπH ]− rL− k2z (7)

The number of loans funded also changes, given the misclassification of projects:

L = k[λ+ (1− λ)β] (8)

The optimal number of loan applications that the bank should screen to maximizeprofits is:

k isM =

λπL + (1− λ)βπH − r [λ+ (1− λ)β]

2z(9)






Duopoly Case

Both the screening costs, z, and the probability β differ among the bank and theplatform.

The groups also include high-risk projects, given the probability ofmisclassification.

We asume that the platform has a better technology to screen (βB < βA) and itis also more efficient in the screening process (zB < zA).






According to these new conditions, the profit functions will be for the bank and theplatform, respectively:

ΠisA (kA, kB ) =

kA [λπL + (1 − λ)βAπH ]kB [λπL + (1 − λ)βBπ

H ]

2(10)

+kA(1 − kB )[λπL + (1 − λ)βAπH ] − rLA − k2

AzA

ΠisB (kA, kB ) =

kA [λπL + (1 − λ)βAπH ]kB [λπL + (1 − λ)βBπ

H ]

2(11)

+kB (1 − kA)[λπL + (1 − λ)βBπH ] − rLB − k2

B zB






Screening and Expected Losses

-0.2 -0.18 -0.16 -0.14 -0.12 -0.1 -0.08 -0.06

Expected losses from high-risk projects ( πH)

0

0.1

0.2

0.3

0.4

0.5

0.6

Scr

een

ing

(K

)β

Bank=0.24, β

Platform=0.2, Z

Bank=0.09, Z

Platform=0.04, r=0.03, λ=0.3, πL=0.2

Kps

Platform

Kis

Platform

Kps

Monopoly

Kps

Bank

Kis

Monopoly

Kis

Bank







0.3 0.4 0.5 0.6 0.7 0.8 0.9 1


0

0.1

0.2

0.3

0.4

0.5

0.6

0.7S

cree

nin

g (

K)

βBank

=0.24, βPlatform

=0.2, ZBank

=0.15, ZPlatform

=0.1, r=0.03, πL=0.2, πH=-0.3

Kps

Platform

Kis

Platform

Kps

Bank

Kis

Bank







0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1


0

0.1

0.2

0.3

0.4

0.5

0.6

0.7S

cree

nin

g (

K)

βBank

=0.24, βPlatform

=0.2, Z=0.1, r=0.03, πL=0.2, πH=-0.3

Kps

Kis

Platform

Kis

Bank






Perfect Screening

Loans and Economic Outlook

0 0.1 0.2 0.3 0.4 0.5 0.6 0.7


0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1L

oan

s (L

)Z

Bank=0.09, Z

Platform=0.03, r=0.03, πL=0.2

LpsMonopoly

LpsBank

LpsPlatform

LpsDuopoly






Imperfect Screening

Loans and Economic Outlook

0.3 0.4 0.5 0.6 0.7 0.8 0.9 1


0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8L

oan

s (L

)β

Bank=0.24, β

Platform=0.2, Z

Bank=0.15, Z

Platform=0.1, r=0.03, πL=0.2, πH=-0.3

Lps

Duopoly

Lis

Duopoly

Lps

Monopoly

Lis

Monopoly





Welfare Analysis

The socially optimal fraction of loan applications that should be screened isgreater than the fraction of loan applications that the bank screens.

kps∗M =

λπL

2z> kps

M =λπL − rλ

2z(12)

P2P lending increases loan supply and seems to be a good alternative for thosewho deserve credit, but do not have access to financial services provided byregulated financial institutions. This would be an important innovation indeveloping economies, where many people depend on informal mechanisms thathave forced them to pay high interest rates and pawn or sell assets.

These results are valid when we evaluate the model under perfect and imperfectscreening condition.





Risks and Regulation

The role of regulation

Riskier borrowers: regulators should require platforms to have accurate screeningstandards.

Data and confidentiality

Algorithms and discrimination

Platform’s incentives to reveal information

Monetary Policy





Conclusions

Final Comments

Lower screening costs, a better economic outlook and higher profits from goodprojects promotes the platform and the bank to screen more.

As long as the platform has lower screening costs and better screening quality,then it will grant more loans than the bank.

A lower quality in screening reduces the incentives of screening of both agentsand therefore they provide less credit to the market.

The gap between the optimal amounts of screening under imperfect and perfectscreening conditions reduces as the economic outlook improves.


P2P Lending and Screening Incentives - UCL...

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