On Monday, LendingClub Corp., a leader in the growing online lending space, announced the surprise resignation of its founder and CEO, Renaud Laplanche.  Laplanche resigned in response to a board investigation that revealed a number of internal control failures, including the sale of more than $20 million in loans that failed to conform to the requirements imposed by the acquiring investors and the doctoring of dates on loan applications to cover up noncompliance with respect to $3 million in loans sold.  These developments triggered a massive decline in LendingClub’s stock price, but also contribute to a growing cacophony of questions about LendingClub’s business model and the viability of other online lending platforms.

There is a disturbing similarity between the LendingClub’s actions and the malfeasance by banks and other financial firms that originated home loans with the intent to securitize those loans before the 2007-2009 financial crisis. The massive legal liability that the originators have faced for their pre-crisis failures undermine simplistic notions that separating loan origination from an intent to hold a loan relieves the originator of any incentive to engage in meaningful due diligence.  Nonetheless, the LendingClub scandal breathes new life into concerns that the process of separating ownership and origination leads to significant agency costs.  The irony is that online lending, then known as peer-to-peer (P2P) lending, originally promised to be the solution to this problem.  As one manifestation of the much-hyped crowdfunding phenomenon, P2P lending was designed to directly connect individual savers and borrowers, reducing the number of intermediaries involved in capital supply chains.

As I explain in an article prepared for a symposium on the future of financial intermediation recently posted on SSRN, understanding the evolution of P2P from a technology that promised to enable individuals to displace influential financial intermediaries into a space dominated by those very intermediaries reveals broader lessons about the future of direct finance.  To separate hope from reality, it is necessary to begin by considering the promise that P2P lending seemed to embody when it first emerged. Early advocates depicted P2P lending as poised to fundamentally transform multiple dimensions of the lending process.  With respect to the providers of capital, P2P held out the promise of providing ordinary individuals the opportunity to invest directly in unsecured loans, an activity that historically belonged almost exclusively to banks.  It was simultaneously heralded as potentially expanding the pool of persons who could obtain credit, enabling persons who might not readily qualify for a bank loan to nonetheless obtain needed financing.   In addition to altering the providers and recipients of credit, P2P promised to transform the nature of the relationship between these ends of the investment chain, directly connecting retail lenders to those receiving their funds.

While the industry has since grown dramatically, its promise along each of these dimensions diminished at an equally rapid clip.  The lender base shifted from consisting almost exclusively of individuals making modest investments to a base dominated by large institutional investors.  The few individual investors that remain increasingly rely on automated tools to allocate their funds, eliminating personalized review of the specifics of the loan requests.  At the same time, platforms have become increasingly discriminating in the borrowers they allow to seek funds, and the metrics that platforms use to make this determination are strongly correlated to those long used by banks and other credit providers.   Coupled with the changing lender base, the result is that would-be borrowers are now evaluated in ways akin to banks’ traditional underwriting processes, and the borrower base consists largely of borrowers able to get credit elsewhere.  Finally, because of changes triggered by regulatory concerns, P2P loans no longer create a direct relationship between lenders and borrowers even when the capital comes from an individual.  Instead, lenders typically receive an unsecured claim against the P2P platform, the value of which is set by reference to the performance of the associated loan.  As a result, in a very short span of time, P2P lenders like LendingClub evolved from forces facilitating direct finance to links in complex, highly intermediated chains.

While far from conclusive, the evolution of P2P lending does not bode well for a quick rise in direct finance.  The changes in P2P lending may be due in part to efforts by established intermediaries to use their informational and positional advantages to entrench their positions in socially suboptimal ways, but they also seem to reflect the genuine gains that specialized intermediaries can provide when the exchange is purely financial. Data-driven algorithms have proven relatively effective at assessing borrower creditworthiness and the limited data suggest that individuals are unlikely to have any natural advantages in this process. The regulatory intervention, while potentially poorly executed, was also motivated by legitimate concerns about investor protection.   The changes in P2P lending may also indicate that when acting solely as a borrower or lender, individuals care more about the expected cost of a loan or return on their investment than they do about the nature of their relationship to the party on the side.

The account is positive, not normative, and it does not discount the potential for technology to transform and improve lending practices.  While P2P lending has not changed intermediation in the ways many first hoped and the industry has experienced a range of setbacks, the rapid growth of online lending platforms suggest that they may well serve a useful, even if not transformative, mechanism for credit creation.

Recognizing the market and regulatory forces favoring intermediated finance does not answer the question of whether true direct finance has a future.  In the same speculative spirit that animates the rest of the analysis, the paper identifies and seeks to learn from niches where it appears to have more potential.  The paper focuses on two early success stories—the platform Kickstarter, which connects artists and entrepreneurs with persons who provide financing in exchange for non-financial rewards and a nascent “locavesting” movement—to explore ways that direct finance may yet thrive.  Notably, while these two niches look quite different from each other and the types of exchanges facilitated by Kickstarter are quite varied, they all share in common that the exchange involves something more than the provision of capital. Those seeking funding may get publicity, information about the demand for a project they are considering or the ability to connect with potential customers; those providing the capital enjoy benefits like tangible goods that cannot be acquired elsewhere or the intrinsic satisfaction that comes from helping an artist create a public good.  These nonfinancial dimensions provide a key element that was lacking in P2P—a reason for the direct involvement of individuals.  Financial intermediaries may have a superior capacity to assess the expected financial return on a particular loan or to aggregate a diversified investment portfolio, but only individuals know the subjective value they place on a particular product, and those values may vary significantly from one individual to another.  Similarly, a capital-raising process that entails having a thousand (or a million) individual potential investors watch a video clip about a project can generate significant publicity, enhancing the probability of success in a way not easily replicated when the appeal is made solely to a handful of institutional investors.  These are just a couple of the many ways that direct transactions that bundle capital raising with other undertakings might create value in ways that depend on the direct nature of the exchange.

The notion that technological and other innovations may enable new types of bundling, and that such bundling will at times be optimal, has implications for both theory and policy.  Conventional wisdom has generally assumed that that technological and other innovations will result in capital raising being increasing unbundled from other commitments, and a number of historical developments support this wisdom. At the same time, the paper suggests that there may be a second, simultaneous trend in the opposite direction.  For certain firms, bundling capital raising with other undertakings in ways historically not possible may prove to be optimal.

If the rise of direct finance does at times lead to the creation of new and different bundles, this raises some interesting policy challenges.  In the United States and many other jurisdictions, the agencies and experts that oversee the capital markets overlap little with those who specialize in consumer protection, and there may well be benefits of crowdfunding that are not readily cognizable within any of the established frames.  Without purporting to offer any solutions, the article concludes by identifying some of the opportunities challenges that lie ahead if the paper’s predictions about some of the ways direct finance may yet flourish prove accurate

The preceding post comes to us from Kathryn Judge, Associate Professor of Law and Milton Handler Fellow at Columbia Law School.