From Matthew Cropp:
In recent years, the emergence of “peer-to-peer” (p2p) lending has been one of the most interesting and discussed trends within the world of financial services. A number of for-profit companies, such as Prosper.com and LendingClub.com, have sprung up which allow individuals to make loans directly to each other (minus a service fee), and the open-source project Rain Droplet has been pioneering the provision of such services on a quasi-cooperative basis. The fast-growing industry, which has originated hundreds of millions of dollars in loans, has even been recently featured in the New York Times.
The reason to which much of the media ascribes the success of this phenomenon is that p2p lending represents technologically facilitated dis-intermediation of the provision of credit. By cutting out a large percentage of the bureaucratic apparatus that separates the person with surplus savings from the individual with need for credit, the story goes, “depositors” can receive higher rates of return and “borrowers” lower rates on loans than either would get from a traditional financial institution.
While true as far as it goes, a myopic focus on this dynamic neglects another factor that has been key to the explosive growth of p2p lending: “social capital.”
According to the sociologist Robert Putnam, social capital is the idea that “social networks have value. Just as a screwdriver (physical capital) or a college education (human capital) can increase productivity (both individual and collective), so too social contacts affect the productivity of individuals and groups.”[1]
In the case of the provision of credit, social capital is key to determining the riskiness of a particular loan in two vital ways.
First, it allows for the lender to more accurately assess the riskiness of a borrower. At a traditional financial institution, the relationship between the loan officer who decides whether or not a loan is extended and the potential borrower is generally characterized by a low level of social capital.
Working with such sources as credit scores and interviews in which borrower attempts to put the best face on his or her situation, even the most skillful professional will be left with a great deal of uncertainty that has to be priced into a loan. As a result, many borrowers must pay more than would be necessary had their financial institution access to perfect information, and some deserving borrowers are excluded from credit altogether.
By contrast, the information that a lender who is also a personal acquaintance of a borrower has to work with can potentially be far more comprehensive. Not only can the p2p lender see the same “objective” measures as the aforementioned loan officer, but he or she can also factor in the idiosyncratic knowledge that can only be gleaned from observing the potential borrower in a variety of social situations over time.
Thus, while a borrower with a bad credit score might be rejected by an institutional lender, an acquaintance who better understands the full context of that number might judiciously decide that the borrower could, in fact, meet the desired obligation, and thus decide to extend him or her credit.
In and of itself, such an informational advantage would likely be sufficient to drive the growth of p2p lending. However, its effect is augmented by the fact that greater social capital doesn’t simply allow for more accurate predictions of default risk; rather, it actively reduces that risk.
When an individual defaults on a loan originated by a large institution to which he or she has little social connection, the consequences are predictable and almost entirely economic. That person might have certain objects repossessed and will have more difficulty obtaining institutional credit in the future, but the fabric of relationships that constitute his or her social life remains relatively unaffected.
In addition to carrying the economic consequences outlined above, defaulting on a loan from an acquaintance can have profound social consequences. Not only can it disrupt the valued relationship with the lender (including access to the resources and opportunities that said relationship provides), but the default can also spill over and affect the defaulting borrower’s relationships with mutual acquaintances. Unless there is a very good reason for the default (such as an unexpected job loss or catastrophic health event), those mutual friends would interpret the default as an injustice inflicted upon the lender and might thus socially punish the borrower in a variety of ways.
As such, borrowers are incentivized to work far harder to continue servicing p2p debts than they would debts originated by impersonal financial institutions.
By leveraging social capital in these ways, it is clear that, all other factors held equal, p2p lenders can rationally provide cheaper credit than can impersonal financial institutions. However, when recent journalistic reports have contextualized the practice as a new phenomenon that is entirely dependent on recent technological innovations, they’re ignoring a fundamental fact: that, for its first fifty-odd years, the growth of the credit union movement was driven by the very same dynamics, and that it can, in fact, be understood as having pioneered p2p lending.
More to come in Matt’s next post, including his opinion on why social capital in today’s world can help credit unions.
[1]Bowling Alone, 18.
Matthew Cropp is author of the blog Credit Union History and earned his MA in History at the University of Vermont.
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