P2P: Rules of the game

In October 2017, the Reserve Bank of India (RBI) issued master directions for peer-to-peer (P2P) lending and borrowing in India. P2P lending platforms that, for fees and charges, let lenders give loans directly to borrowers have been around in India for some years now. The rise of these loan facilitation intermediaries has been catalysed by increasing internet penetration, digital lending and fin-tech revolutions. But until recently, they were operating largely in a regulatory vacuum, leading to some undesirable practices by some platforms and rising scepticism among market-watchers.

The RBI guidelines of October 2017 were a shot-in-the-arm for P2P platforms — with the central bank setting eligibility criteria, mandating registration of platforms as non-banking financial company-peer to peer (NBFC-P2P), codifying the rules of the game and, in the process, giving the much-needed credibility to the nascent segment.

Over the past year and a half, the eligibility filters have resulted in the number of P2P platforms in the country reducing from more than 30 before the guidelines to 11 as of April 30, 2019. But with regulatory cover, activity on the registered P2P platforms has reportedly picked pace with more lenders and borrowers joining in, and transaction volumes rising.

For lenders with a high-risk appetite, these platforms seem to present a high-return opportunity.

Case study

Take the case of Kumar Prakash (name changed) who started lending in December 2018 on two P2P platforms. Prakash, a 30-year old post-graduate in economics, works in an MNC in Bengaluru and is an experienced investor; he has funds deployed across stocks and mutual funds. What prompted him towards P2P?

Prakash says that he was attracted to P2P lending primarily by its attractive returns. He says that it is akin to investing in fixed income instruments (debt investments) but with returns much higher that what typical debt investments such as bank deposits give. He says that his average annualised return so far on one P2P platform is about 40 per cent and about 18 per cent on the other — much higher than the 7-10 per cent annualised returns on most debt investments.

‘P2P is like a debt investment with equity-like or even higher returns’, as he puts it. The repayment of loans is in the form of equated monthly instalments (EMIs) — with both principal and interest components — unlike other debt investments in which the principal is repaid only when the instrument matures.

Prakash adds that he feels good about lending to borrowers who would not have got loans from traditional financiers such as banks and other NBFCs, and might have ended up borrowing from money-lenders and loan sharks at usurious rates. In that sense, he says, he is enabling financial inclusion. The RBI regulations, Prakash says, give him the comfort that he is not doing anything illegal and is not transacting on shady platforms — both the platforms he lends on are registered with the RBI as NBFC-P2P.

But true to the risk-return paradigm, such high returns come with attendant high risks. Loans given out on P2P platforms are unsecured — they are not backed by assets that can be sold to realise the money in case the borrower defaults. Also, unlike bank deposits or many other safe fixed income investments, the possibility of default is real on P2P platforms. Borrowers on these platforms are often those who might not have got loans from other sources due to various reasons such as low income levels or lack of credit track record.

There is always the risk of some of these borrowers not repaying, despite the P2P platform running checks, credit assessments and risk profiling before listing them. In the event of a default, the loss is the lenders’. Though the P2P platform aids in recovery efforts, it will not partake in the loss. While there are consequences for the defaulting borrower too in terms of adverse reports sent by the platform to credit rating bureaus, the lender will have to take the big hit with loss of money.

Prakash says that even so, his experience thus far has been rewarding. Of about 250 borrowers that he has lent to on one P2P platform (short-term two to three-month loans of ₹500 each), three have defaulted so far — about 1 per cent of the pool. On this platform, the borrowers that he has chosen to lend to, are in the very high-risk category. So, he was anticipating some defaults but had calculated that the trade-off from high returns would still work to his advantage.

Despite these defaults, Prakash says his expected annualised return from the portfolio is about 40 per cent after the platform’s charges of about 3 per cent of the amount lent. On the other platform, of the 10 loans (₹10,000 each for 18-24 months) that he has lent to a less risky category of borrowers, there has been no default so far and his expected annualised returns are about 18 per cent after charges of about 1 per cent of the amount lent.

Prakash says that he plans to allocate 10-15 per cent of his portfolio to lending on P2P platforms. But he doesn’t intend going overboard, given the risks involved. In any case, he cannot lend more than ₹10 lakh across P2P platforms -- the maximum allowed currently as per RBI’s rules.

Checklist

Kumar Prakash might have had a good run until now. That need not necessarily be the case with other P2P lenders. Also, the past is never guarantee of what the future holds, especially when it comes to money, interest rates and defaults. So, if you intend lending on P2P platforms, be sure of what you are getting into.

Make sure that the platform is registered with the RBI as NBFC-P2P. Look for relatively low borrower default rates; this information on portfolio performance is given on the platforms’ portals. Evaluate what the platforms charge, the ease and speed of operations, and the friendliness of their user-interfaces. Start with small amounts and low-risk borrowers to understand how it works and then scale up, if convinced. Adopt a diversification approach — take exposure to a pool of borrowers to reduce risk.

Understand the regulations, the documentation, how much you are allowed to lend overall and to single borrowers, the risks you are taking for potential rewards, and the operational aspects. Know what the P2P platform will and will not do, and at what charge. Understand the tax implications.

As a borrower too, make an informed decision. Know how much you can borrow across platforms. Assess realistically whether you can afford to service the loan on a monthly basis at the agreed rate of interest.

Be clear about documentation and charges of the P2P platform. Understand that delays and defaults even on P2P platforms will mean penalties, charges and dents in your credit score that will impede future borrowings.

Below are some key things to be aware of.

Regulations

The RBI’s directions on P2P lending cover both online and offline platforms; most platforms are online though. They must have a net-owned fund of at least ₹2 crore and obtain registration from the RBI as NBFC-P2P. The leverage ratio (total outside liabilities divided by net owned funds) of the platform should be maximum two times. Outside liabilities mean those that are on the balance-sheet of the platform and do not include customers’ funds — lent or borrowed — using the platform.

The participants on the platform — lenders and borrowers — can be individuals, firms, companies or other legal entities. Lenders and borrowers must register with the P2P platform to be able to transact. The platform must collect relevant details and documents from lenders and borrowers as part of the registration process.

P2P platforms are meant to connect lenders and borrowers who may not be known or related to each other. So, platforms that cater only to specific customers are not considered P2P platforms.

The platform has to reveal the identity of the borrower to the lender, but it should not reveal the identity of the lender to the borrower. Also, while the identity, loan amount, interest rate sought and P2P platform-assessed credit score of the borrower are disclosed to the lender, the platform should not reveal the contact details of the borrower to the lender. This could be to prevent harassment of the borrower in case of default. The platform will let the borrower know about the lender’s proposal — amount sought to be lent and interest rate — but not the lender’s identity and contact details.

While the RBI does not specify the eligibility norms for lenders and borrowers, P2P platforms can lay down their own criteria. They must specify rules of matching lenders and borrowers without discrimination. There must be no international flow of funds on the platform.

The RBI has put restrictions on the lending and borrowing amounts. A lender cannot lend more than ₹10 lakh to all borrowers across all P2P platforms. Similarly, a borrower cannot borrow more than ₹10 lakh from all lenders across all P2P platforms. Also, a single lender cannot lend more than ₹50,000 to the same borrower across all P2P platforms.

The maximum tenure of the loans can be 36 months. P2P platforms are not happy with the restriction of ₹10 lakh and, say, that the limit is low and impedes growth. They have sought higher limits. But, as things stand, the ₹10 lakh overall exposure for lenders and borrowers and ₹50,000 to single borrower and lender, need to be adhered to. Given the chaos in the P2P market in China, partly due to lax regulation, the RBI seems to be adopting a conservative and calibrated approach.

Besides the RBI’s prudential norms, P2P platforms can have their own exposure limits to diffuse risk. For instance, it could lay down that a lender can meet a maximum of 20 per cent of a borrower’s fund requirement. It can also specify the maximum amount a single borrower can seek on the platform, say ₹5 lakh.

The lender, borrower and P2P platform must enter into agreements, laying down clearly the terms and conditions. Before the loan is disbursed, lenders must approve borrowers, and they must sign loan contracts. Lenders should attest that they understand the risks in the transaction, including no guarantee of return and the possibility of loss of principal. Apart from facilitating unsecured loans from lenders to borrowers, the P2P platform can sell loan-specific insurance products. They cannot cross-sell other loans, or provide credit enhancement or guarantees. The platform must also carry a disclaimer saying that the RBI does not provide any assurance for repayment of loans.

No cash transactions are allowed on the P2P platforms; they have to be done through bank transfers. The P2P platform must have at least two escrow accounts — for funds received from lenders and for collections from borrowers. Transfer of funds from these accounts maintained with a bank has to be handled on instructions from a trustee. The escrow account mechanism is a safeguard for the moneys put in by the lenders and repaid by the borrowers.

The P2P platform must have and disclose its fair practices code and grievance redressal mechanism. It must maintain confidentiality of transactions. The platform must submit relevant data to credit information companies.

Returns, charges and taxes

P2P platforms do not determine the interest rate on the loan transaction; they charge fees and facilitate matches between lenders and borrowers who agree on the loan amount and the interest rate on the loan. Many platforms also offer an auto-invest option that matches investment criteria specified by the lender, with borrower requirements. The returns for lenders depend on the demand-supply dynamics for the loans, and the risk profile of the borrower. In general, rates can vary from 10-36 per cent annualised; it can be higher for loans in very high-risk and unrated categories. Lenders can start small with loans of ₹500 or so on some platforms.

Platforms usually charge lenders a registration fee that could vary between ₹500 and ₹1,000; this is collected at the time of signing up. Besides, they charge transaction fee that is usually between 1-2 per cent of the loan amount.

In case of default by the borrower, platforms initiate collection and recovery proceedings; expenses related to this are borne by the lender fully in many cases. Penal interest paid by the borrower though could accrue to the lender.

P2P platforms have to carry out a detailed check and assessment of borrowers, including a credit evaluation before listing them. Borrowers may have to pay registration/listing fees that could vary between ₹500 and ₹1,000; this is often adjusted against the loan processing fee once the loan is given. Based on the assessment by the platform, borrowers are graded as per their risk profiles. Lower the risk profile, lower the interest rate.

The loan processing fee is calculated as a percentage of the loan amount and varies with the interest rate that will be paid by the borrower on the loan. Lower the interest rate, lower the processing charge. It can vary from 3 per cent of the loan amount for lower interest loans to 5 per cent or more for higher interest loans. Pre-payment of loans by borrowed is often allowed, but sometimes after a minimum period, say three months; there could be prepayment charges.

Delaying or defaulting on loan repayments can be quite costly for borrowers. Besides high penal interest that in some cases is 18 per cent or more, there could be collection penalties that could increase with the delay periods. The cost of legal notices, if any, is also on the borrower. Slipping up on loan repayments also harms the credit score of borrowers since the platform has to update credit bureaus regularly. A good repayment record, on the other hand, will improve the borrower’s credit score.

Tax on interest

The interest that lenders receive on their loans is taxable at their slab rates. The P2P platform or the borrower do not deduct tax on the interest that is paid to the lender. It is the lender’s responsibility to declare and pay the tax on the interest income.

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