Peer Lending: the new savings account?

Bill Gates once said, “Banking is essential.  Banks are not.”

Banking used to be a useful way to save for the future – who can forget “Fidelity Fiduciary Bank” from Mary Poppins?

But a ‘tuppence’ doesn’t compound as fast as it used to.  Currently “saving” accounts offer investors near 0% interest on their deposits; with an inflation rate that exceeds this interest given by the banks, ‘savings’ accounts are actually ‘losing’ accounts. This begs the question: how can one invest better?

Equities for the Long Term

An alternative for investors looking for higher returns is the stock market; the S&P averaged a 7% annualized return over the past 10 years. But for short-term investments though (3-5 years) stocks may not be the wisest investment. Equity prices fluctuate unpredictably day-to-day, and transaction costs can eat into returns.

Equities are the correct location for long-term investments; in fact, the longer the time frame, the less risk equities contain. During a 10-year time frame, the S&P 500 would lose money only one time in its history: between the .com bubble (1999-2001) and the crash of 2008 (2008-2010). There is no period that an investor would have lost money if one considers a 15-year investment time frame.

Debentures for the Short Term

Banks fulfilled the short term borrowing niche with C.D.s. Even now, banks are locking up people’s money in 1, 3, and 5 year Certificate of Deposits. They are paying the depositors between 1%-2%, and loaning out those funds at 5%-7%.

There was a time when this sort of system made sense. The main risk in debentures (loans) is that the borrower will default, which is protected against by spreading the risk over a large portfolio of loans. Few individuals have the cash resources to buy enough debt to make these investments make sense. Banks and credit unions pooled the resources of many depositors in order to buy enough loans to make a safe investment.

Peer-to-Peer Lending taking over

Technology has changed this, and CDs are a prime target of Peer-Lending. Instead of locking up money for 1-5 years and letting banks loan out the money, investors cut out the banks and loan directly to borrowers. Peer lending offers good returns (an average of 7%, on par with the S&P over the past 10 years). Notes are fractured into small pieces and expenses are a fixed percentage of the note amount. This makes peer-lending a viable investment vehicle for short-term investments; individual investors are able to buy a diversified portfolio without incurring a detrimental expense ratio.

Goldman Sach’s lists this as taking a major bite out of banks profits:

“[W]e estimate $11bn+ (7%) of annual profit could be at risk from non-bank disintermediation over the next 5+ years.”

But instead of just C.D.s., Peer Lending may take a more ambitious target soon; savings accounts themselves.

The New Savings Account?

In the not-so-distant future, a typical personal finance transaction may look like so:

Instead of being deposited into a bank account, your monthly paycheck is deposited into a Peer Lending account. An algorithm takes stock of your historical cash flow needs and automatically knows you’ll need $2,000 in 29 days to pay your mortgage. The system looks for very small and notes that mature within your time frame and purchases those notes. Notes that have not matured by the time you need the money are sold, and by the morning of the 30^th the necessary cash is waiting for you in your checking account, with the interest you’ve earned during the past 29 days is automatically reinvested into new loans.

Banks will still be in the background, earning small fees for facilitating transactions (it will be hard to cut the banks out entirely), but process will be more efficient while keeping risk minimized for the individual.

Banking is slowly being separated from banks.  There are a lot of challenges to get to this point, but one can see the traditional ways eroding as investors cut out the bloated banking system and allow their ‘tuppence’ to compound ‘semiannually’.