In my Money and Banking class, I spend two lectures explaining why banks exist and how banks reduce the costs of getting money from savers to borrowers. The two principal costs which I stress are those associated with reducing adverse selection and moral hazard. However, since the 2008 financial crisis, there has been a surge of interest in crowd-funding or peer-to-peer lending. This is where borrowers pitch for loans on a designated website and savers decide whether or not to lend to them. One example of this is Funding Circle, which has already lent £223m to businesses and has over 60,000 savers lending funds. To date, the average saver is earning an attractive 5.8% per annum. However, Funding Circle stresses that by joining it, you will be helping the economy by lending to British businesses.
So is finance going to regress back to direct finance by bypassing the banks? Are banks going to disappear? I foresee several problems with peer-to-peer lending. First, there is a liquidity problem for savers. If you want to withdraw your money, you have to find someone willing to buy your loans. This could prove difficult during economic downturns or when many savers are hit simultaneously by a consumption shock. Second, although Funding Circle do a credit assessment of borrowers, it may not be as rigorous as that performed by a bank. Third, once bank balance sheets recover, they will be able to offer better rates and terms to businesses. Fourth, I'm not sure how the moral hazard problem is addressed in this system. What prevents borrowers from misusing funds?