RBI Paper on Peer-to-Peer Lending: A Case of Unmindful Contradictions

The RBI's first-ever consultation paper on P2P lending lacks vision and direction. Rather than holding onto existing frameworks, we need to encourage finance-based innovation.

Archimedes, the great mathematician, once remarked, “Give me a place to stand on, and I will move the Earth.” Although he originally said this in the context of the mechanical lever’s power to multiply input force, the relevance of his statement to today’s world cannot be underestimated. Ideas, innovation and entrepreneurship can indeed spawn a world leader in a third world country.

However, the regulatory atmosphere in India fails to encourage the novel practices of ever-enthusiastic entrepreneurs in dynamic markets. In fact, whenever an opportunity arises to give entrepreneurs a place to stand, they take several backward steps.

Seemingly ignorant of developments around the world, the Reserve Bank of India (RBI) recently published its first ever consultation paper on ‘peer to peer lending’ (P2P lending) – a publication that has already shaken the ways of financing around the world. The paper is, however, devoid of any vision or direction. It is demonstrative of a proud and often arrogant regulator that is struggling to come to terms with a young enterprise of the contemporary world – namely, P2P lending. The paper is perhaps well intentioned. At best, however, it illustrates an almost hysterical sense of the premises and promises of P2P lending in India and at worst, a manifest usurpation of jurisdiction concerning a novel segment. Equally disconcerting is the sloppy groundwork underpinning the paper, its shallow assertions, hurried conclusions, and if one may add, strikingly plagiaristic undertones. 

What is P2P lending?

On the surface, P2P lending is business as usual. Most of us, if not all, have resorted to some form of P2P lending in our lives. Think of the time when you loaned your flatmate money for their share of rent or borrowed from them for yours. That is P2P lending.

In its most general form, online P2P lending is an activity in which a person who wants to invest money (the lender) meets a person who wants to borrow money (the borrower) over the Internet through a matchmaker known as a ‘P2P platform’. P2P platforms also provide a host of ancillary services, such as arranging paperwork and checking creditworthiness. In this way, they do what we humans have always done. The only difference is, the lending takes place over the internet.

Isn’t P2P lending a banking activity then?

Absolutely not, although it may bear a striking resemblance. To understand what is, and isn’t, a bank, let’s consider a thumbnail sketch. People with excess capital ‘deposit’ that in a bank and those in need take a ‘loan’ from the bank. Depositors see their savings grow and borrowers gladly utilise the borrowed capital. Situated in the middle, the bank maintains its balance sheet, with loans as assets and deposits as liabilities, and profits from the difference between interest given and interest taken.

The system looks simple and keeps everyone happy. Therefore, one may wonder, why are banks so fragile?  

Banks are fragile because they lend long-term loans against short-term deposits. Thus, unexpected deposit withdrawals or a surge in defaults on loans can bring banks to the edge of insolvency.

Enter the central bank, which imposes stringent capital, liquidity and leverage ratio requirements to insulate banks from liquidity concerns and balance sheet mismatches. In simple words, a capital-cushion ensures that banks comfortably absorb losses. Over and above this, bailouts and emergency liquidity support by the central bank come to the rescue during periods of crisis.

Let’s now understand how a marketplace P2P platform is different from a bank. Banks play a dangerous “balance-sheet game” by advancing long-term loans against short-term deposits. But a P2P platform does neither. It neither commits its own funds to the borrower nor accepts deposits from the lender. It merely makes money by charging fees from them both. So, the ones who advance the money – individual lenders – take the hit of defaults. Better yet, there is no central bank or state guarantee to sway them, because the P2P does not hold the portfolio of loan assets or deposit liabilities. Consequently, no balance sheet risks are involved.

If not banking, isn’t P2P lending a financial activity?

According to the RBI, P2P lending is a financial activity. But let’s not come to easy conclusions. Let us revisit the conceptual framework, which has hitherto remained untouched by the RBI. Under Indian banking laws, the RBI regulates both ‘banks’ and ‘non-banks’. Banks performing lending and borrowing activities have to obtain a banking license. Similarly, non-banks engaged in ‘financial activity’ have to obtain a certificate of registration from the RBI. To determine whether or not a company is engaged in financial activity, the RBI applies the ‘principal business’ or ’50-50′ test. The assets and income pattern of a company are examined from the last audited balance sheet. If its financial assets are more than 50% of its total assets and its income from financial assets is more than 50% of its gross income, such a company will be classified as ‘non-banking financial company’ (NBFC). Needless to say, this classification comes with a host of regulations.

But what happens if a company does not meet the requirements of the ’50-50′ test? There are three possible outcomes. First, the company would not be classified as an NBFC. Second, its principal business would be non-financial. Third, it would be classified, under the RBI’s own rubric, a ‘non-banking non-financial company’. The RBI does not regulate such companies, which makes sense. After all, the RBI’s intention is prudent – to regulate only those who predominantly engage in ‘banking’ or ‘financial’ activity.

The RBI’s approach in its paper, however, is anything but prudent. For better or worse, the implications of its approach are far-reaching. To classify P2P platforms as NBFCs is a tragic mistake. Unlike banks, P2P platforms source their income predominantly from arrangement fees. They do not accept deposits on their balance sheets or engage in proprietary lending. Rather, they do what their name suggests: they facilitate. No reasonable assessment could label this activity ‘financial’. From what follows, P2P platforms are simply ‘non-banks’ and ‘non-financial companies’. Regulating P2P platform under the guise of NBFCs is regulatory appropriation. The appropriate nodal regulatory authority for ‘non-banking non-financial companies’ is the Ministry of Corporate Affairs. The RBI simply has no right to assert its sovereignty over P2P platforms.

What does the RBI’s consultation paper offer?

Simply put, it offers nothing. As it stands now, it is a half-baked position paper that is poorly articulated and woefully unsubstantiated. Strong claims against P2P lending have been made. Phrases such as “potential impact” and “associated risks to financial system” have been peppered throughout the paper with outrageous liberty. Unfortunately, one finds no footnotes with sources that support such claims. It is astonishing to see that no empirical research has been conducted and no evidence presented.

The reasons given for and against regulating P2P platforms testify to the paucity of academic and policy rigour. The paper places too much reliance on a media report to inform itself on the size of the industry that it seeks to regulate. Additionally, it demonstrates a blurring of the line between inspiration and plagiarism. Sentences and, frequently, entire paragraphs have been lifted from unofficial and unreliable sources. This is certainly vexing from a policy perspective.

Is there even a methodology at play? It seems doubtful. Ironically enough, the RBI employs a world-renowned academic at its helm. One wonders if he has failed to establish any academic standards at all in the institution.  

P2P lending – an innovative solution

We wholeheartedly concede that the RBI is a vigilant, powerful and responsive regulator. There is no doubt about that. As demonstrated in the past, it has all the expertise and experience to ferret out and remedy regulatory arbitrage. Remember the microfinance saga?

However, regulating P2P is not a cakewalk but an arduous task. The old mantra of ‘one size fits all’ will not work here. Fundamentally, it demands adjustments to regulatory thought and will. The RBI needs to accept that existing structures were simply not built for such models of direct finance. They were designed for a totally different world. Moreover, in a sense, P2P lending depicts the perfect regulatory arbitrage exam hypothetical, often baffling the top legal minds.

What do we do then? To begin with, let’s not be swayed by easy answers. Let’s topple our old guards. Let’s not retrofit emerging market players within the regulatory maze created for other situations and models. Of course, this won’t be easy either. After all, risk-taking has to be tempered with regulatory wisdom. But it would be wrong on our part to write off this sector just yet when this world is in dire need of innovation, finance-based or otherwise. As are the people who have traditionally been left ‘unbanked’. Let us think of answers that instil confidence in the financial system, maintain market order and above all, foster innovation. That would make this world, perhaps, a lot more interesting.