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IntroductionAdvantages
Adverse Selection, Trust and ReputationThe Model
Welfare AnalysisConclusions
P2P Lending and Screening Incentives
Dairo Estrada & Paula ZamoraThe Second International Workshop P2P Financial Systems 2016
September 6, 2016
P2P Lending and Screening Incentives
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IntroductionAdvantages
Adverse Selection, Trust and ReputationThe Model
Welfare AnalysisConclusions
Overview
1 Introduction
2 Advantages
3 Adverse Selection, Trust and Reputation
4 The ModelPerfect ScreeningImperfect ScreeningFinancial Inclusion and Welfare
5 Welfare Analysis
6 Conclusions
P2P Lending and Screening Incentives
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IntroductionAdvantages
Adverse Selection, Trust and ReputationThe Model
Welfare AnalysisConclusions
Composition of Crowdfunding by category
Source: Company Data, Morgan Stanley Research estimates
P2P Lending and Screening Incentives
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IntroductionAdvantages
Adverse Selection, Trust and ReputationThe Model
Welfare AnalysisConclusions
Peer to peer Lending Process
Source: Aveni(2015)
P2P Lending and Screening Incentives
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IntroductionAdvantages
Adverse Selection, Trust and ReputationThe Model
Welfare AnalysisConclusions
Loan Distribution Originated by P2P platform
Source: Company Data, Morgan Stanley Research estimates
P2P Lending and Screening Incentives
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IntroductionAdvantages
Adverse Selection, Trust and ReputationThe Model
Welfare AnalysisConclusions
Advantages of P2P Platforms
Have broader access to information (Big Data)
Lower costs compared to the intermediation operations of banks
Improve financial inclusion
Quick adjustment to new market conditions (technology, new instruments)
P2P Lending and Screening Incentives
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IntroductionAdvantages
Adverse Selection, Trust and ReputationThe Model
Welfare AnalysisConclusions
Costs and Interest Spreads for Banks and Lending Club
Costs in Basis Points
Sources: Aveni (2015) and Lendit 2013
P2P Lending and Screening Incentives
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IntroductionAdvantages
Adverse Selection, Trust and ReputationThe Model
Welfare AnalysisConclusions
Information Role
The agility of the system, customer satisfaction, the success of the platform andits growth depend directly on the number of agents willing to participate in themarket on both sides.
The challenges:1 Build a solid performance history to generate credibility.2 Maintain users’ confidence in the system.
Importance of the screening process: platforms are highly interested in enforcingstrict lender and borrower requirements to guarantee quality in the transactions,increase reputation and guard against misbehavior and fraud.
P2P Lending and Screening Incentives
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IntroductionAdvantages
Adverse Selection, Trust and ReputationThe Model
Welfare AnalysisConclusions
Perfect ScreeningImperfect ScreeningFinancial Inclusion and Welfare
The Model
A model with screening activities
Agents receive a pool of loan applications and decide the amount of them to bescreened (k) in order to grant loans.
The agents cannot identify directly the type of project without screening, butthey know the share of good (low-risk) projects in the economy, [λ ∈ (0, 1)].The bank’s optimal number of loans granted is small relative to market demand.
Two questions:1 How do the economic outlook, the screening costs and the quality of screening affect
the incentives of the bank and the platform to screen potential borrowers?2 What is the resulting impact on loan supply in the market?
P2P Lending and Screening Incentives
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IntroductionAdvantages
Adverse Selection, Trust and ReputationThe Model
Welfare AnalysisConclusions
Perfect ScreeningImperfect ScreeningFinancial Inclusion and Welfare
Monopoly Case
Timing of the Bank’s problem with Perfect Screening
P2P Lending and Screening Incentives
-
IntroductionAdvantages
Adverse Selection, Trust and ReputationThe Model
Welfare AnalysisConclusions
Perfect ScreeningImperfect ScreeningFinancial Inclusion and Welfare
Monopoly Case
The profit function:
ΠpsBank (k) = kλπL − rL− k2z (1)
L = kλ is the amount of loans that the bank grants
The optimal amount of loans granted by the bank is:
LpsM =λ2πL − rλ2
2z(2)
P2P Lending and Screening Incentives
-
IntroductionAdvantages
Adverse Selection, Trust and ReputationThe Model
Welfare AnalysisConclusions
Perfect ScreeningImperfect ScreeningFinancial Inclusion and Welfare
Monopoly Case
Amount of loan applications screened by the bank
P2P Lending and Screening Incentives
-
IntroductionAdvantages
Adverse Selection, Trust and ReputationThe Model
Welfare AnalysisConclusions
Perfect ScreeningImperfect ScreeningFinancial Inclusion and Welfare
Duopoly Case
A bank and a platform are active in the credit market and they randomly andindependently choose which loan applications to assess. Hence, we can find fourgroups of loan applications:
P2P Lending and Screening Incentives
-
IntroductionAdvantages
Adverse Selection, Trust and ReputationThe Model
Welfare AnalysisConclusions
Perfect ScreeningImperfect ScreeningFinancial Inclusion and Welfare
Sequence of decisions in a Duopoly lending industry with Perfect Screening
P2P Lending and Screening Incentives
-
IntroductionAdvantages
Adverse Selection, Trust and ReputationThe Model
Welfare AnalysisConclusions
Perfect ScreeningImperfect ScreeningFinancial Inclusion and Welfare
Duopoly Case
The profit function for agent i is:
Πpsi (ki , kj ) = kikjλ
2πL + ki (1− kj )λπL − rLi − k2i zi (3)
zA > zB
The number of loan applications that agent i decides to finance is:
Lpsi = kikjλ
2+ ki (1− kj )λ (4)
P2P Lending and Screening Incentives
-
IntroductionAdvantages
Adverse Selection, Trust and ReputationThe Model
Welfare AnalysisConclusions
Perfect ScreeningImperfect ScreeningFinancial Inclusion and Welfare
Duopoly Case
The optimal values of kA and kB expressed through the exogenous parameters are:
kpsA =λ2
2(r − πL)2 + 2λ(r − πL)zBλ2
4(r − πL)2 − 4zAzB
(5)
kpsB =λ2
2(r − πL)2 + 2λ(r − πL)zAλ2
4(r − πL)2 − 4zAzB
(6)
P2P Lending and Screening Incentives
-
IntroductionAdvantages
Adverse Selection, Trust and ReputationThe Model
Welfare AnalysisConclusions
Perfect ScreeningImperfect ScreeningFinancial Inclusion and Welfare
Duopoly Case
Screening and Economic Outlook
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7
Economic Outlook ( λ )
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1S
cree
nin
g (
K)
ZBank
=0.09, ZPlatform
=0.03, r=0.03, πL=0.2
KMonopoly
ps
KBank
ps
KPlatform
ps
P2P Lending and Screening Incentives
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IntroductionAdvantages
Adverse Selection, Trust and ReputationThe Model
Welfare AnalysisConclusions
Perfect ScreeningImperfect ScreeningFinancial Inclusion and Welfare
Monopoly Case
Screening is costly (z > 0) and imperfect, β ∈ [0, 1]. The risk that the bank orthe platform approves unqualified loan applications rises as β increases.
Mistakenly approved bad projects have an strictly negative expected revenue forthe agent.
P2P Lending and Screening Incentives
-
IntroductionAdvantages
Adverse Selection, Trust and ReputationThe Model
Welfare AnalysisConclusions
Perfect ScreeningImperfect ScreeningFinancial Inclusion and Welfare
The profit function for the bank is then as follows:
ΠisBank (k) = k[λπL + (1− λ)βπH ]− rL− k2z (7)
The number of loans funded also changes, given the misclassification of projects:
L = k[λ+ (1− λ)β] (8)
The optimal number of loan applications that the bank should screen to maximizeprofits is:
k isM =λπL + (1− λ)βπH − r [λ+ (1− λ)β]
2z(9)
P2P Lending and Screening Incentives
-
IntroductionAdvantages
Adverse Selection, Trust and ReputationThe Model
Welfare AnalysisConclusions
Perfect ScreeningImperfect ScreeningFinancial Inclusion and Welfare
Duopoly Case
Both the screening costs, z, and the probability β differ among the bank and theplatform.
The groups also include high-risk projects, given the probability ofmisclassification.
We asume that the platform has a better technology to screen (βB < βA) and itis also more efficient in the screening process (zB < zA).
P2P Lending and Screening Incentives
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IntroductionAdvantages
Adverse Selection, Trust and ReputationThe Model
Welfare AnalysisConclusions
Perfect ScreeningImperfect ScreeningFinancial Inclusion and Welfare
According to these new conditions, the profit functions will be for the bank and theplatform, respectively:
ΠisA (kA, kB ) =kA [λπ
L + (1 − λ)βAπH ]kB [λπ
L + (1 − λ)βBπH ]
2(10)
+kA(1 − kB )[λπL + (1 − λ)βAπ
H ] − rLA − k2AzA
ΠisB (kA, kB ) =kA [λπ
L + (1 − λ)βAπH ]kB [λπ
L + (1 − λ)βBπH ]
2(11)
+kB (1 − kA)[λπL + (1 − λ)βBπ
H ] − rLB − k2B zB
P2P Lending and Screening Incentives
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IntroductionAdvantages
Adverse Selection, Trust and ReputationThe Model
Welfare AnalysisConclusions
Perfect ScreeningImperfect ScreeningFinancial Inclusion and Welfare
Screening and Expected Losses
-0.2 -0.18 -0.16 -0.14 -0.12 -0.1 -0.08 -0.06
Expected losses from high-risk projects ( πH)
0
0.1
0.2
0.3
0.4
0.5
0.6
Scr
een
ing
(K
)β
Bank=0.24, β
Platform=0.2, Z
Bank=0.09, Z
Platform=0.04, r=0.03, λ=0.3, πL=0.2
Kps
Platform
Kis
Platform
Kps
Monopoly
Kps
Bank
Kis
Monopoly
Kis
Bank
P2P Lending and Screening Incentives
-
IntroductionAdvantages
Adverse Selection, Trust and ReputationThe Model
Welfare AnalysisConclusions
Perfect ScreeningImperfect ScreeningFinancial Inclusion and Welfare
Screening and Economic Outlook
0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
Economic Outlook ( λ )
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7S
cree
nin
g (
K)
βBank
=0.24, βPlatform
=0.2, ZBank
=0.15, ZPlatform
=0.1, r=0.03, πL=0.2, πH=-0.3
Kps
Platform
Kis
Platform
Kps
Bank
Kis
Bank
P2P Lending and Screening Incentives
-
IntroductionAdvantages
Adverse Selection, Trust and ReputationThe Model
Welfare AnalysisConclusions
Perfect ScreeningImperfect ScreeningFinancial Inclusion and Welfare
Screening and Economic Outlook
0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
Economic Outlook ( λ )
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7S
cree
nin
g (
K)
βBank
=0.24, βPlatform
=0.2, Z=0.1, r=0.03, πL=0.2, πH=-0.3
Kps
Kis
Platform
Kis
Bank
P2P Lending and Screening Incentives
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IntroductionAdvantages
Adverse Selection, Trust and ReputationThe Model
Welfare AnalysisConclusions
Perfect ScreeningImperfect ScreeningFinancial Inclusion and Welfare
Perfect Screening
Loans and Economic Outlook
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7
Economic Outlook ( λ )
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1L
oan
s (L
)Z
Bank=0.09, Z
Platform=0.03, r=0.03, πL=0.2
LpsMonopoly
LpsBank
LpsPlatform
LpsDuopoly
P2P Lending and Screening Incentives
-
IntroductionAdvantages
Adverse Selection, Trust and ReputationThe Model
Welfare AnalysisConclusions
Perfect ScreeningImperfect ScreeningFinancial Inclusion and Welfare
Imperfect Screening
Loans and Economic Outlook
0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
Economic Outlook ( λ )
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8L
oan
s (L
)β
Bank=0.24, β
Platform=0.2, Z
Bank=0.15, Z
Platform=0.1, r=0.03, πL=0.2, πH=-0.3
Lps
Duopoly
Lis
Duopoly
Lps
Monopoly
Lis
Monopoly
P2P Lending and Screening Incentives
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IntroductionAdvantages
Adverse Selection, Trust and ReputationThe Model
Welfare AnalysisConclusions
Perfect ScreeningImperfect ScreeningFinancial Inclusion and Welfare
Imperfect Screening
Loans and Economic Outlook
0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
Economic Outlook ( λ )
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8L
oan
s (L
)β
Bank=0.24, β
Platform=0.2, Z
Bank=0.15, Z
Platform=0.1, r=0.03, πL=0.2, πH=-0.3
Lps
Duopoly
Lis
Duopoly
Lps
Monopoly
Lis
Monopoly
P2P Lending and Screening Incentives
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IntroductionAdvantages
Adverse Selection, Trust and ReputationThe Model
Welfare AnalysisConclusions
Welfare Analysis
The socially optimal fraction of loan applications that should be screened isgreater than the fraction of loan applications that the bank screens.
kps∗M =λπL
2z> kpsM =
λπL − rλ2z
(12)
P2P lending increases loan supply and seems to be a good alternative for thosewho deserve credit, but do not have access to financial services provided byregulated financial institutions. This would be an important innovation indeveloping economies, where many people depend on informal mechanisms thathave forced them to pay high interest rates and pawn or sell assets.
These results are valid when we evaluate the model under perfect and imperfectscreening condition.
P2P Lending and Screening Incentives
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IntroductionAdvantages
Adverse Selection, Trust and ReputationThe Model
Welfare AnalysisConclusions
Risks and Regulation
The role of regulation
Riskier borrowers: regulators should require platforms to have accurate screeningstandards.
Data and confidentiality
Algorithms and discrimination
Platform’s incentives to reveal information
Monetary Policy
P2P Lending and Screening Incentives
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IntroductionAdvantages
Adverse Selection, Trust and ReputationThe Model
Welfare AnalysisConclusions
Conclusions
Final Comments
Lower screening costs, a better economic outlook and higher profits from goodprojects promotes the platform and the bank to screen more.
As long as the platform has lower screening costs and better screening quality,then it will grant more loans than the bank.
A lower quality in screening reduces the incentives of screening of both agentsand therefore they provide less credit to the market.
The gap between the optimal amounts of screening under imperfect and perfectscreening conditions reduces as the economic outlook improves.
P2P Lending and Screening Incentives
IntroductionAdvantagesAdverse Selection, Trust and ReputationThe ModelPerfect ScreeningImperfect ScreeningFinancial Inclusion and Welfare
Welfare AnalysisConclusions