As person-to-person online lending grows, how should it be regulated?

Introduction

Internet sites offering person-to-person lending have surged in popularity as borrowers look for help paying off credit card bills and investors search for double-digit returns. What’s less clear, though, is how this new style of lending should be regulated as it evolves.

Prosper Marketplace, Inc. and LendingClub Corp. are the biggest for-profit companies offering online platforms that let individuals act as lenders by investing in loans to borrowers.

Both are overseen by a combination of state regulators plus the Securities and Exchange Commission (SEC), the Federal Deposit Insurance Corp. (FDC) and the new Consumer Financial Protection Bureau (CFPB), according to a new Government Accountability Office report.

Together, the two companies have connected borrowers and lenders for a total of about 63,000 unsecured loans totaling $469 million through March 2011.

“[Person-to-person lending platforms are] rather small right now, so they’re not at the scale that they could potentially represent any systemic risk,” Matthew Sciré, GAO director of financial markets and community investment, told iWatch News. “So the argument for moving towards more of a consolidated approach is not compelling. There are certainly arguments on both sides of this.”

A consolidated approach would designate one federal regulator, such as the CFPB, to take primary responsibility for both borrower and lender protection. The CFPB might, for example, set disclosure requirements for lenders and borrowers, impose restrictions on certain lending practices, and perform examinations of lenders.

While the size of the Internet person-to-person lending market is still modest, Prosper and LendingClub are attracting more sophisticated individual and institutional investors, which could lead to new regulatory issues, the GAO report said.

A new unit of LendingClub, LC Advisors LLC, has already registered with SEC and state regulators as an investment adviser firm that will offer accounts for high net worth investors and institutional clients.

“The continuing evolution and growth of person-to-person lending could give rise to new regulatory concerns or challenges, making it difficult to predict what the optimal regulatory structure will be,” the report said. If Prosper or LendingClub decide to offer more complex loan products like auto loans or mortgages, regulators will need to ensure fair and transparent lending terms.

The SEC told the GAO that it is monitoring the growth in Prosper and LendingClub, as well as any changes in their business models, through the companies’ securities registration filings.

The CFPB, which opened for business earlier this month and will police consumer protections at big U.S. banks, has not yet determined how it will monitor person-to-person lending but will collect complaints from borrowers, the GAO said.

“We’ve done a lot of work to address the model and how we fit into this square hole,” Chris Larsen, co-founder and CEO of Prosper, told iWatch News.

But the novel concept that has made Prosper and LendingClub so successful — removing the middleman — also brings additional risks for both lenders and borrowers. Borrowers face unique privacy issues in using the online financial platforms while lenders risk losing both interest income as well as the principal amount.

To reduce risk to lenders, both Prosper and LendingClub require potential borrowers to fill out a type of loan application, which documents how many lines of credit an individual has and their debt-to-income ratio. The companies are required to file summaries of the information with the SEC within two business days of posting each loan request on their websites, and the filings try to conceal the identity of potential borrowers to protect their privacy.

However, the GAO said it was sometimes able to identify borrowers by piecing together information from prospectuses, such as the name of a home town or intended use for a loan.

“We’re always seeking to improve borrower privacy, so the fact that it can happen even once is problematic,” Renaud Laplanche, co-founder and CEO of LendingClub, told iWatch News.

Fast Fact: Nonprofit Kiva Microfunds also operates a person-to-person lending platform which lets individuals lend as little as $25 to needy farmers, small businesses, womens’ cooperatives, and entrepreneurs around the world. Kiva told the GAO it has coordinated about 273,000 interest-free loans totaling about $200 million.