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Peer-to-peer lenders get ahead of regulation with voluntary code

Aaron Pressman
A woman looks at her phone as she passes by a Lending Club banner on the facade of the the New York Stock Exchange December 11, 2014. REUTERS/Brendan McDermid

With government agencies taking a hard look at the growing peer-to-peer lending industry, some of the biggest lenders are getting together to head off the need for potentially crippling regulation.

A group of the lenders focused on small businesses, including Funding Circle, Fundera and Lending Club (LC), unveiled a list of six best practices giving more rights to borrowers. Even as the industry has grown rapidly, stories of abusive lending practices, such as hidden fees and sky-high rates have proliferated. The U.S. Treasury Department last month initiated a public review of the industry.

The voluntary code of best practices, dubbed a Small Business Borrowers' Bill of Rights, includes full transparency around rates and fees, responsible underwriting that doesn't lend to those who can't repay and non-discriminatory access to credit.

"We're very conscious of the fact that this is a new ecosystem," says Jared Hecht, co-founder and CEO of Fundera. "A few bad actors could ruin everything." The new principles, which were developed over the past six months, are "really just rooted in common sense," he says.

The group unveiled the principles at an event at the National Press Club in Washington, D.C. on Thursday.

Agreeing on best practices could help the industry alleviate regulatory concerns and reduce the risk of "enhanced scrutiny," says Mark Palmer, an analyst who follows the sector for BTIG Research. "Increased regulation is near the top of the list of investors’ concerns about the space, so it made sense for online small business lenders to get out in front of the issue," Palmer says.

U.S. regulators are taking cautious approach so far, seeking to eliminate abuses while allowing the market as a whole to thrive. That's because the peer-to-peer lenders are bringing credit to a segment of borrowers ignored by mainstream banks. For a variety of reasons, including new rules put in place after the credit crisis, banks have shied away from making small loans to consumers and businesses.

That's left room for the fast growing industry to fill the gap. Peer-to-peer lenders raise money mostly from institutional investors, even including some banks, and make rapid decisions for small borrowers who apply online. Loans hit $12 billion last year, after doubling every year since 2010, Morgan Stanley noted in a June 17 report. With big banks out of the segment, peer-to-peer lending could grow ten-fold to $122 billion by 2020 just in the United States, the firm estimates.

While peer-to-peer loans to consumers are regulated by the Consumer Financial Protection Bureau, loans to small businesses appear to have fallen into a regulatory gap for now. Generally, business loan rules are overseen by bank regulators but since peer-to-peer lenders and their funders are not banks, it's not clear how they should be regulated.

"It's really important that this industry find a strong path forward on this front," says Karen Mills, former head of the U.S. Small Business Administration who helped design the list of principles. "This is a great innovation and even the banking world is beginning to benefit."

Hype around peer-to-peer lending has eased this year, after two of the leading companies in the business have seen their stocks slump. Investors have discovered a flood of players entering the space, including even investment bank Goldman Sachs (GS), creating competition that's likely to drive up marketing costs and hit profit margins.

Lately, the growth rates of some leading peer-to-peer lenders have slowed, which could be another reason for Thursday's initiative emphasizing borrower rights, says Oliwia Berdak, senior analyst at Forrester Research. While sources of funds to lend are plentiful, the tougher job has been attracting qualified borrowers, she says.

"This imbalance is making it difficult for them to keep their costs down and keep the interest rates on loans in line with the risks," Berdak says. "So one motivation behind the code is probably an attempt to appeal to more borrowers."

Lending Club went public last December and saw its share price hit $29 within days, but lately it has slumped beneath its IPO price of $15. It dropped another 3% to $14.03 on Thursday. On Deck Capital (ONDK), which isn't part of the group backing the voluntary principles, went public in December at $20 per share and has lost more than half its value since. Still suffering from a poor earnings report earlier this week, On Deck lost 4% to close at $9.07 on Thursday.