In balance sheet lending (also called portfolio lending), the platform entity provides a loan directly to a consumer or business borrower. As p2p platforms involved with balance sheet lending provide a loan option outside of a traditional bank it is often categorized as alternative lending. Here, it is one of the two main types with the other one being peer-to-peer lending.
The main difference between traditional p2p lending and balance sheet lending is how the risk is structured if a loan goes bad. In p2p lending, the platform does not lend to the borrower but merely link borrowers with investors between who the loan agreement is made. This stands in contrast to balance sheet lending where the p2p platform (or another type of balance sheet lender) assumes the risk itself, meaning that it is directly liable for any losses. Thus, balance sheet lending can take many different forms, but the common trait of all balance sheet lenders is that they provide loans on their own risk.
This article will focus on balance sheet lending from the perspective of peer-to-peer platforms and crowdinvesting, so if that is your focus of interest – please read on to learn more as we dive into the details below.
Balance Sheet Lending Versus P2P Lending
Where does the money used for lending come from? This question is crucial for understanding which of the two main alternative lending models, p2p lending or balance sheet lending, a loan belong to. Therefore, a useful question to ask oneself is: Do the money come from the marketplace (p2p lending is also known as marketplace lending) or the balance sheet of the p2p platform entity?
As established above, traditional p2p lending platforms provide a service that makes it possible for investors to lend to companies and consumers in search of funding but do not issue the loan themselves. A pure p2p lending platform is usually providing three services called Origination, Loan Servicing, and Recovery. These services are basically what you pay for (through fees) when you invest at such platforms. Here, origination consists of locating borrowers that can be either consumers or businesses and accessing their creditworthiness (which includes rejecting those who are deemed too risky and classifying the rest into risk categories); loan servicing is the task involved with handling payments and monitoring the loan performance; and recovery is the work involved in debt recovery from defaults. In other words, a p2p lender provides the infrastructure needed to facilitate the funding arrangement between investors and businesses or consumers.
The model of balance sheet lending, in contrast, is closer to that of traditional bank lending, and balance sheet lending usually requires that the platform has a banking license. The structure of the loans provided in balance sheet lending is fundamentally different from the loans in peer-to-peer lending because the loans in balance sheet lending are issued on the risk of the balance sheet lender. Essentially, this means that if a borrower is not able to repay the money lend, the balance sheet lender, the p2p platform entity, will end up losing their own money, if it is not possible to recover the debt via collateral provided by the borrower – a crucial contrast to p2p lending where the lender is a peer-to-peer investor funding a loan facilitated by the platform and not the platform itself.
Cost Structure and Funding Process
In balance sheet lending, the p2p platform originates the loan and keeps the money used for lending on its balance sheet. Thus, the platform will earn revenue from both their fee structure and from the interest payments accruing from loans. For the platform, the downside of this is that it also assumes the credit risk. This also has consequences for the cost structure and the funding process.
One of the main costs associated with balance sheet lending is the cost of capital or the price of obtaining the funds needed to provide loans. Since the balance sheet lender assumes the risk of the loans itself, another important cost that must be covered is the cost associated with covering losses on bad loans.
As mentioned above, investors in traditional peer-to-peer lending take both the risk and the return (in the form of interest payments). This makes the cost structure significantly different between balance sheet lending and p2p lending, as the capital is provided by the investors, or set aside funds to cover loan defaults, as the risk is covered by the investors and not the platform itself. Therefore, the platform company in a pure p2p lending model does not have to acquire capital to finance loans. In the same way, a p2p lending platform does not have to set aside funds to cover loan defaults, as the risk is covered by the investors and not the platform itself.
In general, when comparing the cost structure of balance sheet lending and p2p lending we find that the cost structure of pure p2p lending platforms is more transparent for the investor and often creates more value, but only if the investor is able to manage his/her risk by diversifying across these five key elements for diversification in p2p lending.
In terms of speed, the funding process between p2p lending and balance sheet lending is also very different with consequences for both investors and borrowers. Here, the advantage of balance sheet lending is that the money is available and ready to be disbursed the moment the borrowing application is accepted. On the other hand, p2p lending platforms are in a constant struggle to balance the capital demanded by borrowers (consumers or businesses) and the capital supplied by lenders (investors). As an investor, this can lead to a shortage of loan to invest in, and as a borrower, it can lead to a prolonged funding period.
The Future of Balance Sheet Lending and P2P Lending
The models of balance sheet lending and p2p lending described above are what can be called ideal types, meaning that the traits described are the two models in their pure form. In reality, many platforms are hybrids trying to harvest the benefits from both types of alternative lending. The market of both balance sheet lending and p2p lending as alternative lending sources is still very young and in rapid development, so predictions of the development of the market are still very speculative. However, as balance sheet lending is becoming more common, especially in the United States and the Americas Region, it is not unlikely that p2p lending, in general, could move more in the direction of bank lending with more sophisticated interfaces available to borrowers and with traditional p2p lending platforms only serving certain niche markets. This could also mean that we will see more banks engaging in cooperation with p2p platforms or running their own lending platforms.