The 5Cs of Credit, P2P Lending, Social Lending, Self-Directed Lending

While I agree with the need for change and transparency I do not necessarily agree with Mr. Fink’s comments that more derivatives and fiduciary outsourcing are the answer. As a futurist and former banker I think that less outsourcing of responsibility is needed if financial markets are to operate more effectively. More effective lending may require less abstraction and more disintermediation.

 

There is an axiomatic formula for evaluating loan decisions known to all bankers as the 5Cs which are usually given as Character, Capacity, Credit, Capital and Collateral. Capacity metrics are simple ratios that indicate the borrower’s ability to pay. Credit, Capital and Collateral also lend themselves to easy quantification and measurement; however, Character, the borrower’s willingness to pay, is not so easy to measure.

 

In terms of importance, Capital and Collateral are relatively equal. Capacity and Credit are important but Character is regarded among bankers as the most important of the Five Cs. Character is important because it is believed that people with good Character will tend to overcome obstacles to meet their obligations.

 

Qualities of Character such as reputation, respect and integrity began to be ignored with the invention of automated loan decisioning systems. At first lending systems were used to augment human decision making but soon the human element was eliminated altogether for small loans. More recently car loans and even mortgage lending decisions were automated. Ignoring Character may not be an issue during prosperous times but the systematic elimination of Character from the lending equation combined with the severance of relationships between borrowers and lenders (due to the packaging, repackaging, commoditization and trading of loans) has created a crack in the foundation of our financial system which is still in need of repair.

 

New technological solutions may provide a means to improve the efficiency of lending. One possible solution is Peer-to-Peer (P2P), or social lending. I call it “Self-Directed” lending. Self-Directed lending is in sync with the self-service movement that has gained traction in areas from investing to grocery store check-out lines. Conceptually the idea of Self-Directed lending is simple and powerful – allow savers to lend directly to borrowers rather than through financial institutions. Now more than forty VC-backed and private companies world-wide including Zopa, Prosper, Lending Club, Kiva and Virgin Money are championing this concept. This is now the fastest growing form of lending in many markets.

 

In theory, a Self-Directed lending paradigm may be more robust than a financial system dominated by large centrally controlled banks. Self-Directed lending is a self-organizing matrix or network (like the Internet) composed of millions of interconnected individuals acting within their right to choose how and to whom they lend their money. Distributed self-organizing systems can adapt and react quickly to dynamic changes in the environment, operate efficiently and grow rapidly whereas by comparison centrally controlled systems (like our current financial system) appear to be less efficient and more prone to catastrophic failures.

 

The information, knowledge and tools invented by institutions for lending are becoming ubiquitous. Today both individuals and institutions can quickly assess four of the 5Cs (i.e., Capacity, Credit, Capital and Collateral) using highly automated tools; however, only individuals have the opportunity through Self-Directed lending to bring Character and personality back to lending.

As Self-Directed lending evolves financial institutions may need to reinvent themselves but the opportunities for both institutions and individuals in this new paradigm are many.