Most people think that banks take deposits and then re-loans the funds at a higher rate to borrowers. Also, most people think that bankers are extremely risk adverse. Nothing could be further from the truth.
Banks are the ultimate risk takers. Banks accept huge sums of money on deposit and guarantee a return. Banks loan out trillions of dollars with nothing more than a promise to repay in many cases. So if banks are big risk-takers, why do they make so much money? Shouldn’t these risks go badly every so often?
The secret to banks’ profitability is their ability to assess risk, particularly in lending. The loan departments at banks are charged with properly assessing loan risk and lending money at a much higher rate than is statistically required.
Banks double dip by charging a risk acceptance premium for depositors. Banks guarantee deposit returns in exchange for a discount. This spread between deposit interest paid and loan interest charged equals much of a bank’s profit.
However, peer lending websites like zopa.com and prosper.com threaten the traditional banking model. These websites connect traditional depositors with borrowers. These sites allow depositors to become direct lenders and accept risks typically taken by bankers and venture capitalists. By assuming a small amount of risk, investors can pocket much higher returns. Zopa.com even has a risk-assessment department similar to a loan approval department at a bank. For a small amount of additional risk, depositors can earn over 8% vs. 1.5% on a CD or 4% on a 10 year treasury.
In the past, the only way to earn rates higher than banks was to become an angel investor. This involves great risk and great potential reward. The average venture capital return on investment is over 30%. However, most people cannot access angel investments or venture capital. Sites like zopa.com reside in-between traditional banking and venture capital. They allow average folks to assume some banking risk and make significant returns for the trouble.
The hundred thousand dollar question is: Will peer to peer lending sites cause significant disruption to the traditional banking model?
