Introduction
As the Chinese economy progresses rapidly throughout the decades, its people has also became increasingly wealthy as more cash begins to flow into the public market. Many small businesses saw this as an opportunity to expand themselves, however lacked the funds to take such action. And as a result of this demand for funds, P2P(peer-to-peer) lending became vastly popular among small companies that needed urgent money, as well as people who are willing to take a risk to lend the money for a greater return. Yet with the growing popularity, problems between borrowers and lender also begin to arise. From XinHua news, it was listed that in the year 2013, only 76 P2P platforms had credit issues, and yet only 2 years later in 2015, this number has risen to 896.
The article itself presents the problem that P2P is still mostly unregulated in China, and that platforms are abusing the P2P system for their own benefits, whereas in one case the platform owner scammed 900,000 investors into a poor investment. If the problem is not dealt with soon enough, more companies and private investors that invest their money into P2P would find that their opportunity cost in P2P is not worth the risk that they are taking, hence pulling their money out and resulting in the collapse of P2P platform due to the shortage of funds.
Building the Model
This cause and effect could be clearly explained by the lender and borrower model despite the different platforms P2P take places on. We could simplify it to a model that is composed of two lenders and two borrowers, whereas the platform itself exists as both the lender and borrower. The platform on one hand collects the money from multiple lenders that expects return, and on the other hand it lends the money to investors that they trust.
The problem with this platform is the ex-post moral hazards and the ex-ante moral hazards that the original lender faces, where ex-post moral hazard is the case where the P2P company receives the profits from the original lenders and reject to inform them about the outcome, and ex-ante moral hazard is the case where the platform fails to return profit from their investments. In both of these cases, despite the different outcomes, the original lender cannot observe the risks they face as they invest the money into the P2P platform. It is the platform that determines the actual investments.
Risks and Rewards
If we return to the news post, we could learn that the lack of regulation increases both of these two types of risks, as investment companies may make poor investment decisions that yields negative returns due to the lack of the background check for its borrowers, or simply because the platform tries to take all the profit and pretends to have failed the project, which in both of these cases the original borrower loses their investment.
However, despite many investors are aware of the risk, the opportunity cost of the P2P investment is too large to be ignored. In the year 2015 alone, P2P yields an average return of 13.29% (China Economic Watch, June 27), far exceeding the bank interest rates as well as other wealth management products. Both lenders and platforms saw this opportunity as China’s outstanding loans skyrocketed from $4.3b to $71b in only two years. But despite this rapid growth, the regulations still remain to be old and outdated, giving risky borrowers and platforms opportunities to take advantage of the lender since the punishment is minor in comparison to the profits.
Yet the lack of regulation isn’t completely negative in terms economy development. It is similar to a double edged sword, and in this case the borrower benefits the most from this system. The lack of regulation and background check enabled certain poor people to qualify for P2P loans, whereas in other financial institutions they would have been rejected. And in China, this situation is actually more common than we think (Banking On the Poor in China, March 10) as current microfinance services does not come close to meeting its demands. Government and bank regulations make it difficult for small businesses to get access to the loans they need, and the smaller the scale of the business, the harder it becomes due to the risks it poses. Therefore, these small companies could only seek investments from P2P platforms in order to continue their businesses. But because of the high risks, the platform charges borrowers extremely high interest rates as compensation in order to reduce ex-ante moral hazards, Hence P2P has high risks but also higher rewards.
Conclusions
Therefore, in order to both reduce moral hazards P2P faces and satisfy the need for microfinance services, new regulations have been imposed which puts different limits of lending on different people (Bloomberg News, Aug 24). This reduces ex-ante moral hazard because even in the worst case scenario, investment yields no return, the company would still be able to function rather than collapsing and losing all of its investors’ money, and that the lending amount would still help small businesses while having a decent payoff for the platform. And in terms of reducing ex-post moral hazards, monitoring and laws must be enforced to ensure the clarity of platforms such that their cost of taking the risk of defaulting is much higher than not taking such action.
References
Martin Chorzempa (June 27, 2016), P2P Series Part 1: Peering into China’s Growing Peer-to-Peer Lending Market, Retrieved May 2, 2017, from https://piie.com/blogs/china-economic-watch/p2p-series-part-1-peering-chinas-growing-peer-peer-lending-market
Brendan Rigby (March 10,2011), Banking On the Poor China, Retrieved May 2, 2017, from http://www.whydev.org/banking-on-the-poor-in-china/
Bloomberg News (August 24, 2016), China Imposes Caps On P2P Loans to Curb Shadow-Banking Risks, Retrieved May 2, 2017, from https://www.bloomberg.com/news/articles/2016-08-24/china-imposes-caps-on-p2p-lending-to-curb-shadow-banking-risk
Perspectives on Development Economics 
I think this post does a good job of drawing attention to the unique nature of the P2P lending system. It’s interesting to think how the standard moral hazard problem is changed when essentially three agents are involved (lender, platform, and borrower). There is a lot of room for conflicts of interest between these three parties.
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I never realized how prominent P2P lending is in China; the fact that it creates tens of billions of dollars in outstanding loans is incredible. It is very interesting to see how lenders continue P2P when the possibility of default and/or moral hazards is so likely. I completely agree that there needs to be some sort of regulation involved in P2P lending because the lenders are facing risks that can potentially be avoided in the future.
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You noted that lenders charge very high interest rates to compensate for the very high risks that they take when lending on these platforms, but that ultimately the borrowers are still the primary benefactors because it allows poor people to have access to loans. Is there some evidence that this situation is inefficient? Surely if lenders could perform background checks they could charge lower interest rates for safer loans and these lower interest rates would mean that poor people could still readily have access to loans. Would these safer loans with lower interest not be ultimately better for society? Your conclusion seems to agree with this idea, but how much study has been put into any inefficiency in P2P lending?
– Nafee Ahmed
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