Opinion: Financial Reforms Threaten Innovative Lending Option

(June 17) -- Like many young entrepreneurs, Lydia Hamilton had a great idea but lacked the money to start her own business. She knew that few upscale clothing stores in Milwaukee offered fashionable dresses in plus sizes and saw an opportunity to open up her own specialty boutique. Even though she had good credit and a solid income, banks would not give her a loan.

So she turned to Prosper, an online peer-to-peer lending site, where she found that a number of ordinary people, just like her, were eager to lend her the money to open Boutique Larrieux.

By displaying her business plan on her online profile, Hamilton was able to attract individual lenders who found her idea promising and quickly received the funding needed to open shop. Now she has a successful storefront as well as an online store. Peer-to-peer (P2P) lending financed Hamilton's dream even when traditional banks turned her down.

The P2P business grew as the availability of traditional credit tightened during the recession. Today, two companies lead in the field -- Prosper, which has originated more than $198 million in loans, and Lending Club, which has originated more than $122 million in loans.

Yet, peer-to-peer lending, and those it finances, are under threat from new legislation.

Congress is working to reconcile the Senate and House versions of the controversial financial reform bill. The House version of the bill sets new standards for regulating P2P lending that, if ultimately included in the law, would drastically change the nature of the industry and its relationship with the government.

Currently P2P lending is regulated by the Securities and Exchange Commission, which treats borrowers, like Hamilton, more like businesses issuing bonds than individuals borrowing money to pay down debt, go to school or start a small business.

This is far from ideal and creates problems for P2P lending. For example, Prosper ceased lending activities for nine months in 2009 in order to comply with SEC rules. Furthermore, state securities policies only allow the company to operate in 28 states. Lending Club also went through SEC registration and compliance, which stalled lending for six months in 2008.

While P2P companies, and their borrowers and lenders, would benefit from more holistic regulation and consumer protection, the proposed changes in the House bill fail to address the dynamic nature of the industry, and could ultimately cause more harm than good. Three problems:

• The bill gives regulatory authority to the new catch-all regulator, the Consumer Financial Protection Agency. While it might be a good idea to remove P2P from the SEC and treat it more like a lending institution, the CFPA isn't the best fit. Among other things, uncertainly about how the newly formed agency will proceed will foster further insecurity within the P2P industry, causing a reduction in lending and borrowing while people wait for decisions out of Washington.
• The House bill strictly defines peer-to-peer lending as an Internet business model. This might not seem like a big deal, but this would leave little to no room for improvement and expansion. The bill would, for example, restrict P2P companies from lending directly to small businesses and nonprofit organizations and from expanding to other media beyond the Internet.
• It also focuses on the core activities of P2P lending while leaving out current changes to the business model, such as Lending Club's secondary market. By restricting the industry to this specific definition, the bill would limit future competition by favoring current P2P companies and static practices.

As the nation recovers from a staggering financial crisis, America needs a solid, responsible and adaptable lending market. Government reform shouldn't stifle competition but should support consumer protection and encourage improvement.

Fewer regulatory hurdles and less uncertainty will benefit all students, entrepreneurs and homebuyers seeking loans through P2P, as well as the good-hearted investors who lend their money.

More importantly, every American will benefit from the resulting innovation that spurs our economy and improves our lives.

Stefanie Haeffele-Balch is a master's fellow at the Mercatus Center at George Mason University.


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