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January 5, 2016

Peer-to-Peer Lending’s Stress Test

Peer-to-Peer lending is a promising corner of the financial technology sector. The P2P lending process is relatively simple: First, prospective borrowers choose a loan amount and post a listing.

Prospective lenders review these listings, and select loans that match their investment needs.

Once the loan is established, borrowers make fixed monthly payments, and investors’ P2P lender accounts receive a portion of the payments directly.

P2P loans are increasingly popular because they are fast, large and low-interest in comparison to credit cards. Lending Club, the most popular service in the space, demonstrated this popularity when it turned its first profit in October.

However, this upward trend is being challenged by a recent and horrific incident. A San Francisco-based P2P lender called Prosper Marketplace recently made a $28,500 loan to San Bernardino terrorist Syed Farook. Farook reportedly gave most of this money to his mother after leaving their child with her.

The Farook loan represented a tiny slice of Prosper’s business. Last year, $1.6 billion in loans originated from their service. The total represents a year-over-year jump of roughly 350%.

In response to the San Bernardino shooting, Congress is weighing new regulations on the sector.

The political situation surrounding Prosper’s situation is atypical. Congressional Republicans tend to be friendly to financial services companies, but the Farook incident is provoking security concerns and close scrutiny. Additionally, the Treasury Department had already issued a “request for information” about the P2P lending industry earlier this year. It’s a scenario that foreshadows new legislation and rule-making.

Prosper maintains that it engaged in no wrongdoing, as Farook was a US citizen with a respectable job and no criminal record. Through a spokesperson, they released this statement:

“Prosper is prohibited by law from disclosing any non-public, personally identifiable information regarding any loan originated through our platform. All loans originated through the Prosper platform are subject to all identity verification and screening procedures required by law, including US anti-terrorism and anti-money laundering laws. As part of our standard procedures, we also confirm that all loan funds are disbursed into a verified US bank account in the borrower’s name. Like all Americans, Prosper is shocked and saddened by recent events in San Bernardino.”

Despite this, it seems likely that P2P loans will be required to be submitted to a Federal database. This will result in new costs for lenders as well as disbursement delays for borrowers.

That’s not all: once the federal government acts, the industry could be subjected to a wide range of state-level regulatory efforts, as well as attendant lobbying costs. It’s also likely that lawmakers could extend this towards new rulemaking for other FinTech services, such as payment systems that make it quick and easy to transfer money. We could also too-big-to-fail financial competitors back the new rulemaking and use their lobbying resources to create new burdens on these upstart competitors.

Despite Congress’ appetite for action, it’s hard to see how new regulations could have detected Farook’s intentions. No one in his local community suspected his violent extremism, and the size of his loan was too small to prompt an investigation.

It goes without saying that lawmakers should do whatever they can to reduce the incidence of terrorism. Limits on peer-to-peer lending, however, figure to stifle FinTech innovation and reduce borrowers’ access to badly-needed capital.

With this in mind, members of the House and Senate should scrutinize new legislative proposals closely. Proposed laws that won’t detect terrorism represent legislative lip service, and shouldn’t be pursued.

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