My secret confession is that I once got excited when I heard that everyday people, philanthropists, and non-profit organizations could, right over the internet, donate money or offer interest free loans to the entrepreneurial poor in developing nations. And who wouldn’t? It’s fast – It’s hassle-free – I select who I want to help.

When you consider the cost of obtaining loans ( 8-15% ) and operating expenses of microfinance institutions ( 10-25% ), I thought online micro-lending could revolutionize the way people give. But having served several months as Organizational and Communications Advisor for a leading microfinance institution in Cambodia and having worked closely with an online micro-loan platform provider had altered my perception about the zero interest excitement.

Rewinding to 1999, eBay.com had enabled person-to-person buying and selling of goods. Napster.com shocked the music industry by allowing the public to share music files online. Priceline.com lets consumers name their own price on airline tickets. Lendingtree.com enables consumers to fill out one form and receive up to 4 competing offers from lenders. Yet, ditech.com revolutionized consumer lending by allowing consumers to apply for loans directly online – cutting out the broker. At about the same time, PayPal.com re-invented the money transferring business by allowing consumers to send and receive money faster, easier – without the high fees of Western Union and MoneyGram.

These days, it seems everyone is turning to the internet or GPS devices to find friends, dates, books, music, movies, and now money. It was virtually nonexistent a few years ago, but now experts predict peer-to-peer lending will reach $5.8 billion in 2010. All these business models share one distinct goal and vision – To cut cost or to cut out the middleman. But does it?

Traditionally, there was no concept of banks or financial institutions. There was only person-to-person lending or there were rich local money lenders who were lending money to the needy. As society evolved institutions began acting as intermediaries between lenders and borrowers. In short, middlemen ( banks ) were created.

Lending institutions of all sizes primarily benefited from scale and diversification. By pooling the local money supply and lending them out to many borrowers, the impact of a default is minute compared to the timely payment of the vast majority loans outstanding. The downside to the traditional model is that it introduced greater administration overhead and removed community loyalty from the equation.

Advantages

• Lenders get a fixed return.
• Risk management is moved to the institutions.
• Borrowers can get loans with or without collateral based on the financial strength of the borrowers.
• Intermediary institutions gains are based on economies of scale and on the spread between the lending and borrowing rates.

Disadvantage over long term:

• Many institutions failed and lenders and depositors lost their capital due to failures in the risk management of these institutions. You don’t have to look pass the 2008-2009 global financial malaise to see that even the best financial advisors and institutions failed. This happened even though these institutions were regulated by the central banks of their respective countries.
• Inefficiency started increasing when the central banks started using these institutions to fund government deficits. Banks were asked to maintain cash and a certain percentage of the deposit in government securities with lower return rates than the loans.
• Central banks started evolving deposit guarantee schemes, however the amount of such coverage was for small deposit holders and the large deposit holders were unsecured creditors for the banks. So in case the banks failed, these depositors were getting paid on left over monies.

Intermediaries charged the spread for the following reasons:

• Credit Risk
• Risk Management Cost
• Operational cost
• Operation Risk
• Profit margin for the intermediaries.

A natural solution to the problem was person-to-person lending or peer-to-peer lending. The first P2P lending company to launch was Zopa in the UK in February 2005. In principle two models have evolved in the P2P lending space: secured P2P and unsecured P2P lending.

Secured person-to-person lending

With this model, the lender gives money to the borrower against the strength of the collateral given by the borrower. The advantage of this model is that the capital and interest of the lender is secured to the extent of the realizable value of the collateral. The Dis-intermediator provides risk management as per the terms and condition agreed upon by the lender and the borrower.

Unsecured person-to-person lending

With this model, the lender gives money to the borrower based on the credit rating of the borrower. The lender runs the risk of the capital and interest in case of failure on the part of the borrower. Two variants have evolved in this space.

Pooled Lending – the lender lends the money to a pool of borrowers with similar credit ratings. In this model the risk of capital and interest for the lender is defaulters in the pool. The risk of capital and interest of the lender is reduced considerably.

Direct Lending – the lender lends money to a borrower based on their credit rating. In this model the risk of capital and interest for the lender is that the borrower could default on.

But unlike traditional lending, P2P Lending allows individual lenders to self-direct their own capital, as opposed to the traditional bank lending models which pool all funds together and completely remove the lenders who actually own the money from the decision-making process regarding who may borrow that money, loan term, or rate. Cutting out the bank reduces overhead, for one, which translates to better rates for borrowers and lenders. Additionally, peer-2-peer lending creates a sense of community. Instead of a bank deciding who will get funded, individual lenders make the call, paying attention not only to their expected returns but also the reasons borrowers are asking for funding.

There are two primary variations: An “online marketplace” model and a “family and friend” model.
Whereas the primary benefit of the marketplace model is the “match making” aspect, the family and friend model emphasizes online collaboration, loan formalization and servicing.

Peer to peer platforms like Prosper, Veecus, Kiva.org, MyC4, Microplace, Zopa, VirginMoney.com, LendingClub, globefunder and others have created alternatives to personal loans from commercial banks in the developed world. These models have proven to reduce transactions costs, and increase efficiency in the marketplace.

Models like Zopa are affiliated with credit unions across the country, which members must belong to, and lenders invest in certificates of deposit and choose which borrowers get financial help. Also, Lending Club and Zopa require a FICO score of at least 640 and a debt-to-income ratio of no more than 30% and 50%, respectively. Virgin Money primarily serves as a mediator between friends and family who want to loan each other money. The site helps borrowers present a formal proposal, draw up a promissory note with interest, and develop a repayment plan.

Prosper, the first such matchmaker in the U.S., which started in 2006 and now has 600,000+ users, and Lending Club, are sort of financial eBays: borrowers post a request, and lenders bid on how much and at what interest rate they want to give. Several people can fund the loan at a rate agreeable to all. The intermediary runs a credit check, calculates returns and takes a fee.

Peer to peer lending has created opportunities for private individuals to lend as much as $30,000 to people on Prosper, most of whom have never met. And this is not new since its predecessor Zopa started in the U.K. One of the differences is that Prosper.com focuses on groups that know each other or have common interests. It also has a more evolved bidding model so lenders bid to have the lowest (and thus winning) interest rate for a particular lender. Another service, Loanio, an auction-based peer lending platform enables individuals to borrow or lend money to one another, aims to serve the needs of those with poor or no credit profile histories. Borrowers with questionable credit scores will be permitted to participate on the p2p lending platform by using a co-borrower or a guarantor.

Perhaps the most interesting new player is a platform called GlobeFunder.com, whose concept is to lower borrowing costs globally with market-driven rates while providing a new marketplace for investors to earn profitable returns.

But can similar rewards be offered to microfinance lenders?

Peer-to-peer (P2P) lending, social lending, transparency lending, whatever you want to call them, it has become more and more prevalent. Because of the internet and other mechanisms which facilitate rapid and efficient communication, People looking to borrow money and people looking to lend money no longer have to rely on a financial intermediary like a bank. Further, transparency lending enables individual lenders to identify individual borrowers and vice versa. Some transactions may also be conducted between borrowers and lenders who already know one another. Yet, this “new” phenomenon isn’t at all new.

Lending without banks, facilitated by the internet, is a radical development for borrowing. So was microfinance, the idea of lending small amounts of money to the poor. Put the two together, and you get de-institutionalised micro-loans, those with a little extra money making small loans to those with no access to capital.

Many individual lenders defend that a one-to-one process is inherently more transparent than contributing to a charity or NGO, which simply redistributes the donations; just as important, making a direct microloan gives the lender a greater sense of engagement than would an indirect donation. The lenders can self-direct their money to help their pre-selected borrowers, and will in turn receive regular updates on the start-up’s progress.

The first opportunity was provided by the web-based microfinance operation Kiva.org. Kiva is the brainchild of Matthew and Jessica Flannery, a California couple who have lived in central Africa; During several month’s work in rural Kenya, Tanzania, and Uganda, Jessica, then a staff with Village Enterprise Fund (villageef.org ) later received seed capital to start Kiva.org.

The Kiva website, a non-profit organization, allows select microfinance institutions to post profiles of individual loan applicants for financing by visitors. Kiva lenders do not earn any interest on their loans, and if the borrower defaults they lose their money. Yet since its launch in late 2005, Kiva has frequently had difficulty posting enough loan applications to meet the demand from lenders. As of September, 2009, Kiva has provided over $82 million in microloans from Cambodia to Togo to Iraq. At their current growth rate, they are raising $1 million every 12 days.

Total value of all loans made through Kiva $82,894,610
# of Kiva Lenders 529,403
# of countries represented by Kiva Lenders 183
# of entrepreneurs that have received a loan through Kiva 200,790
# of loans that have been funded through Kiva 118,638
% of Kiva loans which have been made to women entrepreneurs 82.86%
# of Kiva Field Partners (MFI) 107
# of countries Kiva Field Partners are located in 48
Current repayment rate (all partners) 98.61%
Average loan size $413.10
Average total amount loaned per Kiva Lender (includes reloaned funds) $156.95
Average number of loans per Kiva Lender 4.43

Similarly, in its first three months after launching, MicroPlace.com successfully raised more than half a million dollars in investment capital for MFIs. Babyloan.org later followed with a peer-to-peer microfinance site, supported by French banks (BRED, Credit Coopératif) and the international NGO, ACTED.org. Similarly, backed by Opportunity International NGO, optinnow.org offers a similar service, mirrored later by MYC4 (Denmark) which connects lenders to micro-entrepreneurs in Africa.

Comparative Market Analysis

Peer-to-MFI-to-Peer:

With this model, services such as Kiva, OPTinnow.org, babyloan.org, and veecus.com act as matchmakers and do not allow borrowers to finance their loan applications directly. Rather, the online services collaborate with local microfinance institutions which post profiles of their clients on the websites for funding. The online platforms wire the funds raised to the microfinance institutions, who disburse the loans in local currency and collect repayments. Loan repayment is wired back to the online services which return to the lenders. Despite a revenue model for that bases entirely on receiving donations from lenders/donors to cover operating cost, microfinance institutions keep any interest they charge on the loan to cover their operational costs ( 15-30% ).

This process allows lenders to finance applicants who cannot directly access peer-to-peer lending websites because of illiteracy, remote location, or lack of any disposable income for internet cafes – in other words, the majority of the developing world’s population.

The provider Microfinance institutions will use a whole range of incentives – including peer pressure through group lending, putting borrowers’ local reputation on the line by signing repayment contracts publicly, regular visits by loan officers, and reporting delinquencies to credit bureaus and regulators – in addition to the promise of further loans for clients who fulfill their repayment obligations. Further, the MFIs will provide follow-up stories, funding impact and status of borrowers.

The disadvantage is that there are not nearly enough microfinance institutions in most poor countries to meet entrepreneurs’ demand for small business loans, and online service’s rigorous screening process means that only a small minority of these organizations are eligible to fundraise on their website. Moreover, overhead costs for microfinance lending operations tend to be very high, typically around 20-30% of an organization’s loan portfolio. Though the online site’s interest-free lending service lowers its partners’ cost of capital dramatically, the high overhead costs of the intermediary organizations ( 15-30% ) must still be passed on to borrowers.

The decision to provide peer-to-peer lending services through carefully screened partner institutions is a trade-off, as depth or the ability to reach the poorest borrowers who do not use the internet themselves comes at the cost of broader reach to those who are not clients of the online partners, as well as transaction costs incurred by the intermediary lending organization. This trade-off means that an organization serving an alternative niche – eschewing intermediaries and pursuing broader scale by allowing borrowers with internet access to finance their own loan applications – would add value by expanding the range of microfinance options available to entrepreneurs in poor countries. The major obstacle to widespread access to microfinance services is not the willingness of lenders, but rather the need for mechanisms to connect lenders with borrowers on a large scale. A self-regulating direct microfinance lending platform would be a valuable contribution to bridging this gap.

Peer-2-Peer

Here, services like MyC4.com ( Focusing in Africa ) and wokai.org ( Focusing in China ) can bypass traditional microfinance intermediaries and connect borrowers and lenders directly via the internet. The services collaborate with local microfinance and development institutions, only as transaction facilitators, to disburse funds lent on their websites. As much as the two services are alike, MYC4.com is the only peer-to-peer service that allows the lender to charge interest. Not surprisingly, by enabling the lender and borrower to transact directly, the risks often assumed by the MFIs are shifted to the individual lender including:

1) Fraud: The online services will record the number of on-time, late and missed payments for each borrower, a greater number of repayments gives lenders a more complete picture of a borrower’s track record.
2. Currency Risk. The dollar values of developing country currencies often fluctuate dramatically. If the dollar value of a local currency loan declines before it is repaid, the lender will lose money. This may encourage the more investment-minded lenders to shun countries whose currencies are expected to devalue.
3. Market Risk. How big is the market for low-income entrepreneurs who use the internet but lack access to financial services? Will this need still be relevant five or ten years down the road? These issues must be handled and managed by the individual lender.

Security Issuer

Here, a service like MicroPlace.com partners with a security issuer and MFI. The Security issuer sells debt securities on MicroPlace.com, to be directed to specific MFIs. The Investor selects the MFI to be funded and purchases online security from the security issuers partnering with MicroPlace. The Security issuer uses funds generated to invest in selected MFIs. The Investor receives interest and principal payments from security issuer over length of investment.

Guarantee loans to micro-entrepreneurs

The service UnitedProsperity.org will enable an individual to guarantee a loan to the micro-entrepreneur they choose to connect and support. The guarantee allows the microfinance institution to raise funds in local currency from local banks and make a loan to micro-entrepreneurs. Since the guarantee is only for a part of the loan amount, the guarantee allows the guarantors to multiply the impact of their money.

Summary:

The complexity of micro-financing may or may not include peer-to-peer lending but I am a firm believer in local MFI engagement. It appears, for the time being – despite all the transparency afforded by the internet – microfinance institutions will continue to play a vital role of serving the world’s Micro-entreprenuers. Without the local MFIs there would be no workforce to disburse the money, fill out the forms, collect the monthly payments, enter the data, send the stories, and provide face-to-face services for the borrowers. Clearly current online giving venues provide a quick and easy way for lenders/donors to give, yet fail to achieve the original intent of providing low cost funding to poor entrepreneurs, vitiated by high operating cost of intermediaries.

Perhaps, the peer-to-MFI-to-peer lending platform could learn from its commercial sibblings where local intermediaries bid to offer savings. This is not at all difficult because Prosper.com, the first such matchmaker in the U.S., which started in 2006 has a proven model: borrowers post a request, and lenders/intermediaries bid on how much and at what interest rate they want to give.

This will systematically encourage microfinance institutions to cut their operating cost ( or find ways to do it ) and pass savings down to those truly in need of low cost funding. No matter how one slices the fact, current online giving platforms have failed to lower cost for poor borrowers because of their dependency on high-cost microfinance operations.

Absense a fully integrated web-based microfinance model, or one where the local MFIs compete to lower cost for borrowers, micro-giving on a large scale has room for innovation. In the near future I imagine more microfinance institutions will be building their own online fundraising wagon to lower the cost of funding. Let’s hope this leads to lower cost of borrowing to the entrepreneurial poor.