Recent years have seen the rise in peer-to-peer lending, with entities like Prosper.com providing a way for people to borrow money from individuals they don’t know rather than from banks and other financial institutions. A good portion of this money is being borrowed by entrepreneurs to finance their businesses.
The growth of peer-to-peer lending, and the participation by entrepreneurs as borrowers, is an observable fact. And the reason why entrepreneurs go to peer-to-peer lenders makes a lot of sense. Entrepreneurs are able to get funding for their businesses from individuals even when they can’t get them from financial institutions.
The question that’s puzzling is why individuals lend money to entrepreneurs that institutions won’t finance. We don’t have any carefully done studies that answer this question, but here are some possible explanations.
1. The lenders are foolish. Individuals have less stringent criteria for making loans than institutions because they know less about the risks of lending money to entrepreneurs. And they gather less information on which to evaluate different borrowers. As a result, they make loans that aren’t very good and have poorer performing loans than banks or other institutions would tolerate.
2. The lenders have low return expectations. Because institutions have higher costs than individuals (who aren’t paying salaries to loan officers, managing bank branches, or paying interest on deposits), the individuals are willing to make loans at a reasonable interest rate. To make the same loans, banks would have to that charge such a high interest rate that usury laws prevent them from making the loans.
3. The transactions costs are too high for institutions. Individuals can make small loans that institutions can’t afford to make because they have much lower administrative costs. So individuals make them and institutions don’t.
4. The lenders find it enjoyable. Individuals often do things for personal satisfaction that company managers, who have to act in the best interests of their shareholders, can’t do. Lending money to other people in need might be fun or might provide a feeling of emotional satisfaction. Thus lenders get non-financial compensation and don’t really care about making money. Banks, and other institutions, can’t make the same trade-offs of non-financial for financial compensation and so don’t make the loans.
Why do you think individuals will lend money to entrepreneurs that banks and other financial institutions won’t finance? I’d be interested to hear your thoughts.
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About the Author: Scott Shane is A. Malachi Mixon III, Professor of Entrepreneurial Studies at Case Western Reserve University. He is the author of seven books, including Illusions of Entrepreneurship: The Costly Myths that Entrepreneurs, Investors, and Policy Makers Live By and Finding Fertile Ground: Identifying Extraordinary Opportunities for New Ventures.