RBI and peer-to-peer lending: One step forward, two steps back

Regulating P2P companies as non-banking financial companies (NBFCs) and requiring them to adhere to commensurate minimum capital requirements will merely act as an immense market barrier for new start-ups.

In the C.D. Deshmukh memorial address that Reserve Bank of India (RBI) governor Raghuram Rajan recently delivered, he quoted a Chinese proverb to underline RBI’s commitment to promote innovation incrementally: “Crossing the river by feeling the stones.” Unfortunately, RBI’s first policy move in the context of financial innovation, The Consultation Paper On Peer to Peer Lending, released recently suggests it would prefer staying land-bound rather than crossing the river at all.

There are two principal reasons to be skeptical of the proposals in the consultation paper: these proposals appear to be a case of regulatory overkill—and as a corollary, will inhibit growth of the nascent peer-to-peer (P2P) industry rather than promoting it. Alternative policy options exist that RBI could use to better regulate this nascent industry.

Extremely High Regulatory Capital Requirement

As the Consultation Paper points out, P2P companies are principally involved in ‘matching’ borrowers and lenders on the platform for a fee and do not originate any loans themselves. Indeed, as it further points out, the role of the platform is proposed to be limited to performing that matching function “without the lending and borrowing getting reflected on its balance sheet.” If so, the proposal to prescribe “prudential requirements” of Rs20 million appears a clear case of regulatory overkill. Regulating P2P companies as non-banking financial companies (NBFCs) and requiring them to adhere to commensurate minimum capital requirements will merely act as an immense market barrier for new start-ups. That in turn reduces the possibility of some such start-up bringing in potential innovation in areas such as matching algorithms and determination of credit risk profile, etc.

On the other hand, not having a market entry barrier at all can attract fly-by-night operators, potentially hurting the nascent company’s reputational capital. In this regard, the model adopted by the Financial Conduct Authority (FCA), UK , could be a good template. It has balanced the risks of regulatory overkill with competing concerns. The FCA has established a transitional minimum regulatory capital regime pursuant to which P2P companies will have £20,000 through 31 March, 2017 and £50,000 thereafter. The FCA also links the minimum regulatory capital requirement to the quantity of loans outstanding by the platform. For example, after 31 March, 2017, the P2P companies will be required to hold the higher of:

A fixed minimum amount of £50,000; or (0.2% of the first £50 million of the total value of loaned funds outstanding) + (0.15% of the next £200 million of total value of loaned funds outstanding) + (0.1% of the next £250 million of total value of loaned funds outstanding) and so on.

This ensures that the minimum capital requirement does not act as an implicit market barrier for enterprising start-ups (since by definition, the initial minimum capital requirement will be low for a platform that proposes to just start out). Note that at the current exchange rate, a P2P company starting out in the UK will merely need Rs5 million—whereas the RBI has provided a very crude minimum regulatory capital that is as much as four times as high, in a market that is considerably smaller. As it grows its arranging book, the additional minimum regulatory capital to be brought in by a P2P company in fact decreases in UK. This calibrated, scalpel-like approach appears to be more balanced than the hammer-like proposal to prescribe Rs20 million as minimum capital requirement.

Lack of Methodological Rigour

Finally, a word about the methodology followed by the Consultation Paper: while it discusses the pros and cons of regulating the sector in very general terms, it does not offer any reason as to why and how the supposed benefits of regulating the sector override the costs of regulating it, assuming without further discussion that the balance of advantage would lie in regulating. The Consultation Paper thus assumes the very fact that it is meant to argue out.

Moreover, the rationale for regulating the sector is sketched out in extremely speculative terms. For instance, one of the reasons cited for regulating the sector is: “If the sector is left unregulated altogether, there is a risk of unhealthy practices being adopted by one or more players, which may have deleterious consequences.” No footnotes support the claim and no illustrative examples of what these unhealthy practices might be or what deleterious consequences these might lead to are provided. Regulating based on such speculation will only inhibit the growth of a nascent industry.

Financial regulators often get the benefit of deference from other branches of the state given their expertise in their area. The flip side of that deference, however, is the risk of regulatory lack of rigour. The solution lies in Ronald Reagan’s Cold War maxim: Trust but verify. It is important we start holding RBI and its brethren to a higher threshold of proof. Rule of law and dedication to liberty warrant nothing less.