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There are myriad ways to measure credit risk, and sometimes "softer" is better. A new Harvard Kennedy School (HKS) Faculty Research Working Paper co-authored by HKS Professor Asim Ijaz Khwaja explores the promising potential for utilizing unconventional risk assessment methods when evaluating smaller borrowers.
Khwaja and his co-authors Rajkamal Iyer of MIT, Erzo Luttmer of Dartmouth University and Kelly Shue of the University of Chicago, found that conventional credit scores alone do not show the entire picture, particularly when dealing with lower quality borrowers. Peer-to-peer lenders, they write, are effectively using nonstandard or “soft” information to measure the creditworthiness of such borrowers.
Information available to lenders in peer-to-peer markets, the authors write, includes “non-standard information, such as the maximum interest rate the borrower is willing to pay as well as softer and less quantifiable information, such as the borrower’s picture and a textual description of his/her reasons for the loan application,”. These types of indicators, when considered in addition to standard financial variables, lead to better results when trying to predict whether a borrower will default on a loan, they argue. And it’s a practice that more lenders in peer-to-peer markets successfully use.
The study provides fresh evidence that the peer-to-peer lending market can offer a realistic alternative for small borrowers who are often overlooked by traditional banks.
“In banks, [acquiring soft information] is time consuming and is often bypassed when screening smaller borrowers,” the authors write. “Given peer-to-peer market’s ability to effectively screen borrowers, and given their non-collateral-based lending structure, such markets can offer a potential capital source for small borrowers who may otherwise be limited to more costly sources of finance.”
The study is published at a time when more and more borrowers are going the route of peer-to-peer lending. In the U.S., there are currently 12 active, online peer-to-peer lending websites, and many more are serving borrowers in Europe and Asia. Prosper.com alone has funded more than $500 million in loans and currently has almost two million members.
However the broader issue brought forth by the authors is to what extent peer-to-peer markets can complement traditional lenders, such as banks. They conclude that “peer-to-peer markets can indeed complement existing lending models and improve access to credit. Their success also points out the value to traditional banks of incorporating more credible, but softer or more subjective information in screening smaller borrowers or borrowers who fall into the 'lower-quality' category."
Asim Ijaz Khwaja is Professor of Public Policy at Harvard Kennedy School. His areas of interest include economic development, finance, education, political economy, institutions, and contract theory/mechanism design. His research combines extensive fieldwork, rigorous empirical analysis, and microeconomic theory to answer questions that are motivated by and engage with policy.