Small is beautiful as peer-to-peer lending flexes its muscles and Zopa takes lead in the UK

Many people doubted whether peer-to-peer lending would take off. However, it appears that the sector, also known as social lending, is going from strength to strength and increasingly accepted as a credible alternative to the banks.

Compared with mainstream banking, this new breed of finance is still in its infancy. Zopa, the UK’s first peer-to-peer lender, celebrated its seventh birthday last month.

A lack of confidence in the UK banking sector since the credit crisis, combined with high borrowing rates and low savings returns, has helped the peer-to-peer market flourish.

Zopa remains by far the biggest player and to date has arranged more than £185 million in loans, including a monthly record of £8.2m this January alone.

A more recent arrival on the peer-to-peer scene and acting as the middle man for individual savers and borrowers is Ratesetter. Launched in October 2010, it has already provided more than £18m in loans.

Along with Zopa and Funding Circle, Ratesetter formed the Peer2Peer Finance Association, a UK trade body set up to ensure that the sector maintains high minimum standards of protection for consumers and small business customers.

The peer-to-peer market is not solely aimed at individuals, and with banks tightening credit policy and reportedly increasingly reluctant to lend to small firms, we’ve seen the emergence of a new breed of business lenders including Funding Circle and Crowdcube.

Funding Circle has lent more than £25m to businesses since launch in 2010, with the average loan at around £40,000. The company pools the savings of private investors, who have averaged returns in excess of 8 per cent, while the current bad debt ratio is just 0.3 per cent.

Crowdcube, on the other hand, has secured over £2.5m for new businesses just starting out.

These alternative banking sources shouldn’t be viewed as a soft touch, however, as strict credit scoring criteria ensures defaults are kept to a minimum in order to give people confidence to continue to deposit their savings with the peer-to-peer companies.

Ratesetter, for example, recently stated that only 10 to 15 per cent of loan applications are approved, so while it may offer a simpler and fairer way to borrow money, if you don’t have a clean credit profile you’ll probably have to look elsewhere.

One of the main concerns with people depositing their cash with peer-to-peer providers is that although the returns far outweigh those paid by the banks, they don’t offer the cast iron guarantee to savers that bank customers enjoy under the Financial Services Compensation Scheme.

Even though tough credit scoring criteria is in place, there is still an element of risk – albeit a small one – that you don’t have with a bank or building society. As long as you understand this, their lower overheads, from not having to run a nationwide network of branches, mean you can obtain better returns in peer-to-peer.

Providers have their own methods of trying to mitigate the risk to depositors. Zopa for example, will spread your money among a wide range of borrowers, whereas Ratesetter adopts a different approach by operating a “provision fund” which is built up from borrower fees, and reimburses lenders in the case of late payment or default.

The more established this market becomes, the more confidence consumers will have and if the industry continues to keep rates competitive and bad debt levels at current levels, peer-to-peer could soon become a much bigger player.

l Andrew Hagger is head of communications at Moneynet.co.uk.