Credit risk management in peer-to-peer lending

Fintech risk analysis and management

Sarra Yahyaoui

Nawress Sabri

Aymen ben Hmida

Ella Ben Nasr

Content:
Introduction 4

What is P2P lending? 4

How does P2P lending work? 5

The P2P lending market: 7

P2P lending platforms: 7

P2P lending trends: 9

P2P lending risks: 12

Credit risk in P2P lending 12

Methodology 13

Exploring AI and credit scoring models in p2p lending: 13

Digital Footprint Analysis model: 13

Ensemble machine learning algorithms model: 14

Artificial neural networks model: 16

P2P lending benefits: 18

Results: 19

Conclusion: 20

Abstract
 The Emergence of peer-to-peer lending along with its rapid growth has opened many attractive opportunities in
micro-financing. However, this lending process has a high risk of investment failure due to the lack of expertise on
the borrowers’ creditworthiness. In addition, information asymmetry, the unsecured nature of loans as well as lack
of rigid rules and regulations increase the credit risk in peer-to-peer lending. This paper clearly clarifies and defines
the concept of peer-to-peer lending and its tactical strategies in the market. In addition, it highlights some of its main
regulations on the available platforms mentioned. Nevertheless, detects some of its tools. All in all, to observe well
the behavioral flow of the phenomena such as the trends, benefits gained, it accordingly assess the risk that borrower
and lenders are confronted with.This paper aims to focus on the solutions needed today to help control and avoid
that risk; including models designed specifically in order to precisely control it. We can state mainly “The digital
footprint analysis” first, besides the emergence of machine learning and its influence on credit risk management, as
well as the artificial neural network model applied and how it really functions.

Introduction
What is P2P?

P2P stands for "Peer to Peer." In a P2P network, peers are computer systems connected together through the
Internet. Systems on the network can directly share files without the need of a central server. In other words, peer-
to-peer services are decentralized platforms whereby two individuals communicate directly with each other, without
passing by intermediaries. In these platforms, the buyer and the seller transact directly with each other via the
service. The P2P platforms provide many different services such as search, screening, rating, payment processing, or
escrow.
an Internet connection and P2P software are the requirements needed for a device to join a peer-to-peer network.
The most known and used P2P software programs are Kazaa, Limewire, BearShare, Morpheus, and Acquisition.
These programs are linked to a P2P network, such as "Gnutella," which gives the computer access to thousands of
other network systems.

Once connected to the network, P2P software allows users to search for files on other computers connected to the
same network, but only within a single folder that the user has designated to share .

What is P2P lending?

Peer-to-peer lending, also referred to as “social lending" or "crowd lending," is about individuals directly receiving
loans from other individuals, which implies that there is no need for the financial institution as an intermediary. P2P
lending is now known as an alternative funding process. It was created in 2005, but platforms such as Peerform,
Funding Circle, Prosper, LendingClub, Upstart, and Payoff are already on the market and competing fiercely,
making the P2P lending process exist all over the world.

How does P2P lending work?

P2P online lending platforms vary in the way the interest rate of the borrower is set. But the principle behind all P2P
networks is the same as it "directly connects borrowers to investors." Each website specifies the interest rates and
the terms and allows for the transaction. Many platforms have a wide variety of interest rates depending on the
applicant's creditworthiness.

The first step in the platform, an investor opens an account and deposits a sum of money to be used as loans. The
financial profile of the loan applicant is assigned to a risk category that determines the interest rate that the applicant
will pay. The applicant for the loan can review offers and accept one. (Some applicants split their applications into
chunks and approve several offers.) The transfer of money and the monthly payments are managed through the
platforms. It is possible to automate the process completely, or lenders and borrowers may opt to haggle.

Sites such as prosper.com use an auction mechanism in which investors can set a maximum interest rate they are
prepared to pay. Lenders will then position their bids for a limited period of time (the auction lasts 14 days until they
prosper) by naming the amount of money they are willing to fund and the minimum interest rate they are willing to
accept. Even after the loan has been completely funded, by providing financing at lower minimum interest rates,
lenders can still position their bids and undercut other lenders. In this scenario, those bids with the lowest minimum
interest rates are chosen where more bids have been put than required to finance the loan. All lenders then receive
the highest bid interest rate that has been included in the loan for their investments, even though their bids have
reduced their minimum interest rates.
Other platforms, such as the German "smava.de", measure interest rates for a loan application based on the
characteristics of the borrowers (financial and demographic). (financial and demographic). (financial and
demographic). After the loan has been completely financed, the bidding process stops, as additional bids will not
have an effect on the resulting interest rate.

Such sites often vary by their specialization of various categories of borrowers. For instance, StreetShares is built for
small businesses. And the Lending Club has a "Patient Solutions" category that connects doctors, who propose
financing services, with prospective patients.

Stakeholders: Parties of the P2P process:

Structuring the different groups and individuals that are part of the lending process helps to identify gaps in existing
research. To define stakeholders, we followed Freeman’s general statement that states that “a stakeholder of an
organization is (by definition) any group or individual who can affect or is affected by the achievement of the
organization’s objectives”.

We will focus on external stakeholders of commercial lending platforms (excluding Micro-Finance Institutions that
are in most cases only relevant for non-commercial platforms).

Lenders, Borrowers and Communities:

Online P2P lending is a two sided market, Lenders and borrowers are the main target groups of all P2P lending
activities. Therefore these two are considered the major stakeholders and are essential for the success of the lending
process. While lenders seek opportunities to invest money as profitable as possible at a given level of risk,
borrowers look for sources of liquidity with different default risks. P2P websites act as intermediaries to bring the
two sides together by trying to match the expectations and fill the needs of both parties.

Lenders and borrowers sometimes share the same interests, so they form a community.

Regulatory Authorities, Partner Banks, Credit Bureaus:

Being a part of the financial market contains several different regulatory restrictions. According to some national
regulations, having original banks as partners in operative business is a requirement. The involvement of banks is
mainly to facilitate the process of lending. This process also includes the confirmation of the borrower’s data by
credit bureaus or other external monitoring agencies.
 The P2P lending market:

The idea of private loans without the financial institution's intermediation is not a new business concept. It is the
standard way, without mediation, for private individuals to borrow money. Due to the internet, P2P lending is a
young phenomenon by developing and creating several online P2P lending platforms.

P2P lending platforms:

The first lending platform “Zopa” was established in 2005 in Europe (UK). Since then various forms of lending
platforms followed. In a limited time, the number of existing platforms increased rapidly to reach 24 platforms in
2008.

The United States launched its first lending platform in February 2006 prosper.com. As for Germany Smava
(smava.de) was their first platform founded in February 2007. Today there exist 251 P2P lending platforms all
around the world, most of them work on a national level, due to different legal requirements in different countries.

These platforms differ in type and the approach adopted. Which can be classified into two types: commercial and
non-commercial. Commercial platforms, in general, are limited to national markets while the non-commercial
platforms often operate globally. The major difference between the two platform types is the lender’s general
intention and his expectations concerning returns. A lender who engages in commercial platforms gets a reasonable
interest for the risk taken. In non-commercial platforms lenders get no or little reward. In the latter, lenders rather
“donate” small loans to projects in economically underdeveloped regions in the world.

According to Investopedia, the following table shows the best P2P lending platforms in December 2020:
P2P lending trends:

there are 7 Key trends in the P2P lending industry which are the following:

1. More small to midsize lenders will enter the game:

The P2P model has opened many doors to the financial services world. Nowadays, breaking into the lending niche
costs less than ever. No need for tremendous investments and workers. Also, regulations are no longer as difficult as
traditional banks.

This means that there is now a wave of smaller and hungrier online rivals among the old-school financial
institutions. But despite being small, due to recent developments in lending, the new P2P lenders often provide
better service.

2. Banks don’t intend to give up:

Large companies have a harder time adapting to the complexities of digitalization and shifting their gears takes them
a lot of time. But the boards of directors are aware of the developments in the industry and see the need for P2P.
Banks worldwide are slowly but gradually beginning to add P2P features. Setting as an example Monzo adding the
P2P functionality to their system.

Today, digital banks are most likely willing to start offering peer-to-peer lending as well as the traditional banks
which have also started to adjust their systems as they go through their own digitalization. A prime example would
be the Royal Bank of Scotland. All the way back in 2015 the company started to refer clients to Funding Circle and
Assetz Capital for p2p loans. We can also mention the two community banks, Titan Bank and Congressional Bank,
who are buying loans through the Lending Club platform.

Instead of using and customizing the current and proven products which are already on the market, traditional
institutions often opt to create their own solutions. This route takes longer, and the systems are often low, inaccurate,
and not user-friendly. This suggests that only banks with a more flexible strategy can adapt to the market in order to
compete against rivals that are light-on-their-feet.

Big banks also offer a sense of stability and efficiency and many clients trust them. Small and medium-sized lenders
will need to work a little harder and compete a little more fiercely to prove to consumers that they are as good or
even better. But P2P lenders are already doing very well and the major players in the industry demonstrate that the
achievement of success is possible.

3. Financial inclusion for under-banked areas:

Consider the two previous points, you'll see that if a lot of smaller lenders compete with big banks, the market wins.
The prices of loans decrease and corporations try their best to hit the markets and populations that were under-
banked. The overall aim of all the responsible members of the lending community is global financial inclusion, and
this competition serves this purpose perfectly.

Lending software providers are developing better solutions to safely and easily process more of the right loans, and
lenders are seeking to tap into new markets and demographics. For instance, Upstart's AI-powered models result in
75% less mistakes and 175% more approvals than conventional banks' models. Besides offering a more versatile and
quick online experience, the smart approval processes allow people who were previously underserved to be served.

4. More markets and jurisdictions:

The more lawmakers see P2P lending running, the more they make it legal and begin dealing with it as they deal
with other financial instruments. Just last April, the Brazilian Central Bank approved P2P lending across the world,
and new governments are constantly joining in. For example, Malaysian authorities launched A P2P System for
those who are buying houses for the first time. And in the US, these systems and platforms are now recognized and
controlled by the SEC as well as other financial instruments.

Some nations followed the Australian route where financial start-ups can operate without a license for a year called
the development of a FINTECH SANDBOX. The UK, SWITZERLAND, and SINGAPORE have used similar
mechanisms to promote the development of the FinTech industry.

5. Regulations:

The concept of P2P lending does not mean that lenders can do what they want without any repercussions. .
Governments are always controlling them and setting regulations.

Authorities learned from China's bitter experience of letting P2P work without adequate control. The experience
contributed both to drastic growth there and to the industry's dramatic Collapse. In 2019, more governments come
up with a clear set of regulations to not allow and facilitate all P2P lending services.
6. The go-to choice for younger audiences:

Over half of the P2P market is composed of people aged 22-37 in Europe. This is not something new that young
people do not want to deal with stuffy corporate institutions, rather they want the choices that are more user-friendly
and up-to-date where they can. Besides that, young people also simply can't get a loan from traditional lenders on
reasonable terms. Mostly because they really don't have the financial standards that baby boomers have. So the trend
will continue for young borrowers to prefer going to P2P lenders.

7. Dominance of fiat currencies:

It looked like any FinTech project wanted to keep an ICO, and P2P lending was no exception. Either the public was
not prepared for such a dramatic paradigm change or the technology and the idea were not sufficiently powerful.
While projects can still use blockchain effectively as data storage and operating technology, there will be fewer
coins for crypto and more dollars and cents. This shows that the time of ICOs is over.

P2P lending risks:

Although P2P presents many advantages and benefits, as we have seen, it includes several risks that can be divided
into external and internal risks. The table below shows the different types of them:

External risk ● Credit risk

● Competitive risk
● Network risk
● Policy risk

Internal risk ● Platform update risk

● Product design risk
● Management risk
● Personnel ethics risk

Credit risk in P2P lending

Our study is focusing on credit risk. Investors in the P2P industry face a large amount of information asymmetry
( Information asymmetry is when one of the two parties has more information than the other one). Borrowers
typically have a very good idea of their ability to repay based on private information such as earning potentials as
well as any outstanding obligations while lenders do not. Using data from Germany and Paolo in 2016 found that
P2P platforms were catering to a riskier segment of borrowers and supplying them with microloans. Moreover, they
found that the return on P2P lending after adjusting for the risk was lower relative to banks. Notably it was found in
2019 that riskier borrowers in the marketplace tend to self- select into longer term loans which are costlier in the
long run. A Chinese study found in 2017 that lenders in the marketplace face a higher credit risk than traditional
banks due to adverse selection. They also found that the order of credit rating and borrowers with high credit lines
tend to perform well. In another study the determinants of credit risk were found to be the existing amount of debt of
the borrower, the credit grade assigned by the platform, loan purpose as well as housing situation. Most studies have
focused on identifying some determinants of credit risk and possible ways to improve the P2P market

Methodology
Exploring AI and credit scoring models in p2p lending:

❏ Digital Footprint Analysis model:

In order to decide how likely they are to default, businesses began looking at the whole life of a person and even
their massive digital footprint. This is regarded as "alternative data” concerning potential borrowers. The premise is
that additional information not only offers more insight into individuals with proven FICO ratings, but that it can be
especially helpful in assessing the creditworthiness of individuals without a conventional credit history.a full AI
solution would be automated in terms of data identification, data testing, and making decisions based on the data
testing.such as including hard-coded and logic rules
An example of a start-up that uses advanced machine learning actively to search through large sources of alternative
data to predict an individual's credit rating is lenddo. The business started in 2011 and focuses on emerging markets
where traditional credit histories or even bank accounts are often lacking in the rising middle classes. They say that
5 million individuals have earned loans from their partners since their system has been able to determine their
creditworthiness.

Lenddo looks at the entire digital footprint of a prospective applicant to determine their credit ratings by having
people download their app.

It examines more than 12,000 variables, including the use of social media accounts, internet browsing, geolocation
data and other information about smartphones. Their machine learning algorithm turns all of this information into a
credit score that can be used by lenders.

❏ Ensemble machine learning algorithms model:

Ensemble machine learning algorithms and preprocessing methods are used in p2p lending to discover, evaluate and
decide the factors that play a crucial role in predicting credit risk:

The processing of a loan application from a borrower requires first gathering user data such as annual income, credit
history, bank balance, other loans, etc.

Identifying the subset of these attributes that are capable of classifying the loan application as one with or without
possible default risk is the primary priority.

Stage2 is data processing and cleaning transforming the raw dataset into an understandable format.

Stage 3 the feature Selection in which redundant attributes are removed (i.e. the attributes that carried same or
similar information). And attributes with 10-15% of missing data, are handled by using the median of the available
data, as the placeholder. Also excessive attributes are removed using an intuitive approach on the remaining
attributes, with an objective to eliminate the least important ones. In this model Extra Tree or Extremely
Randomized Forest classifier was chosen which is a tree based ensemble classifier that uses Decision Tree as the
base learner.

Stage 4 classification, where decision tree classifiers are used which is a supervised learning algorithm which builds
a binary tree where each node level has an attribute value split. A Decision Tree is built top down from a root node
and involves partitioning the data into subsets that contain similar values, also a Random forest classifier is used
which is another tree based ensemble supervised learning algorithm that generates multiple Decision Trees (forest)
for random subsets of the data, and predicts the class with highest frequency after running the sample on all the
Decision Trees generated. Random forest helps in overcoming the over-fitting problem experienced in Decision
Tree classification. It provides a significant increase in the accuracy of the model. The classification step ends with
Bagging involving bootstrapping the original dataset and using the subsets to estimate the performance of another
classifying algorithm, by voting. The randomness introduced in bootstrapping reduces the variance or the over-
fitting problem

Bootstrapping is a sampling technique to obtain an approximate statistic estimate of the sampling distribution by
choosing a random subset with replacement, multiple times and learning from it

❏ Artificial neural networks model:

Two key linear statistical tools, discriminant analysis and logistic regression, were typically used frequently to build
credit scoring models. In addition to these linear methodologies, non-linear approaches are used such as artificial
neural networks. Neural networks provide a new alternative to LDA (linear discriminant analysis) and logistic
regression, especially in situations where complex nonlinear relationships are exhibited by dependent and
independent variables
A neural network is a collection of algorithms that, through a mechanism that mimics the way the human brain
works, aims to identify underlying relationships in a set of data. In this context, neural networks refer to organic or
artificial neuron systems. Artificial neural networks emerge from the attempt to replicate the physiological structure
and functionality of human brain structures artificially.

Artificial neural networks consist Processing Elements

The Input Layers are the in-put neurons that receive the stimuli that comes in.According to a basic function called
the Transfer function, input neurons process the inputs selected and transmit the result to the next layer of neurons.
The input neurons then forward the data to all middle layer neurons.Data is not simply sent to the intermediate
neurons, but weighed. It means that the result obtained from each neuron is sized according to the weight of the
connection between the two neurons. A transition function and a threshold value define each neuron. The threshold
is the minimum value the input must have for the neuron to activate. Each neuron of the middle layer sums the
inputs that are presented to its incoming connections.

Neural networks may adapt to evolving inputs, so the network produces the best possible outcome without the
output criteria having to be redesigned.

The flexibility and objectivity of neural networks models can provide strong support in combination with linear
methods of analysis for the efficiency of the processes of credit risk management of a lending fintech.
P2P lending benefits:

P2P lending provides several benefits:

1. Faster online application:

The application process is convenient and quick as peer-to-peer lending platforms are online. The majority of the
platforms include a list of investors to provide loans to borrowers. Combined with an automated matching process,
the turnaround can be very short.

2. Lower rates are accessible:

Thanks to P2P lending, borrowers have access to lower interest rates than offered by banks. There are no overheads
that most financial service providers have, as investors are giving money directly through a P2P platform, which
makes it beneficial to both parties.

3. Getting an initial quote will not affect your credit score:

You can have a customized quote if you’re interested in getting a personal loan. This option gives your clarity about
the rate you will be offered the affordability of any loan.

4. There is an additional option for a loan to traditional lenders:

Peer to peer platforms are fulfilling an important role for those interested in alternative finance among their
financial needs, which creates a healthier marketplace for customers.

5. Even Though loans are from individuals, you only need to deal with the platform:

The platform is an effective intermediary between both parties. You receive a loan anonymously and all repayments
are made through the platform.
Results:
Traditional banking can have profound changes by the p2p lending platform over the next decades. P2P
lending is the largest online credit market in the world, facilitating personal loans, business loans, medical
financing, and more.The main objective of P2P lending platforms is democratizing consumer finance services. For
more efficient distribution and guarantees of credit, technology was used by these plat-forms. To borrow money,
individuals can make their pitches and credit can be provided by investors without the involve- ment of
financial institutions. . Over the last few years, many researchers have developed and applied many models and
algorithms to analyse the P2P. Hence the ultimate goal of this research paper was to eventually propose the
appropriate models that are quite used and fitted to manage the credit risk faced in peer to peer lending including the
Digital footprint analysis model , the machine learning algorithms and finally the Artificial networks model.
Conclusion:
From the study, we managed to explore the field of p2p lending and deduce that there are key benefits as well as key
risks resulting from the investments made. Peer-to-peer loans are exposed to high credit risks. Many borrowers who
apply for P2P loans possess low credit ratings that do not allow them to obtain a conventional loan from a bank.
However innovation and progress in artificial intelligence and machine learning has made it easier, more efficient,
and effective to assess, analyze, and manage these risks using advanced models and approaches.