In the cover story of the Economist dated 9 January 1988, the article titled “Get Ready for the Phoenix” provided a glimpse into the future we are now living through:
“The biggest change in the world economy since the early 1970’s is that flows of money have replaced trade in goods as the force that drives exchange rates… Thirty years from now, Americans, Japanese, Europeans, and people in many other rich countries, and some relatively poor ones will probably be paying for their shopping with the same currency…. As the trend continues, the appeal of a currency union across at least the main industrial countries will seem irresistible to everybody except foreign-exchange traders and governments… national economic boundaries are slowly dissolving.”
With the acceptance of China’s Yuan as one of the new “basket” of reserve currencies, the global economic order is rapidly moving towards an aggregated currency valuation referred to as Special Drawing Rights or SDRs. The implications of this shift is profound, laying the ground work for a new level of global money flow pegged not to the US Dollar but to the SDR that will seek to pierce national boundaries and expand consumer access. This will open the door for new levels of consumer purchasing and most notably, new opportunities to offer consumer credit, irrespective of geo-political domicile.
One of the most important developing market trends in the SDR model is Peer-to-Peer (P2P) lending. With increasing downturns in consumer confidence of banks, increased degrees of comfort with online platforms, increasing consumer demand for credit and ease of access via digital interface (versus traditional brick and mortar points of sale) P2P loans can leverage currency valuation based on the SDR to create a form of common currency. To accomplish this, new methods of individual risk evaluation must be developed.
P2P lending to include personal and small business loans offer one of the greatest growth opportunities in the lending and digital transactions markets in the coming decade. Estimated by PricewaterhouseCoopers (PwC) to be a $150 Billion business by 2025, the market is gaining increased support from investors and consumers alike. Though P2P loans are currently geo-politically pegged, the increased access and positive user sentiment of using internet platforms to apply for funding opens the opportunity for a shift away from geo-politically defined applicant pools towards models that support global customer bases.
The leading P2P lenders have incorporated a range of risk approaches to value the risk of the loans. These approaches have included factors such as use of social media, Facebook friends lists, and even view habits on the lender’s site. While these have so far offered some success, there remains high levels of concern that current approaches to lending in these environments is creating a new loan bubble. Paul Solman of PBS News Hour points out the inherent faults and risks of the current approach,
"...the intermediary [P2P] companies are giving investors the impression that they are conducting greater underwriting on the borrowers than they actually are... If the underwriting process used by P2P lending companies provides no greater and more reliable borrower credit information than that obtained by traditional credit card companies, then lenders need to question why they are offering reduced risk premiums to these borrowers."
The concern is valid, especially if P2P offerings are made on the global market. Current systems are not well suited to deal with the complexities and nuance of cultural and economic influencers that are needed to evaluate risk in the global markets, especially emerging markets.
Consider the challenges of risk valuation in the emerging BRIC economy of Brazil. Brazil’s promise of improved economic opportunity has created significant social challenges. As more people become mainstreamed into the licit economic sectors, they are burdened with taxation and caps on wage growth that do not affect illicit sectors the same way. Illicit economies in Brazil function like a counter balance. Their existence absorbs the population segments that cannot find work within the licit economy, and/or offers opportunity for increased income opportunities for those in the mainstream economy where strong barriers to wage growth and opportunity remain. While growth as a global emerging economy requires growth within licit economic domains, Brazil’s economy has developed a symbiotic relationship with its illicit economic growth, with illicit economies contributing to overall social stability.
Adding further complication is the overall acceptance of illicit economies, demonstrated through sentiment analysis. The majority of illicit revenue in Brazil comes from over-invoicing. While the sentiment analysis identifies strong positions against traditionally stereo-typed illicit activities such as Government corruption and drug trafficking, the illicit economic activity for the large part is accepted.
The neutral sentiment towards illicit economies creates significant challenges to any risk valuation. Essentially, Brazilian’s will not make the same distinctions between transactions of a licit or illicit nature. This in turn has impact not only valuing the consumers potential ability to repay a loan, but potentially with compliance with US or EU regulations. Current models for valuing risk are not equipped for this.
Though Brazil has seen big gains in an increased middle class, combined economic growth of both licit and illicit economies has been nearly equal. This will remain an ongoing issue for Brazil. Of even greater significance is that a disorganized effort by the Government to address a widening budget deficit has resulted in painful tax increases, adding further stress to family budgets. Though the middle class increased to 112.6 million people in 2013, up from 67.9 million people in 2003, wages have been rising less than inflation, putting 35 million people of the lower middle class at risk. With inflation approaching 10%, many of the poor have been forced to stop buying meat. The rising inflation, taxes and unemployment threaten to derail the country’s progress in reducing the income gap. The reduced buying power is reflected in the Brazilian Real (down 33% to the US dollar and ranked as one of the poorest performing currencies) as well as investor confidence with Brazil’s emerging market growth. These strategic factors directly impact the consumers ability to repay the loan. Again, current risk models are not equipped for this.
The majority of credit scoring in the US is based on FICO scores. FICO is software from the Fair Isaac Corp. started in 1956. Fair Issac began licensing its code in 1989 to the three national credit-rating firms, Experian, TransUnion and Equifax, to produce scores ranging from 300-850. Though the formula is secret, it has relied on a stable currency and a relatively stable economy to build its risk valuations for consumers. As a way to improve risk scoring, the latest P2P risk valuation systems are trying to factor in behaviors using varieties of data taken from the users mobile platform. What is missing is the ability to develop social, cultural and financial context for the user, that addresses their current and future potential for inclusion or exclusion within the emerging markets.
Economic globalization is increasing almost daily. It is only a matter of time before the investor driven P2P market seeks to expand the market opportunity beyond geo-politically defined consumer boundaries. Valuing those risks in a manner that will be able to address the speed of digital transaction and consumer desire with the proper risk valuation irrespective of global domicile requires a new way of thinking about the problem. As much as the modern socio-cultural experience tries to persuade the belief of a common humanity, we are all very locally tied to our environments. Risk analysis in this day of global digital interconnectedness and the new economic world order must find a way to include socio-cultural aspects to place us within a proper context.