chit funds, crowdfunding and p2p banking (I)

chit funds in emerging markets

I began to look at smaller Asian markets as an investor in 1985.  It was there that I encountered the informal self-help savings and lending associations that are typical in developing economies.  My introduction came through chit funds in Thailand and Taiwan, but these structures exist throughout the developing world.

what they are

the simplest

In their simplest form, the associations are groups of friends of neighbors who contribute a specified amount of money to a pool on a regular basis.  The funds pooled each time the group meet are lent to a single participant, determined either by the implied interest rate bid or on a rotating basis.

more complex

At a higher level of organization, groups come to a designated place at a specific time–like by having a meal at a certain restaurant on Saturday–and offer to third parties the money they’re willing to lend.  They may signal their intent simply by piling their money in the center of their table.  Prospective borrowers move from table to table to negotiate loan terms.

the pinnacle

For the largest such chit funds, agents for the fund do the collection and forward the money to the fund’s central headquarters.  Lenders don’t have any direct contact with the borrowers.

why chit funds?

There are a number of motivations, normally all based on the idea that the formal banking system doesn’t function well. For instance:

1.  There may not be any local banks.

2.  Banks may offer very low interest rates to depositors.

3.  Banks may decide to lend only to large companies.

4.  Potential depositors may worry about bank solvency–the possibility that they’ll lose their money in a bankruptcy or nationalization.

5.  People may not want to reveal the extent of their wealth, or the extent of their taxable income.

the US equivalent

Interestingly enough, this emerging world form of microfinancing is beginning to make a strong showing in the US.  It’s taking two forms:

–Congress recently passed the JOBS (Jumpstart Our Business) Act.  JOBS greatly simplifies the procedures for a small company to make an offering of equity.  For companies with less that $1 billion in annual sales, JOBS does away with the requirement that they present audited financials to potential investors (not a stellar idea, in my opinion).  JOBS also defines the maximum amount that low-income investors can put into a given offering.  By so doing, it legitimizes the efforts at equity crowdfunding (see my post) now underway in the US.

–John Mack, former head of Morgan Stanley, recently joined the Lending Club, a P2P (peer to peer) lender.  P2P lending is chit funds come back to life, but on the internet instead of in your local restaurant.  You can go to the websites of P2P firms like Prosper and Lending Club and select the borrowers you wish to lend to by yourself.  Or you can hire a financial advisor to do this for you.

why now?

To start with the obvious, the technology needed to run P2P or equity crowdfunding is readily available.

Interest rates have been low for a long enough period of time–with little relief in sight–that more conventional means for savers to obtain high returns have been exhausted.  Not only that, but getting a return above 2% in Treasury bonds requires committing money for a very long time, exposing the lender to the risk of loss as/when rates eventually begin to rise.

I see the JOBS ACT as an attack (maybe as the first step in a prolonged attack) by Washington on the current IPO practices of Wall Street investment banks.  Conventional IPO costs in the US are very high by world standards, and a private individual stands about the same chance of getting an IPO allocation as a snowball in northern hemisphere July.

The naming of the JOBS Act suggests that Washington wants to be seen as doing something to create jobs.  What a commentary if this is the best they can do.

My first reaction to P2P is that it may be a true innovation, like money market funds and junk bonds were in their day.  P2P could end up being a very big business–unlike JOBS, which I see, in its present form, as gimmicky and filled with opportunities for fraud.

That’s it for today.  Tomorrow:  historic problems with P2P lending, including a word on Bernie Madoff.

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