Analysis of the Impact of Collateral on Peer-to-Peer Lending

Peer-to-Peer (P2P) lending provides online services that match lenders with borrowers. Although the service is cheaper and faster than the traditional financial institutions, P2P lending may have high defaults, which the lenders may never recover. One remedy to this situation is collateral: a fund that is reserved to pay off the defaulted loans. However, implementing an effective collateral requires the consideration of many issues such as governmental regulations, borrowers' credit and the lending interest rates, so that the collateral won't deter potential customers. This research investigates the impact of collateral on P2P lending. We first developed a theoretical model to analyze the P2P lending with and without collateral. The results show collateral increases both the lenders' willingness to offer loans and the borrowers' loan payoff probability, hence leads to more successful transactions. Next, we validate the analytical results by conducting simulation using the Bianconi-Barabasi network model. The results show the P2P lending network with collateral has a more balanced degree distribution than that without collateral, indicating financial transactions are not dominated by a few but shared by more customers under collateral. Consequently, P2P lending with collateral is less vulnerable to system risks generated by a few big players. Both results support collateral as an effective mechanism to achieve more stable P2P operation, to generate more successful transactions and to benefit more customers in satisfying their financial and investment goals.