Competitors' club

These aren’t the best of days for the online lending industry. Renaud Laplanche, the founder of industry leader Lending Club, resigned as CEO in May after news surfaced that Lending Club had misrepresented its lending practices. The next day, the U.S. Treasury Department released a report calling for greater scrutiny of the rapidly growing industry.

Before barging in with new restrictions, regulators should take a deep breath and count to 10.

Online lenders tout themselves as the new way for consumers and small businesses to borrow in the 21st century. Most of these borrowers currently use bank loans and credit cards for their borrowing needs. But bank loans can be very hard to get, especially when the economy is shaky. The only way to get a bank loan, the joke goes, is to show you don’t need it. Credit cards are much easier to come by, but their interest rates are often sky-high.

Enter Lending Club and its competitors—such as Prosper Marketplace and SoFi in California and Zopa and RateSetter in London. Online lenders play matchmaker between investors and borrowers, sidestepping the traditional borrowing process altogether. Loan applicants need only go to a website and fill out a simple form. The money comes from investors who are attracted by the opportunity to earn a fairly generous return.

The original idea was for ordinary people to make loans to other ordinary people. That’s why it’s often called “peer-to-peer” lending. In reality, hedge funds and other sophisticated players provide most of the funding, so some now call it “marketplace lending.”

Even for those of us who think online lending is a clever and important innovation, there’s something worryingly familiar about the business model. Online lenders like to compare themselves to Uber, Amazon, and other disruptive innovations that have lowered costs for consumers. But the business model also looks a little like the rush to make loans to anyone and everyone that occurred during the housing bubble before the Great Recession.

Lending Club’s current crisis is a warning sign. The company has grown rapidly—according to its website, it had funded $18.7 billion in loans as of the end of March, including $2.7 billion last quarter alone. Lending Club apparently misrepresented the quality of $22 million in loans that it sold to the investment bank Jefferies. The Justice Department has now opened an investigation. Perhaps this was isolated misbehavior, but it could signal deeper problems.

It would be a mistake, though, to smother the industry with new regulations. Online lending provides valuable competition for bank loans and credit cards, and thus fills an important niche.

A new study co-authored by Columbia Law School professor Robert J. Jackson Jr. shows just how quickly heavy-handed intervention could leave its mark. After the U.S. Court of Appeals held last year that loans made in New York, Vermont, and Connecticut are subject to those states’ interest rate restrictions, rather than to the laws of the lenders’ home states, online lenders immediately started acting like banks. Borrowers with high credit scores could still get a loan, but the interest rate restrictions prevented the online lenders from charging higher interest rates to riskier borrowers, so the lenders stopped making those loans.

Online lending isn’t likely to disappear. The simplified process makes too much sense, and it draws on technology younger Americans have grown up with.

But its immediate future may depend on Lending Club’s response to its scandal. If Lending Club comes clean, and imposes stricter oversight of its lending process, perhaps regulators will be dissuaded from micromanaging the industry. If not, the most exciting recent innovation in lending may soon lose its luster.