Skin in the Game: The Incentive Structure in Online Social Lending

This paper analyzes the certification mechanisms and incentives that enable lending markets to match demand and supply despite the absence of financial intermediaries with skin in the game. Our analysis of the online social lending market, in which there is no financial intermediary, shows that the creation of self-organized groups helps the market to work efficiently but allowing group leader rewards, similar to origination fees in securitization, is detrimental. We are able to take advantage of a natural experiment in which group rewards are eliminated to examine how the same groups behave once these origination fees are removed. In general, group leaders signal borrower quality to other lenders by endorsing and submitting bids for listings in their groups. Borrowers in these groups have a significantly higher likelihood of receiving a loan, pay significantly lower interest rates, and default less often than comparable borrowers outside groups. However, when group leaders receive an origination fee for successful loan listings, it creates adverse incentives so despite bids and endorsement, loans originated by such group leaders have higher default rates. Group leaders become more careful in screening after the elimination of these rewards, and if their loan participation is high, i.e. when they have skin in the game and are thus severely hurt by a borrower default. These results have important implications for the question of how lending markets can function properly and for the ongoing debate about the future of securitization and the originate-to-distribute model