Borrowing rates

Much of the issue stems from bank capital adequacy regulation (Basel II and in particular Basel III). The regulation is complex and subject to interpretation. However (and here I'm radically oversimplifying), Basel III basically breaks down borrowers into three classes: states (and their local governments), households and companies. Banks are not required to hold any regulatory capital against debt issued by states. They are required to hold more capital against household debt but this depends on security. A 90% LTV mortgage may required 6 times the reg cap that a 60% LTV mortgage requires. You can see this by looking at the historical spreads between 2-year fixed rate mortgages for 60% and 90% LTVs before and after the introduction of new reg cap requirements. For debt or loans to companies they typically have to hold 100% reg cap (though there are exceptions given securitization). The bottom-line is that Basel III tells banks that states are risk-free, property is a bit risky and companies are very risky.

Banks essentially attempt to maximize profit by leveraging their risk capital. This now favours them buying government bonds or lending on low LTV property over lending to companies. Take a concrete example: the bank could lend to a company £10mm for 5y at 10%, borrowing at 0.5%, to make £950k in interest/year but would use £10mm of capital. Alternatively they could buy £190mm of UK 5-year gilts at 1%, borrow at 0.5%, make the same £950k interest but use zero risk capital. The capital ratios are thus driving the bank's economics and decision process regarding who and who not to lend to. This may seem silly since most people would much prefer to take the credit risk of say Apple with $70bn in cash in the bank than most households and many European countries! However, this makes quite a bit of sense politically since banks are a major owner of government debt and by risk-weighting it at zero this make it more attractive to banks. Similarly if households were risk-weighted like companies, mortgage approvals would collapse which is not a vote winner (remember the Tory government has had to explicitly step in to make high LTV mortgages available since for banks it was not economically viable to offer 95% mortgages at lower rates).

So banks have been driven out of many areas of riskier corporate lending (read SMEs) and a "shadow banking" sector is now growing to take up the space they have vacated. The shadow banking sector is populated by entities who are not regulated as banks and therefore do not have to conform to reg cap rules. This is effectively reg cap arbitrage. Before the bank borrowed at 0.5% and lent the company at 8%; now the bank borrows at 0.5%, lends to the "shadow bank" at 1.5% (say me with a <50% LTV offset mortgage!) and then the shadow bank lends to the company at 10%. We've added another layer of intermediation so as usual that increases costs to the end company. It should also be clear why the BoEs PRA is not really concerned that the banking sector will trigger the next credit crisis - it's been regulated to death - but the almost totally unregulated, and rapidly growing, shadow banking sector is a major concern.

Of course not. P2P/P2B is currently so small as too be completely irrelevant in any systemic sense. Globally, credit formation to SMEs fell substantially post 2008 and bank regulations mean that they are not able to step up. The issue then is how do you create a replacement sector (call it "shadow banking", of which P2P is just one component) that can provide the same funding without just recreating the same risks in another place. Risk does not go away, it generally gets moved around and shoved in a dark place where nobody can see it. As a regulator, if you over-regulate the new sector, it won't grow fast enough to replace the banks and SME growth will be stifled. Under-regulate and in 5 or 10 years time, you suddenly wake up with the next crisis on the front-page of the newspaper and you're out of a job ... and they have to change the name of the SFA/FSA/FCA again! So regulators aren't worried about P2P right now but they can see that it could easily be part of the next crisis some time in the future.