Judging Borrowers by the Company they Keep

Your friends say a lot about you — and can even determine whether you can get a loan. That’s the finding of new research from Siva Viswanathan, associate professor of decision, operations and information technologies. 

Viswanathan has been studying crowdfunding markets, websites that allow borrowers to seek loans from many individual lenders. A key difference from traditional lending is that the investors, not finance experts, make funding decisions. Viswanathan studies how well these untrained investors in the crowd make decisions, because he says crowdfunding markets won’t survive in the long term if people aren’t making good investments. 

Viswanathan’s study looks at one of the first crowdfunding markets, Prosper.com, in which people seek small loans (typically less than $25,000). Borrowers create profiles that explain why they are seeking funding. Prosper.com verifies borrowers, similar to how credit-card companies verify clients, and makes that information available to potential lenders. A decentralized network of lenders has access to all borrower information, and they can create their own terms for loans. 

Like traditional banks, crowdfunding lenders use “hard” data, such as credit history and FICA scores, to make the right choices. In Viswanathan’s study (conducted with Smith PhD Mingfeng Lin, now at the University of Arizona, and Smith associate finance professor Nagpurnanand Prabhala), borrowers with better scores got better outcomes. But the thing that really piqued the researcher’s interest was how efficiently the crowd used “soft” information about borrowers to make investment decisions. 

This information includes the borrowers’ self-created profiles, details information about why they need the loan, and lists connections to “friends” in their social network. Viswanathan found these have a significant impact on lenders’ investment decisions. Individual lenders are using the hard and soft information very rationally in making their investment decisions, said Viswanathan. 

Having a lot of friends doesn’t necessarily matter for borrowers. What does matter is whether a borrower’s friends are actually lending to them, or are at least willing to lend to them. These people are more likely to get funded and get better interest rates, and are less likely to default on loans, says Viswanathan. The researchers also found that default seems contagious: If a borrower’s friends have defaulted, that increases the likelihood he or she will default. 

“There is a lot of valuable information in a borrower’s social network and the textual information that they fill in that banks could potentially collect,” he says. “What our study shows is you could actually substantially reduce the risk of your loans by taking this soft information into account along with hard information. That could substantially change the risk that is incurred by any lender — including banks —and that could make a huge difference.”