How Wise Are Crowds? A Comparative Study of Crowds and Institutions in Peer-to-Business Online Lending Markets

49 Pages Posted: 21 Mar 2016 Last revised: 9 Jun 2018

See all articles by Ali Mohammadi

Ali Mohammadi

Copenhagen Business School - Department of Strategy and Innovation; KTH Royal Institute of Technology

Kourosh Shafi

University of Florida - Center for Entrepreneurship and Innovation

Date Written: August 15, 2016

Abstract

Funding small businesses used to be the exclusive domain of angel investors, venture capitalists, and banks. Crowds have only recently been recognized as an alternative source of financing. Whereas some have attributed great potential to the funding provided by crowds (“crowdfunding”), others have clearly been more skeptical. We join this debate by examining the performance of crowds to screen the creditworthiness of small and medium sized enterprises (SMEs) compared with institutions in the context of new online peer-to- business lending markets. We exploit the randomized assignment of originated loans to institutions and crowds in the online peer-to-business platform of FundingCircle, and find that crowds underperform institutions in screening SMEs, thereby failing to lend at interest rates that adjust for the likelihood of defaulting on a loan. The interest rates set by crowds predict default 39% less accurately than institutions. Moreover, the underperformance gap of crowds compared with institutions widens with risky and small loans, suggesting that crowds lack the expertise to assess the risks or the incentive to expend resources to perform due diligence. Overall, our findings highlight when crowds face limitations in screening SMEs.

Keywords: crowdfunding, peer-to-peer lending, institutional investors, online loan market, wisdom of the crowd

JEL Classification: G23

Suggested Citation

Mohammadi, Ali and Shafi, Kourosh, How Wise Are Crowds? A Comparative Study of Crowds and Institutions in Peer-to-Business Online Lending Markets (August 15, 2016). Swedish House of Finance Research Paper No. 17-10; 2017 Emerging Trends in Entrepreneurial Finance Conference. Available at SSRN: https://ssrn.com/abstract=2752085 or http://dx.doi.org/10.2139/ssrn.2752085

Ali Mohammadi

Copenhagen Business School - Department of Strategy and Innovation ( email )

Kilen
Frederiksberg, 2000
Denmark

KTH Royal Institute of Technology ( email )

Stockholm
Sweden

Kourosh Shafi (Contact Author)

University of Florida - Center for Entrepreneurship and Innovation ( email )

United States

HOME PAGE: http://www.kshafi.com

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