According to Club Lending there are several types of risks in lending using Lending Club services. The risks listed are different from the traditional financial investment risks which are foundational enough to deserve to be addressed in a separate post. Below (in the quote sections) is the risk information provided by Lending Club:

Participating in any financial transaction carries elements of risk, and online person-to-person lending is no exception. We strive to create an easy, safe and private environment for people to bypass the banks and borrow or lend money at better rates. Below, we address the main types of risks associated with online financial transactions in general, and explain the measures we have taken to reduce these risks.

I agree with that statement because every investment carries general economic condition risk and inflation risk. However, other investments, such as money market savings or US government bonds, do not carry the same risk as participating in a P2P lending network. P2P lending lenders must carry principal risk which investors in US government bonds do not carry. However, if you invest in governemnt bonds, you increase your inflation risk. (The term Inflation Risk will be linked to soon to-be published post.)

Data Security
A key area of risk to be concerned about is the degree to which a company can protect the security of the information it receives and stores from its customers. Lending Club takes strong steps to safeguard your personal and financial information through vigorous physical, electronic and operational policies and practices. We use the latest technology available to provide a safe and secure platform. We store all sensitive financial data such as Social Security numbers in encrypted form at a secure, off-site database. We help protect the security of all accounts through implementation of session time-outs, policies protecting account numbers, and a rigid ID theft policy. For more information on our security practices, please refer to our Privacy Policy, which includes all security measures.

This makes me a little nervous that a lending institution would even mention this as a risk and I suppose that there is greater risk with Lending Club (or any other smaller banking institution) in security than a traditional bank. However, that risk is likely always present.

Operational
Lending Club has established internal security procedures with real time monitoring, as well as periodic external reviews and audits. Internal operations personnel constantly monitor our systems and transactions, as well as those of our partners, to ensure that there is no compromise.

Operational risks exist in all financial institutions, but I presuppose that this is likely greater at a newer institution.

Authentication
Lending Club employs state-of-the-art authentication technologies to verify members’ identities. This process reduces the chance for identity theft by using multiple sources of information to establish the authenticity of the online user. In addition, Lending Club also tracks transactions internally and monitors potential fraud and other illegal activities.

Credit Worthiness of transaction partners

When entering into an online transaction, it is important to be able to trust the screening practices of the host platform. Lending Club uses proven methods to determine a borrower’s credit worthiness. We start with the borrower’s credit score. We don’t support any subprime loans, so anyone with a credit score below 640 will be prevented from borrowing. We also look at the borrower’s Debt-to-Income (DTI) ratio and the amount of the loan to ensure that the borrower can afford to pay back the loan. One key area of credit worthiness that separates Lending Club from any other company is the fact that most Lending Club members are also members of other trusted communities. We believe that borrowers are more likely to pay back their loans that have been extended by neighbors, fellow alumni, and friends-of-friends.

The obvious — credit risk. This is the risk of default or principal risk. That is, will the borrower pay back the loan? I am glad to hear that Lending Club does not support sub-prime loans like the mortgage industry which has created a national housing and lending issue. Most surprisingly, Club Lending does not allow people with a credit score south of 640 to participate. Compare that to Prosper’s lending grade chart, where a FICO score of less than 640 is a grade C. Prosper allows down to grade E (560-599) and HR for “high risk” (520-559). Therefore, an “A” does not always equal an “A” across lending services, so ensure that you understand the credit risk of the P2P lending service that you select. Prosper lending grades as of 11/15/2007 are posted below as an image:

Fraud
Lending Club is committed to protect its members and takes financial fraud extremely seriously. We realize that even with the strong securities measures in place, criminals might try to exploit and abuse our systems. Lending Club will work with law enforcement agencies to seek full prosecution of anyone attempting to commit illegal acts using Lending Club’s systems.

Fraud is a type of risk that I normally never carry in a traditional banking transaction. For the most part, barring certain scams, the banking institution takes on the majority of the fraud risk. The main exception that I can think of is accepting a check from a fraudster. P2P lending seems ripe for identity theft loan rip offs.

Investment/Portfolio Diversification
In general, diversification is a sound principle of investing. Lending Club encourages this safe practice by generating well-diversified loan portfolios automatically based on lenders’ chosen risk levels and affinities. Using portfolios, it is possible to lend small amounts to a large number of borrowers who present different risk characteristics (get a portfolio recommendation here). Lending Club employs a complex form of Harry Markowitz’s Modern Portfolio Theory in calculating the optimal portfolio allocation based on the number of loans selected and the amount invested. Following the diversification principles, Lending Club calculates the portfolio loss risk using statistical methods. Lending Club then constructs a recommended portfolio by identifying the degree to which lenders and borrowers are connected.

One of my favorite topics — reduce risk and increase returns by investing in a well balanced portfolio. That is the reason that a large portion of my finds will never be invested in P2P lending. Additionally, no lender should ever invest a significant portion of their P2P lending portfolio with a single loan.

Balancing Risk vs. Reward
There are seven main grades of Lending Club loans: A, B, C, etc., where A-rated loans correspond to the highest credit scores. Because loan listings can differ in risk within each of these grades, we created 35 different risk subgrades in an attempt to more accurately reflect the risk-reward proposition. Balancing risk and reward protects the portfolio because it is constructed based on the level of expected losses that can occur for a given risk grade. Lending Club continuously monitors and reviews its interest rates to ensure that they provide the right risk/reward balance.

The more risk you take on in any transaction, the greater the return on investment you should expect. The reason loans to less credit-worthy individuals pay a higher rate of return is that they are more likely to default — the principal risk.

Summary
Lending money subjects the lender to multiple types of risk, including credit risk, opportunity cost risk, and more specifically, interest rate risk.

* Credit risk is the risk that the borrower will not pay the interest or principal that he or she has promised to pay.
* Opportunity cost reflects the risk that the value that your loan portfolio will underperfom relative to the general market.
* Interest rate risk reflects the fact that the values of fixed-interest loan portfolios tend to fall as interest rates rise.

That is an excellent summary of the risks inherent at a P2p Lending site such as Club Lending or Prosper. Consider them all before getting started lending.