A new Stigler Center case study chronicling the story of Chile’s first crowdfunding platform and its early regulatory challenges illustrates how financial regulations can be effectively used by incumbents to stifle competition.

In June 2012, the founders of Cumplo, Chile’s first crowdfunding platform, were called to a meeting in the office of the country’s banking regulator. They were given an ultimatum: “If you don’t stop doing what you’re doing in 48 hours,” the regulator told them, “I will be forced to report your activity and you may end up spending 541 days in jail.”

Cumplo, said the regulator—a former manager at one of Chile’s biggest banks—was in violation of the country’s banking law, which prohibits any unlicensed individual or organization from keeping deposits or acting as a financial intermediary. The law was originally passed in the early 1980s, during Chile’s banking crisis, to promote financial stability.

Five days later, the regulatory agency in charge of supervising banks in Chile (SBIF) officially charged Cumplo. The company, founded in 2011 by Nicolas Shea and his wife Josefa Monge, countered that it was a mere peer-to-peer (P2P) lending platform, a marketplace that allows borrowers and lenders to connect, borrow and lend among each other directly. 

The regulator insisted that Cumplo was operating illegally as a “money broker.” Shortly thereafter, six armed police agents raided the company’s offices, looking for secret hard drives and files. According to Shea, he improvised a role-playing session to show that Cumplo was not a financial firm. One week later, he says, one of the officers came back to Cumplo’s office to try to renegotiate his retail store loans. Days later, Shea and co-founder Jean Boudeguer were interrogated by the district attorney in the presence of police officers.

The impetus for all this was an article in the Chilean newspaper La Segunda that caught the attention of the incumbent banks and the regulator, in which it was reported that the 8 month-old company was adding new users at a pace of 2,500 per week.

Cumplo, which has since pivoted from providing personal loans to focusing on small and medium-sized firms (SMEs), is the subject of a new Stigler Center case study written by Luigi Zingales [Director of the Stigler Center and one of the editors of this blog] and Magdalena Winter Domínguez, with teaching notes written by Zingales. The story of its early regulatory challenges, as it fought regulators and incumbents banks, illustrates how financial regulations can potentially create barriers to entry for new entrants in the Fintech industry.

Exorbitant rates  

Cumplo was founded in 2011 by a group that included Shea, Monge, Boudeguer (who served as the company’s founding COO), Guillermo Acuña (its current COO), and Felipe Lyon. Shea, then founder and president of Chile’s National Association of Entrepreneurs (ASECH), also founded Start-Up Chile, a government-backed accelerator, in 2010. He is a World Economic Forum Young Global Leader, was previously named Chile’s Entrepreneur of the Year, and a former advisor of entrepreneurship and innovation to the Chilean Ministry of Economy during the presidency of Sebastián Piñera. Monge is a lawyer specializing in corporate communications.

Cumplo was established as a peer-to-peer lender that allowed borrowers to receive unsecured personal loans from individual borrowers. It was meant to provide a more attractive alternative to credit cards, retail stores, and bank loans, after Shea was shocked to learn of the exorbitant interest rates Chile’s biggest banks were charging small borrowers—sometimes over 100 percent. Through Cumplo’s online “marketplace,” borrowers were able to receive financing at much lower rates.

Cumplo, Shea explains, “doesn’t take deposits or make investment decisions. Its role is to curate information about borrowers and loans so investors can decide whether to lend or not under the conditions that borrowers offer. Unlike banks that take deposits from customers and invests other people’s money (financial intermediation), Cumplo is a technology/operational company that allows investors to lend directly to borrowers, at better rates that they could get in the traditional financial market. Cumplo charges for the use of its online platform and the collection of the loans.”

According to Shea, the initial idea to start Cumplo was born after his children’s nanny asked to borrow money, having accumulated $7 million Chilean pesos (roughly $10,000) in debt, at a 73.2 percent APR.

Attempting to help her repay her debts, Shea and his wife found that she was paying an annual compound interest of more than 70 percent. The nanny was not alone: in 2010, according to a household financial survey conducted by Chile’s central bank, the average Chilean household devoted 38.3 percent of its income to repaying debts. Low-income families allocated 6 out of 10 dollars they earned to debt repayment.

This indebtedness was a relatively new phenomenon. Prior to the 1980s, Chile had no meaningful consumer loan market. With inflation around 30 percent, interest rates were negative, and so people saved very little. Access to mortgages was also extremely rare, and the vast majority of the population was renting. Over 90 percent of the population was unbanked.

But as the Chilean economy grew rapidly in the past two decades, so did consumer credit. Chileans started lending, at extremely high rates, with the young and the less-affluent lured into debt through predatory techniques. As people became more and more reliant on credit for paying their bills, banks were charging high rates that made it extremely difficult for borrowers who got into debt to get out.

Those that couldn’t pay their debts were registered as high-risk borrowers in a public database known as Dicom, which tracks individual or company activities in the Chilean financial sector to assess credit risk. Inclusion in this database could seriously harm their ability to apply for jobs and mortgages in the future. It also meant that the terms of their loans were changed, and they were forced to pay a maximum interest rate (Tasa Máxima Convencional) of at least 57 percent. Along with additional costs, like insurance and service charges, this pushed the total annual rate they were paying to well over 70 percent. In 2011, as Cumplo was beginning its operations, there were 4.1 million people registered as debtors in Dicom, out of a population of 17.2 million at the time. 

According to OECD figures, the ratio of household debt to disposable income in Chile is 61.5 percent, which puts it at the low end of OECD countries, compared with 292 percent in Denmark and an OECD average of 129 percent. Nevertheless, the number of people listed as delinquents on Dicom in December 2015 was 3.8 million, despite a 2012 law (known as “Borronazo”) that removed 2.8 million people from the registry.

The law regarding the maximum interest rate also changed in 2013, and the Tasa Máxima Convencional has gone down significantly, but the average (nominal) lending rate for consumers in Chile was still 20-25 percent as of last month

The Chilean banking industry is highly concentrated, with the three largest banks—Santander Chile, Banco de Chile, and BCI—accounting for 50 percent of loans and nearly two-thirds of the profits (as of 2015).

Following Chile’s banking crisis of the early 1980s, the government took control of many of the nation’s banks. These banks ended up with major “subordinated debts” to the central bank, which banks paid annually as a percentage of their profits. These debts, according to the Chilean economist Manuel Cruzat Valdés, created a strong incentive for the government to keep the banking system a “closed club.”

“Authorities disregarded competition for the sake of a Central Bank debt collection, but in the process they concentrated the allocation of capital into a small but powerful group, with negative consequences on competition levels in the credit sector and, by consequence, all over the economy. Credit from banks was—and is—dominant in total credit allocation, as opposed to the U.S., where capital markets effectively allowed credit alternatives to those coming from banks. The end result was extremely high levels of concentration in almost all economic sectors, cross shareholding practices, and interlocking, to say the least. Collusive practices were just a natural but more extreme consequence of this process. However, much more important and damaging because of its massiveness, was a dormant competitive environment born out of these conditions,” says Valdés.

The banking industry’s return on equity was 12 percent in September 2016, down from 15 percent a year earlier and 19.5 percent in 2010, but still relatively high compared to 9 percent in the U.S. According to Shea, “most of this profitability comes from either consumer loans or small businesses because with larger companies, banks have to compete with global capital markets.”  

Banco de Chile, Banco Santander, and BCI jointly own Transbank, which handles all credit card transactions and online payments in Chile. In January, Chile’s competition court (Tribunal de Defensa de la Libre Competencia, or TDLC) asked the executive branch to introduce changes to the banking law that would ban any joint coordination between banks when it comes to Transbank or their other partnerships in debit and credit cards.

The lack of competition in the banking industry was reinforced by a lack of information: in Chile there is no credit score system that is available to the public and to new entrants. Banks and other financial institutions are not required to disclose information on financial transactions, making it impossible for new entrants to have any information regarding borrowers and consolidated levels of debt. This lack of information later proved to be a crucial factor in determining the future of Cumplo.

Cumplo was launched in the aftermath of the financial crisis, at a time when interest in peer-to-peer lending was exploding around the world. Inspired by other peer-to-peer lending platforms such as Prosper.com, it began as a platform offering small consumer loans: borrowers deemed eligible, according to a set of criteria which included the company contacting their employers (installments were paid directly through payroll deductions), were matched with willing lenders. To avoid usury, a maximum installment worth 15 percent of borrowers’ gross monthly income was set. Borrowers set the highest interest rate they were willing to pay and the sum they wanted to borrow. Similar to other crowdfunding platforms, interested lenders could then choose who to give to and how much of the loan they would cover.

Other P2P lending platforms around the world, like Prosper and the Brazilian Fairplace, have faced strong regulatory and legal issues, and Cumplo was no exception. But the response Cumplo faced in Chile was tougher than what other P2P platforms have had to face.

Class presentation of the Cumplo case study. Front, left to to right: Nicolas Shea, Luigi Zingales

Expecting a harsh response from the banking industry, Shea consulted a couple of prominent banking lawyers before starting Cumplo. “You are insane. This can’t be legal and if it were, banks will smash you in a heartbeat,” one lawyer friend told him in 2011. The lawyers, he says, understood that Cumplo did not take deposits and that technically there could not be financial intermediation, but they realized it was a fine line. “We would need to go in further, but from what you tell me, you are the marketplace, not the intermediary, so it is not illegal,” another lawyer told him at the time.

Before launching, Shea met with Chile’s then minister of the economy, Pablo Longueira, who as a senator had spent years on the financial committee. His estimated that Cumplo should not consult financial regulators, since its operation doesn’t take deposits or invests money. Later on, Cumplo consulted Victor Vial, former general counsel of Chile’s Central Bank and a top banking lawyer, for a formal legal opinion. According to Shea and Monge, Vial praised Cumplo’s business model, concluding that “If there is any intermediation in Cumplo, it’s of people, not of money.”

Cumplo was started in August 2011 and its first loan was financed in March 2012. Initially, Cumplo found some success. In its first nine months, lenders on the platform provided roughly $87,000 in loans. The growth of the site attracted the attention of the press, and the article in La Segunda that appeared in May 2012 made the small start-up seem like a potential threat to the banking industry. Subsequently, the regulator charged Cumplo with violating the banking law.

“The banking regulator called [Monge and Boudeguer] up to his office in June 2012. He told them ‘Kids (cabros), I’m glad you came. I wanted to make sure that you understood what is going on here, because what you are doing is illegal and if you keep doing it I will press criminal charges against you,” says Shea. “After explaining what we did and asking him what was wrong about it he said that he didn’t really care to understand. All he said after he couldn’t explain our wrongdoing was ‘I’m not a lawyer, so I can’t go into technicalities. All I know is that I got notice from the general counsel of [an incumbent bank] that what you are doing is illegal and if you don’t stop doing it within the next 48 hours, I will start a criminal investigation against you personally and you will risk 541 days in jail.”’

Hoping the troubles would go away, Cumplo tried to appease the regulators. In meetings with regulators, Cumplo executives were told that the main concern was the platform’s use of virtual accounts. Cumplo did not hold deposits, but it did have virtual accounts in which lenders’ funds were kept as collateral. As a gesture to regulators, the company modified its platform and removed virtual accounts, hoping the situation would then be rectified, but to no avail: a criminal investigation ensued. In July 2012, policemen raided their offices. Days later, Shea and others were interrogated. “‘Let me give you some advice, kid,’” Shea was told by a senior industry representative around that time. “‘Your business is too dangerous and complicated. You should forget about it.’”

As the crisis escalated, so did pressures from both family members and counsels to give up the business. “In October 2012, my 10-year-old daughter asked me, ‘Daddy, will you be home for Christmas or will you be in jail?’” Shea recalls.

Cumplo’s case also received considerable media attention, both from domestic and international outlets like The Economist, which criticized Chile’s government for putting the company “through regulatory hell.” The media attention eventually allowed Cumplo to fend off the initial attacks.

Problems on the business front

While it was dealing with its regulatory challenges, Cumplo was also dealing with another problem: business was not going well. There were too few borrowers, and many of them were extremely high-risk. Lenders, fearing adverse selection, were hesitant to put money into the system. Lacking information on borrowers who weren’t registered on Dicom, Cumplo couldn’t offer lenders to screen for borrowers who they might deem too risky.

Its legal troubles did not help: the company’s investors feared that the toxic mix of legal battles and risky borrowers meant their investment could never be recovered. In its first year of operation, the company lost $487,842. It lost $941,146 in 2014 and $862,003 in 2015.

Ultimately, Cumplo chose to pivot. Instead of providing consumer loans, it would now focus on the SME market. SMEs have limited access to credit, and often face high interest rates. 68 percent of financing for SMEs in Chile comes from equity, compared with 20 percent in the U.S. As a result, although they employ a majority of Chile’s workforce, SMEs account for only 17 percent of the GDP.

For Cumplo, this presented an opportunity: SMEs needed alternatives to bank credit and their risk-level could be more easily discerned. “We moved to small businesses for two reasons,” says Shea. “First, there’s more information on the business. You have balance sheets. You have tax history, and you can assess the business by itself and by the industry. The second is that an invoice is a very strong collateral for a loan.”

In its current iteration, Cumplo has begun to find some success. The company has recently reached the threshold of $10 million loans financed per month and should reach $200 million this year, according to Shea. After five years of operation, last month the company has finally reached break-even. The average loan, he says, is around $37,000 and is financed by 11 investors.

Shea, who briefly attempted to run for Chile’s presidency earlier this year, says he is optimistic about the future of Cumplo, but while the company has found some success in the SME market, its regulatory problems are not over. Nevertheless, its early struggles point not only to the troubles that many other P2P lending platforms face regarding the feasibility of their models, but also to the way regulation can be effectively used by incumbents to stifle competition.