How Financial Regulations Can Create Barriers to Entry: The Case of Cumplo in Chile

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

By Asher Schechter of the Pro Market blog. Excerpts:

"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 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."

"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. 

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.’”"

"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."

"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."