At first glance, peer-to-peer (P2P) lenders appear to have no credit risk. The platforms simply act as shop windows for companies requiring financing, allowing them to appeal directly to retail investors – 28,562 individuals have lent a total of £265.4 million to businesses via the largest UK platform, Funding Circle, for example. But, even if they have no capital at stake in each loan, the P2P firms do take responsibility for the quality of their would-be borrowers and will suffer if investors take heavier than expected losses – a risk profile that makes them roughly comparable to rating agencies.
With the sector growing quickly, and some P2P firms planning to take on higher-risk borrowers, much depends on how this credit-contingent reputational exposure is managed.
"My view is that actually, because of our level of transparency, we have a far more profound level of risk if we don't get this right. My friends and family have money with Funding Circle – we have a duty of care and we need to make sure the environment is risk controlled. If we get it wrong, we jeopardise confidence and trust in what we do, and therefore I think it is in some ways more profound as a risk," says Andrew Mullinger, the London-based co-founder of Funding Circle, who leads its risk management and compliance efforts.
Comments from lenders who have lost money bear this out. In an email exchange with Risk, one US-based investor claims to have lost roughly 15% of the cash he invested via Funding Circle, and to have stopped using the service as a result. "I didn't think it was worthwhile," is his final assessment.
Other lenders voice a variety of frustrations in online forums, with one claiming to have withdrawn the majority of his funds because he was disappointed with Funding Circle's efforts to chase down defaulted borrowers – something banks employ armies to do (see table A).
Our biggest fear as a business is… a rogue within the peer-to-peer lending community
A. UK peer-to-peer lenders
Interest advertised by company
Between 6% and 15%
Between 6% and 13%
Between 6% and 12%
Between 6% and 11%
Between 12% and 18%
So far, though, the critics are in the minority. Funding Circle's official default rate is 1.4%, and it says none of its investors have lost money when pursuing a diversified lending strategy for at least 12 months.
But, even if the lenders keep their own houses in order, it might not be enough. "Our biggest fear as a business is a black swan – a rogue within the peer-to-peer lending community that doesn't lend properly. They do a deal, default and everybody loses all their money. If you ask any of the platforms, it's their biggest fear. All we can do is make sure we do things in the right way so, in that event, we can hold our heads high," says Andrew Holgate, managing director for business loans and co-founder of Assetz Capital in Stockport, in the north of England.
For the time being, Holgate declines to say whether other platforms are doing their job properly. "It's not something we're in a position to speculate on. That's why it's so important we're being regulated by the Financial Conduct Authority (FCA) – the industry now has the benefit of an impartial third party to ensure all firms are conducting business in an appropriate manner," he adds.
The FCA started overseeing the sector on April 1. Platforms are now required to hold capital to guard against sudden insolvency – and must ensure investors do not pledge more than 10% of their net investable assets.
Currently, each platform manages risk in a slightly different way. Some use a mix of credit-scoring services and in-house analysis, while others make their decisions in a decidedly old-school, face-to-face manner. In some cases, they take collateral.
The lenders first emerged about four years ago, when traditional business lending in the UK came under pressure. They now include colourfully named firms such as Assetz Capital, Funding Circle, FundingKnight, Rebuilding Society and ThinCats. Those five have so far collectively lent about £360 million to small and medium-sized enterprises (SMEs). That is a fraction of the £40 billion lent by banks to SMEs in 2013 alone, according to figures published by the Bank of England last month, but the peer-to-peer business model has been gaining credibility.
"We had one guy, who originally came on the platform with £1,000, asked an awful lot of questions about what was going on and then said, ‘I obviously need more on the platform than £1,000,' and he sent £499,000. Later on, we found out he was an investment banker in London. In fact, we have a number of investor-bankers and they tend to be the bigger lenders. There are three lenders who each have over £1.5 million on the platform," says Peter Brown, finance director at ThinCats, which is based near Tamworth in the Midlands.
Funding Circle requires a minimum investment of £20, with the opportunity to earn up to 15% interest, while firms such as ThinCats target higher-end investors and request at least £1,000. In most cases investors compete for loans via an auction system, with each specifying the amount they will lend and at what rate, and the credit facility being filled with the cheapest offers first.
The P2P lenders make money by matching lenders with borrowers, giving a clear disclaimer that the investment return could be variable, and take a small cut every time an SME makes a loan repayment, which is typically every month.
The platforms make equally clear statements about the quality of the lending companies they put in front of prospective investors. "We only allow creditworthy businesses to borrow through Funding Circle," is a typical statement.
With investors relying on the ratings firms provide, the platforms' prospects hinge on how accurately they are able to judge the creditworthiness of individual SMEs and how well they relay this information to individual lenders. There are subtle differences between the platforms on this score.
Funding Circle and Rebuilding Society function in broadly the same manner. Once contacted by an SME, the P2P lender obtains information on the company's financial history through scoring services such as Experian. The borrower's score is fed into an algorithm – which, in Funding Circle's case, took two and a half years for the firm to build. The risk grade it assigns is then assessed by the platform, and might be changed. Funding Circle's grades range from A+ to C-, whereas Rebuilding Society's go from A to C. FundingKnight assigns a so-called ‘shield rating' of between one and five.
How reliable are these assessments? At Funding Circle, 45 of the company's 130 defaulted loans come from grades A+ or A -, which is 35% of the total number of defaults to date, and more than the proportion in grades C and C-. But the company notes that the A+ category is the oldest book of loans, while C- was only introduced in July 2013.
Other firms take a more qualitative approach to credit assessment. SMEs seeking financing through ThinCats, for example, cannot feature in an auction unless they have a sponsor supporting them to assess their business proposals, vet applications for loans and answer questions from lenders. In effect, the firm outsources some of the risk management to these sponsors, whom the firm claims are often financial advisers or ex-bankers with experience in risk assessment.
"ThinCats is not computer based; it's human based. It is really about people meeting with clients who want to borrow money and writing a report, and then people are welcome to ask questions about it. But the human interface is the significant difference. We still look at credit scores, we still look at accounts, but it's all about balancing what the numbers tell you with the non-financial information," says Richard Mason, Birmingham-based director at finance arranger Ludgate Finance – ThinCats' biggest sponsor.
Similarly, Assetz Capital meets with potential borrowers to obtain as much information as possible before making any investment decisions, says Holgate. The process can take anywhere from seven days to six months, but is typically around eight weeks.
Assetz Capital adds an additional layer of protection for lenders by requiring borrowers to provide security in the form of a ‘tangible asset' – often a property. Having that safeguard in place creates a psychological incentive to avoid missing payments, says Holgate, who adds that none of its 80 borrowers have defaulted since the firm started lending 18 months ago.
In addition to carrying out basic credit analysis and, in some cases, collecting collateral, the platforms encourage investors to spread their risk as widely as possible rather than lending to a single company. Funding Circle suggests investors become a member of what it calls the ‘100 club' – lending to at least 100 businesses with a single-counterparty credit limit equal to 1% of an investor's portfolio – and it says those investors who have followed this rule for at least 12 months have seen uniformly positive returns. Platforms also offer a secondary market for loans in which investors can sell all or part of an asset, assuming there is demand, of course.
Despite the dangers that might emerge in a fast-growing, immature sector, P2P lenders are bullish about the future and claim to be ready to take on additional risk. ThinCats expects its loan book to more than triple by the end of 2015, while Funding Circle is considering the introduction of riskier D and E grades in an effort to attract more business.
"We monitor all businesses that come to us, even the ones we reject. If we are to introduce additional risk grades, we need to make sure the businesses we accept into the initial risk upgrade are appropriate for the debt and that it is affordable to them, and that we can accurately measure the risk associated with lending to that type of business. As long as it all makes sense we can potentially go into other risk bands," says Funding Circle's Mullinger.
Assetz Capital's Holgate claims the firm's moral compass will help ensure it does not start cutting corners.
"One of the reasons for setting up Assetz Capital was the way banks had started to become sales organisations and lose their customer focus," he says. "That led us to the payment protection insurance scandal in the UK and the Libor rates-fixing scandal. It was always about where the next pound was coming from. Yes, I'm in business to make money, I won't hide the fact, but you can do things the right way and I think the ethics of the banking industry have been lost somewhere along the way."
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