The Bank of England will soon need to rediscover the use of its trigger finger and fire the starting gun on interest rate rises. Still expected to be slow and steady, tightening policy after nearly seven years of ultra cheap money will nevertheless have a sizeable impact on everything and everyone, pushing up borrowing costs and (hopefully) savings account interest rates too.
For the peer-to-peer (P2P) lending platforms, which enable individuals and businesses to lend and borrow from each other without going through a traditional financial institution, this will be something of a new experience.
Zopa, one of the market’s big beasts, was founded in 2005, before interest rates were slashed to their current level of 0.5 per cent. But as Louise Beaumont of GLI Finance, an investment company that invests through alternative finance platforms, says, “alternative finance providers have taken root in a benign interest rate environment... It will be interesting to see how robust their business models are as the cost of capital starts to increase.”
And this isn’t the only impending development. From April next year, P2P will be eligible for inclusion in the Isa wrapper – the new Innovative Finance Isa. This tax incentive and regulatory stamp of approval is expected to drive much larger volumes of money into the sector. So what could all this mean for P2P as an option for investors, and for the industry itself?
Investment through P2P platforms has grown rapidly over the past few years, by offering lenders better rates than high street banks, very low default rates (partly due to sophisticated credit check systems), and provision funds that will reimburse you if the debt goes bad. In the second quarter of this year, £500m of new money was lent through the eight major platforms, according to figures from the P2P Finance Association.
There are a variety of models in operation. Zopa could be termed “classic” P2P. You choose a lending term, your money is put into a queue and is then split into chunks of £10 that are matched with borrowers. Each month, you receive interest and capital repayments, which you can choose to roll-over into other loans or take out.
RateSetter is slightly different. It also allows you to set the term length, but you can determine what rate of interest you wish to receive on that loan. If no one bites, that money is left unlent, so there is a strong incentive to choose a reasonable rate. RateSetter has ambitions for its “People’s Rate” – dynamically updating to reflect supply and demand on the platform – to replace tarnished benchmarks like Libor.
Competitors include Assetz Capital, Lending Works, and variations on the theme like Landbay (which offers loans secured against buy-to-let properties) and LendInvest (which hosts secured property loans more generally).
The platforms are relaxed about interest rates rising and the economic environment changing. Landbay has even put itself through stress tests (which it claims are based on Bank of England criteria) to show that loss rates on its loans will not prove a problem for lenders, even if the economy tanks and house prices fall by 20 per cent.
Rhydian Lewis, chief executive of RateSetter, agrees that this “odd [monetary] environment has allowed companies like RateSetter to get going. It’s no surprise that, after a period of massive dislocation, new business models emerge.” But he does not think ultra low rates are a precondition of P2P’s success. “The most obvious point is that companies like RateSetter will only thrive if they continue to offer good value,” he says. “That’s the same if rates are at 0.5 per cent as if they’re at 2 per cent.”
IT’S ALL ABOUT THE SPREAD
But will they remain good value? Given that they have already gone out of their way to find a bank-like product that pays much more than the typical savings account, people who use P2P lenders are probably more price sensitive than the average investor. “I don’t think they are people who work in the City staring at yield curves all day,” says Giles Andrews, chief executive of Zopa. “But they are more savvy.”
When the Bank of England raises interest rates from rock bottom, and high street banks follow suit, one argument is that P2P will suddenly look less attractive. “It could be a major issue for those firms which rely on retail investors, who are now drawn to it in search of higher returns than traditional investment can offer, if they withdraw from the sector and go back to other asset classes as interest rates rise,” says Beaumont.
This may not be an issue for two reasons. First, the inclusion of P2P in the Isa wrapper from next year means lenders will effectively get higher returns (given they won’t be paying income tax) anyway. Second, there is an opaque connection between Bank Rate and high street savings account rates. While the base rate has remained at 0.5 per cent for nearly seven years, in April 2011 the average saver could earn 2.7 per cent on a one-year fixed rate Isa, according to Bank of England figures. In August this year, it was just 1.5 per cent.
The platforms also say that this is the wrong way of looking at it. Like banks, they operate within the spread between the rate received by lenders and paid by borrowers. It’s their contention that, due to their simpler, more focused models, and the massive amounts of new regulation facing the banks since the financial crisis, they can continue to offer better rates for both borrowers and lenders, regardless of what happens to Bank Rate.
“When we launched our business in 2005, bank spreads were narrow,” says Andrews. “Because the world was awash with cheap money back then, people were mispricing risk.” During and after the crisis, he says, bank spreads widened dramatically. Importantly, however, the return of liquidity has not seen spreads narrow again. “I believe we have maintained a structural cost advantage… I think bank spreads have returned to what will be their long-term level.”
There is another dimension to this, however. Investments through the P2P platforms are not backed by the Financial Services Compensation Scheme (which reimburses an individual up to £85,000 per institution, if that institution should fail), but default rates have been very low. Lending Works, which has both a reserve fund (to cover arrears) and an insurance policy to reimburse you for bad debt, had a 0.45 per cent default rate in 2014. Historical bad debt on Zopa (which also has a safeguard fund) has been 0.6 per cent since 2005. All the platforms have their own ways of minimising the risks to your money.
But some are concerned about the impact steadily rising interest rates will have on P2P loans. “The issue for lenders to be aware of is that people who have borrowed via unsecured P2P sites are likely to have other debts or outgoings which may be on a floating rate basis,” says Andy Sweeney, head of fixed income products at Ablrate.com. “Repayments on mortgages, credit card bills, and car loan payments would all be prioritised by borrowers above an unsecured P2P loan from anonymous lenders.”
When the tightening cycle begins, therefore, Sweeney expects default rates on unsecured P2P loans to increase more rapidly than those for, say, mortgages. “None of the platforms have been through a full economic cycle that includes rising rates. In a debtdriven society, it’s a rising rate environment that could be a threat.”
This doesn’t mean there is a problem with P2P, of course. It is just one of the risks to be aware of. “Obviously lenders can avoid this… by looking underneath the loan that they are investing in to become acquainted with all of the liabilities of the borrower,” says Sweeney. And some platforms are more transparent about the underlying loans than others. He also doesn’t expect P2P loan rates will need to rise until base rates get to 2.5 per cent or more (which is likely to be some time away).
Will a rising interest rate environment mean people become more attuned to risk? “It should do”, says Andrews. “I would like to think that people should be conscious about risk performance. They should look at the long-run performance of all investments, and make the most informed decision they can.”
And the platforms are more than aware of the potential impact of the economic environment changing. “One of the advantages of the provision fund model [wherein borrowers via RateSetter pay a fee into a fund to cover expected future defaults] is that we recognise that you’re going to have cycles – good lending years and bad lending years,” says Lewis.
So the next few years will be a crucial test. Will this exciting new model struggle in the face of rising defaults and disappointed investors? Or will it be able to prove its maturity and come out the other side stronger?