How P2P platforms mitigate risk

According to the European Credit Research Institute, (The Business Models and Economics of Peer-to-Peer Lending” by Alistair Milne & Paul Parboteeah (No. 17 / May 2016) p. 6) peer-to-peer (P2P) lending in the UK has doubled every year in the past four years, with the stock of loans exceeding £2 billion in 2015.

What’s driving this growth? Borrowers see P2P as a vital supply of capital in a climate of reduced bank lending, (The Business Models and Economics of Peer-to-Peer Lending” by Alistair Milne & Paul Parboteeah (No. 17 / May 2016) p. 4-5) while investors see P2P as a way to earn an inflation-beating investment return when savings interest rates are at an all-time low. P2P platforms connect the two, allowing investors to lend money directly to borrowers.

However, as with any investment product, there are risks involved in P2P investing, with the primary risk for investors being credit risk, i.e. whether borrowers repay. So how do P2P platforms manage this risk from an investor’s perspective? 

Provisions against losses

Some P2P platforms operate provision funds to protect lenders from future losses, setting aside capital they receive from either borrowers or investors to cover these losses. In the event that a borrower fails to repay their loan, or pay the interest due, these provisions are typically used to pay lenders the money they are owed.

At Growth Street, our Loan Loss Provision holds capital to cover expected losses, as well as additional money to cover unexpected losses. Our coverage ratio (calculated as the size of the Loan Loss Provision divided by the amount of losses we expect) is currently 300%, which indicates Growth Street holds a large buffer to cover losses above those that are anticipated.

Diversification to reduce losses

By spreading your capital across different investments, you reduce the impact of a single loan default. There are two main ways that platforms offer diversification. 

Some platforms recommend customers manage diversification themselves. For example, one P2P platform suggests that lenders spread their investments across different borrowers so that no more than 1% of their total investment is lent to a single debtor. This way, lenders can limit the impact of a single loan default and dramatically reduce the likelihood of losing all their money, compared to if they were to invest in just a single loan.

Other platforms (such as Growth Street) offer automatic diversification, by operating a provision fund. By investing through a platform that provisions for bad debt, investors are able to benefit from the full diversification of the entire borrower portfolio, from the very first pound they lend. This is because provisions are used to pay lenders all outstanding capital and interest in the event of a borrower default. Lenders can therefore only suffer capital losses if the provisions are entirely exhausted, and this could only occur if several different borrowers default within a short period of time. Therefore, although lenders make loans to individual borrowers, the risk of them suffering capital losses is spread across every borrower in the portfolio

Different ways to recover losses

Borrowers may be required to provide security or guarantees when taking out a loan via P2P platforms. These are held on behalf of lenders to help recover losses if the loan were to default, by providing the lender with rights over defined assets.

For example, at Growth Street we take a charge over borrowers’ assets - should they default, Growth Street will seek to recover the loan amount by taking ownership and liquidating (i.e. converting to cash) the assets held by the company.

In some cases, we also take personal guarantees from individuals connected to the business. The individuals involved effectively promise to use their personal assets to repay the loan if required.

Integrated data to reduce losses and improve forecasts

Some P2P platforms integrate with external data sources to help measure the credit risk of borrowers throughout the life of the customer relationship, rather than just at the start. Growth Street, for example, integrates with accounting software providers, which give direct access to our borrowers’ financial data. This allows these P2P platforms to spot upcoming challenges in a timely manner, and share this insight with customers so that they can react accordingly. This helps improve the accuracy of risk measurement and allows platforms to more actively manage credit risk on behalf of their customers on an ongoing basis.

Key differences between P2P marketplaces and traditional savings accounts

The Financial Service Compensation Scheme (FSCS) guarantees bank deposits of up to £75,000 for small businesses with an annual turnover of less than £1 million. Investing cash in P2P markets does not carry this absolute protection, but some platforms offer different ways to reduce losses as outlined above.

No matter which P2P platform you invest through, there will always be an element of risk, and this is why these platforms generally offer higher returns than simply holding bank deposits. Therefore, understanding how platforms mitigate risk and protect investor returns should be core to your decision process.

Your capital is at risk if you lend to businesses. Lending is not covered by the Financial Services Compensation Scheme. Please read full risk warning here.

Written on in Investing