Market Lending vs. Traditional Fixed Income: Which has more Risk?

In this second instalment of my Survey of Market Lending from the investor´s perspective, I intend to analyze the risk of market lending, particularly Peer-to-Peer (P2P) Lending, in comparison to traditional fixed income tools such as bank deposits and bonds. While much is written about the advantages of market lending for individual borrowers and small business owners, the fact is that alternative finance will never grow to significantly challenge the incumbent banks unless fixed income investors begin to trust market lending for a significant portion of the investment allocations. Every Pound, Dollar or Euro borrowed is at the same time money invested by a counterparty. As the platforms grow, it is inevitable that a greater percentage of the funds invested must come from institutional investors who manage large sums of money rather than just from individual investors.  The borrower and investor side of the equation must grow together if the impressive growth projections fo

Risk management is a central function, and prime responsibility, of any serious investor advisor. The institutional investor’s perception of the risks entailed in P2P lending and market-based lending will ultimately determine when and how alternative finance becomes a significant challenge to traditional bank lending. A very simple, yet effective definition of risk is the probability of obtaining an outcome different from that which was anticipated when the investment was initially made, most especially negative outcomes, as investors are much more concerned by the possibility of losing their hard-earned capital than they are with the possibility of earning much more than expected in a given time period.

The most common form of savings is a simple bank deposit. American, British and Continental European savers all enjoy varying levels of explicit or implicit government guarantees on their bank deposits, generally amounts which are greater than the vast majority of savers ever hold in a bank account. However, in these times of quantitative easing and very low interest rates throughout the developed world, this guarantee comes at a very high price. The safety of government guaranteed bank deposits requires accepting extremely low or even zero real returns after inflation is taken into account.

As an alternative, many investors turn to traditional bonds, where yields are now generally somewhat higher than bank deposits. However, the real risk of loss of capital for bond investors is higher than most investors realize, even when dealing with the bonds of well known corporations. As can be appreciated from the table below, over 2% of investment grade bonds default on average during a ten year period, as do fully 23% of speculative grade bonds (that is, “high yield bonds” so common in the portfolios of yield-starved investors today)

How does P2P lending compare to traditional fixed income investing in terms of risk? Firstly, as critics (and banks threatened by disintermediation) will quickly point out, those who choose to invest their savings through P2P lending platforms do not benefit from an explicit or implicit government guarantee, as do savers holding bank deposits. While this is undoubtedly true, it is less significant than the detractors of “shadow banking” would like us to believe. It is very well demonstrated empirically by the leading P2P lending platforms that investors in a broadly diversified portfolio of P2P loans (that is, holding a large number of small loans to many different lenders) have enjoyed very good results, and have very rarely if ever lost capital over a several year period. At the same time, average returns for the vast majority of P2P lenders are several times higher than that available from bank deposits or bonds at this time. This very significant returns advantage for P2P investors applies even for those who have selected only the highest quality, and therefore lowest yielding, loans for their diversified portfolio.

However, in my opinion, the higher returns available to P2P lending investors, and the rates of default comparable to traditional fixed income investments are not the most important advantages of market lending over traditional forms of fixed income investing.

The primary advantage of P2P lending, and the reason that my investment advisory clients have fully converted their bond portfolios to market-based lending, is the different kind of systemic risk in the two types of investments. Systemic risk is defined as the risk which cannot be eliminated through increased diversification, that is, the risk inherent to the “system” itself, which will always be present whether investing in 20, 100, or even 10 000 different securities. In traditional fixed income investing, this systemic risk derives from the very nature of our highly leveraged banking system, where bank reserves are only a very small fraction of their outstanding loans and other liabilities. Additionally, another element of systemic risk for traditional fixed income investors is the possibility of a sudden rise in interest rates due to another severe credit event, an increase in the inflation rate, a supply shock to oil or another key commodity, or an incident in the huge derivatives trading markets. Any of these events, all systemic in nature, along with dozens of other possible scenarios, could have a cascade effect adversely impacting the price of bonds worldwide. No bond portfolio manager, no matter how clever, can eliminate these risks through diversification of their portfolio.

In sharp contrast, P2P lending investors face a much more limited, and indeed much more unlikely, definition of systemic risk. For these investors, the only risk which cannot be eliminated through broad diversification of their loans and lending platforms is the possibility of a massive default by a large number of lenders due to some terrible unforeseen circumstance which would suddenly cause default rates to spike to very high levels.  Events which could have this impact might include another devastating war or a global plague. P2P lending investors must concern themselves with minimizing a single risk, that is, credit risk, something that can be achieved through diversification of loans on the same or various platforms, as well as through careful loan selections. The remaining risk that cannot be eliminated through diversification, that is, their particular systemic risk, is both more remote and unlikely than the systemic risk faced by traditional fixed income investors.

I often tell my new clients that one reason for my conversion to market-based lending as a source of predictable, attractive returns for my investors is the fact that during the course of a 25 year career as an investment advisor, I have lived through a “once in a century” financial crisis at least four times. Each of these crises took a huge toll on the value of the fixed income investments, whether held as individual bonds or in the form of mutual funds or unit trusts. I do not want my clients to have to endure losses from another manifestation of the different forms of systemic risk for the traditional fixed income markets in the future. As P2P investors are not leveraged as the banks are, and depend only on the ability to repay of their chosen borrowers, they are not exposed to the vast array of accidents and shocks that can shake the world bond markets at any time.

I recall during the darkest days of the most recent financial crisis, in 2008 just after the Lehman collapse, leaving work after a long and terrible day in the financial markets only to marvel at how in the streets of Madrid life was continuing as normal, businesses functioning, people going about their business, shopping, working and having coffee with friends. While the global financial markets were almost destroyed that week by the systemic risk of the overly leveraged banks, the real economy, though entering recession, continued to function.

Investors who opt for market-based lending are placing their confidence in this same real economy, and the reasonable expectation that despite whatever shocks may rattle Wall Street or The City, the vast majority of carefully selected borrowers on the various platforms will continue to make their P2P loan payments in all but the most extreme imaginable scenarios. I would much rather accept the remote systemic risk of some terrible globe-shaking event causing P2P default rates to skyrocket before accepting the much more likely and varied forms of systemic risk inherent in our overly leveraged and highly politicized banking and bond markets today. History demonstrates that another financial crisis at some point in the coming years all but inevitable. When this occurs, I would rather have my investment funds invested without leverage in a well chosen and very broad selection of P2P loans through a variety of platforms than as a part of the balance sheet of highly geared banks or in traditional bonds, fixed income funds or income unit trusts.