In the previous articles 1, 2, 3 I covered FS Risk – in #oldFS and #newFS - as I have seen it evolve over the past 30yrs from a philosophical perspective.
#oldFS lost its way on risk big time [obviously otherwise it wouldn’t have blown up].
Regulation has lost its way [infinite complexity far from being the answer ends up contributing to the problem]. Banking risk departments now have thousands of people in them and much that passes for “risk” is actually compliance box-ticking.
I find it a sad tale as, for all the increase in computational power and brainpower devoted to “risk management”, we arguably have a riskier Financial Services sector than 30yrs ago.
One of the fundamental issues is structure – risk management is one thing in a simple, limited business and entirely another in third-of-a-million people firms spread all over the globe.
We can hope that “disruptive Fintech” - especially P2P – whether in lending/borrowing or in FX et al - can be a part in a rebirth of the Financial Services industry into smaller, manageable organisations.
Buy-Side and Sell-Side Risk Management in P2P
P2P faces two directions on risk – the borrower-facing side (“buy-side”) and the lender facing side (“sell-side”).
Buy-side risk management consists of acquiring data about potential borrowers and then coming up with a filter (a risk model) to accept or reject. In most of the major P2Ps, as far as one can tell, this has worked very well to date – especially for a new industry.
Sell-side risk management lies with the lender (as the P2P “exchange model” takes (in principle) no principal risk). Naturally the P2P recognises its agency role in this risk process – the whole point of the borrower filter is to come up with healthy loan assets for lenders to invest in. However the lender bears the capital risk.
In order for lenders to “manage” their risk [plenty of media narratives around empowering lenders to do so] they need quality information on the risk they run.
So they get this?
I think – for many/most P2Ps they do not.
If the buy-side risk processes appear to be working well, the sell-side risk information has so far been rather neglected, or is at best vestigial (for the industry as a whole – always exceptions).
Regards risk information for lenders I believe P2P hasn't found its way yet.
The exception to the rule are those platforms that haven’t lost lenders any money. Then one might surmise the risk is low (it’s clearly not zero as I will come onto in the next article re Qualitatitve Risk in P2P).
Most platforms do a pretty decent job of informing lenders what the qualitative risks are.
Next to none – as far as I could see – inform investors of how much risk they would be running if they invest today!!
Say what?
Can you tell what the risk is – quantitatively - in investing on a given platform today?
I can’t.
Can you compare how good each platform is at credit risk management?
Not very easily.
It’s next to impossible if you lend on most platforms today to work out how much risk you are taking.
Nor is the raw borrower data available (in the minority of cases when a tiny part of the data that comes into the filter is presented to the lenders) sufficient for me to be able to model the risk myself. Transparency is a real hot topic in P2P – one simple way of quantifying it would be “what percentage of the data points that a platform has on the borrower you are lending to get communicated to you?” 0%? 10%? 20%? [Of course not all data points are equally important – but this percentage is a start and gets away from black/white views over transparency].
Let’s put this lack of lender risk information and lack of enough raw data to calculate yourself in the context of narratives about “P2P enables lenders to manage their credit risk”.
How on earth can lenders do that without any meaningful risk information?!
What Risk Information Is Published?
I examined all eleven P2Ps with more than 1% market share (~£10m loans to date) on the AltFi Data Volume Index.
About half of my sample publish the P2PFA-format “loan book performance by year”. I think the politest thing one can say about that format is that it is presumably better than what came before. And it is better than nothing. Marginally. Otherwise it’s apples, oranges and bananas and next to useless in trying to work out what your risk is if you invest today.
Actually it’s worse than apples and oranges as we know what they are. Looking at the key “expected losses” – some (conservative) platforms seem to treat that as “expected maximum losses” and some as nearer the mean of expectations.
For an industry that has prospered so well by putting the consumer first furthermore this loan-book perspective is a real “blast from the past” – data which is totally focused on a producers-eye-view of the world.
But this is a near-irrelevance to investors. At best you can tell that the portfolio risk models are not very accurate [generalising they can be 10x too conservative or around 2x too aggressive].
I Come Not To Bury Caesar But To Keep Him Moving Up The Curve
The best P2P platforms have come a long way baby.
I feel that the centre of the P2P peloton is getting on for halfway from the start to the “finish” of being a “fully grown-up”, solid, established FS company. Some are ahead of the peloton and some behind.
There is plenty of “sugar and spice and all things nice” commentary about P2P – but mixing metaphors, in a sector where the glass hasn’t been fully filled yet – there is less commentary on the “frogs and snails and puppy dogs tails”.
In focusing on the glass half empty my aim is not to get crossed off the Xmas card list of every P2P :-D rather to ensure more of them are around for longer and that lenders and investors get superior information in the future.
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It’s very easy to throw coconuts at a shy [actually it’s not – quite easy to miss – that’s the business model Ed. J].
In “How To Quantify Lender Risk In P2P” I cover my thoughts and suggestions about how to simply and usefully convey sell-side risk information to your lenders.
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Conclusion
Buy-side risk performance (filtering borrowers) has, in general, been first class - and excellent in some – especially given the nascent nature of the industry.
However sell-side qualitative disclosure of risk (to lenders) – for those with loss records – um, erm, cough – “has plenty of scope for improvement”.
The investor needs a simple and clear way of assessing his investment risk.
Ideally the industry as a whole (unless it’s going the #oldFS way) needs to help investors compare the risk management performance of platforms.
At present this is not possible – all one can compare (at best) is returns (in which risk is implicit but can only be grossly assessed from existing data).
If you run a platform it’s your choice. You can continue with regulatory body and trade body compliance, tick their boxes, never be blamed, maybe make a billion dollar IPO anyway.
Or you can act with a continuous commitment to upgrading quality and commitment to being a customer-centric business and keep upgrading your risk structure - from a risk committee of the board chaired by a non-exec (as with all established FS), through CRO, through to ever-improving buy-side filters and better calculation and communication of your sell-side lenders’ risks. Surely this will be a competitive advantage, especially with the inflow of institutional money?
And no I don’t think that is a false choice syndrome, I think it’s a real one.
To finish with a story in case you think this is “just” my take. I was talking to one of the few folks I know who understand in depth both #oldFS and #newFS and has been a poacher and gamekeeper.
He had subscribed to the idea of managing his own trading risk and opened a few accounts at some leading players. However he closed them again as he didn’t find enough risk information (or raw data) available for him to be actually able to manage his credit risk.
