As stronger signals regarding interest rate rises begin to emerge from the noise of data regarding the health of the UK economy, there are some interesting challenges ahead for the P2P industry – especially when you consider that the last time rates went up, most of the platforms didn't exist.
As rates rise, will P2P lending continue to be an attractive market for both lenders and borrowers? At Growth Street, we believe the answer is a resounding "Yes!", but as with any change to the rules of a game, there will be some losers as well as winners.
At a high level, P2P platforms currently benefit from a number of structural advantages over banks and are therefore in a position to continue to offer better rates to both sides of the market place. Regulatory advantages aside, P2P platforms operate digital business models and thus operate on a lower cost footing than banks – they employ fewer staff, they don't have branches, and operate more modern (and thus more agile and cost effective) technology systems.
Most will argue that as rates rise, the effect on the P2P industry is that the whole market just notches up to a different level – borrowers are charged more, and lenders receive more – just as it happens in the mainstream banking market.
However banks have considerable balance sheets comprised of all their existing lending and borrowing activities. The net interest margin they earn (the difference between what they pay out in interest to savers vs. the higher amount they charge borrowers) has been squeezed by a low rate environment. Rather than shifting down in lock step as rates fall, the average interest they receive from lending has fallen more than the average interest they pay out.
The reason? A large proportion of deposits held by banks prior to the crisis were already at low rates, and couldn't fall lower than zero. As rates rise, it's likely that banks will continue to maintain a large proportion of deposits at low rates, reducing the cost of funds for their borrowing activities. Banks then have a choice – keep borrowing rates low and under-price the competition, or keep pace with the market and make more profit.
Does the same logic hold true for P2P platforms? Yes and no.
First, recognise that those lending money via P2P platforms are more likely to be price sensitive – it's probably the primary reason they chose to lend P2P rather than put their money in a bank savings account.
Second, look carefully at the rate structure of the main P2P platforms, and the barriers to lenders from withdrawing funds from the platform and investing their money elsewhere (see table below).
|Lender Proposition||Fixed interest rate (the minimum rate is guaranteed) for up to 3 or 5 years||Fixed interest rate for each successful loan bid for terms from 6 months to 5 years||30 day. 1, 3 or 5 year fixed rate markets|
|Borrower Proposition||Fixed interest rate over a 1 to 5 year term set by zopa||Fixed interest rate made from a composite of the successful lender bids||Fixed rate for loans over terms between 6 months and 5 years|
|Early Withdrawal||Another lender must agree to buy the debt. This may require setting the loan at a discount to match the prevailing market rate. The original lender also has to pay a 1% fee and any remaining interest for that month.||Another lender must agree to buy the debt. The original lender can set a discount (or premium) when offering loans for sale.||At RateSetter's discretion and subject to the availabilty of funds (i.e. other lenders are prepared to step in, presumably at the same rate). The original lender also has to pay a 0.25% fee.|
Source: Company websites
Notice that borrowers on the three biggest UK P2P platforms are all paying fixed interest rate loans. As interest rates rise and borrowing gets more expensive for new customers, existing borrowers pay the same. They're winning here as their cost of borrowing is cheaper than the new, higher market rates.
The opposite is true for lenders. As most are being paid fixed rates, they lose, because new lenders are likely to earn higher returns as interest rates increase. Lenders could try and withdraw funds and reinvest at better rates, but that's dependent on another lender being prepared to buy you out.
The dynamic in the RateSetter market is particularly interesting. Fixed rate borrowers are being funded by quasi variable rate money, if the 30 day lender market provides the bulk of the funding. This combination of duration and rate mismatch could set up some interesting challenges for the platform. This perhaps explains why RateSetter recently ran a promotion paying a cash back incentive for lenders to add funds to their 1 year or longer duration markets – and in so doing temporarily caused an inverted yield curve, where short term money attracts a higher price than long term money.
So how will price sensitive lenders on P2P platforms react to rising interest rates? Will they get frustrated when it becomes difficult to take their money out early because no one wants to buy their low rate holdings? Will the withdrawal fees make some lenders reconsider P2P? Will the prospect of earning below market fixed rates make bank deposit rates more attractive next time round? Will more lenders look for variable rate deals for shorter durations? And as for borrowers, will they continue to perceive P2P lending as a better alternative to banks?
It's possible that a significant part of P2P lending was to customers that banks found it uneconomic to serve in a low rate environment. As rates rise, P2P platforms can expect to face increased bank competition for borrowers. Further, new lenders may demand higher rates for their money given the expectation that rates will continue to rise (and taking into account the lock-in periods associated), forcing up the cost for borrowers.
It will be interesting to watch how the market reacts over the coming months and years, and whether the structural advantages of the P2P market will more than compensate for the distribution power and balance sheet size of the traditional high street banks. How the platforms navigate this new, rising interest rate territory could have a significant impact on the attractiveness and vitality of the nascent P2P industry.