How online lending platforms can put in place the back-up servicing arrangements they need

By Marsili Hale, Associate Director at the niche law firm LCN Legal.

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A key feature of the FCA’s approach to regulating online lending platforms is to require that platforms have a back-up plan in place. Something or someone to ensure the existing loan book is run off with as little disruption as possible if the platform fails. This could be a contingency fund and detailed plan as to how to use it or, as preferred by many of the successful platforms, a back-up servicing arrangement. A back-up servicing arrangement involves the appointment of a third party loan servicer to step into the platform’s shoes to continue to administer loans and return funds to lenders in the event of a platform failure. It is fair to say that having back-up arrangements in place with a reputable loan servicer can also enhance the profile of a platform and its loan book in the eyes of lenders, institutional investors and those who may be looking to purchase whole loan books to hold or to securitise.

Back-up servicing for online lending platforms is a competitive market. Established third party loan servicers are actively seeking back-up servicing mandates from online lending platforms. However, platforms commonly face two issues when appointing back-up servicers. Firstly, servicers will do their due diligence thoroughly and will only want to back up those platforms which can give assurance that credit, reputational and fraud risk are managed effectively. Secondly, the fees both pre and post invocation of a back-up servicer represent a significant additional cost for the platform and the rates of returns that can be offered to lenders.

For a platform to attract the best loan servicers at the most competitive rates, preparation is essential. This involves considering four key areas, so that negotiations with prospective servicers can be as effective as possible:

  • on-boarding requirements

  • risk of financial failure

  • reputational risk

  • the proposed contract terms.

On-boarding requirements

In order for a back up servicing arrangement to be effective, a back-up servicer needs to be able to step into the platform’s shoes on short notice. This is described in the market as a ‘warm’ or ‘hot’ back-up servicing arrangement. The work involved to get the loan servicer to this position may involve the on-boarding of loan files, having live access to the loan data, and developing the necessary systems and technology.  To cover this, a set-up fee is typically payable on the signing of the back-up servicing agreement. On-going fees are payable to keep the servicer ‘warm’ or ‘hot’.

A platform should prepare for discussions with prospective servicers by compiling detailed information about the way it operates day-to-day. This will include, for example, details of the technology used to administer the loans, the banking systems and the service levels expected by lenders and borrowers.  To ensure the fast and effective transfer of servicing from the platform to the back-up servicer, there needs to be a certain depth of understanding and confidence in the operations and systems used to perform the loan services and any relevant technology needs to be able to be licenced to the back-up servicer.

Platforms offering niche loan products may find it more difficult to attract the more established loan servicers because of the time it may take to get the servicer up to speed with the asset class. Those platforms generally need to make more effort to document and explain their business and processes.

Risk of financial failure

In an ideal world, back-up servicing arrangements would remain as a back up. Servicers would receive fees for being on standby, but would not incur the risks of actually stepping in. Servicers will therefore want to a make a judgement as to a platform’s financial health to assess the likelihood of ever having to service the loan portfolio directly.  With online platform lending being a relatively new offering, many platforms are still in the start up phase without any real financial track record to assess.  It is therefore important for platforms to be able to present a full and considered picture of their business to loan servicers, including:

  • the platform’s underwriting and credit policy

  • past and present loan information

  • lender and borrower reviews

  • collections and default management policies

  • competencies of the management and operations team

In addition to assessing the likelihood of having to step in, servicers will need to be sure that they will actually get paid on an on-going basis if they do. As a minimum, servicers will want to ensure that their fees get paid first, in priority to all other creditors (including the lenders). Depending on how they assess the risk, they may also look for financial guarantees from the platform’s investors or institutional backers.

Reputational risk

Servicers do not want to have their name associated with a platform or loans that could have a detrimental effect on their reputation. Experienced loan servicers will therefore want to see that the platform has put in place robust compliance and governance procedures and that the management and operations team has the requisite knowledge and experience to successfully run the business in compliance with all applicable regulation. As part of this, loan servicers will need to make an assessment about data security and internal and external fraud risks that are relevant to the platform before committing to any back-up servicing arrangements. A platform seeking back-up servicing should prepare for this by being able to clearly communicate how the platform operates and how it manages risk.

The proposed contract terms

Back-up loan servicing arrangements can be complex, and it is easy for negotiations to be protracted especially if the parties need time to learn about how loans originated on a platform can be effectively serviced by a third party.  To reduce the time and cost involved, it is important to prepare by thinking about which aspects are likely to be most contentious and being able to address concerns upfront. It is also important to be clear about which contractual positions are essential, and where the platform has flexibility.  A free checklist of the key terms of a back-up servicing arrangement is available here

We reached out to some key industry participants, who explained their approach to winding down a loan book. David De Koning, Head of Communications at Funding Circle, said:

"Having a back-up service provider is a crucial aspect of marketplace lending and provides investors with confidence that there is no platform failure risk attached to their lending.”

"At Funding Circle, rather than lending to a bank, you are lending to lots of businesses, and all loan contracts completed are directly between investors and borrowers. This means in the unlikely event that Funding Circle was to cease to trade all loans would remain in place and be unaffected. Our S&P rated servicer of loans would step in and continue to collect repayments from borrowers, and distribute these to investors."

Jaidev Janardana, CEO of Zopa, explained his platform’s approach:

“Zopa has a transparent business model, with origination and servicing fees being the main sources of revenue. Our servicing fee averages approximately 1% annually, which is more than double our servicing expense. Thus, given the scale of our current loan book, the servicing fee revenue generated in a run off scenario will be more than sufficient for paying the costs associated with the run off. We believe that having a self-managed approach is the most efficient and therefore in the best interest of our customers.”

We’ve also received feedback from two well established loan servicers, each of which is currently working with a number of platform clients. Geraint Chamberlain, Principal Consultant at Target Group, offered the following key points on back-up servicing for platforms:

  1. Platforms are going through a dawn of realisation - back-up servicing may not be an option for platforms, institutional funders may insist.

  2. Clear and precisely drafted invocation criteria is essential for the back-up servicer to be able to step in effectively.

  3. The run-out strategy needs to be understood and documented with particular attention given to a customer communication plan.

  4. The amount of preparatory work undertaken by a back-up servicer to step in quickly comes down to the platform’s or the institutional funder’s appetite for risk. 

  5. Periodic reviews of a platform’s business is a good way to check for early warning signs that the invocation of the standby servicer could be triggered. 

  6. The technology of a platform is often bespoke and proprietary which can create challenges for migration of information.  To speed up the data transfer at the point of invocation and to facilitate regular data loads it is beneficial for the platform to provide data in line with the back-up servicers standard on-boarding data formats, as well as the back-up servicer gaining a detailed understanding of the platform’s data structures.

Godfrey Blight, Director at Capita Mortgage Services, also weighed in:

“Capita Mortgage Services are aware that this is a growing market and the needs of the Lenders are similar to a normal Lender. As such the requirement for back-up servicing is high on the agenda for most. Capita Mortgage Services has explored this as a market and has taken on some contracts although the due diligence required in advance of signing a contract is greater due to the additional risks of the market and certain Lender’s short tenure and servicing capabilities.”

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