A few weeks ago, we took a look at both RateSetter and Zopa’s contingency funds and their respective coverage ratios. RateSetter responded to that analysis, assuring investors that its Provision Fund would “withstand the doubters”. RateSetter also removed the expected default rate from its website with the explanation: “These figures are not meaningful for the RateSetter model, since investors should not need to provide for defaults – the Provision Fund’s purpose is to cover defaults and each month we review its ability to do so (which is shown by the Coverage Ratio).”
In a post on its blog yesterday, RateSetter revealed two major changes:
RateSetter is now including income that is contracted to be paid into the Provision Fund by borrowers in the future into the coverage ratio calculation. We are told that this amounts to “
over £6m
”, albeit this figure is discounted by over 18% (RateSetter tell us the discount is actually closer to a third) to account for “
income [that] will not be received due to borrowers paying back loans early or defaulting
.”
The platform is also revisiting the Expected Future Losses figure for its portfolio. RateSetter has updated the expected loss figure
“to build in more prudence across all loans, partly to reflect greater economic uncertainty due to external events”
. This has increased expected losses by some £3.4m or 24.4%. This is a big jump in expectations. This essentially acknowledges that loss rates of recent cohorts have been higher than RateSetter’s initial expectations.
It is important to highlight that there is no new news here in terms of the trajectory of losses. RateSetter have simply updated their view of future losses to bring their expectations into line with the current trajectory.
The upshot of these changes is that, for the first time in the Provision Fund’s history, RateSetter tell us that there is not enough cash sitting in the fund today to fulfill all anticipated claims. However, taking into account the provision fund’s contracted future income, there is sufficient coverage, all other things being equal. Indeed, the coverage ratio has increased from 1.23x under the old methodology, to 1.27x today. This is towards the lower end of RateSetter’s target range of 1.25x to 1.50x.
Yesterday AltFi Data met with RateSetter’s new CRO, Cyrille Salle de Chou, and his team. Cyrille is a relatively new addition to the RateSetter setup, having previously been credit risk director for mortgages at Lloyds Banking Group. Cyrille explained the reasoning behind the recent provision fund coverage methodology change and reiterated Peter Behren’s view that the Provision Fund “will withstand the doubters”. Cyrille and his team were impressive. They have a good pedigree and suggest a strong focus on credit and risk at RateSetter. However the 24.4% upwards revision in expected losses could concern some investors. There is of course nothing to prevent a similar upward jump in the future – particularly if economic conditions were to deteriorate. A second increase in expected losses of a similar magnitude could mean that the Provision Fund’s coverage ratio falls below 1x, which would move RateSetter into uncharted territory – would they call a Resolution Event at that point?
The Provision Fund coverage ratio is a vital metric for investors to monitor. It gives an indication of how well funded the provision fund is in the context of expected future defaults. However investors should also sense check this number with the ‘bad debt fund usage’ figures shown on this page (second table from the bottom - shown in Figure 1 below also). If ‘bad debt fund usage’ is significantly greater than the ‘realised %’ (i.e. proportion of the cohort that has already been repaid), then investors should ask further questions of RateSetter’s coverage ratio assumptions. If significantly more of the part of the fund earmarked for a particular cohort has been used, than principal of said cohort has been repaid, it should ring alarm bells.
Figure 1: Loan performance table taken from RateSetter's website.
Peer to peer and marketplace investing relies on a certain amount of trust. Investors need to trust that Cyrille and the rest of the RateSetter team are getting it right. Investors also need to understand and remember that earning higher returns from P2P investing involves risk. Contingency funds help to reduce some of that risk, but they do not eliminate it. The FCA’s recent review included questions about investor’s understanding of the risks. We learnt yesterday, when the new chief of the FCA appeared in front of the Treasury select committee, that he is “pretty worried” about the way that peer to peer lending is sold to investors, with platforms getting “very near” to promising that investors will get their money back and will receive fixed returns. In providing enough information for scrutiny, encouraging scrutiny and engaging in debate around serious issues such as credit risk, RateSetter is showing that it is working hard to get it right.
