Opinion Alternative Lending

Dear Treasury Select Committee, please think very carefully before asking for skin in the P2P game

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Chris Philp MP made a suggestion in last week’s treasury select committee that will chill the blood of the largest UK P2P lending platforms. These platforms have to date originated over £7bn of vital credit to UK SMEs and consumers. 

Mr Philp made this suggestion to Andrew Bailey the new CEO of the FCA:

‘Why not require these platforms to co-invest, lets say 10% of the loan value, on their own balance sheet, either pari passu, or even the first loss piece, and if their own money was on the line, alongside that of consumers, that would concentrate their minds when it came to making good credit decisions.”

The proposal is perhaps not as alarming as I suggest. The UK P2P sector (or marketplace lending to use more up to date parlance) has heard the same refrain throughout its 10-year existence. A clear consensus has emerged that the commitment of actual capital is deleterious to the model to the detriment of both borrowers and savers.

But while the re-emergence of this question was in itself troubling, Andrew Bailey’s response that was by far the greater concern. 

“It is certainly an idea worth thinking about because it puts skin in the game.”

Mr Philp is identifying an entirely reasonable concern. It is critically important that a platform which originates loans is in some way aligned with the investors that are funding those loans. 

Given this criticism of appropriate alignment between platform and investor, the sector’s growth to date has been impressive. Perhaps more telling is the rapid adoption of the sector by professional investors. Institutional participation in this sector has expanded significantly. In fact, it has grown from a negligible amount two years ago, to nearly 50% of monthly loan origination volume today. With monthly origination averaging £272m over the last 6 months, that equates to £136m per month. This is a significant vote of confidence from professional investors that they are not concerned by a perceived lack of alignment. 

Clearly the regulator is less concerned about institutions. Professional investors should know what they are investing in, or at least understand the risks. But this rapid adoption by the institutions suggests that they have become satisfied that there is sufficient alignment between them as loan owners and the platforms as loan originators. But is that enough to reassure the regulator that retail investors are protected? 

Let’s first explore how marketplace lenders have to date been able to quell concerns about the misaligned incentives. The key factor in creating investor comfort has been disclosure. Most marketplace lending platforms provide investors with statistics about the historical performance of their platform. Many of the largest marketplace lending platforms go a step further, disclosing their loan books to allow investors to analyse the loans that they are making. Investors are able to monitor the behavior of these loans (most importantly whether re-payments being made) and in so doing review the lending track record of the platforms. This creates alignment. With limited barriers to entry, and a thriving competitive landscape, investors could desert a platform at the first sign of a deterioration of standards in their credit underwriting. In sum, if the lending track record of a platform deteriorates, investors could depart. A lack of investors could ultimately lead to the failure of a platform. If a platform makes bad loans, investors will incur losses. But without investors a platform could soon go bust. This means that the fate of the platform is inextricably linked to the performance of the loans that it posts.

The evolving market in these loans makes it extremely clear that investors favour the alignment created by disclosure over the alignment created by capital.    

The chart below shows monthly UK marketplace lending origination volume by platform. 

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The only platform in the sector to use capital to create alignment, rather than disclosure, is a tiny, and shrinking, black segment in the bars of the chart. In fact, the platforms that dominate monthly origination, and are consistently the fastest growing, are the platforms that provide the most disclosure.

Investors, both retail and institutional, are choosing disclosure over capital as demonstrating the clearest alignment between loan originators and loan owners. Mr. Philp’s ‘skin in the game’ idea is seemingly being rejected.

So why are investors not reassured by ‘skin in the game’? The commitment of capital by platforms, alongside investors, would seem to create the best form of alignment. However, in practice, it is hugely flawed. Firstly, the presence of capital being risked by a platform only brings reassurance if investors perceive the platform to be blessed with excellent insights into credit decision making. If management make bad lending decisions, it doesn’t matter that the platform will lose too – the investor could still incur losses. As such, allowing investors to review the lending decisions of the platforms in real time is infinitely preferable.

Secondly, the capital at risk only creates alignment if the loss of that capital would significantly hurt those who are making the lending decisions. In effect the founders, senior management, and the credit decision makers would all need to have significant amounts of their own capital at risk for any meaningful reassurance to be created. This is possible, but appraising how much capital needs to be risked for the action to be meaningful, and by whom, and in the context of their own personal net worth, is extremely difficult in practice. How much capital would the persons making the key decisions need to have ‘in the game’ for them to feel suitably exposed? One must not forget that Lehman Brothers had the highest employee ownership of any major investment bank, but that didn’t stop the bank making poor decisions.

Thirdly, requiring the platform to commit capital removes the valuable differentiation that this sector has created. As long as a platform is a simple matching engine between borrower and lender, huge costs can be saved, allowing a better rate for both parties. As soon as capital is introduced into the equation, these platforms begin to look like banks, the regulatory burden rises, and the value that has been created is eroded. This would also act as a huge constraint on growth, reducing choice for borrowers and shrinking the expansion of this welcome new entrant to the borrower landscape. Not to mention the regulatory challenge. The regulator would have to monitor how much capital was being invested, what type of capital was being invested, how it was being invested, etc.

All of these factors explain why investors are not reassured by platforms that lend alongside their investors but are instead favouring the platforms that use disclosure to create alignment. And this leads us to the strongest argument that should discourage the FCA from seeking to adjust the status quo, which is that the alternative, disclosure, is already functioning extremely well. 

And standards of disclosure are improving apace. As transparency improves, the alignment it creates between platform and investor becomes even clearer. The UK P2PFA, the industry body that represents the vast majority of the UK marketplace lending sector, made loan book disclosure a requirement of all member platforms last October. As a result, all platforms now disclose their lending track record. This is a clear indication that the platforms understand how important disclosure is in providing reassurance to investors and that they have every intention of providing the information required to allow for the appraisal of their lending performance.

That is not to say, however, that static loan book disclosure cannot be improved upon. The loan books in question are complex, and certainly beyond most retail investors in terms of allowing them to meaningfully assess what is going on. In practical technology terms alone, few consumers are likely to have the computing power, still less the expertise, to analyse a CSV file of as much as 22MB.

Equally, whilst key definitions have been standardised by the P2PFA, comparing platforms on a like for like basis using these loan books is near impossible. The characteristics of the loans vary, understandably so given the differing nature of the lending. Furthermore combining the various loan books is an extremely complex task. Certainly the statistics provided by the platforms themselves are hard to compare without making certain adjustments.  

The sector is working hard to develop disclosure into tools that can allow meaningful analysis of lending track records on a like for like basis. Zopa,Funding Circle,RateSetter and Market Invoice – 4 of the largest UK platforms by origination, together representing over 65% of the UK sector – allow exceptional scrutiny to be brought to bear on their lending by disclosing loan-by-loan, cash flow data to an independent data analytics company. AltFi Data uses this information to power a market data tool that allows in-depth, like for like, analysis of their lending on a real time basis. The charts below are a small sample of high level statistics showing lending rates, bad debt rates, and net investor returns. 

  • Average monthly gross interest rate by borrower type

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  • Cumulative defaulted principal, net of recoveries, expressed as a % of origination principal.  Industry aggregate figures.

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  • Net return, after platform fees and defaults, with recoveries added back, expressed as a 12 month trailing percentage. Industry aggregate figures.

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Further analysis is available including arrears, lending term, net lending, principal outstanding. All of this data can be viewed at the industry aggregate level, or by platform, or split up by loan type, security type etc. Analysis at the platform level can be sub-divided by risk grade, or borrower type, term etc. And the data sets can be downloaded, making the analytical permutations almost endless. Finally, as a result of the data being made up of every cash-flow from every loan, the analysis stretches back to the inception of the industry in 2005. 

This kind of tool, provided by an independent third party, brings huge credibility to the sector, and allows significantly more scrutiny to be brought to bear on platform lending. This in turn hugely enhances the alignment that can be created using disclosure.

As disclosure is developed into tools that allow rapid like for like analysis of lending performance, platforms can allow due diligence to be easily performed, further underlining their alignment with investors. It is worth reflecting, however, that whilst tools like this highlight the long track record that this sector has of delivering returns to its investors, the asset class is still incredibly young in the context of the wider capital markets. As an illustration, AltFi Data Analytics, the tool from which these charts have been lifted, was only launched in June of this year, i.e. the industry has 10 years of track record, but has only had a tool with which to credibly illustrate that track record for a little over one month. Building a track record takes time. Turning that track record into a credible history takes even longer. The leading platforms in this sector now deliver a near-complete level of disclosure. But those platforms must work hard to ensure that regulators and lawmakers are aware of these developments. Just as investors have derived reassurance from the sector’s transparency, so should the regulators and lawmakers.

Andrew Bailey conceded that he needed to take a closer look at this sector. In fact, he rather modestly inferred that, as yet, he would not class himself as being as expert as he would like. As a regulator, with one eye on systemic risks, one would imagine that when he sees the granularity of data that this sector is built up around, he will be pleasantly surprised. Firstly, he can provide assurance to Mr Philp that this level of disclosure serves as a significant mitigant to the risk of ‘misaligned incentives’. Further to this, he will likely also recognise that this level of disclosure has positive implications that reach across the entire financial system. His most obvious challenge will be encouraging all platforms to match the standards of disclosure that are upheld by the market leaders.

Given his desire to ensure that retail investors are provided with adequate protection, Mr. Philp is likely to recognise that the biggest beneficiary of disintermediation tends to be the consumer. If adequate levels of protection can be assured, then this disruption of the legacy banking system must surely be encouraged. Reversing that disruption would be a significant retrograde step. An appreciation of the unprecedented levels of disclosure that marketplace lending platforms are delivering should encourage Mr. Philp to support the better rates for both borrower and lender that the sector is providing. The treasury select committee was informed by Andrew Bailey, in the very same meeting, that the single biggest challenge facing the retail financial services landscape at present is ‘the long term savings, retirement and pensions issue’. The challenge now is for the marketplace lending industry to communicate to government that they are not part of that problem, but a critical part of the solution. To do that, the sector should aggressively advertise the extent to which it is using transparent disclosure to manage perceived agent/principal conflicts. When one also considers the associated benefits that this disclosure brings to the appraisal of risk across the system, it should represent some welcome good news for Mr. Bailey et al.  

Footage from the treasury select committee meeting is available here. Philp’s questioning about crowdfunding begins at around 15:27:00.

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