Talk to any bond investor and they’ll probably be able to very quickly rattle of the credit rating of their top investments. Rating or grading bond securities is now completely common place and regarded as an essential part of the bond investor due diligence toolkit.
Lending to smaller businesses by contrast, especially SME (small and medium sized enterprises), has always been a much riskier game – everyone knows these small businesses are risky but exactly how much riskier are they? Efficient lending in all parts of the financial ecosystem is increasingly dependent on some form of rating or grade – in consumer lending for instance, grading systems are common place.
Big banks have traditionally operated their own internal credit scoring systems for SMEs, but these are rarely if ever revealed to outside investors. Lending platforms such as Funding Circle also offer simplified risk grades from A to E which give investors some idea of the ‘riskiness’ of the borrower (based on their own internal credit analytics). But many investors, especially those used to the ratings available on bonds, are probably looking for something a tad more comprehensive – imagine a hybrid between consumer credit analysis and big business bond rating service with transparent criteria and hard numbers to back up the analysis?
Peer to peer lender Thin Cats reckons it’s now come up a with a new tool that might just do the trick. It’s just announced a new two-tiered grading system for all loans on the platform’s primary market. According to Thin Cats this new system will allow investors to quickly determine two key factors that determine the quality of a loan: credit quality and security quality. Credit quality, the ability of a company to service its loan obligations, will be represented by a one-to-five-star grading. Security quality, the value of the underlying assets relative to the size of loan, will be represented by a one-to-five-padlock grading.
Alongside the existing loan information pack, which provides an in-depth overview of each loan, the new grading system will give quick-to-reference additional guidance to help investors decide whether to lend to a company, and the interest rate they would like to receive.
Thin Cats says each component used to construct both grades has been subjected to extensive testing against proprietary analysis, both previous loans issued on the ThinCats platform and the wider UK SME market – some three million firms, of which 0.5 million are borrowers.
“As peer to peer rapidly becomes a mainstream investment proposition, it’s even more vital that investors are armed to make sound decisions about the credit-worthiness of the businesses they choose to lend to” says John Mould, Chief Executive of ThinCats.” We’ve invested heavily in this part of the business, and will continue to introduce developments that improve service, and make peer to peer lending a reliable and rewarding mainstay for investors.”
This new grading system has been developed by Rolf Hickmann, Head of Credit Analytics at ESF Capital, ThinCats’ parent company, a specialist in the analysis of SMEs. ESF says Rolf has a reputation for deep analysis of business demographics, growth prospects, and sources of finance. According to Rolf “the star grading system developed for SME loans combines proven credit analytics with overlays of factors which our analysis has shown have a significant impact on insolvency rates. We believe that the resulting grading is the most accurate predictor available of an SME’s ability to service its debt across the cycle.”
Any rating or grading system that shines a light on the underlying risk characteristics of a loan is to be welcomed, especially one that offers a transparent set of criteria. The question though is how accurate these grades will prove, especially in a recession, although to be fair ESF (ThinCats parent company) does have a reasonably long track record in lending to smaller businesses.
Cynics might also observe that even the mainstream bond ratings can sometimes be dangerous, luring investors into a false sense of complacency – more than a few big institutions could be heard questioning after the global financial crisis, why their supposedly Triple A rated loans ended up being worthless. ThinCats to its credit emphasizes that its grades are only advisory, and that “lenders must make their own judgement when lending on the platform. The grades do not represent recommendation of specific loans by ThinCats.”