Funding Circle has run stress tests on its loanbook after being called on by institutional investors for a demonstration of post-Brexit resilience. The tests were in fact underway prior to June's vote, but plans were accelerated by the UK’s decision to leave the European Union.
In Funding Circle's base case (prevailing market conditions), the lifetime net yield of the existing loanbook was 7.2 per cent. The lifetime net yield for new loans was the same. Funding Circle ran two stressed scenarios: its own model, which mirrors 2008/9 conditions; and the Prudential Regulation Authority’s 2016 stress scenario, which is considerably more severe.
In the former case, net yield for the existing loanbook was 6.4 per cent, while new loans were projected as delivering 5.8 per cent. These returns are projected in spite of 36 months of recession (beginning January 2017), SME failure rates doubling, and a 20 per cent fall in the House Price Index. This final point is important because a significant proportion of Funding Circle’s book is now comprised of property backed loans.
The PRA scenario entails a recession, starting immediately, and running for 60 months; an unprecedented property crash, with HPI down 30 per cent; GDP growth down by a third; earnings growth down 20 per cent; CPI growth reduced by a fifth; the 5 year gilt rate decreasing by 40 per cent; and the base interest rate falling to 0.0 per cent. Speaking at a breakfast meeting this morning, Funding Circle’s chief risk officer Jerome Le Luel,who joined from Barclays in July of last year, said that the PRA effectively run this scenario to “shock the system” and to understand which of the big banks would fail. Under these conditions, Funding Circle’s existing portfolio yielded 5.7 per cent, while new loans delivered a net yield of 3.9 per cent. The full results are shown in the table below.
These results, as Le Luel and co-founder James Meekings (pictured above) reminded attendees, do not mean that no Funding Circle investors would sustain losses. But what they do suggest is that overall pool of loans “makes sense”. Of course, not all investors will be fully diversified, and concentration risk would likely play a key role in determining individual performance.
Meekings also said that all forecasts point to there being a “mild recession” post-Brexit, if there is to be one at all. In a mild recession, net yields at Funding Circle would sit somewhere in between the platform’s base case and the 2008/9-style scenario.
Both Meekings and Le Luel made great play of Funding Circle’s flexibility as a means of being able to anticipate and react to downturns in the economy. The latest stress test assumes that Funding Circle changes nothing about its credit criteria for new loans, but in reality the platform would likely tighten procedures in advance of a recession. Le Luel suggested, for instance, that the platform could stop offering E loans, a risk band which Funding Circle introduced last summer.
Le Luel pointed to examples in the form of Funding Circle’s US and European businesses. Both more recent addition additions to the brand (both via acquisition), Funding Circle has been forced to scale back lending while tightening credit in the US and in Europe over the past few years. A particularly poor performance in the US business’ Q1 2015 loan vintage prompted Funding Circle to temporarily slow down lending while taking the time to understand what had gone wrong. Similarly in Europe, following the acquisition of Zencap in October 2015, Funding Circle found that gross rates on the continent were too low, at 7-8 per cent, and had to be bumped up to around 10 per cent in order to deliver a solid net return to investors. Meekings argues that banks simply cannot make adjustments in the way that online lenders are able to. Le Luel added that Funding Circle loans “wash away” very quickly because they are amortising loans. Banks, on the other hand, have vast amount of overdrafts and revolving credit on their balance sheets, making adjustments more difficult to execute.
Meekings hopes that the stress test will help to quell fears about Funding Circle not having been through a recession. However, he also made the point that while the platform only launched in 2010, 53 per cent of the platform’s borrowers have been around since before 2008. In other words, the majority of Funding Circle’s borrowers have weathered a recession, even if the platform itself hasn’t.
Funding Circle last ran a stress test in January 2015, using the scenario set by the PRA’s 2014 banking stress test. The methodology and the scenario each differed from those used in the most recent test, but the bottom line was that average annualised returns for Funding Circle’s investors remained upwards of 5.5 per cent. The 2015 test was administered by independent consultancy firm Hymans Robertson.
Asked point blank about growth over the coming months, Meekings said: “Are we going to slow down because of Brexit? No. We can keep our foot on the accelerator.” Le Luel concurred, saying that the platform’s current growth trajectory was optimal, while suggesting that faster growth would be difficult to maintain.