Brexit Confronts UK's Online Lenders With Biggest Test Yet

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at 2016.10.25
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Brexit Confronts UK's Online Lenders With Biggest Test Yet

British peer-to-peer lenders were preparing for serious trouble even before the Brexit vote rocked the U.K. on June 23.

QuickTake Peer-to-Peer Lending

Funding Circle Ltd., the No. 1 online lender to small and medium-sized businesses, carried out a stress test envisioning a three-year recession beginning in January 2017 that would crater the property market. If the U.K.’s split from the European Union wreaks that type of havoc, investors in the platform’s loans should still pocket a net return of 6.4 percent, says Jerome Le Luel, the firm’s chief risk officer. That’s not far off the 7.2 percent the loans should generate without a crisis.

“It’s good to know that when pushed to the extremes you can still make money,” says Le Luel, the former head of group risk analytics at Barclays Plc. “We’re not promising something that is going to explode.”

Yet that’s exactly what skeptics fear as Brexit menaces an industry that’s never endured a punishing economic cycle. With the falling pound already spurring inflation and gross domestic product growth expected to slow to 0.1 percent, the prospect of stagflation looms. So do loan defaults by distressed borrowers. Unlike banks, which underwrite loans and cushion risks with collateral and regulated levels of equity capital, peer-to-peer lenders connect borrowers with willing investors. The loans are often unsecured. 

Chris Philp, a Conservative member of Parliament who sits on the Treasury Committee, says Brexit could reveal how a model hailed as revolutionary may prove fundamentally flawed.

Skin in Game

“These companies are writing a large volume of loans knowing that if anything does go wrong they won’t suffer the consequences,” says Philp. “They don’t have any skin in the game and I am concerned that one of these companies could go ‘pop.”’

“That’s really misinformed,” counters Giles Andrews, the co-founder and executive chairman of Zopa Ltd., the biggest and oldest British peer-to-peer company. Zopa, which only serves prime-rated borrowers and has a default rate of 0.5 percent on its 2012 class of loans, would lose its reputation and fee income if it relaxed credit-management practices to expand lending, he says. “About a third of our revenue is earned through the life of the loan and that will stop if it doesn’t perform,” Andrews says. “To me that’s incredibly important skin in the game.”

The debate shows the tension at play as the industry, which accounts for just 3.6 percent of total lending to small businesses and consumers in Britain, tries to move into the mainstream. First developed 11 years ago by Zopa, the model has taken off around the world: Global peer-to-peer loan volume is projected to hit almost $350 billion this year, a 12-fold increase since 2013, according to research firm AltFi Data Ltd.

China, U.S.

Torrid growth has opened cracks in the industry’s two biggest markets. In May, LendingClub Corp., the No. 1 platform in the U.S., disclosed that it had misdated loans sold to an investor and committed other irregularities, triggering the departure of CEO Renaud Laplanche. The San Francisco-based company’s shares have fallen by more than half this year as delinquencies grew and new loans declined. Then in August, Chinese regulators launched a crackdown to curb widespread fraud.

The British market, the third largest with 7.7 billion pounds in cumulative loan volume, has so far sidestepped these pitfalls. Zopa, Funding Circle, and the other big platforms use the same credit-scoring databases as banks and diversify their investors’ lending across dozens of borrowers to lessen risk. In 2014, they asked the Financial Conduct Authority to regulate them to bolster their credibility.

Turner Turnabout

The British industry is winning over critics. In February, Adair Turner, the former head of the U.K.’s Financial Services Authority, predicted that peer-to-peer lenders “will make the worst bankers look like lending geniuses.” After taking a closer look, he changed his mind. “They might be able, if managed well, to do established forms of credit analysis as well or better than the incumbent banks,” Turner said in a speech in London on Oct. 11.

Last November, Funding Circle hired Le Luel, who was the chief risk officer at Barclays’s credit-card unit before taking charge of the bank’s group-wide risk analytics team. Soon enough, he noticed an alarming spike in delinquencies in debt originated by the firm’s U.S. division in the first quarter of 2015. He directed it to halve the number of loans it was arranging.

“We tightened the tap until we could figure out what was going on,” Le Luel says. While regulators haven’t asked online lenders to conduct stress tests, Funding Circle CEO Samir Desai agreed that it would be a good idea.

The fallout from the Brexit vote isn’t the only source of uncertainty facing the industry. After more than a year of review, the FCA has yet to clear the way for Funding Circle, Zopa and other big platforms to tap a deep well of new customers: the government’s Individual Savings Account program. Millions of savers use so-called ISAs to manage assets worth 518 billion pounds.

Under Threat

Meanwhile, Philp, the member of Parliament, is pushing for changes that could upend the industry’s economics. He’s asked Andrew Bailey, the head of the FCA, to consider requiring peer-to-peer lenders to invest their own capital as a portion of every loan they arrange for investors. He says this will motivate the platforms to be more diligent. It would certainly force the firms, many of which are struggling to reach profitability, to raise and deploy additional cash. With Funding Circle and Zopa now securitizing and selling their loans to institutional investors, Philp draws a comparison to the U.S. subprime mortgage crash. “We saw a similar situation in the run-up to 2007,” he says. “Whoever was doing the origination wasn’t keeping any balance sheet risk at all.”

Zopa’s Andrews says using your balance sheet to make loans doesn’t mean you know how to manage risk. Philp’s proposal would undo the innovation at the heart of the peer-to-peer model, he says. By playing matchmaker instead of using their own capital, these platforms can issue loans to borrowers in days instead of weeks and more efficiently. 

Policy makers keen to stimulate economic growth are embracing the approach. The week of the EU referendum, the bloc’s European Investment Bank started distributing 100 million pounds in loans to British small businesses through Funding Circle’s platform. The firm was hopeful it would be the first tranche of a recurring program. Now, due to Brexit, it’s probably a one-off.

At first blush, Brexit hasn’t frightened off investors. In September, British platforms originated a record 364 million pounds in loans, a 30 percent jump over September 2015.

“Small companies will need financing through Brexit and there is a real opportunity for us to grow market share,” says James Meekings, Funding Circle’s co-founder. “But clearly to do that we have to make sure our credit risk management is robust. We will live or die on this assessment.”

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Published at Tue, 25 Oct 2016 09:16:34 +0000

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