P2P: interesting UK study analyses recession risks

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Hand over your money to hundreds of strangers, trusting that they pay the money back plus interest: it sounds like a venture for the most risk-prone of investors – or the plain reckless.

Yet peer-to-peer (P2P) lending has exploded in popularity. In a decade, £2.6bn has been lent out by 100,000 Britons in peer-to-peer loans with investors putting away around £6,000 each. It matches the typical amount held in cash Isas.

The Government has noted this and will, from next April, allow the inclusion of these “savings” in Isas.

Research published today predicts this will lead to a fourfold take-up. Yorkshire Building Society said 405,000 savers will plough their money into the new tax-free accounts. The Peer-to-Peer Finance Association (P2PFA) expects the sector to double in size every six months for the foreseeable future.

Ben Hammond and his wife, Sophie, pictured, are among those already hooked, with 15pc of their savings in P2P.

The industry began life a decade ago, with savers lending money directly to borrowers. Cutting out the banks hands both sides a better rate.

Peer-to-peer: track record

The typical lender earns 5pc – easily beating traditional savings. But some experts are concerned. These firms are not covered under the Government-backed compensation scheme that protects deposits up to £85,000, per financial institution, if it goes bust, falling to £75,000 in January.

Despite the risks, no investor has lost money using the four biggest platforms: Zopa, RateSetter, Funding Circle and Landbay, they claim.

So far the “default” rate, the proportion of money not repaid, among P2P borrowers is less than 1pc. But these big players also hold a “reserve fund” which compensates if too many borrowers default (see the below chart).

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But chartered financial adviser Patrick Connolly of Chase de Vere said that most advisers won’t recommend P2P. “This is a growing market that hasn’t been tested through a long and difficult period. As it becomes more and more popular we see new entrants coming to the market and they are of lower quality,” he said.

Among the newcomers is failed firm TrustBuddy, which this week froze all lender cash due to suspected misconduct. The Swedish firm has halted new business due to concerns it was giving lenders’ money to fund existing bad debts. It opened for lending in 2013 offering Britons rates of up to 12pc. The typical rate across the industry is just 5.2pc. It has now frozen an estimated £20m.

“I don’t know of any financial advisers who would promote peer-to-peer simply for this type of scenario – there is no compensation if a P2P firm folds,” said Mr Connolly.

Data from the Financial Conduct Authority, which has regulated P2P since 2014, shows 30 firms have so far withdrawn applications for approval.

Peer-to-peer Isas: what we know so far

From April 2016 new “innovative finance” Isas mean savers will be able to put in £15,240 sheltered from tax. It will undoubtedly improve the attraction, and the credibility, of P2P.

The Hammonds, who live in Hampshire, are among those who would benefit. “I’d definitely wrap my loans in an Isa as I’m a higher-rate taxpayer,” said Mr Hammond, a property lawyer. He said the traditional “safe havens” for cash did not offer attractive enough rates and that peer-to-peer had become a “place where my money is safe but I also get a reliable return”.

  Photo: Philip Hollis

Mr Hammond, 41, began with Zopa, the biggest and oldest firm, and which lets you fund unsecured personal loans.

“I quickly decided I knew property better and decided to switch to Landbay, which lends to landlords. That way, I knew if they could not repay their loans there is the asset to fall back on,” he said.

The Hammonds are expecting a baby next month and want less risk. He now earns 3pc plus Bank Rate.

When “innovative finance” Isas are available, savers will be able to lend through just one peer-to-peer platform in the Isa. The Government has yet to confirm if old Isas can be transferred to the new one.

What could burst the peer-to-peer bubble?

History tells us that bad borrowers play a large part in economic meltdowns. When bankers ploughed investors’ money into the mortgage market before the credit crisis in 2008, they took on more and more risky borrowers.

A similar spiral could conceivably happen, warned Neil Faulkner of 4thWay, a risk rating agency.

There is a shortage of borrowers. Mr Faulkner said: “As the peer-to-peer lending platforms grow they also, to an extent, have to accept worse borrowers. This imbalance could worsen causing some firms to lose their discipline and take on bad borrowers in a bid to stay attractive to lenders.”

Zopa, with £789m on its loan book, is a “victim of its own success”, said Mr Faulkner, because it has too few borrowers. It used to accept 1pc of applicants but now takes on 20pc, although this is similar to the acceptance rate for bank loans.

Landbay also took on more risk in response to demand from lenders. Previously it would only approve buy-to-let mortgages with a 28pc deposit but will now accept borrowers with 20pc.

As investors pour into peer-to-peer, interest rates will drop making it less attractive. “In this way, we could see a ‘see-saw’ effect when the lender-borrower imbalance goes the other way,” said Mr Faulkner.

For the first time, peer-to-peer firms have been subject to a “stress test” similar to those imposed on banks which models the impact of a recession on their loan book.

Tests carried out by 4thWay show lenders using the biggest P2P firms, who lend over a five-year period, should not lose capital during a crisis. They assume a severe scenario: a one in 100-year recession, roughly as extreme as the 2008 credit crisis.

• How safe is peer-to-peer lending?

Only one firm, Zopa, was around to endure the last crisis. But now that it accepts more borrowers the impact could be worse, warns Mr Faulkner. The Zopa “reserve fund”, currently 2pc of money lent out, would be completely depleted once its loan book loses £13m of its £448m stock. Each investor would lose 3pc, which would be paid for over one year’s interest.

Funding Circle lends directly to businesses, broadly reflecting UK industry, including 15pc retail, 11pc construction and 6pc agriculture.

Its co-founder James Meekings said its “no start-ups” rule and average age eight of its businesses, meant it would be able to weather a recession where bad debts increase by 65pc. Its own stress test conducted by consultants, Hymans Robertson, showed rates would drop 7pc to 5pc.

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4thWay predicted Funding Circle investors who lent only to the safest businesses – its “A+” borrowers that return 5pc a year – would face losses of around 5pc of their original investment. This would be covered by interest earned, it said. But lenders who opt for its highest-risk businesses except those placed in its new “E” grade – where expected returns exceed 7pc – could lose 9pc which would not be offset.

Landbay, the only firm focusing exclusively on buy-to-let mortgages, carried out an independent test by consultancy firm Wriglesworth. Lenders would see their returns drop from around 7pc to 5pc during a recession as rent arrears would reduce landlord income by 6pc.

Telegraph