“There is a world of difference between the returns and risks related to peer-to-peer lending and the – albeit historically low – rates on offer from banks where your cash is at least protected by the Financial Services Compensation Scheme up to £85,000 per person per account. As ever, investors who do not make the right comparisons cannot hope properly to gauge the respective risks involved.”
So ran the conclusion to Differing accounts, The Value Perspective’s first look at peer-to-peer lending, and in the four months or so since that was written, it has become clear plenty of others share our concerns about the idea – not least the Financial Conduct Authority (FCA), which recently published a consultation paper entitled The FCA’s regulatory approach to crowdfunding (and similar activities).
For some consumers, a significant part of the appeal of peer-to-peer lenders will be the headline rates that are often advertised alongside those on offer from selected banks. Clearly a rate of, say, 4.5% will catch the eye when set next to the 2.5% or 3% available on the high street. This, however, is about the extent to which peer-to-peer lenders are willing to advertise comparisons between themselves and banks and building societies.
There is little to be found, for example, about the possibility of a ‘run’ on a peer-to-peer lender. After all, one of the problems that eventually brought down Northern Rock in 2008 was people growing concerned about its financial strength and queuing up to withdraw money, much of which had been lent on as mortgages that were supposed to take 25 years to repay.
While peer-to-peer lenders carry the same risk of a run as a bank, they typically hold far less cash and other short-term assets to cover that possibility. As such, if you were to want your money back sooner than, say, five years, you would have to sell your interest on to another lender – an eventuality that brings with it all sorts of conditions.
One typical condition is you cannot have any defaults in your pool of peer-to-peer borrowers and yet, if you invest – notice we do not say ‘save’ – more than £2,000 with a typical peer-to-peer lender, they will split your money between 200 borrowers. This means, if the default rate is above 0.5%, which in a future downturn it very well could be, you would be unable to sell your investment on to someone else.
You would not, in other words, be able get your money back – something that is not immediately apparent from the websites and other literature of every peer-to-peer lender and a possibility in which the FCA has expressed particular interest. Here on The Value Perspective we suspect there are plenty of people who might not fully understand the implications of this lack of liquidity.
Similarly, to build on the thrust of our earlier article, some people might not be wholly aware that, if you put your money in a bank account, not only do you have that state protection up to £85,000 per person per account, there is also the capital specifically set aside from the bank’s equity to meet any losses on loans so its depositors do not get burnt.
In behavioural finance terms, some peer-to-peer investors could be suffering from an availability bias, focusing on the immediately attractive aspect of a proposition – in this case, the 4.5% headline rate – and not on less obvious factors, such as the risk of suffering losses should borrowers default. Default rates may be low now but they will, for example, be higher if – or rather when – interest rates do rise.
We are currently living through an unusually benign environment but it cannot last forever and peer-to-peer lenders would do better to seek out a more realistic basis for comparing default rates. According to the figures of one large peer-to-peer lender, for example, default rates on loans made just before the credit crisis were as high as 5%, with some tranches of lending suffering 20% losses.
Those who fail to focus on liquidity could also be said to be suffering from reduced risk aversion. Peer-to-peer lending is a clear example of the current low rates forcing people to make riskier choices – in other words, to receive what, in normal circumstances, would be a less than heroic return of 4.5% over five years, people are now taking all sorts of default risk lending to consumers and small businesses.
One final point we would make relates to the degree to which the interests of peer-to-peer lenders and their investors are actually aligned. Peer-to-peer lending businesses make money by charging people around 1% of the money they invest. As such, they are more incentivised to grow their overall assets under management than they are to investigate thoroughly the creditworthiness of potential borrowers.
Clearly large losses would be bad news for any peer-to-peer lender but, even so, such businesses are far more about growing assets and not taking on credit risk themselves. All things considered, there seems to be a great deal of risk involved just to obtain an extra 150 basis points or so of return and potential peer-to-peer investors should think very carefully about whether they are happy with such a balance.