Peer to Business Lending
Alternative Finance Sector Report - November 2014
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PEER TO BUSINESS LENDING
ALTERNATIVE FINANCE SECTOR REPORT
PUBLISHED
November 14
AUTHOR
Luke Jackson
Samantha Goins
PROVISION FUNDS VS. PHYSICAL SECURITY
Security should be one of the main considerations for investors when undertaking their due diligence on P2B investment
opportunities. The security offered by platforms can vary but it will generally consist of either a provision fund or asset
backed physical security (or a combination of both). Each has positives and negatives, with the overarching aim to protect
investors’ capital.
PROVISION FUNDS
A provision fund (protection or compensation fund) is designed to compensate lenders if a borrower fails to repay their loan.
This is similar to cash reserves held by a bank and is commonly used for non-secured lending. Cash reserves should always be
larger than the platforms actual or predicted loss rate, which on average is 1.5% across the UK P2P market (this of course will
vary from platform to platform).
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A number of P2P platforms offer provision funds of up to 2% of their total outstanding loan book. In comparison, the Royal
Bank of Scotland held cash reserves (Tier 1 Capital) of around 5% of their loans during the financial crisis. This wasn’t enough
to cover their bad loans and in 2009 they had to be bailed out. With platforms only holding 2% this does not leave much
margin for loss should there be a large default on loans – investors will face losses if default rates rise over 2%.
Platforms generally fund the provision reserves from a small percentage taken from each loan they issue, and therefore over
time (as long as there are no significant defaults) the size of the provision fund should increase and provide further protection,
but it is unclear whether they will adequately cover future defaults. At present there is no requirement for platforms to hold
a minimum amount of reserves within their provision fund. Ratesetter hold a provision fund of over £8m (October 2014) and
their loans are very small relatively, typically thousands of pounds, meaning that the provision fund is well matched to the loan
book risk. The risk is that some platforms offer very large loans, such as Wellesley with their recent record £8m loan, whilst
their provision fund may account for less than 10% of the size of a single loan, meaning there is substantial exposure to risk
on a single loan defaulting compared to a platform making a large number of small loans of say £10,000 with a multi-million
pound provision fund such as Ratesetter.
Provision funds do not generally guarantee loans or provide insurance against losses although this may be technically
possible in the future. The fund will usually be controlled by a 3rd party (or trustee) who will consider claims and often grant
compensation at their discretion in order to avoid the FCA Unregulated Collective Investment Scheme rules. Lenders often
do not have a legal right to compensation.
BENEFITS
Repay investors should borrower default
Simple and universal across all loans
Loans can be advanced more quickly
Loans/lending criteria can be more flexible
RISKS
Aren’t sufficient should default rates rise
Unfair on lenders who don’t use it
Drags down overall performance
Sometimes unclear how investors can claim
compensation
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