By Mark Sisson
Since recession took hold, lending to small businesses has reduced significantly as banks look to boost balance sheets to meet stringent capital adequacy requirements. And so enter, crowd-funding or peer-to peer-lending which threatens to fill this void. Add to that the persistent low interest rates which have resulted in savers getting a very poor return via the traditional savings route, and the returns offered by crowd-funders starts to look very appealing indeed.
From the borrower perspective, there are certainly a string of benefits to be had; speed of decision for one – after all, banks are bound by process and may take months to make lending decisions, but a crowd-funder could make an advance in half the time. But while limited due diligence is required to secure start-up funding, significant equity is often expected as part of the deal so one might argue it’s not a panacea. Then you have choice of investment; one chooses which sort of business to invest in, that way owners feel their investors are genuine enthusiasts and endorsers of their business idea. And of course you have the spread of invested funds across multiple opportunities (often hundreds) so any individual failure has an insignificant effect on return.
What could possibly go wrong? I’ll tell you.
Lack of robust data analysis
While the quality of accepted loans and equity sourced via crowd-funding has typically been good in the past, it’s likely that as the market grows, a more diverse set of applicants will use this route to gain funding. Simultaneously investors will become more willing to move down the risk curve in search of higher returns. That in itself is fine; however, growing larger and more diverse requires a significant improvement in the quality of the analysis available to investors; ideally, to mitigate the information asymmetry between traditional lenders and retail investors using crowd-funding sites.
Credit risk is not child’s play and pricing correctly for the long term has taxed experts’ minds and has yielded only limited success. Crowd-funded lending is by its very nature a market; markets are good at discovering the price of commodity items which are easily transferable, be that company shares or bushels of corn. Loans to individuals and small companies are not in themselves a commodity, the loans are provided to individuals and small companies that differ widely in their ability to repay and how they might react in an economic downturn. Large financial institutions can treat pools of loans as a commodity but only with the backing of robust and comprehensive data and analysis. Sloppy underwriting and inaccurate information can quickly catch even relatively large well-capitalised investors out. To expect individuals to compete with volume players is unrealistic; they will more likely get their fingers burned to the detriment of the industry and possibly the economy.
When is a good idea not a good idea?
The other danger of crowd funding is that business ideas that would ordinarily fail the rigour and scrutiny of the traditional bank loan would nevertheless gain funding approval through less-rigorous channels, whether they are particularly good or innovative ideas or not, resulting in a market akin to the dotcom boom in the late nineties. One has to question if you you can’t convince educated, savvy backers to invest in a business perhaps the idea isn’t so good after-all?
From an investor perspective, whilst funds are spread thinly and widely across multiple investments, there remains the possibility that the crowd-funding company itself will fail for the above reasons alone, resulting in total loss being incurred.
To avoid the potential of total loss, would-be investors need to understand the risks via:
1) Publishing detailed tracking information. This should include expected and measured performance of risk grades for similar assets lent to in the past as well as the performance of the debt collection function on debts that have defaulted.
2) Providing the underlying anonymised facility level data so independent parties can verify that performance and check model assumptions.
3) Providing a flexible online tool to make it easy for prospective investors to understand the potential losses of their portfolio under different stressed economic conditions.
Closing this information gap would be a big step forward in countering potential regulatory concerns of the downsides of crowd-funding that are not fully apparent to investors.
One of the key risks for potential investors is also to understand the liquidity and credit risk of their pool of loans. In basic terms, this translates to how easy would it be to get your money out before the legal maturity of the loans and how much will you be able to recover if the counterparty you are lending to defaults on their obligations? In a standard bank account the answer is that unless the bank is made bankrupt you can take your money out at any time and the counterparty risk is nil (the bank covers any losses out of capital). To ensure that banks can live up to those promises and always give your money back the regulators require them to hold sizeable capital buffers. Beyond this there is a FSCS scheme that ensures the first 80k of losses even if the bank does go bust. This makes banks pretty safe to ordinary depositors.
By contrast while returns may be much healthier for peer-to-peer lenders and crowd-funding sites, there is either no guarantee on liquidity and credit risks (buyer beware), or the crowd-funding site assumes this risk. If the latter then for this to mean anything it would need to be capitalised in the same way as banks are and currently they are not.
While this area has hitherto been poorly regulated, changes are afoot. The PRA and FCA are under mounting pressure from the Government and other outside bodies such as credit unions who are bringing pressure to bear on these organisations. This will undoubtedly push up their cost base resulting in lower returns to investors and more punitive terms to borrowers.
What’s next for crowd-funding?
Expect more scrutiny from the PRA in terms of ensuring crowd-funding organisations retain sufficient capital to meet potential losses and stand behind any guarantees they have made. Separately from the FCA, they will want to ensure that consumers are given appropriate, transparent and accurate information about the potential investments they are making. Comparing the investments returns to standard bank savings in marketing material has already been highlighted as inappropriate given the different nature of the risks involved.
The BIG investor question
In conclusion, the key question for investors is – do crowd-funding and peer-to-peer lending sites offer better returns because they cut out the middle man and provide a more efficient market, or are the improved returns a financial slight of hand borne out of regulatory arbitrage that hides risk in the system? At present the answer is both – until crowd-funders can demonstrate the same rigour as their regulated cousins in banks then they don’t yet deserve to be a mass-market phenomenon.
About the author
Mark Sisson is Managing Director at 4most Europe. Having started life in the computer industry in the early 80’s, Mark worked as a sales manager for Sperry Computers, later becoming Unisys when acquired by Burroughs Corporation in 1987. In 1990 he was co-founder of a private sales development company called IMAJ Associates before launching marketing analytics company, IMAJ Consulting in 1996. IMAJ Consulting was acquired by CACI Ltd in 2004 where, up until early 2011, Mark was retained as Insight and Analysis Group Director. Mark is one of the co-founding partners at 4most Europe.
About 4most Europe
4most Europe Ltd is a specialist credit risk analytics consultancy with offices in London and Edinburgh. The company provides a range of products and services across credit risk, fraud and pricing, working with blue chip clients predominantly in the retail banking and mobile sectors. The company offers a flexible, competitive model, either working with clients to manage regulatory change or delivering and implementing business critical solutions.