As marketplace lending has expanded at exponential rates, those early – once favourable – sentiments towards these “new kids on the block” have hardened. The sharks are sensing the smell of future blood and are already circling in advance of an anticipated (but as yet unknown) crisis erupting that decimates those lenders associated with marketplace lending.
Lending Club’s Fall from Grace Casts Doubt on the Whole P2P Market
Lending Club (LC), perhaps the World’s highest profile P2P lender, recently sacked Renaud LaPlanche (the CEO) and other high ranking staff following (apparent) irregularities in the sale of a US$22 million loan book to an investor. LC should be commended for taking rapid action in correcting the matter and for dismissing those staff – including the CEO – responsible for the problem.
However, the fact it happened at all is damaging not just for LC but for the entire market place. In LC’s case this latest disaster follows on from concerns (raised by a Rating Agency) – earlier this year – about the quality of its previously securitised loan books; and previous complaints to the SEC (in July 2015) that LC does not disclose critical operational measures that investors need to monitor its business.
When sentiment is negative any mis-step is seized upon by concerned commentators and its adverse impact can be enormous for all those associated with the P2P market.
After all, LC is huge in marketplace lending terms, has been around for over a decade, and is a quoted company subject to SEC regulation and disclosure requirements. So if LC is a cause for concern how worried will folk be about other firms in this area – smaller, much less transparent, not subject to material regulatory oversight, and lacking any track record of operating through a downturn in credit?
Regulation and a Need for “Skin in the Game” is Coming
Regulators are rightly nervous and (now that the momentum of new regulation in more traditional financial services sectors has started to slowdown) are looking much more closely at those operating in the marketplace lending sector.
Additionally traditional lenders have highlighted as unfair the lack of regulation, compliance requirements, and need for capital buffers within the P2P sector. To be sure, regulators these days are proactive and will seek to regulate in order to prevent a crises emerging – rather than waiting to “shut the stable doors once the horse has bolted”
In particular increased regulation, disclosure and a requirement that P2P lenders “hold skin in the game” by retaining a minimum proportion of each loan granted are inevitable. It is a question of “when” and not “if” those requirements arrive.
This nevertheless risks being a major blow to the marketplace lendingsector. Those lenders that are not already prepared for those changes will find themselves inwardly focused, investing to bring their operations up to standard and scrambling to comply – just at the time that traditional lenders are emerging from their own compliance-led efforts. In other words: higher costs and less focus on growth and profit during a period of increased competition.
A Lack of Robust Credit Analytics Coupled with Declining Credit Quality is a Recipe for Disaster
Irrespective of marketplace lenders pretensions to the contrary, borrowers (even sophisticated ones) rely heavily on the internal scores and ratings produced by the lender. Moreover, lack of adequate disclosure of loan characteristics (while showing some signs of improvement) still leaves a lot to be desired and increases borrowers’ reliance on such scores.
Although some marketplace lenders appear to be using credit scoring methodologies that may be deemed satisfactory, others are deploying simplified or poor methodologies that may not easily weather a credit downturn. Still others have been enchanted by so-called new data and new analytics – effectively indulging themselves with unproven credit assessment approaches and leaving their lenders and investors bearing the risk if those methodologies prove wanting.
Moreover, as the number of marketplace lenders multiply, many borrowers now “cherry pick” the loan with the best terms for them. If the interest rate offered is genuinely commensurate with the inherent credit risk of each borrower then that is not a major problem.
However, when there is a lack of robust analytics (particular when competitors are more sophisticated in their risk pricing), a marketplace lender secures business for which its interest rates are too low relative to risk (and loses business to competitors for which its interest rates are too high relative to risk). Over time that is a disaster leading to declining loan volumes, reduced ROI, increased defaults and losses for investors. For younger, rapidly expanding P2P lenders any analytical short-comings will start to manifest themselves as the book matures and growth slows.
Added to this, talk of a looming downturn in credit quality has also been gathering momentum in recent months. Lenders employing robust analytics for credit assessment have no need to fear such a downturn but those that have skimped on analytics face the prospect of being ship-wrecked particularly if the downturn is severe or protracted.
Profile of Success
Inevitably, all marketplace lenders’ risk is being “tarred with the same brush” once the storms hit. So how can today’s lenders differentiate themselves and prepare for survival (and future success)?
- Mind Set. Recognise that you are in the financial intermediation space (and not a technology company) and behave accordingly. Your platform can provide a competitive edge for your business (and reduced operational costs) but only if your analytics are robust.
- Robust Analytics. Accurate credit assessment and pricing (through assigned interest rates) has to be your core competency. It will be your key competitive advantage (relative to those that will not survive). It also demonstrates business integrity and maturity – a prerequisite for being prepared for increased regulation.
- Proactive Preparation for Regulation. The likely shape and content of future regulatory requirements is already clear. Survival involves preparing your business and operations now to be compliant with those expected requirements.
- This needs to increase dramatically in terms of: detail of the loans granted, more informative analysis of past performance; disclosure of key operational processes including credit risk assessment, borrower detail validation, recovery processes; and the financial and operational structure of the P2P firm itself.
- Balance Growth and Financial Profile. Ever expanding growth in loan volumes coupled with soaring operating losses smacks of a bubble waiting to burst rather than a sound operational business profile. Fund exceptional growth for equity or debt issuance (coupled with a sound, transparent project plan).
Paul Waterhouse is a seasoned credit risk management expert who held a Managing Director position at Standard & Poors where he globally led the Analytics and Innovation practice within the risk management sector. Paul is also a Fellow of the Actuarial Society.
Paul is Associate Director at Vedanvi, where taking responsibility for developing a credit risk management practice. He can be contacted at firstname.lastname@example.org or on his mobile +44 7905 089896.