What is the best provision fund structure?
PROVISION FUNDS are designed to cover peer-to-peer investors in the event that a borrower defaults on their loan, but the way they are funded and operated varies widely across platforms. So what should investors be looking for and is there an optimal structure to reduce their chances of losses?
One key difference is whether pay-outs from reserve or provision funds are automatic or discretionary.
RateSetter is credited with the invention of the provision fund concept, which has been part of its business model since it launched in 2010. It is funded by borrowers’ repayments and money is automatically reimbursed to investors if loans go into arrears.
“We manage the size of the provision fund so that there is more money in there than all the expected missed payments by borrowers,” RateSetter said on its website. “We continually monitor the performance of loans and our provision fund and if needed we can make adjustments.”
Growth Street’s chief executive Greg Carter said that its provision fund is a key component of the platform’s investment proposition, adding liquidity which is vital for the revolving lines of credit it offers businesses.
Its pay-out mechanism is automatic, using an internal counterparty rather than a discretionary trust, and kicks in even before a borrower has defaulted, as soon as they are 30 days late with a payment or even if it looks like they will not be able to repay.
Interestingly, it is partially funded by capital from the platform’s founders, which Carter said aligns their interests with those of their customers. “What the provision fund does is put skin in the game and means if we make bad decisions, we pay for those before investor returns are affected,” he said.
In contrast, Landbay’s provision fund is less central to its offering, according to chief executive John Goodall, who pointed instead to the low-risk nature of the platform’s loans.
The provision fund is discretionary, so there is no guarantee an investor will see bad debts repaid from it, but loans are secured against property, meaning they will usually get something back in case of default. He argues a provision fund cannot call itself automatic as, by definition, it could run out and so is not guaranteed.
Discretionary payments may also be slower: in December, Lendy apologised to customers for delays to discretionary pay-outs on some bad loans.
Should provision fund mechanisms be standardised across the industry to make them easier for investors to understand? “I would welcome standardisation,” said Carter. “I would hope it wouldn’t require regulation, but if that’s what it takes then great.”
But Goodall said this would not take into account the differences in the way P2P lenders operate, and whether loans are secured. “To force them all to run in the same way would not be good for consumers,” he added.
Goodall said a better assessment of the safety of a P2P platform is to look at the whole offering, the underlying loans and the rates on offer, rather than the provision fund itself.
It must be noted that a provision fund is a method of mitigating risk, but does not guarantee that investors’ capital is safe.
This article featured in the May issue of Peer2Peer Finance News, now available to read online.