Peer-to-peer lending has thrived on both sides of the Atlantic, in an era of low interest rates and solid economic growth. But how will the sector hold up if conditions change?
Peer-to-peer lending platforms have built a global following off the back of low interest rates, with the eight biggest lenders in the UK attracting £8bn, while US P2P giant Lending Club has originated $25bn (£20.1bn) of loans, as of 31 December 2016.
The sector is thought to be worth £106.4bn globally, according to a recent joint study by accountancy firm KPMG and the Cambridge Centre for Alternative Finance. But the changing global outlook and unfolding of issues such as the new Trump administration and Brexit could all weigh on inflation and interest rates, hitting confidence among P2P investors.
This comes at a time when the P2P market is arming itself with institutional investors and successful securitisations, but could an interest rate rise and changing global landscape dampen demand from lenders and borrowers?
The US and UK economies have mainly defied expectations of their demise so far. In the US, President Trump’s support for infrastructure, financial services and home-grown companies has helped the Dow Jones Industrial Average break through the 20,000 barrier for the first time.
Employment figures showed 246,000 new jobs were added in January, the highest rise since June 2016.
Similarly, in the UK, the gross domestic product data for 2016 showed the economy grew by two per cent over the year, the fastest in the G7, despite dire warnings over the Brexit vote.
Even the Bank of England has raised its forecasts. It is now predicting two per cent growth in 2017, revised up from 1.4 per cent and 1.6 per cent growth in 2018, up from 1.5 per cent.
The FTSE 100 has also been breaking records, surpassing the 7,000 barrier.
But analysts on both side of the pond are not sure that the good times will continue.
“Despite a seemingly ongoing resilient performance at the end of 2016, 2017 is likely to be an increasingly difficult year for the UK economy. Like a slow puncture, we suspect that the economy will gradually lose air as the year proceeds,” said Howard Archer, chief European and UK economist for research firm IHS Markit.
“Specifically, we expect GDP growth to slow to 1.4 per cent in 2017 as consumer fundamentals weaken markedly and uncertainty is heightened by the government triggering Article 50 to formally start the UK’s exit from the European Union.
“Consumers are highly likely to face markedly diminishing purchasing power over the coming months as inflation rises appreciably and earnings growth is limited by companies striving to limit their costs. In addition, unemployment seems likely to rise over the coming months, despite the recent resilience of the labour market.”
A subdued economy would dampen business growth, which would have a knock-on-effect on P2P business lenders looking for suitable borrowers. Meanwhile, shrinking purchasing power, low wage growth and rising joblessness could shrink the pool of good quality borrowers for consumer platforms.
There have also been some signs of caution in the US, with GDP estimates coming in below expectations at 1.9 per cent in 2016, when many economists anticipated growth of more than two per cent.
While President Trump’s plans to boost infrastructure spending have buoyed the markets, he is an inexperienced politician who has not fleshed out many of his policies yet and the long-term outlook is still uncertain.
“The unpredictable nature of a Trump administration creates uncertainty, especially if protectionist rhetoric starts to outweigh promises of stimulus,” said Trevor Greetham, head of multi asset at Royal London Asset Management.
“Political risk is likely to create bouts of negativity in 2017. We have a new and unpredictable leader in the White House, Brexit negotiations and a series of important elections in Europe and it would not be surprising to see red on the screens from time to time.”
This widespread uncertainty across the Western World is already feeding into inflation. Consumer price inflation in Europe jumped to 1.8 per cent in January, from 1.1 per cent in December 2016.
In the UK, the cost of living rose to a 31-month high of 1.8 per cent in January, up from 1.6 per cent the previous month.
And in the US, it climbed to a four-year high of 2.5 per cent in January, from 2.1 per cent the previous month.
Central banks could respond to rising inflation by raising interest rates, which most analysts believe the US Federal Reserve will do. But a rate rise in the UK seems further away; Archer believes the Bank of England will hold off through this year and next.
Either way, P2P platforms face contending with a higher interest rate environment or lenders with less purchasing power, or both. Gill Cardy, insight consultant at financial research firm Defaqto, says the changing outlook will make individual lenders take more time assessing the type of borrowers they lend to.
“Investors may wish to see more information presented as part of the due diligence made available to help their decision making,” she tells Peer-to-Peer Finance News.
“From the investor point of view, a continued low interest rate environment will continue to make P2P seem an attractive option, but there should be a greater focus on identifying the accompanying risks associated with each particular business model.”
Cardy says platforms will need to be better at showing how loans would perform in different scenarios.
“Whilst platforms tell us that they engage in stress testing, few are quite as good at actually telling investors what returns they may expect in different scenarios, net of defaults,” she explains.
“Some platforms do disclose an anticipated default rate across their total business, but turning that into ‘what does that mean for the rate of return you are quoting to me?’ is harder to come by.”
Other industry analysts feel it would take a big rate rise to have a material effect on the P2P sector.
“P2P lending is very likely to respond to interest rates in the same way that bonds, the stock market and many other investments do,” says Neil Faulkner of 4th Way.
“When interest rates increase slowly, the attractiveness of P2P lending will not significantly change, keeping pace to stay significantly ahead of savings accounts.
“If interest rates rise swiftly, this is typically caused by rapid inflation. During these times, the attractiveness of P2P lending will fall, because it will temporarily be difficult to keep up with inflation, although the same will also be true for savings accounts and non-P2P investments.”
However, he warned that there was a risk that if bank rates got very high, some investors would consider it unnecessary to lend in P2P during those times and would move to safer savings accounts and cash ISAs.
The growing alternative finance market has proved attractive to institutional investors in the investment trust space, with funds such as the P2P Global Investments (P2PGI) and VPC Specialty Lending set up to invest in P2P loans.
They have already started responding to the changing global outlook. For example, P2PGI has aimed to mitigate more competitive, tighter personal loan pricing by shifting its focus to asset-backed investments. The latest investor update from P2PGI in January highlighted property-backed loans and trade finance as growth areas for the market and said the risk-adjusted returns were more attractive.
But some of the main P2P platforms seem less concerned about changes to interest rates.
David de Koning, head of communications at Funding Circle, says the platform’s estimated annual return of seven per cent should appeal to investors regardless of the interest rate environment.
“Ensuring businesses can access finance is crucial for economic growth,” he explains.
A RateSetter spokesperson similarly affirmed that their proposition would still be attractive, regardless of a rate hike.
“When the Bank of England base rate rises, it is likely that there will be a prompt increase in the cost of borrowing from banks,” he says.
“It’s not clear that banks will be so quick to pass on a rise to their savers. For example, if you look at the period of January 2011 to July 2016, the average rate paid on a savings account fell 1.29 per cent to 0.34 per cent despite no change in the base rate.
“But if you assume that they do, what will happen is that rates for savers and borrowers will both rise but the spread is likely to remain consistent.
“We believe that supply and demand would cause rates on our platform to rise – both for borrowers and investors – and they would remain within that spread, meaning that we still offer a good deal to both sides and rates remain attractive.”
Even if fewer people were borrowing money and investor returns fell, the spokesperson said this would be likely to be balanced out by similar conditions in the wider economy.
Another risk for P2P is that increased uncertainty could hit institutional investor confidence in this nascent asset class. Institutional money now makes up around a third of the UK P2P market, while in the US it is more than 90 per cent.
Securitisation – where platforms package up loans and sell them on to institutional investors – is commonplace in the US and is starting to happen in Europe as well.
Funding Circle became the first European P2P platform to have its business loans securitised in April last year and was followed by Zopa in the consumer space last September, with both offerings well received by investors.
De Koning says Funding Circle is not planning to change its strategy. “Increasing the number of securitisations to promote new sources of funding for small business loans is a stated aim of the Bank of England,” he says. “We are proud to have participated in the first securitisation of SME loans in Europe and we look forward to supporting more in the future.”
Funding Circle’s confidence in the capital markets suggests that institutional interest in P2P is not going away any time soon. “More P2P securitisations are inevitable as funds, platforms and financial advisers seek to capitalise on investors who want to take part in P2P through more traditional investing channels,” says Faulkner.
“There has been relatively little political uncertainty about the P2P lending industry, thanks to the overall high standard of performance and competence within the industry, and the lure to the government of being at the forefront of the burgeoning fintech industry.
“For the most part, the government and the regulator have been highly supportive, even as they learn how to better regulate this new industry to ensure its standards remain high.”
There may be uncertain times ahead, but borrowers will always need finance and savers are constantly on the lookout for a decent return. Traditional banks tend to shut up shop when times get tough, but now could be the time that P2P, born out of the most recent financial crisis, shows its innovative side once again.