THE INNOVATIVE Finance ISA (IFISA) is starting to take off after a slow start – in the last tax year, subscriptions rose more than 700 per cent – but potential investors may still be unsure about the risks involved.
It is important to note that all investments come with an element of risk.
Money put into peer-to-peer loans – with or without the IFISA wrapper – is not covered by the Financial Services Compensation Scheme (FSCS).
FSCS protects consumers’ savings in bank accounts up to £85,000 and certain investments up to £50,000.
While the P2P industry is Financial Conduct Authority-regulated, your money is not covered by either elements of FSCS.
This could be a worry for investors, especially against a backdrop of rising default rates. Several P2P platforms have said they are reviewing their return projections in the face of record consumer and business insolvencies.
Others such as Funding Circle have made a point of stress testing themselves to try to prove to investors that they would be resilient in the event of a downturn or a rising interest rate environment. But are platforms’ own due diligence procedures reassurance enough? What if they start granting riskier loans in order to meet growing demand from people wanting to lend through their platforms?
Neil Faulkner, managing director of P2P ratings agency 4thWay, says bad debts in P2P lending are rising for two reasons.
“Firstly, it is a matter of scaling,” he comments. “We can take Zopa as an example. When Zopa first started, there was so little investor money available that it could be super selective of its borrowers and, indeed, far more selective than it ever needed to be. It was approving just 0.5 per cent of loan applications.
“Now, Zopa is approving approximately 20 per cent of loan applications, which is much more in line with the high-street banks. This is still fine for the sorts of loans that Zopa does, but it also means that it is not approving loans exclusively to extraordinarily excellent borrowers any more. Naturally, the default rate has therefore risen.
“Secondly, default rates have risen at many platforms, because it was always inevitable at some point. We have just gone through a particularly benign period where default rates in peer-to-peer lending and at the banks have been unusually low. This was always to going to reverse at some point. Defaults today still look easily containable.”
The platforms do have their own schemes to protect their investors from bad loans, typically funded by investors themselves through fees. RateSetter, for example, has a Provision Fund to shield the money held in its IFISA. All its borrowers pay a fee into the Provision Fund, which reimburses them if a borrower misses a payment. If the loan goes into default, the Fund takes over the loan and repays outstanding capital to the investors. RateSetter says this has meant “no individual investor has ever lost a penny, although past performance is no guarantee of future success”.
Zopa, the oldest P2P lender in the UK, used to have a similar facility called a Safeguard fund but retired the fund in 2017. Zopa says if it were to go out of business, it has planned to use loan servicing fees to cover the ongoing costs of managing its loanbook.
Another platform, Growth Street, has a Loan Loss Provision which it says has so far meant no investor has lost any of their initial investment or interest owed, despite 10 loans defaulting as of the end of last year.
New P2P lender Loanpad has an Interest Cover Fund which continues to pay daily interest to investors if one of their loans defaults. Subject to available funds, this continues until the loan has been recovered or a full capital loss occurs.
“Lending results are cyclical, but not to the extreme that we witness in the stock market, where investors as a group can easily lose 20 per cent in a year,” says Faulkner. “That said, reserve funds and similar safeguards are not intended to completely protect lenders from a severe recession or property crash. Lenders should therefore assume that sometimes those safeguards will be overwhelmed by severe bad debts.”
He urges investors through P2P platforms to make sure they are spreading their money adequately across a large number of providers, and ideally hundreds or thousands of loans to contain the risks.
“Reserve funds should therefore be seen as a bonus rather than the main defence, which is why as a group those sorts of additional protections are known as ‘credit enhancements’ and not called essential safeguards,” he adds. “The most important factors are whether the platforms can assess the borrower and security properly, and price interest rates appropriately for the risks. For the most part, platforms have established a good record in these areas.”