FUNDING Circle’s decision to apply higher credit standards to its lending will sacrifice growth in favour of higher quality loans, according to Canadian credit rating agency DBRS.
The publicly-listed peer-to-peer lender recently downgraded its outlook for loan growth due to an uncertain economic environment in the UK.
The platform also announced its decision to curtail origination of riskier loans, which DBRS views as an overall credit positive, it said, leading to improved credit quality overall.
Funding Circle lends to small- and medium-sized enterprises (SMEs), with loans ranging in quality from A+ to riskier loans graded E. The platform began lending in the riskier E category in 2015.
The change of direction will not affect Funding Circle’s existing portfolio of loans but should improve future performance, an analyst note from DBRS said.
“The credit cycle appears to be peaking and this, along with the potential impact of Brexit on SMEs, could cause defaults and losses to increase in the next several years,” DBRS said.
“For marketplace lenders competing with banks and their large balance sheets, it is particularly important to ensure that they do not over extend themselves and chase volume over quality.
“Funding Circle has proactively taken the decision to tighten its lending criteria and not chase the higher yields from lower-quality loans.”
Although loans in the riskier E band are lent at higher interest rates, they also come with lower-quality performance, DBRS said, calculating an average 14.8 per cent annualised probability of default based on adjusted outstanding loan count over the 2015 to 2018 period.
However, the data only covers a fairly benign period of economic growth, DBRS said.
The ratings agency incorporated stressed assumptions for a recessionary period of the economic cycle – and found that during a recession, loans in the riskier E category have a probability of default as high as 44.5 per cent.
Over a six-year cycle, assuming four benign and two recession years, DBRS modelled that loans graded E have an average probability of default of 24.71 per cent.
That compares to an average probability of default of 2.9 per cent in the A+ category and 5.09 per cent in the A category.
Exposure to risk band E is limited, however, representing just 3.3 per cent of the outstanding portfolio balance at closing.
Assuming the same four benign and two recession years, DBRS also found that loans graded B have an average probability of default of 8.08 per cent, loans graded C of 9.41 per cent, and loans graded D of 15.87 per cent.
Funding Circle has completed four securitisations of UK SME loans. Its first and second securitisations were valued at £129m and £206.5m, in 2017 and 2018 respectively, and a third in April this year was valued at £187m.
Its latest was valued at £232m.
DBRS upgraded the loans in Funding Circle’s second securitisation, SBOLT 2018-1, to a higher A rating in May this year after better than expected performance.
“We have remained cautious on marketplace lenders and the potential risks associated with volume-driven fee-based business models.,” Carlos Silva, head of the European structured credit team at DBRS and lead analyst for the two DBRS-rated transactions said.
“Other originate-to-distribute models had very dire consequences in the last crisis.”
“Funding Circle’s decision to tighten credit standards by sacrificing growth is welcome from a credit risk perspective and demonstrates a focus on the long-term sustainability of its activities rather than on a growth-at-all-costs formula.”