RATESETTER is planning to introduce stress testing to its provision fund over the next financial year.
The ‘big three’ peer-to-peer lender’s provision fund is a buffer that protects investors against losses should any of its loans default. Borrowers pay cash into the provision fund in accordance with RateSetter’s assessment of their creditworthiness.
RateSetter manages the provision fund so that it can pay out more than the firm’s entire expected losses.
“Currently, we manage the provision fund to an interest coverage ratio in excess of 100 per cent of expected losses in order to provide for unexpected losses – in other words, we provide for stressed scenarios via the excess,” RateSetter founder and chief executive Rhydian Lewis (pictured) told Peer2Peer Finance News via email.
“I have been wanting for some time to look at an alternative way of doing this which is to provide for stresses through the expected losses figure instead and therefore we are planning to introduce stress testing to the provisioning over the next financial year.”
If a loan goes into default, the provision fund repays the investor’s outstanding capital. The fund then aims to get the loan back on track or makes recoveries, which are then paid back into the fund.
Due to the nature of RateSetter’s short-term loans, the firm can react quickly to defaults, and top up the fund accordingly. In the event of higher levels of defaults, the company could also start making loans to less risky borrowers in order to increase the overall quality of the portfolio.
“Another thing worth bearing in mind is that our loan portfolio is short duration which means a fast feedback loop on credit performance,” Lewis said. “This gives us confidence that our expected losses calculation, the underlying assumptions of which are updated and reviewed every quarter, reacts to any emerging stresses promptly.”
The provision fund means that every investor’s exposure is fully diversified across the entire loan portfolio, sharing risk across all active loans between all investors. This means that credit risk is the same for each investor, and it nullifies the risk of any single investor receiving lower returns as a result of being matched to one or two bad loans.
Although RateSetter’s provision fund has so far had a good track record, the company notes on its website that it is not a guarantee of the future and that investors’ capital is at risk if the provision fund were to be depleted by increased borrower defaults.