P2P Lending: Understanding The Risks
Peer-to-Peer lending is a higher-risk form of investing than regular bank saving and lenders and prospective lenders must not treat the two as substitutes. Lenders’ capital is entirely at risk and lenders may receive back less than the value of their original investment.
The following is a very high-level review of some of the risks currently associated with Peer-to-Peer lending. It is not intended as a comprehensive record, nor a substitute for financial advice.
There is no protection from the Financial Services Compensation Scheme
Unlike the majority of FCA-authorised bank and building society savings accounts and Cash ISA accounts, the Innovative Finance ISA (and Peer-to-Peer lending activities generally) are not protected by the Financial Services Compensation Scheme. In the event of borrower default or platform failure, lenders are not entitled to receive compensation from the FSCS. Lenders’ capital is entirely at risk.
Reserve Funds are no guarantee
Some platforms have taken the measure of introducing internal “Reserve Funds”, which are intended to provide a degree of protection to the lender in the event that a loan cannot be fully recovered. Lenders should bear in mind however that such platforms are non-statutory and operated entirely at the discretion of the platform itself. There are presently no guarantees that any claim against any fund would be automatically paid out (or even that enough cash will have been contributed to the fund to make good a given loan shortfall). Further, a platform’s Reserve Fund policies may change over time.
Credit risk and diversification
Borrower creditworthiness must be considered, yet many first time Peer-to-Peer lenders are unlikely to have had to deal with borrower credit risk on such terms before. Some platforms operate an automatic bidding process which sometimes aims to build-in an element of diversification by spreading each lender’s funds across multiple borrowers. However, diversification is not always built in to the automatic bidding process, and lenders must consider the mechanics of the autobid process on whichever platform(s) they are intending to use. Other platforms provide highly-detailed credit analysis, which the lender can then use to make their own judgement over which companies he or she wishes to lend to; again, this process can be very difficult, particularly for the inexperienced.
Lenders must consider the extent to which they feel lending to multiple borrowers represents true diversification. It would arguably be unwise and simplistic to consider lending to multiple borrowers alone to be an adequate form of diversification; lenders must consider their exposure to Peer-to-Peer lending itself, within the context of a wider investment portfolio.
Differences in risk bandings
Many platforms have their own risk grading (or “risk banding”) system which is used to classify borrowers according to that particular platform’s assessment of borrower risk. The key consideration here is that – at the time of writing – such risk bandings are not directly comparable across platforms. A borrower may be graded “A+” by one platform, but another platform (with a different approach to risk classification) may grade the borrower as “Level 2”. It can be very difficult to compare individual borrower risk (and risk band classifications more generally) between multiple Peer-to-Peer lending platforms.
Accessing your money early
Even if there are no issues with borrower creditworthiness and the loan is being repaid in accordance with the agreement, the lender may wish to access his or her money early. It is important to consider that Peer-to-Peer lending activities are not the same as cash saving and that lenders’ capital is effectively tied up during the course of the loan. The length and structure of the individual loan agreement will determine the timing and extent to which lenders’ capital is out of reach.
Even where “secondary markets” exist, a lender’s ability to “sell” the loan to another lender should be treated with scepticism for a number of reasons; first, the ability to sell the loan is entirely dependent on their being a willing buyer and seller. Second, any buyer is likely to seek a discount on the face value of the loan – meaning that cashing in a loan mid-term might mean the lender has to accept a reduction in the amount they receive from the buyer. Third, there are very likely other costs – such as fees imposed by the Peer-to-Peer lending platform itself – which one must factor-in.
Please note that lenders and prospective lenders are encouraged to seek their own tailored and professional financial advice when considering investing in Peer-to-Peer lending.