Fourteen percent

fourteen percent

Maybe an odd title for my first blog, but I will come back to the significance of that number later.

After a long history in credit risk management across diverse products and countries, I have recently joined RateSetter in Sydney as Head of Credit Risk. I wanted to share with you some observations from my first month on the job.

There are many business models within the world of lending. The development of peer-to-peer or marketplace lenders has further broadened the range of lending business models in existence. What may be less apparent to outside observers, however, is that across all lending business models – including peer-to-peer lending – the core tenets of risk management are (or should be) virtually identical.

Key principles

No matter the business model, I believe a number of risk management principles must be met:

  • First, there must be transparency around key business areas such as marketing, credit and operations, and expectations must be effectively communicated so there are no surprises
  • Second, risk management must be prioritised across the organisation – from product design to customer service, to loan book management – so that risk awareness and mitigation is deeply ingrained in the organisation’s cultural DNA
  • Third, the right tools, processes and resources must be available so that credit risk can be effectively measured, priced and managed

During my first month at RateSetter, I have confirmed my view that the above foundations are indeed in place. This has allowed me to focus my time on analysing the RateSetter loan book and the Provision Fund. The concept of provisioning, or setting aside funds for future losses, is something banks have been doing for centuries. In marketplace lending in Australia, however, it is something quite unique to RateSetter.

RateSetter’s provisioning

The mechanics of RateSetter’s provisioning are straightforward: when a personal loan is underwritten, the probability of default and expected loss given default are estimated, and a corresponding charge is applied to a loan. This amount is transferred to RateSetter’s Provision Fund where it is held on trust for the benefit of investors.

The idea is that the Provision Fund grows as loans are drawn so that funds are available to help compensate investors in the event a borrower is late in making payment or defaults on a loan. The absolute priority, unsurprisingly, is to ensure that enough funds are allocated to the Provision Fund so investors are protected from defaults on a through-the-cycle basis (ie in both good and bad economic conditions).

Of course, the Provision Fund doesn’t provide investors with a guarantee. Rather, investors rely on RateSetter retaining its proud track record of ensuring investors receive every amount of principal and interest due, and on the transparency with which they are provided – including credit performance to date, the amount of money in the Provision Fund, expected defaults, current loan arrears and so on.

So, back to ‘fourteen percent’.

A key question investors might ask is: “what loss rate would the loan portfolio have to experience before my principal investment is at risk?” Given the number of assumptions involved, this is a difficult statistic to calculate, but it’s something that I can shed more light on.

My analysis suggests that if among other assumptions, RateSetter in Australia were to stop approving loans today, historical amortisation rates continued to apply across the average loan term, and the portfolio loss rate was constant across the amortising loan book, I estimate the loss rate would have to increase from the current 0.2% to approximately 14% before, on a portfolio basis (not on an individual investor basis), the amount in aggregate paid back to investors would be less than the current value of loans outstanding.

Further, RateSetter could, if it started to see a deterioration in credit performance or the economy experienced a significant shock, utilise levers in its underwriting and risk-based pricing to help mitigate overall credit risk.

As I expressed at the beginning of this blog, a critical component of effective risk management is transparency. So to that end, I look forward to sharing further insights with you in the future.

This post is accurate as at 31 May 2016. No responsibility or liability is accepted by RateSetter or its related entities for any errors or omissions or misstatements however caused or arising. Any opinions, forecasts or recommendations reflect the judgment and assumptions of RateSetter and its representatives on the basis of information at the date of publication which may later change without notice. It is not intended that this post be updated to reflect any changes in RateSetter’s opinions, forecasts, judgements or assumptions.

This information does not constitute financial advice and you should consider whether it is appropriate to your circumstances before you act in reliance on it. Any opinions, forecasts or recommendations reflect the judgement and assumptions of RateSetter as at the date of publication and may later change without notice.