Today’s start of the 2016/17 tax year sees the Government’s introduction of the Innovative Finance ISA, a new tax wrapper which sits alongside the traditional Cash ISA and Stocks & Shares ISA and which will allow individuals lending money through the Peer-to-Peer (P2P) sector to receive loan interest tax free.
The P2P lending sector has matched thousands of individual borrowers with individual lenders over the past decade and, in recent years, the sector has enjoyed unprecedented growth in uptake – over £5 billion in P2P loans have originated in the UK so far. Many individual lenders have enjoyed a level of return not seen since the days of the 6 percent Cash ISA – by now a distant memory for many cash-rich, yield-poor investors. Meanwhile, borrowers continue to sing the praises of the various P2P platforms, whose streamlined loan application processes make applying for a loan quick and stress free. Yet the key questions are these: will the introduction of the new Innovative Finance ISA shift Peer-to-Peer lending away from being an interesting, but largely obscure, form of ‘alternative’ investment, and into the mainstream? And, more pressingly for potential lenders, are the returns worth the risk?
First things first – the Financial Conduct Authority (FCA) has made it clear that prospective lenders must be made aware that Peer-to-Peer lending has very different risk characteristics to straightforward deposit-style saving, such as bank or Cash ISA saving.
One of the major differences in risk that any would-be Peer-to-Peer lender must consider is that of loan liquidity, and its impact on how readily cash can be accessed. Whilst it is the case that, as with many bank savings accounts, the platforms generally offer a choice between short and long term options, having ‘instant access’ to funds deployed through a P2P platform is almost entirely reliant on there being an established secondary market – within the platform itself – in which willing sellers can be matched with willing buyers. Further, assuming a willing seller and a willing buyer can be successfully ‘paired’ within the platform, the process of reaching a satisfactory buy/sell price means that – in reality – ‘instant access’ could very well mean having to sell the loan on at a discount to its original face value.
Another important difference that would-be lenders must consider is that – unlike most Cash ISA and other savings products – the Innovative Finance ISA (and Peer-to-Peer lending itself) are not covered by the Financial Services Compensation Scheme (FSCS).
The FSCS is the UK’s statebacked statutory compensation scheme for the banking sector, protecting savers who use FCA-authorised bank and building society savings accounts by as much as £75,000 in the event of that bank or building society collapsing. In the event of a Peer-to-Peer loan (or loans) becoming unpaid for any reason, the individual lenders would have no basis on which to seek compensation from the FSCS.
As a result and in an effort to provide assurance to both current and would-be lenders, a number of platforms have introduced their own internal ‘reserve’ funds, which have been designed to protect lenders in the event of either individual borrower default or – in some cases – total platform failure. A platform might for example contribute a portion of its fee and margin income to an internal reserve fund, the idea being that – where a borrower defaults on their loan repayment obligation – the platform then has the ability to make an internal claim against the fund for any remaining principal and interest due.
It is very important that lenders understand however that these reserve funds are not statutory. Where they are in place, they are operated on a purely discretional basis – meaning that there are very likely no guarantees that any individual claim would be approved, or even that sufficient cash will have been reserved to make good any shortfall that the lender may be experiencing. There is additionally an ongoing risk to the lender that any given platform may, at any time, choose to change its reserve fund policy – this may sound unlikely, but it could happen for all manner of reasons.
Borrower credit risk also represents a key consideration and one that many ISA savers may not have previously had reason to consider. Whether the platform operates an individual (manual) loan bidding process or whether it uses automated bidding to pool lenders’ capital across a range of riskbanded loans, each underlying loan carries its own risk profile and if Peer-to-Peer lending platforms are to provide consistently strong returns over the long term they must ensure that they deploy adequate credit underwriting processes,as Lord Turner’s comments highlighted back in February:
“You cannot lend money to small and mediumsized enterprises (SMEs) without someone doing good credit underwriting. This idea that you can automate that on to a platform, it has a role to play, but it will end up producing big losses.”
Successful credit risk underwriting for SME loan applications is far from straightforward, and relies very heavily on the successful deployment of comprehensive legal and financial due diligence processes, which are expensive and which require specialist skills and experience.
Once this risk underwriting process has been completed and the loan application approved, most platforms then grade applicant borrowers according to their own internal risk benchmarks or ‘bandings’. Unfortunately, it can be very difficult, if not impossible, to compare credit risk bandings across multiple platforms on a truly likeforlike basis. What makes comparing credit risk across multiple platforms particularly difficult for lenders is that, in effect, Platform A’s risk bandings do not necessarily correlate to those of Platform B. Or do they? It is very difficult to say.
All things considered however, the sector has for the most part delivered returns which have been broadly in line with both the platforms’ and lenders’ expectations – though not without exception. Prospective lenders and those considering opening an Innovative Finance ISA should bear in mind that the UK has not yet seen a full economic cycle of boom-and-bust during the relatively short timeframe in which the Peer-to-Peer lending sector has operated at its current levels. Ultimately, time will tell how this form of investing performs during a period of economic difficulty but – as with any form of investing – it is important to understand that regardless of the prevailing economic climate, past returns are no guarantee of future performance.
For more information, visit www.innovativefinanceisa.org.uk