Peer to Peer Lending Will Pass Base Rate Rise Test
One of the most common questions we get from investors, particularly newcomers to the peer to peer lending (P2P) industry, is:
"What will happen when interest rates rise?"
Last week, the Bank of England (BoE) increased the base rate, albeit marginally, by 0.25% to 0.5%. Although this change is too small to have a ripple effect on the P2P market, it could signal a trend for interest rates to rise. This is the first base rate rise since 2007 as indicated by the chart below.
Figure 1: Bank of England Base Rate Over time
Unlike a bank, lending rates at P2P platforms are not directly affected by the BoE base rate. The rates earned by lenders (paid by borrowers) are driven by supply and demand. As the banks change their lending rates (as example, BoE base rate change), however, the competitive landscape of the P2P borrower market changes and inevitably we will see changes to P2P interest rates. It’s unlikely that we’ll see P2P rates change when the base rate moves 0.25%, but if it moved by 2% we would see a variation. Therefore, tracking the base rate is important.
Despite Zopa operating when interest rates were above 5% (2007), there is no doubt that P2P has flourished in a low-yield environment. With savings rates below inflation, the real value of money held in savings accounts declines over time. The challenging conditions of savings accounts may have motivated people to focus their attention on alternatives, such as P2P. Peer to peer lending in the early days was often pitched as a savings alternative and people were potentially willing to accept the risks associated with lending to individuals or businesses in return for inflation-busting returns, but, we are now faced with another question:
"If the BoE base rate was to continue to increase, to a level where people once again benefit from 5% returns on their savings, would people stomach the risks associated with P2P?"
If we are set on comparing P2P with savings products, which is incorrect (P2P is an investment, not a savings product), the answer to this question depends on how much premium P2P platforms can offer investors above their saving rates. This differential is the premium investors deserve for the extra risk they are accepting for investing in P2P.
As we’ve stated, the P2P platform rates will indirectly follow the base rate. In today’s market, P2P returns on the mainstream platforms are sitting around 5.5%; a 4.5% increase on Cash ISA rates if we assume a Cash ISA rate of 1% (generous). If the base rate was to rise to 5%, similar to pre-2007, we may see P2P returns reach levels of 9.5% per annum. Great! This is of course speculative and probably the best-case scenario which depends on one other major factor: borrower origination.
Achieving a perfect equilibrium of borrower requirements and investor capital is very difficult, particularly when the P2P platforms have to source customers (either lenders or borrowers) from two entirely separate markets. As the P2P market has grown in popularity, more and more investors have become attracted to the stable, attractive returns that P2P offers. The brand of ‘P2P’ generally, and the brands of the top P2P platforms, have become increasingly appealing to investors. Borrowers, however, want quick access to capital at a low cost. They are not sensitive to whether the funds are sourced from a traditional lender or a P2P platform. Reputation and brand is therefore not as important on the borrower side of the equation.
The increasing reputation of P2P amongst the investor community has created an imbalance on some of the larger P2P platforms. Zopa, for example, has been closed to new investors for most of 2017. Although it has been reported that Zopa is struggling to source borrowers this is in fact not true. In 2017 to-date, the platform has originated over £731 million consumer loans, already surpassing its 2016 total of £689 million. The platform has been successful in acquiring borrowers, it’s just not enough to meet the demand of investors.
A higher investor return caused by an increasing base rate is not going to help the P2P market originate more borrowers. Particularly when the purpose of the base rate is to control the amount of lending in the market. If an oversupply of capital forces the P2P platforms to decrease borrower rates and, consequentially, investor returns, in a high interest environment we may see a narrowing of the gap between the Cash ISA rate and the returns on mainstream P2P platforms. If the returns are too close to the saving rates, P2P simply won’t be worth the risk.
The only solution is for the P2P platforms to beat the banks at originating borrowers. Either market conditions could deter the banks from competing or P2P platforms will need to beat them at sourcing borrowers and delivering a superior user experience. Easy for Orca, a P2P aggregator focused solely on investors to say, perhaps!
Regardless of whether the base rate is 0.25% or 5%, providing P2P platforms can continue to offer value to both borrowers and investors, the industry will pass the test of rising base rates. As P2P weathers different market and economic conditions, people, and the wider financial services industry, will understand that the fundamental structure which underpins P2P does, naturally, deliver value to both investors and borrowers.