New Generation Moneylenders
By Jeremy Hazlehurst Wednesday, 01 June 2011
Banks have never been popular, but borrowers haven't had a choice. But a new generation of peer-to-peer lenders is harnessing the internet to offer better rates and higher returns. Where's the catch?
Hate the banks? You're not alone. Their unwillingness to lend to small businesses is potentially slowing the recovery and putting jobs at risk. But, despite the bankers' stinginess, life goes on, and a new generation of lenders and borrowers are cutting out the banks completely and opting for a new alternative - peer-to-peer, or P2P, lending websites.
The first P2P site was Zopa, which launched in 2005. Inspired by eBay, it aimed to harness the internet's power to create a feeling of community and create a marketplace where lenders and borrowers could come together. It was followed by another similar site, RateSetter, and now the banks' reluctance to lend has triggered a new generation of copycats such as Funding Circle and Funding Store that facilitate lending not to individuals, but to businesses.
So how do they work? RateSetter was launched last October by Rhydian Lewis, an ex-Lazard investment banker, and former RBS man Peter Behrens. Borrowers want to do ordinary things, like buy a car or pay for a wedding, but for whatever reason can't or don't want to go to the banks. Potential borrowers simply register, explain how much they want, why, and give some details about their financial affairs. The site credit checks them and if they are deemed reliable they can ask for cash. Lenders then each offer a fraction of the loan, at a cost they choose. So, somebody who wants £3,000 for a conservatory might be loaned £20, £50 or £100 by dozens of people at a variety of rates.
Is it risky? RateSetter says that as long as you do your due diligence and credit-checking properly, a large book of consumer loans is a very stable and predictable asset. To boost lender confidence, RateSetter lends only to 'prime borrowers', which it rates as A-star and A credit risks - just 12% of applicants have been approved so far.
This explains why, with £3m lent, there has not yet been a single default, although the company admits that this can't last forever. And, as it is regulated by the OFT rather than the FSA, peer-to-peer lending is inherently riskier for investors. P2P firms are not part of the Financial Services Compensation Scheme, which guarantees that high street bank customers get their money back if the bank goes bust. Some make their own provisions by way of compensation - RateSetter has a Provision Fund, into which all lenders pay a small amount, which aims to ensure that all investors get compensated in the event of a default or late interest payments. The fund has worked for the small number of late payments that have been encountered, but is untried for defaults.
So far, returns look pretty healthy, at least by comparison with those offered by regular savings accounts. Over three years, lenders - a mix of individual investors and businesses - get an 8.5% annual return, inclusive of all fees (although they have to pay tax on this), while borrowers pay on average 10.9%. Alternatively, there is a one-month rolling loan that allows you to get your money back any time you like and that pays out 3.8% to lenders - borrowers on this scheme are charged 7%, which RateSetter claims is 'the cheapest consumer credit available in the market today'.
Funding Circle is a different proposition, being aimed squarely at businesses. One of its chief attractions is its speed. Applications, the firm says, can take as little as 25 minutes and - once submitted - the underwriters will come back with a yes or a no within 48 hours. If you get a green light, the loan request is listed on the online platform and an auction begins. Once the loan is fully subscribed, investors may compete with one another, offering better rates and cheaper repayments for the borrower. Such auctions can last for up to two weeks, although borrowers are also free to accept offers as soon as their loan is fully funded if they need the money more quickly. The quickest so far has been two days, much faster than a bank would normally process a loan request.
Potential borrowers are placed into bands depending on their calculated likelihood of default, so lenders can manage their risk. There is even an eBay-like 'autobid' feature that automatically bids on loan requests, and buys parts of existing loans from other lenders. So far Funding Circle has facilitated loans of £10m to about 150 businesses. There are 'several thousand' lenders and 'tens' more sign up every day. As yet, the default rate is zero (it only launched late last year) and over the long term the predicted loss rate is 0.5% to 2.3%.
Although it's still early days, with these tiny default rates and decent returns, peer-to-peer lenders look like a no-brainer. But will they scale, and can they survive when the banks start lending again? Nick Badman of Cass Business School's Centre for Entrepreneurship is sceptical. 'At the moment, there is a big space for peer to peer - it is the debt equivalent of angel investing - because the banks lent too much and are now massively over-correcting,' he says. 'In the longer term, when they sort themselves out, the cycle will shift again and they will come back to the SME market because of the huge potential profits in it. They have powerful distribution and this will put peer-to-peer under pressure.'
And then there's the question of why so many individual investors are ploughing their money into P2P. As soon as interest rates start rising, these frustrated savers may well move back into more conventional products, where their deposits are guaranteed.
For their part, the P2P sites like to see themselves as providing the sort of old-fashioned personal service that banks no longer do. They also play up the online community angle, which goes down well with eBay fanatics and the IT crowd (who were early adopters). P2P lenders need to be a fairly hardy and active breed - with only the sites' own credit-checking systems to help them, they have to fall back on their own instincts. A quick look at Zopa reveals that among those individuals asking for a loan are 'a part-qualified accountant' who claims that he always lives within his means; somebody who wants to buy a VW campervan; and another, who claims 'I am super-reliable', wants to borrow £10,000 to buy a second-hand car for his other half and reveals he has a penchant for expensive holidays. With businesses, things are both better and worse. You can look a business up and make some sort of judgement about it, but to an extent you have to assume that most people are honest and that the site's checks are solid. If and when the online scammers move in, there could be trouble.
There's also the slightly disingenuous way the sites refer to lenders as 'savers'. With no guarantee that your money won't vanish, 'investors' might be a more accurate description.
Unsurprisingly, the peer lending sites argue that they are here to stay. RateSetter thinks that peer-to-peer lending could make up 20% of loans in the UK - according to government figures, 92% of SME lending currently comes from the five biggest high-street banks. Andrew Mullinger, co-founder of Funding Circle, says that the fact that the financial services are 'in flux' means the industry has a great opportunity. 'Once we can show that the credit risk is managed and SMEs can see us as an alternative then this model will be adopted and understood,' he says. 'We are looking at the banks' model and saying that this is a more efficient way of doing it.'
Sceptics may claim that it's all just a product of the downturn, but something is certainly afoot. Another alternative funding platform is Invest BX, a service that puts SMEs looking for investment in touch with investors, and advises businesses looking to raise up to £2m of equity. It also runs a local stock exchange for Midlands businesses. It's an intriguing idea, albeit arguably something of a throwback. Once there were dozens of such local stock exchanges in the UK, but technology that made it easier and more productive for everyone to list in London wiped them out. The Invest BX company index lists only three businesses.
Perhaps a middle ground is one of Funding Circle's innovations, which encourages investors to form 'circles', groups of like-minded investors who can share knowledge of an industry or a geographical region, rather like a Facebook or LinkedIn group. Among the most popular are 'support UK manufacturing and engineering' and 'London small business' circles, which suggest that online communities of knowledgeable and committed investors could be willing to back the kind of specialist ventures that the banks always struggle with. Nobody knows if any of this will survive long. But the alternative funding scene is throwing up some intriguing possibilities.
THE ENTREPRENEUR - GILES ANDREWS, CEO OF ZOPA
'I'm not the typical entrepreneur,' says Giles Andrews (above). In fact, his route was rather unusual - after Oxford he became a car salesman. He quickly rose through the industry and after an MBA at Insead was approached in 2004 to set up a peer-to-peer lending business. The model, he says, was 'an online credit union', with a slightly more sophisticated concept. Corporations borrow on the bond market, where ratings agencies assess risk, and the Zopa founders realised that you could do the same with individuals, with personal credit ratings playing the role of the agencies.
The second spur was eBay. 'Part of its success was the interest people had in interacting with each other. They created a social value as well as an economic one.' And so Zopa was born.
It didn't take off immediately. 'For every person who thought it was a great idea there were others saying that surely every deadbeat on the planet would come along and ask for money. Until you have three, four years of track record it's hard.'
But then came the credit crunch. Zopa has now facilitated loans of £130m to over 26,000 people, while similar numbers have lent - the average being around £5,000, which is tied up for up to five years (but you can cash in at any time). Returns over five years are 'around 7%'. Zopa takes 1% of returns once a year and charges borrowers a flat £130.
Borrowers typically want to get a new kitchen or a car. The maximum loan is £15,000 and default rates are 0.7%. Zopa does soft credit checks and won't take on people it sees as risky. Zopa says its loans are 20% cheaper than the banks'. Nearly all are paid off early and there are no fees for doing so. It's quick too - the average decision takes two days.
The hardest thing for Zopa has been changing behaviour. 'People don't like banks, but they understand them,' Andrews says. Maybe that won't be enough any more.
P2P IN NUMBERS
Average yield for lenders from P2P sites:
Funding Circle: 7.3%
Cost of borrowing:
Zopa: 8.2% (average)
Funding Circle: 6.4%-10.7%
THE BORROWER - TIM LORD, BERKSHIRE RIDING CENTRE
Tim Lord has been banking with Barclays for 40 years, ever since he was 17, so when he wanted money to build a new barn at his flourishing Berkshire Riding Centre he naturally asked the bank. Amazingly, although it had known him for decades as a private and a business customer and knew that he was a good risk, it wouldn't give him what he needed.
'Barclays would lend me £25,000 unsecured, but for more than that it wanted me to secure it against my house,' says Lord. In the current climate, he says, this reluctance to lend to even the most solid businesses means that 'as far as I can tell, the banks are a hindrance to small business growth'. And so, after a letter from Funding Circle dropped on his doormat he decided to give it a try.
'I went on the website and it was very straightforward, it took an hour or two to fill in. Most of it was information that you can find in Companies House, the rest was a few projections about the business, nothing very complex.' After a review of his details, Lord was given an A-plus rating - the highest - and the request for £50,000 went up on the website. You can choose to be anonymous, but Lord thought it was only fair that people could check out him and his business. Only two people even emailed him to ask for more information, the rest were happy with what he had posted. Within two weeks he had raised the money from '500 to 600 people' at a rate of 7.35%, compared with the rate in the low teens that the banks were offering.
The problem with the banks, says Lord, is that they price a loan as if they are taking a huge risk, when they know that with a business like his they actually aren't. Unless they drop their rates down to the levels available from alternative funding providers, Lord sees no need to use them again. 'If I had any more financing needs I would certainly use Funding Circle,' he says. 'And I would certainly recommend it to other people.'