What happens if defaults increase?
As we only lend to creditworthy borrowers, the rate of default is very low, but we're not complacent. The level of defaults can change over time, and we monitor the performance of loans closely. We run regular scenario tests which model the impact of changes in default rates on the Provision Fund.
The following chart uses our published data to illustrate what the effect could be if loan default rates increased. Of course, RateSetter actively manages Provision Fund contributions to reduce the potential impact on investors.
*An estimate of how RateSetter’s consumer loans would fare in 2009’s credit conditions based on Equifax data
In July 2016, we updated our expected loss figures and also began to factor in contractual future income due to be paid into the Provision Fund. We are updating the chart to reflect this and will provide a new one shortly.
This chart shows what would happen to investments on the RateSetter platform at various default rates.
In short, if defaults were to increase significantly, the following things would happen:
- Firstly, the Provision Fund reduces in value.
- It may take longer than expected to receive your money back and access to your funds will be restricted.
- The Provision Fund is large enough to cover expected defaults 119 times over, but if it fell to zero then firstly, the amount of interest earned would decrease: the money that investors put in (capital) would be unaffected but they would earn less interest than they expected.
- If defaults rise further, investors would start to lose capital, which means that they would get back less money than they put in.
The Provision Fund is designed to absorb defaults, so investors are protected from losses as long as the Provision Fund has money in it. If defaults increase, the Provision Fund reduces in size, because money is being taken out of it to repay investors.
If the Provision Fund runs out, a Resolution Event would be declared (see next section), and further defaults would mean that investors begin to lose interest – that is, the full amount of capital that they put in would be unaffected, but they would receive less interest. In the chart above, investors interest would reduce if defaults passed 3.0% until defaults reached 11%. However, they would not lose capital: they would get back at least as much as they put in.
Only when the default rate exceeds 11% would investors lose any capital, and get less money back than they put in. If default rates reached 14%, investors would be expected to lose 2.5% of capital (that is, they would get back just over 97p for every £1 they had invested).
For the sake of clarity, this chart makes three prudent assumptions, which mean that it underestimates the protection of the Provision Fund:
- RateSetter actively manages the Provision Fund, by determining how much borrowers pay into it. If the Provision Fund was falling significantly in value, it’s likely that RateSetter would increase contributions into the Provision Fund. This is not reflected in the chart.
- Borrowers pay into the Provision Fund regularly, over the lifetime of the loans. This ongoing contribution into the Provision Fund is not reflected in the chart.
- The chart assumes that any default is a total loss – but in reality, RateSetter makes substantial recoveries (which means that we are able to recover money owed to us even when it is defaulted), and these are repaid into the Provision Fund, increasing its size over time.
What happens if the Provision Fund becomes depleted?
The good news is that this is highly unlikely - the Provision Fund has grown significantly in size over time and currently stands at £15,513,293 and we actively manage contributions to ensure that it is well funded.
In the event of the Provision Fund becoming depleted, RateSetter would declare a ‘Resolution Event’. This would mean that all outstanding loan contracts would be automatically assigned to the Provision Fund, and all loan repayments would be collected by the Provision Fund on behalf of investors.
Repayments would then be shared out (pro rata) to investors to ensure diversification of default risk. There would be a material delay in repayments being made.
The Resolution Event would work to give all investors a reimbursement of, for example, £0.95 on every £1.00 invested.
What happens if RateSetter ceases trading?
Thankfully, this is also very unlikely. But if the worst happened, we have a fully-funded run-off plan that would kick in, as required by regulation.
Contracts remain binding between investors and borrowers and loan repayments and the Provision Fund would continue to operate, even if RateSetter ceased trading.
During the winding up process any fees owed to RateSetter would be used to cover the costs of the run-off process to ensure that contracts with borrowers are fulfilled and investors are repaid in line with those contracts.
Investors’ money would always remain entirely separate to RateSetter’s money throughout the run-off process.