Inside RateSetter: how we manage credit risk
Michael Hoare is RateSetter’s Chief Credit Officer, overseeing the management of credit risk, loan pricing and underwriting, and analysis of portfolio performance. Following our interview with Michael last summer, we talked to him again to find out what the coronavirus epidemic could mean for credit risk.
What does the Credit team do?
RateSetter’s Credit team has three main responsibilities:
- Accepting or declining loan applications. For loan applications which are not processed automatically – which is all Property Finance and Dealer Finance applications – we have teams of expert underwriters who liaise with the applicant to review all the relevant information, and then approve or decline the application;
- Setting RateSetter’s automated credit strategies. In Consumer Finance we process many loan applications automatically. There are many that we can approve immediately based on the information provided by the applicant, Credit Reference Agencies and the proposed terms of the loan. We can also immediately decline a proportion of applications that are outside of our risk appetite. Overall, in normal times, we approve around 20% of Consumer loan applications. Setting these credit strategies is a complex process of analysing performance and building statistical models;
- Calculating Expected Credit losses for loans in the portfolio and new loans we are bringing into the portfolio. The calculation for existing loans keeps the Interest Coverage Ratio up to date, while the calculation for new loans ensures that they are priced appropriately. This process is driven largely by statistical models for Consumer Finance and individual reviews of loans for Property Finance and Dealer Finance.
What types of loans are in RateSetter’s portfolio, and how does RateSetter ensure the loan portfolio is high quality?
Our strategy is to spread lending across different types of borrowers. We consider this to be a strength of the RateSetter model as it helps to diversify risk because different types of borrower perform differently through the economic cycle. You can see our lending criteria for each loan type here. At the end of March, the loan portfolio was as follows: 69% Consumer Finance, 19% Property Finance, 2% Asset Finance and 10% other loans, mainly legacy and run-off portfolios.
RateSetter Consumer loans are typically for £7,500 over a term of around 4 years, to people in full-time employment with an average annual salary of £32,000 who own their home outright or with a mortgage. Our Property loans are typically for £1-2m over a term of 12-15 months, to experienced developers, with an average loan to future development value of 60.2% which provides a cushion. Our Asset Finance loans typically make available £100k-£150k (up to a maximum of £500k) to experienced independent car dealerships to purchase stock at trade prices for a period of 12 months. These loans are secured against the cars and supported by director and shareholder guarantees.
Alongside our strategy to diversify lending and spread risk, RateSetter has a Risk Appetite policy (much like a bank does) which is agreed at Board level. This policy defines the level of risk that we are prepared to accept across the portfolio, and this is reflected in our lending criteria. The Credit team monitors new loan originations and the loan portfolio overall to ensure that lending stays within the Risk Appetite. Should performance look to be moving out of line with our Risk Appetite, my team would work with our Executive Credit Committee and Board Risk Committee to agree actions to address this (potential actions could include changing the mix of lending or changing lending criteria within a portfolio to reduce the projected risk levels).
What is the expected economic impact of COVID-19?
The outbreak is an unprecedented event and there is still a great deal of uncertainty about how severe the economic impact might be and for how long it will go on. The causes and impacts are very different to the financial crisis in 2008-09, so that recent experience provides few clues as to how the current situation might play out. The responses of the government and regulators are evolving day by day as well, which means that economic forecasts also change continually.
My team is closely watching a number of portfolio metrics, such as the number of borrowers seeking support via breathing space arrangements and missed payment rates. We are also watching external metrics which are highly correlated with loan performance such as economic growth and employment data, forecasts and related measures.
Over the next few months we will provide more commentary around our usual monthly updates of Expected Future Credit Losses and the Provision Fund Interest Coverage Ratio, outlining how we have incorporated potential impacts from the pandemic.
Have you seen any impact of COVID-19 on the performance of RateSetter loans so far?
The government has put in place an unprecedented amount of support for both consumers (such as furlough arrangements to prevent redundancies) and businesses (such as the Coronavirus Business Interruption Loan Scheme) which we believe will help borrowers manage the financial impact of the lockdown.
Some of our borrowers have contacted us seeking breathing space on loan payments – to date this has amounted to around 3% of the Consumer loan portfolio by value, and a similar proportion of customers with legacy business loans.
We are monitoring a range of metrics and our analysis feeds into our management of the loan portfolio and Provision Fund.
Have you made any changes to RateSetter’s criteria for new lending since the epidemic started?
We are lending, but at a much-reduced level. We continue to meet our obligations to borrowers, for example, we are supporting existing Property Development Finance customers as they complete their developments – allowing construction to continue where possible as this is in the interests of borrowers and investors. We have significantly tightened our creditworthiness and affordability criteria for Consumer Finance, and we have also increased the amount new loans pay into the Provision Fund.
When will you provide the next update on portfolio performance and the Provision Fund?
Our portfolio performance data will be updated and published in the last week of this month in the usual way. This month we are undertaking our scheduled quarterly update of projections for the Provision Fund inflows and outflows and we will publish this along with commentary in the last week of the month.
What does RateSetter’s recent debt sale mean for the Provision Fund?
The debt sale was a positive development as it brought forward money that was expected to be recovered over time from non-performing loans into a cash payment into the Provision Fund. This will be reflected in our Provision Fund data when it is updated. Broadly, the movements from the debt sale will be an increase in Provision Fund cash, and a reduction in Expected Future Income, along with an increase in Expected Future Losses because we will recover less in future to offset Future Expected Losses.
|The Provision Fund we offer does not give you a right to a payment so you may not receive a pay-out even if you suffer loss. The Fund has absolute discretion as to the amount that may be paid, including making no payment at all. Therefore, investors should not rely on possible pay-outs from the Provision Fund when considering whether or how much to invest. Learn more|