Inside RateSetter: Provision Fund metrics

In last week’s blog our Chief Operating Officer, Jonathan Hodge, explained what the Provision Fund does and how it operates.  This week we asked Chief Credit Officer, Michael Hoare, about the Provision Fund’s key metrics and how they are calculated.

What is the effect of the Provision Fund for investors?

By acting as a buffer against credit losses and spreading every investor’s risk across the entire portfolio, the effect of the Provision Fund is that investments perform more consistently and more predictably.  Outcomes are base on the performance of the portfolio rather than the specific loans an investor is matched to.  If the Provision Fund didn’t exist, missed payments and loans that don’t repay in full would be deducted from returns and invested money, with outcomes varying between investors depending on performance of the specific loans that they are matched to.

What is the Coverage Ratio?

Our headline metric for the Provision Fund is the Interest Coverage Ratio.  This is a measure of the ability for the Provision Fund to ensure investors receive their interest.  An Interest Coverage Ratio at or above 100% means the Provision Fund is able to cover expected future credit losses and investors receive all their future interest.  A figure below 100% means the Provision Fund will not be able to cover expected future credit losses without some future investor interest being at risk.

Alongside this we publish the Capital Coverage Ratio.  This is a measure of the ability for the Provision Fund to ensure that all investors’ capital is protected.  Investor capital is protected by the Provision Fund resources plus future investor interest – in other words, if expected future credit losses are greater than the size of the Provision Fund plus future expected interest, then investor capital is under threat.  A figure at or above 100% means investor capital is fully covered.

We publish both Coverage Ratios on our statistics page and we update them at the end of each month with data from the start of the month.  We also include the latest data in the monthly investor statements.

How the Coverage Ratios are calculated?

To work out the Interest Coverage Ratio, we first calculate the total resources the Provision Fund has.  This is the cash it holds, plus cash that existing loans will pay into the Provision Fund as they make repayments (we reduce this number to take into account the fact that some loans will not repay in full and some will repay early, with the typical reduction being 30% mainly due to early repayments).  This gives us the size of the Provision Fund resources.

Separately, we calculate expected future credit losses for every loan in the portfolio and add this up into a single figure.  This expected future credit loss number is the value of future defaults, less any recoveries we expect to achieve on those loans and historic defaults the Provision Fund has already covered.

Then we divide the Provision Fund resources by the expected future credit losses to give the Interest Coverage Ratio.

To calculate the Capital Coverage Ratio, we add the expected future investor interest (also reduced, as above) to the Provision Fund resources and divide this by expected future credit losses to give the Capital Coverage Ratio.

How does RateSetter calculate expected future losses?

When we provide a quote for a loan we determine the borrower’s creditworthiness.  This assessment drives an estimate of the expected future credit losses from that loan, which in turn determines how much the loan pays in the Provision Fund.

Every month we update expected future credit losses based on the movement in the loan portfolio and any bad debt experienced in the month.  Every quarter, we review the assumptions underlying our forecasts, adjusting them as necessary.  After each quarterly review, we update our statistics page and provide a Provision Fund update to investors via the RateSetter Notices of your account dashboard (the quarterly review for Q1 2020 was integrated into the announcement of the temporary interest reduction).

Why did you use an external economic forecast to calculate the increase in provisions as part of the temporary interest reduction announcement?

To reflect the uncertain economic environment, our latest quarterly review used economic forecasts from Oxford Economics, an economic forecasting specialist, as we do not have an in-house economic forecasting team.  We used their downside economic case, rather than the base case in our quarterly review.

How robust are the Provision Fund numbers?

Our objective is for all the numbers we publish to be as robust and accurate as possible.  As part of our quarterly review processes we make refinements to the way we calculate the Provision Fund numbers in order to improve accuracy.

The Credit Risk team conducts analysis of the expected future credit loss numbers which then go through a governance process via RateSetter’s Executive Credit Committee before publication.

What happens behind the monthly numbers on a day to day basis?

Each day, money flows in and out of the Provision Fund.  Loans pay into the Provision Fund at the point they start, and they also pay in over their lifetime as part of their schedule of repayments.

Missed payments are dealt with as soon as the missed payment is recorded, and the Provision Fund steps in to make the payment to the investor.  If a loan cannot repay in full it is taken over by the Provision Fund and the outstanding capital is paid to the investor. 

How do you treat requests for forbearance from borrowers?

By providing support and breathing space to borrowers through times of difficulty we maximise the chances of getting loans back on track so they repay in full.   We speak to each borrower that requests breathing space so that our support is tailored to their financial circumstances and we keep the arrangements under review.  If breathing space arrangements mean that a borrower misses a payment, the Provision Fund steps in to reimburse the investor in the usual way.

What does the temporary interest reduction mean for the Coverage Ratios?

The Interest Coverage Ratio currently stands at 74% and the Capital Coverage Ratio is 166%.  This means that while investor capital is protected, not all future expected interest is.  The temporary interest reduction puts more money into the Provision Fund and will take the Interest Coverage Ratio back to 100%.  This means that future expected interest, during the interest reduction and then afterwards, is protected.