Inside RateSetter: the Provision Fund

RateSetter was awarded the prestigious Queen’s Award for Enterprise last year specifically in recognition of our pioneering innovation of the Provision Fund model.  We spoke to Jonathan Hodge, RateSetter’s Chief Operating Officer to find out more about the key features of the Provision Fund.

What does the Provision Fund do?

The Provision Fund is designed to help investors manage credit risk and to make investing simple.  The key things it does are:

  • Provides a buffer against credit losses: if a borrower misses a payment, the Provision Fund steps in and makes the payment to the investor. If a borrower cannot repay their loan, the Provision Fund takes over the loan contract and pays the outstanding capital back to the investor, who is then matched to other loans in the portfolio.  The Provision Fund then seeks to get the loan back on track or make recoveries.

 

  • Spreads risk: because the Provision Fund gives the same level of protection to every investor, it has the effect of spreading every investor’s exposure across the performance of the entire loan portfolio of 200,000+ loans. In other words, it is the performance of the loan portfolio as a whole that matters to investors, not just the performance of the loans they are contractually matched to.  This diversification removes the potential for bad luck from being matched to a loan that doesn’t perform, and it means that every investor is protected in the same way which makes the returns more consistent. 

Spreading exposure also means that we can support borrowers through difficult circumstances, such as those we are all experiencing now, without impacting a specific investor.  Enabling borrowers to take short breaks in their repayments is called ‘Breathing Space’.  This is a type of ‘forbearance’, which means helping to ease loan repayment challenges for borrowers over the short- or long-term.  RateSetter is working with a number of borrowers on the short-term impacts of COVID-19 and the Provision Fund means the effects of that support are spread across all investors – rather than just the investors that happen to be matched to borrowers that are being supported (which would be the case if the Provision Fund were not there).

Does it do anything else?

Yes, the Provision Fund also means that investors can see today what we expect to happen in future.  This is because the Provision Fund aims to cover all expected credit losses over the full lifetime of the portfolio, figures that we publish each month on our statistics page that help investors take a view on future performance and credit risk.  So RateSetter investors can always see the expected future losses over the lifetime of the loan portfolio plus the ability of the Provision Fund to cover those expected losses.

Is the Provision Fund similar to how banks provide for losses on loans?

Yes, it is a similar principle – both approaches are designed to put money aside to deal with future credit losses.  The latest accountancy rules (called “IFRS 9” – IFRS stands for International Financial Reporting Standards) mean that banks must provide for the expected losses over the next 12 months for non-impaired loans (i.e. loans that are repaying) and for the lifetime expected losses for impaired loans (i.e. loans that are in default and will not repay in full).  RateSetter provides for the expected losses for the full lifetime of all the loans in our portfolio.

Where does the money in the Provision Fund come from?

Every borrower pays a fee into the Provision Fund.  The amount paid in is adjusted for every borrower in accordance with RateSetter’s assessment of their creditworthiness.

Recoveries of outstanding debt also go into the Provision Fund – typically each month our recoveries team returns £500k+ to the Provision Fund.  More detail on collections and recoveries can be found in our recent blog.

In the current environment, RateSetter has implemented a temporary interest reduction for investors, with 50% of interest going to the Provision Fund until the end of 2020.  You can find out more about this here and via your RateSetter account dashboard.

How do you decide how much each borrower pays in?

When a borrower applies for a loan, our credit team makes an assessment of their creditworthiness.  Using this information, we calculate how much the borrower should pay into the Provision Fund.  This is included in RateSetter’s quote for the loan and is factored into the borrower’s APR.

What about loans secured against an asset?

For secured loans, the borrower still pays into the Provision Fund in accordance with their creditworthiness.  The asset provides another layer of security.  The security is held on behalf of investors by a separate RateSetter company, called Security Trustee Services Limited, which keeps the security clearly separate from RateSetter’s own assets.

What are ‘Expected Future Provision Fund Inflows’?  Is this money from loans you haven’t written yet?

The money each loan pays into the Provision Fund is split between upfront fees that go into Provision Fund cash, and fees that are spread over the lifetime of the loan and are paid into the Provision Fund as part of the loan’s repayments.  The fees spread over the term are the expected future inflows.  Spreading some of the fees over the lifetime of loans provides a stream of inflows into the future – this is good for sustainability as it means we don’t need to write new loans purely to add more cash to the Provision Fund.

Where is the Provision Fund’s cash held?

The money in the Provision Fund must always be readily available to reimburse investors if a borrower misses a payment or defaults, so it is kept in cash or cash equivalents with a good level of access rather than return maximisation.  The Provision Fund is able to invest to achieve a degree of diversification along with moderate capital growth but as it stands it is all in cash in UK bank accounts.

Is the Provision Fund part of RateSetter or separate? Does RateSetter take money out of the Provision Fund?

The Provision Fund is held in a company called RateSetter Trustee Services Limited, which is owned by RateSetter. The money in the company is ring-fenced and kept separate to RateSetter’s other assets. Money held in the Provision Fund is used to reimburse RateSetter investors and to cover costs of operating the Provision Fund.  If the Provision Fund builds up a surplus relative to expected credit losses, this surplus ultimately belongs to RateSetter but a surplus is not the objective with the Provision Fund’s role being to protect investors.

Does the Provision Fund help with investment release requests?

The Provision Fund does not provide funds for investor release requests.  Delivery of release requests depends on liquidity – that is the availability of other funds in the market to replace money that is being released.

However, because the Provision Fund means that every investor has the same level of risk no matter which loans they are matched to, where investors must select individual exposures to buy or sell.

Would RateSetter ever remove the Provision Fund?

The Provision Fund has always been an integral part of RateSetter’s proposition for investors and is at the heart of what makes our investments stand out – I don’t expect this to change anytime soon!

You can read further details about the Provision Fund in our Provision Fund Policy here.

 

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