Responding to feedback on Provision Fund flexibility
We are proud of our track record that every RateSetter investor has received every penny of capital and interest that they expected. The Provision Fund is at the heart of this, acting as a buffer against missed payments and bad debt, and we manage the Provision Fund with the aim of maintaining this perfect performance into the future.
For some time now we have gathered feedback that while this is a fantastic track record, the Provision Fund is too “binary”: either delivering all interest and capital perfectly on time or winding down with a seemingly unquantifiable loss. We have listened to this feedback and agree with it. So today we are announcing how we propose to build flexibility into the Provision Fund consistent with the interests of our investors.
The interest buffer
We know that our investors understand that there is a risk in lending through RateSetter, but we also believe that they wish for us to do everything we can to manage that risk.
We display a graph on our website which illustrates the extent to which defaults would need to rise in order for investors to actually lose capital as opposed to just not getting all their expected interest. To express this in concise terms, there is effectively a ‘Capital Coverage Ratio’: the factor by which Expected Losses would need to rise before anyone’s capital is at risk.
As it stands today, the Provision Fund has a value of £22m. This, based on our latest estimates, should be sufficient to absorb all of the £18m Expected Losses with a margin to spare. We express this as the Provision Fund Coverage Ratio of 120%, which is updated in real time as loans are both written and repaid.
We estimate that the interest ‘buffer’ sitting beneath the Provision Fund currently stands at over £30m. It is important to say that this figure is the lifetime interest owed on existing active loans with an appropriate discount applied to reflect that loans may repay early or not at all.
If you add the £30m interest to the £22m Provision Fund and then look at this combined buffer in relation to the £18m Expected Losses, then you arrive at a ratio – a ‘Capital Coverage Ratio’ – close to three times Expected Losses. This is illustrated in the table below.
We hope the concept of a Capital Coverage Ratio will reassure investors because it shows that the chance of actually losing money by lending on RateSetter is quite low because, over and above the Provision Fund, there is an additional buffer of interest that would protect investors against a capital loss. We will start reporting the Capital Coverage Ratio on our website.
The Capital Coverage Ratio should also be helpful in the context of the wider P2P industry because it is a ratio that can be compared to P2P platforms who choose not to have a Provision Fund but do quantify the factor by which losses would need to rise before investors would lose money.
Updating Lender Terms
We will update our Lender Terms in order to make it explicit that in times of severe stress the interest buffer would be available to the Provision Fund. This will allow for the interest received by every investor to be reduced equally and for this foregone interest to accrue to the Provision Fund.
So, for example, if the reduction was 20%, the total interest due to all our investors would reduce by 20% and this amount would instead flow into the Provision Fund. This period would be kept to a minimum duration and as soon as the Provision Fund Coverage Ratio was sufficiently strong, it would stop and return to normal.
If the outlook got worse and investors’ capital was at risk – not just their interest (in other words, the Capital Coverage Ratio was in danger of dropping below 100%) – then all investors’ capital would be reduced equally, as well as all of the interest. This capital and all interest would go into the Provision Fund to strengthen it.
During these periods, the secondary market would remain open, although investors should expect that liquidity would be lower and the cost of accessing money early would be higher. In either scenario, RateSetter would of course seek to rebuild the Coverage Ratio and return to business as usual as quickly as possible.
We would like to emphasise that it is not in RateSetter’s interests as a business for either scenario to occur and we are highly incentivised to maintain our track record of delivering all our investors’ capital and interest in full.
For the avoidance of doubt, we are making this update because it is always important to consider adverse scenarios, however remote – but we are not anticipating such scenarios! The purpose of this update is to introduce a structure that allows stability in the event of worse than expected outcomes. We believe this is in the overall interest of our investors.
Our intention is for the new Lender Terms to be effective from 1 March 2017. We will post further information in advance of that date.