Stress Testing Ones own Marketplace Loan Book David Gustin - January 28, 2015 3:50 AM | Categories: Alternative Finance | Tags: Funding Circle, stress tests There is a lot of noise around marketplace (formerly known as Peer to peer lending). It’s been almost a decade since the first UK P2P Lender Zopa launched, back in April 2005. Investors are hungry for these loans. Many institutional funds such as Blue Elephant Capital Management are raising capital to invest in marketplace loans. But what about understanding loss rates as economic fundamentals change. These are turbulent times. This is where stress tests come into play. Stress tests were made famous by the Federal Reserve to basically become the de facto capital standard to ensure banks could withstand various economic shocks to the economy. We certainly have some shocks now - $45 oil as one example, and currency devaluation in Canada or appreciation in Switzerland. So how will marketplace lenders hold up? What would happen to the their loan book, payback rates, and investor returns if we encountered further adverse economic conditions. I can tell you that no one Regulator saw $50 oil in any of their stress tests. Regulators in the States, England and Europe have conducted stress tests with their important banks, and many times found leading banks lacking in capital to withstand downturns. (thirty banks in 12 European countries must raise a combined 115 billion euros - about $150 billion). So how do some of these fast growing marketplace lenders conduct stress tests? In one lenders case, Funding Circle, they used an outside consultancy to build a stress testing model for their loan book to find out how their returns would vary during another downturn in the economy. According to Funding Circle, The primary component Hymans Robertson used when building their stress model was data surrounding historic insolvencies by sector over a period of 23 years of data (1990 – 2013). This data, available from The Insolvency Service, provides invaluable insights into how every UK sector fared during the 1992 and 2008 recessions. These are complicated models to build. Imagine trying to adjust things like unemployment rates, interest rates, inflation, wages and many other variables to then tie back into loan performance, loss given default, and investor returns. Of course, the net conclusion of the Funding Circle tests was that even in the most severe environment, their average annualized returns for investors would remain above 5.5%. You have to wonder how much of this is the Fox watching the Hen house. Also, when loans turn sour, banks have an advantage with their relationships. In the analog world, relationships matter. In a digital one, it seems data is the only thing that matters until loans sour. There is no relationship business with the borrower to create loyalty to get greater insight of needs or ability to pay. It is strictly a collection effort. p.s. to receive our weekly digest every Monday, sign up here Related Articles Discuss this: Cancel reply Your email address will not be published. Required fields are marked *Comment Name * Email * Website Notify me of new posts by email.