Digging into the Data: The evolution of the assessment process
With the United Kingdom voting to leave the European Union, we wanted to assure you that despite the current political and economic uncertainty, Funding Circle has a robust credit assessment process to seek to ensure the businesses you lend to are resilient.
In this edition of Digging into the Data we will be looking at how our credit assessment process works in more detail, its development and improvement over time, and announcing the latest changes we are making. We will also discuss how we have stress tested our loanbook to seek to ensure Funding Circle portfolios are able to weather periods of volatility.
How does our assessment process work?
When assessing a business, we use a balanced mix of risk tools to ensure we create a full picture of the borrower’s financial health. These are centred around three key pillars; statistical credit models, expert judgment and policy criteria.
Statistical credit models
We have developed proprietary statistical credit models that rank potential borrowers by order of risk, taking into account thousands of individual criteria both from publicly available data sources (like credit reference agencies) and our own database of historical data (including more than five years of information on UK companies). These statistical credit models are used to assign a risk band to the loan, from A+ to E, and identify businesses we are unable to help.
As Funding Circle has grown over the last five years and more loans have matured, this has provided us with more credit performance data, allowing us to make even more accurate statistical credit models. Since we launched in 2010, more than 14,000 businesses have been funded on the platform. We regularly update our statistical credit models to ensure we leverage this valuable experience. As you can see from the below graph*, our 2016 models benefit from being built on a population size significantly larger than what was previously available to us:
More data allows us to determine with more precision which factors influence whether a business is more or less likely to default on a loan. This means we get better at ensuring the right businesses are approved, creating more lending opportunities for investors while increasing confidence in the predicted loan performance. This accumulation of experience over time creates a virtuous circle:
Alongside our statistical credit models, each business is manually assessed by a member of our credit assessment team.
Our team is made up of specialist small business credit assessors, with extensive experience working at some of the UK’s most well known banks. The team reference multiple sources of data; including financials provided by the borrower and leading credit reference agencies, plus the company directors’ own personal finances.
This creates a comprehensive picture of the business’ financial position – allowing the in-house credit assessment team to raise and clarify any potential questions with the borrower before making any lending decision. If the risk of default is deemed higher than our risk bands allow for, the business will be rejected.
By combining expert judgment with statistical credit models, we can make balanced credit decisions resulting in robust credit performance. More information on the expected and actual default rates for our risk bands can be seen on the statistics page.
Funding Circle receives thousands of applications from small businesses, and having a simple set of policy criteria has enabled us to filter out businesses that have a low likelihood of being approved.
Policy criteria are designed to give direction to business owners so they know whether they may be eligible for finance. This means our credit assessment team only spend time on the right type of applications. As we have accumulated more data on UK businesses over the past five years, we have found that a certain number of creditworthy businesses might have been overlooked, despite being successful and healthy businesses.
To ensure we can help more creditworthy businesses, we regularly review these policy criteria and make any necessary adjustments, retaining the criteria that have proven to identify borrowers outside of our risk appetite. Our latest set of policy criteria are:
- A minimum of two years trading history
- At least 1 year of filed or formally prepared accounts
- No outstanding County Court Judgments larger than £250
With the 2016 generation of statistical credit models and the latest version of policy criteria, we expect estimated average returns to remain consistent: for loans that were originated in 2016 the estimated average return is 7.2%**, with an expected annualised loss rate of c.2%. We also expect performance by risk band to remain the same, although as always, it is important to highlight that your capital is at risk when lending to small and medium businesses.
Consistent results over time
As a result of our improving statistical credit models, our ability to determine which loans are more likely to default has increased. When Funding Circle started, loans accepted on the platform had a similar default rate to those rejected at the final stage of the assessment process. As we have incorporated a wider variety of tools and data sources this ratio has improved, so that by 2015 loans rejected at the final assessment stage were five times as likely to default as those accepted on to the platform.
The below graph shows our bad debt performance against expectations for loans originated each year since Funding Circle started. The data shows the loss rate for loans after 12 months, net of total recoveries received for those loans, for each cohort as a percentage of our expected loss rate. Please note our 2015 cohort is not included as it has not yet seen a full 12 months of performance:
As losses are shown net of total recoveries, previous cohorts have received an additional 12 months of recoveries than subsequent cohorts. Over the last four years, loss rates on the platform have been consistently within or below expectations, despite making changes to our assessment process and introducing higher risk bands.
For up to date information on marketplace performance, including bad debt performance over time by year of origination, please visit our statistics page.
Are we prepared for a downturn?
Following the referendum result for the United Kingdom to leave the European Union, you may have questions about the potential impact an economic downturn may have on your portfolio. Although we are unable to predict exactly what will happen in the future, we have always made preparations to ensure that we are well equipped to weather periods of economic uncertainty.
In 2014 we invited an industry leading external consultancy, Hymans Robertson, to undertake a full assessment of our loanbook. Simulating economic conditions experienced in both the 1992 and 2008 recessions, we were able to see how returns could vary if we saw another downturn in the economy. The full results can be seen on our blog, and we are currently undergoing a new stress test with the results to be published in due course.
At this stage, we don’t expect any potential fallout from the referendum result to create a credit situation worse than previous recessions, and since the performance of our loanbook has remained stable over the past two years, we think that the 2014 stress test exercise still provides a relevant view of what an economic downturn could mean for returns.
In parallel, we have also deployed contingency plans regarding our portfolio tracking and collections activities, scrutinising any sign of stress and ensuring we are ready to take action quickly if credit performance showed any sign of deterioration.
We are committed to enabling investors to earn consistent attractive returns, by lending directly to British businesses and helping to support economic growth. We will continue to make improvements and adjustments to our assessment process, including in response to changing conditions in the wider economy, so you can have confidence lending to businesses through Funding Circle.
We hope you found this piece useful, and if you have any questions please join the conversation over on our forum, or if you have further questions about how our credit assessment policies work, you can watch a recent interview with our Chief Risk Officer, Jerome Le Luel, here.
The Funding Circle team
* The graph shows the number of loans originated on the platform that were at least 12 months old, as of July for each year.
** You can see how our estimated returns are calculated here.