Digging into the data: What could happen to your returns in an economic downturn?
At Funding Circle our aim is to build a stable and sustainable platform, where you can earn predictable returns by lending to creditworthy businesses. Following the recent referendum result for the UK to leave the European Union, you may have questions about the impact any future economic uncertainty might have on your returns.
We have always made preparations to be well-equipped to weather periods of economic uncertainty, and wanted to share the results of a recent stress test we conducted.
What do we mean by ‘stress test’?
Stress tests are an integral part of any financial organisation’s risk management strategy as they provide estimates around what might happen in an economic downturn. We first conducted a stress test in 2014 to simulate what could happen to investor returns during a particularly stressed period, or recession. A recession is characterised by a sustained period ‒ typically two consecutive quarters ‒ of negative GDP growth.
What did we do?
At Funding Circle we have an experienced team of credit and risk analysts, who have many years of experience working at some of the world’s leading banks and financial institutions. Leveraging historical data available to us from leading credit reference agencies and our own database of over 15,000 UK businesses, we were able to apply a number of stressed scenarios to an example of a typical investor portfolio, to analyse the potential impact on investor returns.
The starting point for our stress test was to create an example portfolio, and to review how we expected those loans to perform if the UK economy remained stable. To broadly reflect the proportion of loans that have been originated over the last 12 months, we tested an example portfolio made up of:
- 70% unsecured small business loans
- 30% secured property loans
We estimated that these loans would deliver a 7.2%* annual return after fees and losses during a stable economic environment. By conducting rigorous stress testing, we were able to simulate what would happen to these returns should the UK economy enter a period of recession.
What data did we use?
As part of our stress test, we analysed a number of factors including macroeconomic indicators and specific indicators relevant to both small business loans and property loans.
Small business loans
1) Insolvency rate
When building the model we used data from the Insolvency Service, which shows the rate at which businesses are unable to pay their debts. This is known as the insolvency rate. Looking at the graph below showing the insolvency rate of UK businesses during the 2007-08 recession, you can see that the insolvency rate was two times (2.0x) higher at the peak of the recession in 2009 than it was in 2016.
Source: The Insolvency Service
We used this insight to guide our understanding for what the default rate for small businesses could increase by at Funding Circle during a recession. We also investigated specific segments of small businesses that share the characteristics of Funding Circle borrowers (such as turnover, trading length and number of employees) and found that for those businesses the increase in insolvency rate was actually 1.6x during the same period – suggesting less volatility than the average market. By examining the average age of Funding Circle borrowers, we could also confirm that the majority (56%) successfully traded through the last recession.
2)Timing and duration of a recession
Two other important factors we considered when estimating the impact of a stressed scenario on small business loans were the timing and duration of a recession.
Typically, defaults on a group of loans start to occur approximately six months after loans are made. This trend then naturally decreases over time from the second year. In addition, all of the small business loans amortise as borrowers pay back a proportion of their principal along with interest each month. Both factors are likely to reduce the severity of a recession that would start later, on existing loans.
The age of a group of loans at the time a recession occurs influences the magnitude of the financial impact. Therefore we have stress-tested both the existing book of loans, which are less exposed due to being partially matured, and an example portfolio of brand new loans, which are potentially fully exposed to recessions through their entire lifetime.
Property loans are secured against properties. The major factor we considered when assessing the impact of any stressed scenario on property loans is a fall in the value of house prices. The graph below shows that during the 2007-8 recession, house prices across the UK fell by an average of 19% over 18 months.
To understand risks on this portfolio, house price fluctuations have to be compared with the loan-to-value (LTV) ratio, or the value of each secured property against the amount borrowed. The below chart shows the distribution of loans by loan-to-value bands for outstanding Funding Circle property loans. Data is correct as of 31st August 2016.
We looked at what would happen to the property portfolio if house prices fell by either 10%, 20% or 30%. Outside of our base estimated default rate of 0.5% a year for property loans, in the mildest scenario (10% fall in house prices) investors would be unlikely to experience an increase in defaults as the loan-to-value on any of the property loans does not exceed 85%. Even in an extreme scenario where house prices fell by 30%, we estimated that the majority of the outstanding property loans would be well-placed to weather a recession.
Our stress test scenarios and results
For the first scenario, we simulated a recession similar to the one experienced in 2008. The second scenario was based on data from the Prudential Regulation Authority (PRA), where we applied a number of macroeconomic changes provided by the PRA to simulate a recession significantly more severe than experienced in 2008. For both scenarios we also anticipated that the recovery rate on defaulted loans would decrease by 33% during the stressed period.
Taking the estimated annualised net return of 7.2%* in our base case as a starting point, the results were as follows:
The existing example portfolio is likely to be resilient in both scenarios. New loans are also likely to be resilient, although with lower returns due to the timing impact. Also, in the case of a major recession, Funding Circle would take action to mitigate losses ‒ with such benefits not factored into this simulation.
We have a number of processes in place to help anticipate and react to worsening economic conditions. We monitor, with a lot of scrutiny, both the internal performance of our loanbook and external macroeconomic conditions. Looking at factors including changes to Gross Domestic Product (GDP), income gearing (how much income there is available for a business to service debt), Consumer Price Inflation (CPI) and the overall insolvency rate for UK businesses, we should be able to identify when a downturn may be approaching.
If there were indications that economic conditions were worsening, or that our loanbook was not performing as well as it should be, we would adjust our credit assessment process to price in some of the effects of an incoming downturn on new loans. You can read more on how we assess businesses on our blog.
These results show that investor returns are likely to remain attractive even in a recession deeper and longer-lasting than was experienced in 2007-08. We’re committed to helping investors earn attractive returns by building a stable and sustainable platform, and are confident this would remain the case even during the most adverse of downturns. Diversifying, where you spread your lending across lots of different businesses, can help your portfolio be more representative of the wider pool of loans we have tested. You can find out more about this here.
We hope you’ve found the above information useful, and you can read more about the performance of Funding Circle loans on our statistics page. If you have any questions please don’t hesitate to get in touch.
The Funding Circle team
* Estimated returns are after fees and bad debts but before tax, and please remember by lending your capital is at risk. As you lend to your own individual portfolio of loans, your actual return may be higher or lower than our estimates. You can see how we calculate our estimated annual return at origination here.