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.

Methodology

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.

Insolvency

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.

Amortisation

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

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.

HPI

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.

LTVWe 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:

results

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.

Remember

 

Conclusion

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.

Enjoy lending,

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.

Jack Pritchett

Customer Communications Manager

 
  • Bart

    Great article, thanks for the work involved in putting it together. Not only reassuring to see the measures you take but also educating us on risk/diversification factors to consider in loan selection too.

  • Truth Revealed

    Seems to cover the base cases and seems logical in presentation.

    The problem is that making a serious assessment is based on sector/age/financial strength/exposure to recession/ and other factors. Generally most stock market investors move the “consumer staples” & utilities in times of stress and into gilts and gold.

    Perhaps an analysis by sector (for example retail suffers particularly in a down turn) might add greater insight.

    • fundingcircle

      Hi, thank you for your question. Although different industries are affected in different ways, the Funding Circle loanbook is well diversified across UK regions and industry sectors, and is broadly representative of the UK small business market as a whole. We would expect the loans we stress-tested to react to a downturn in a similar way.

      • Truth Revealed

        The Funding circle loan book may be well diversified on a “blanket bombing” investment approach but seasoned stock market investors often run through a cycle of investment based on the position into the economic cycle and there is logic in that.

        Therefore you can homogenise and take the “pain” with the “pleasure” but ideally you would rather just take the pleasure.

        Therefore, for example a retailer of non consumer staples (or luxury goods) may be doing well at the end of the economic cycle and get a loan rated A+ on it recent history.

        However, being late cycle, a recession is highly likely and its the type of business that will suffer far more than most in a recession.

        Therefore, should it be rated on past performance AND likely forward economic environment in mind.

        That way, the investor gets a rate that better reflects the likely risk with the above A+ business being rated B or C or even lower and a higher interest rate paid.

        You approach suggests that years of “stock market wisdom” is hokum, but price action suggests otherwise and the belief on sector rotation base on the position in the economic cycle is wrong.

        In essence, you loan risk assessment is entirely backward looking, but the lender’s risk is entirely forward looking and as they say in stock markets “past performance is NOT a guide to future returns”

        And they are right…….

  • Nicholas Walker

    This analysis shows what happens in the event that borrowers ability to repay is reduced in a recession. What happens to the Funding Circle model if a high proportion of investors wished to withdraw at around the same time, such that there is not enough investment to fulfil the existing loan book?

    Under the Funding Circle model, would there be a need to lock-in investors in the same way as recently happened for commercial property funds?

    • Hobbit_CZ

      What do you mean by that? Investors cannot “withdraw” from FC like from a fund. Here they have to sell their investment on the secondary market and find a buyer for that. I know, currently the liquidity there is outstanding, but in a case of extreme crash they will be probably unable to do so. But that’s just natural and there is no FC involvement in it. So no “lock-in” is necessary as the investors are locked in by the nature of the platform.

      • Nicholas Walker

        Thanks- this does answer my query, and yes, I did misrepresent the model in my final sentence. It’s clearly important investors understand liquidity (and whether they need it) before buying in.

  • Statsman

    Good work. I have 2 points for caution, though.

    First, the assumptions on the PRA stress scenario are unrealistically benign. For istance, I’d suggest to check the extent of the real estate price adjustments in Japan in the 80s or America in 08-09 (the thinking “this has never happened here” was proven wrong in each of those regions when it eventually happened). Equally GDP growth reducing by 1/3 is a blue-sky scenario considering than in severe stresses in the last century or so GDP growth went actually signficantly negative, ie same absolute number but different sign. Same considerations apply to earnings growth.

    Second, the framing when reading the conclusions can be misleading. Saying – like the author does – that in the stress scenario the majority of property loans “would be well placed” frames the issue in a positive way – perhaps too optimistically – when compared to the other possible conclusion – supported by the same research numbers – that in that scenario around 30% of property loans would default, equal to between 5x and 15x the current expected level.

    That said, the idea to explore the impact of future recessions is certainly laudable.

    • fundingcircle

      Hi, thank you for your feedback. We have clarified the PRA section of the results table to present the information in a clearer way, however please note that the drop in nominal GDP growth and earnings covers the period from the beginning to the end of the stressed period. During the PRA recession itself, year-on-year nominal GDP falls by 6%, highlighting the severity of the recession. You can see the full PRA stress-test scenario here: http://www.bankofengland.co.uk/pra/Pages/supervision/activities/stresstestscenario.aspx