Seven experts weigh in on how a Fed Rate hike would affect Peer Lending
The Federal Reserve Interest Rate
The Federal Reserve uses interest rates as a mechanism for controlling the overall US economy. In a booming economy the Fed raises interest rates to prevent bubbles and runaway inflation; in slow economies the Fed lowers interest rates to spur borrowing and grow the economy.
During the last decade, the U.S. suffered the worst financial recession in 80 years. The Fed responded by dropping rates to the lowest they’ve ever been: 0.25%. Rates have remained at this record low since the financial collapse of 2008-2009, but some say there is finally indication of recovery and growth in the U.S. economy.
While growth in the economy is seen as positive, there is fear that too much growth may result in an economic bubble. In the current economic environment this is seen as being particularly dangerous, since most of the tools used to boost the economy are currently in use. This means there won’t be much to stop the slide if a bubble forms and pops.
The Federal Reserve is contemplating tapping the breaks and raising interest rates. An increase in the interest rate is meant to make the cost of borrowing more expensive, and it is expected that as borrowing gets more expensive, fewer borrowers may ask for funds. Additionally, investors they may wait to lend if they expect rates to continue to increase. This would have the desired effect of slowing economic growth.
How will an interest rate increase affect Peer-to-Peer Lending?
Experts have been forecasting an imminent interest rate increase since 2011. This increase has yet to materialize, and current betting odds are 94% against a rate hike will happen this week. When interest rates finally do rise, it will be for the first time since Peer-to-Peer Lending has gained SEC approval.
Lending Club’s stated Risk
Lending Club, the largest U.S. peer-to-peer lending platform, lists an increase in interest rates as a risk to their business. From the Lending Club prospectus:
“… fluctuations in the interest rate environment may discourage investors and borrowers from participating in our marketplace, which may adversely affect our business.”
There are two main ways the prospectus lists as potential dangers for the platform:
1) Fewer borrowers may take out loans
“Fluctuations in interest rates could negatively affect transaction volume… additionally, potential borrowers could seek to defer loans as they wait for interest rates to settle,”
2) Current investors lose the opportunity to take advantage of the higher interest rates
“… investors who have already committed capital may not have sufficient capital available and may lose the opportunity to take advantage of the higher rates.”
A Comparison to Bank Consumer Debt Market
There are many retail investors who utilize peer-to-peer lending as an investment platform. These investors lend directly to borrowers, and hence enjoy potentially much higher returns than depositing funds in savings accounts or buying certificates of deposit. A by-product of this disintermediation is that the risk of default also falls to the investor.
Data for what will happen to the peer-to-peer lending loans themselves in this event does not yet exist, but a comparison can be drawn to bank owned consumer debt.
As seen above, an increase in the interest rate is typically followed by a rise in delinquencies. Interest rates have remained unchanged at their lowest level in history since December, 2008. Perhaps as a consequence, charge off rates have also dropped to their lowest point in more than thirty years.
There is some speculation that an interest rate increase may be detrimental for peer-to-peer lending platforms.
Ben McLannahan of the Financial Times puts forth the theory that an increase in fed rates will destroy the budding Peer-to-Peer Lending industry for two main reasons:
1) An increase in the default rate for Peer-to-Peer Lending notes default will cause larger institutional investors to become nervous and withdraw their cash, and
2) Traditional asset returns will rise, and therefore will be more appealing
Origination fees are the bulk source of revenue for Peer-to-Peer platforms. Additionally, platforms typically earn a 1% fee from investors for servicing the loans. If the funding for notes dries up, some loans will remain unfunded and platforms will miss out on both on both the one time loan origination fees as well as the ongoing service fees.
Peer-to-Peer Industry Expert Opinions
We’ve gathered opinions from prominent industry experts to weigh in on how the potential Fed Funds rate increase will effect Peer-to-Peer Lending. Interestingly, they all think a rise in interest rates would have little impact:
“If [the] prime rate rises, … then Lending Club’s rates will rise too. And it is silly to associate rising rates with higher defaults. If anything, delinquencies should drop in a period of economic expansion.”
“[I]f long-term bond yields rise to about 5 per cent, say, his core product — refinancing government-backed loans at 6 or 7 per cent — could be less appealing to investors. But such rates are a long way off.”
“Any rise in base rates will benefit both our lenders and borrowers as bank spreads will increase as they always do as interest rates rise. Commentators have been talking about the prospective increase in bank profitability as interest rates rise and that will have to be paid for by consumers, making our alternative proposition even more compelling.”
- Sam Hodges – Cofounder of Funding Circle
“The expected rate-rise is likely going to be a non-event for marketplace lenders. Because we can change the pricing of new cohorts of loans we’re not exposed to rate risk, and as a group we’ve largely already built expected rate increases into our loan pricing; even with a rate increase, loans originated through Funding Circle should remain an attractive investment opportunity — the closest credit index meaningfully outperformed high-yield in the last downturn.
“Current investors are achieving returns in the high single digits through the teens; by all accounts, the magnitude of the rate change expected over the coming months (and the next few years) will be small: the fed has a dual mandate of a low inflation and high employment.
Given all the trends we see in the US and globally, there’s very limited core and aggregate inflation (particularly given global deflationary pressures and low commodity prices) and unemployment continues to drop in the US. As such, we expect low, steady economic growth in the US and, with that, a gradual rise in rates.”
- Simon Cunningham – Founder of Lending Memo
“Peer lending will definitely have to adjust to rising interest rates in the coming years. That said, the bigger point is not to try and preserve the state of lending as it stands today, but to appreciate that a permanent breakthrough has occurred within investing as a whole. Low rate A-grade loans may indeed struggle to get funding within a higher rate environment while other grades should do just fine. More importantly — a new and rewarding asset class is here to stay.”
- Peter Renton – Founder of Lend Academy
“When the Fed raises rates I expect we will see interest rates rise at the platforms. The unanswered question is how will this impact borrower supply? My gut feeling is that even if the fed raises rates 100 basis points it will have no material impact on the supply of borrowers or investors coming to marketplace lending platforms.”
- Emmanuel Marot, CEO of LendingRobot
“Compared to traditional finance, Peer lending is simultaneously cheaper for borrowers, and able to bring higher returns to investors. Even when interest rates will go up, both relative advantages will hold true. Besides, in period of changes, the businesses faster to adapt usually win. While some people expect peer lending platforms to suffer if interest rates go up, I think the fundamental question remains ‘who will be able to adapt the fastest?’, Internet-based platforms or traditional banks?”
- Stephen Zentner
- October 27, 2015
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