Oh to be a fly on the wall this morning, listening in with CEOs from the alternative finance space as they munched their Rice Crispies while listening to the BBC’s Today programme.
Lord Turner, former boss of the City regulator, lobbed the equivalent of an intellectual hand grenade by declaring that “the losses which will emerge from peer-to-peer lending over the next five to 10 years will make the bankers look like lending geniuses”. GrowthStreet has posted a transcript of the somewhat incendiary volley. In truth Turner’s comments were mostly focused on lending to small businesses but I think his comments are a mixed bag. My own sense is that in aggregate a case can be made for saying that the respected ex regulator – and author of a new book – is in effect scare mongering, although the industry does need to take on board the deeply held fears that Turner is articulating.
First that scaremongering point. Just how bad could losses from P2P get and will those numbers make the bankers look like geniuses?
Let's be very clear that most P2P lending has until very recently been to consumers. And in this space the banks have a terrible record. Look at the tech enabled sub prime mortgage scandal which is what actually caused the global financial crisis. The banking geniuses that lent money in the US were responsible for losses of $750 billion to $2 trillion.
Dwell on the engineering of these structures for one moment. Interest only mortgages accounted for 37% for all sub prime loans, with 38% no money down and 43% with no proof of income. That doesn’t sound very sophisticated to me.
Me thinks that not a lot of bankers visited the less salubrious parts of Detroit. A further dive into the figures reveals the true horror of this supposed lending intelligence. In the 2006 loan vintage – the biggest and costliest vintage – cumulative mortgage default rates for prime mortgages had hit over 10% by month 24 and over 35% for sub prime. In fact for the latter, 23% defaulted in the first 12 months and 43% within 21 months.
So given both the absolute size of the mess produced by the global financial crisis and the default rates I mentioned, I struggle to see how anyone, P2P or otherwise, could rival this ineptitude. Let's say in an amazing year at some point in the distant future, peer to peer platforms lent out $2 trillion – a mean feat – I could just about imagine a scenario where defaults on consumer loans smashed past 10%. That would be double the stressed levels of 2009 where US consumer credit defaults hit 5.5%. But even allowing for this grim scenario the total losses would only be a couple of hundred billion dollars. That would indeed be painful but nowhere near the potential losses of trillions from the bank foul up last time around.
But of course the real thrust of Adair Turner’s attack is SME lending. Here the gist of the argument is that the good guys – banks – have complex risk analysis that extends to visiting businesses (kicking the tyres) and making informed judgements based on complex criteria. By contrast the potentially bad guys – marketplace lending platforms – are in essence dumb mechanisms based purely on data. If this was true I would have some sympathy for this view but sadly it isn’t. I personally bank with challenger outfit Handelsbanken which is jam packed full of former high street bankers. They all now make personalised decisions at the branch level, including visits. But they are the absolute exception. Virtually no one else matches their bespoke analysis. These managers have also to a man and woman told me that in their old high street banking jobs, credit analysis was at a wholesale level, housed in risk silos, built on a credit scoring matrix that they sometimes struggled to understand – or justify to customers. So the bespoke risk analysis charge doesn’t stand up to scrutiny. Banks don’t do what Turner says they do which is kick the tyres. By contrast what the smart online lenders do provide is intelligent use of the plentiful big data now on offer.
On this data side of the debate, I suppose a credible argument could be made for the banks sitting on legacy information allowing them to make more informed decisions. Crucially the ability of a chief risk officer to make a decision is hugely valuable BUT not infallible. This command and control vision of risk management is not necessarily superior to the alternative which is distributed market intelligence built on big data.
Online platforms go through iterations of data crunching, sucking in information from all sorts of places, many of them very diffuse and heterodox. Talk to macro economists, especially those studying micro economic signalling and they will tell you that distributed knowledge utilised by a wide variety of market actors can be more accurate than the opinions of so called experts.
Another small side note. Proponents of the Austrian school of economics will argue that free markets are more powerful risk control mechanisms than Stalinistic heads of risk. And given that risk officers of huge banks can be easily suborned by central bankers, worried by the credit creation mechanism and its impact on the wider economy, why the hell should that be regarded safe or wise?
So, are bankers smarter? Case not proven, I would say. Could future losses be even bigger than the GFC? I very much doubt it unless the industry grows at a truly extraordinary rate! Might default rates be higher than for mainstream bank lenders, especially in the SME sector? Possibly but I would suggest that the banks don’t have a great track record on this score either.
Where Turner is on the stronger ground I would argue is his broader theme of suitability. Put simply banks and institutional lenders are relatively sophisticated investors who can, hopefully, make a judgement call on risks and returns. If they muck up they can always go cap in hand to the central bank.
Ordinary retail investors by contrast won’t be bailed out. They might also use mental shortcuts to inform their decision making. Put simply investors will usually ignore the small print and go for the highest yield on offer. They won’t carefully scrutinise every loan request, and they would probably be happy to click a button that says it’ll do all the hard work for them.
At its core this reflects a deeply held view amongst regulators that behavioural finance is important. Investors simply can’t be trusted to make informed decisions and that they should thus be herded into safe options. This form of nanny state policy making has its merits but in effect it infantilises investors. It treats them as fundamentally irrational, unknowledgeable players in a landscape dominated by sharks and sharp suits. At its core a profound philosophical view of the world that is antithetical to free markets or even the fintech revolution. It has a level of coherence but I would argue that is misguided.
Investors only learn by making mistakes. Mistakes will be made and losses incurred over the next few years. My own suspicion is that the platforms – and the risk analysts they employ –are probably hopelessly optimistic about the scale of losses that could come from SME lending in a future downturn. In the very worst case analysis I suspect that the 24 month cumulative vintage year default rates (i.e. how many loans made in a given year will default over say a two year period) could hit as much as 15 to 20% in a bad recession for the riskiest loan borrowers. If that worst case scenario happened that would amount to losses in the hundreds of millions or even low billions, but nowhere near the size imagined by Lord Turner. And actual total lender losses might be even smaller given the high yields these investors would have already received.
But I also suspect that internal risk algorithms at the platforms will learn from this painful process and become more accurate in future recessions. Along the way the disintermediation provided by the online marketplaces will reduce the cost of capital and improve overall market intelligence. And that surely is a big enough prize to justify the inevitable losses in a future downturn.
21 March 2023
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