Reserve Funds Don’t Give Full Protection, But There’s Something Better

RateSetter (which recently closed its P2P business with all lenders in profit after being sold to Metro Bank) and Lending Works* both had to adjust lending interest rates during the pandemic to cover the additional losses from the recession. Their reserve funds alone didn't cover the full amount of bad debts.

Some Assetz Capital lenders will lose money on some loans. It's not yet clear whether any of Assetz Capital's lending accounts that are protected by reserve funds will see the reserve funds depleted and interest rates lowered as a result. But it's not completely out of the question that this will happen: if not in this downturn then perhaps in one of the next.

And yet:

No-one has actually lost money by the time their loans have been repaid in full in any of these reserve-fund protected lending accounts.

That's remarkable when you consider we're talking about well over 100,000 lending accounts between just those three P2P lending companies. Indeed, in Assetz Capital's case, interest earned by lenders has outweighed losses on bad debts by 20 to 1.

Reserve funds are not meant to protect from all losses

It's not surprising that we've recently heard from a few investors who have been worried, irritated or angry that reserve funds have failed to protect them from every penny of bad debt. (Indeed, Neil Faulkner forecast this shock two years ago in Future Reserve Fund Shock To Upset Many P2P Lenders.) Yet, if you feel this way, I need to nudge you to think differently. Because reserve funds are not made to cover losses in all conditions. This is normal and expected.

Imagine if reserve funds were so large that they protected lenders completely. And that's in every single recession and property crash, regardless of which types of people, businesses or borrowers were worst hit in that downturn. What would people do about this remarkable investment? They would pile cash into it, is what they'd do.

And when they did, there would be a massive flood of money that outweighs the volume of loans needed by borrowers.

Supply-and-demand effects then come in. These effects could show themselves in two ways. Firstly, it could mean that you can only lend a very small portion of your money, because too many others are sharing the loans.

Secondly, you might have to out-compete other lenders to lend by accepting lower and lower lending interest rates. Rates would get so low that there was no point lending. Not when you could just use ultra-safe savings accounts, protected by the government if the bank fails.

Another way the story could end is that the P2P lending company approves more borrowers at much higher-risk levels to satisfy the demand from lenders. The reserve fund now will no longer offer the complete protection that you expected. In one of the next downturns you would be shocked to find that the reserve fund proved insufficient.

How large are reserve funds?

Reserve funds are an attempt to cover all ordinary losses in ordinary times. They aren't usually fat piles of cash. There can be as little as 20p in the reserve fund for each £1 on loan, although it can rise to £5 per £100, or even more.

Sometimes the cash is not even in the pot up front, but paid in each month as borrower payments come in. That's the case with Lending Works.

In other cases, there's no fixed amount that will be paid in, the P2P lending provider can remove funds from the account to keep for itself when it feels it won't be needed, and the amount in the fund is not contractually agreed with lenders or borrowers. This is the case for Assetz Capital. Particularly in these cases, you need to look at the results over many years to see if the funds function well.

The interest you earn is usually the bigger defence

Usually, you are paid more in interest than the P2P lending provider pays into the reserve fund. Indeed, lending interest typically far outweighs the reserve fund by at least half and sometimes considerably more. This means the larger defence against losses is your interest cover.

You should take reassurance from the fact that, once a reserve fund is depleted, you can usually expect the interest you earn to be an even larger defence, although you will now earn less than you expected on your loans.

What happens when a reserve fund runs out of money?

The additional cost is usually taken out of your lending interest, although sometimes a P2P lending company pays for some or all of the difference out of its own pocket.

When you pay with your interest, it's sometimes shared proportionally between lenders. Assetz Capital states that this would be the case for its lending accounts.

Sometimes, it's sort of proportional, in that it's adjusted to ensure that no-one loses money even if some would have done with a proportional hit, e.g. because they had just recently started lending and hadn't earned any prior interest cover. This is the case with Lending Works.

Other times, once a reserve fund is depleted, each lender might suffer any remaining losses themselves on whatever loans they hold. Particularly in such lending accounts, its important that you've spread your money across lots of loans, dripping your money in over several months if necessary to do so.

What should you do if a reserve fund is depleted?

Your job at this stage is to be patient, as you need to wait for all your good loans to be repaid with the interest due to them, and wait for any recoveries of bad debt to come in. P2P lending is about patiently lending until all borrowers have repaid, with the early exit option being just another nice bonus in the good times.

In bad times, calm lending strategy is to wait it out until the loans are naturally repaid. For banks and individuals who have adopted this strategy to money lending, the returns have proven to be highly satisfactory and very stable over many, many decades.

As stable as money lending is compared to the stock market and other investments that are re-priced in a volatile way every second, this doesn't mean that you'll earn the same amount on each investment all the time. Accept the fact that some batches of loans will not be as profitable.

What happens if the reserve fund and interest is not enough?

If there was no real risk of an overall loss over the life of a portfolio of loans, interest rates would be almost identical to savings accounts. This is why you spread across lots of loans, and at least six P2P lending accounts, to hugely reduce the risk of ever suffering a loss. This is an extraordinarily powerful way to protect your money.

Accept that you will need to consider your overall lending portfolio results when one or more of your lending accounts goes through a particularly rough patch.

Don't assume that poor results from one provider after a long history of great results means that you made a mistake or that they are no good. If you've done your research properly in advance and believe the people behind the P2P platform are truly good at what they do, that is the most important thing.

What to do if you didn't know any of that…

If any of the above was new to you, or you had forgotten it, I suggest you take a refresher by reading through our 10 Core P2P Lending Guide pages.

Articles mentioned above:

Future Reserve Fund Shock To Upset Many P2P Lenders.

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