Are Bad-Debt Provision Funds Higher Risk?

I listened to the Money Box interview Neil referred to in P2P Lending is Not Like Picking Shares. (Yes, I'm eight months late too, but I hadn't even heard of 4thWay^® back then.)

In that interview, Andy Mullinger of Funding Circle, a business loans P2P lending website, defended his company quite well considering he was put on the spot.

However, he was also a bit scathing of bad-debt provision funds. These are pots of money that some P2P lending companies set aside to pay lenders back when any of their loans go bad.

So what's not to like about that?

Why use a bad-debt provision fund

I'll explain a bit more about what's to like about them first.

Funding Circle has chosen not to build and maintain a provision fund. Mullinger said the reason was that it gives you an illusion of safety.

I don't think that was his best argument against provision funds.

If a peer-to-peer lending company is clearly choosing very safe borrowers and has a fat bad-debt provision fund set aside to cover losses, and lenders spread their money across 100+ borrowers, then losing money even in tough economic times is not going to be easy. Not at all!

Although you do still have to watch out for slackening standards being disguised under these funds, as Neil pointed out in When The First Bad-Debt Provision Fund Will Fail. Perhaps this is what Mullinger meant with his safety illusion.

In support of no bad-debt provision fund

I think the real reason to consider using P2P lending companies with no bad-debt provision funds is that they should, on average, offer higher rewards to individual lenders after fees, bad debts and taxes.

Why? Because investors – including lenders like you and me – usually demand better rewards the higher the risks are:

• That's why we accept a measly 0.5%-2% interest when using savings accounts, because we know the chances of making a sudden large loss are extraordinarily low.
• And it's why we'll almost bust the bank to own our own home, because after several decades it's still likely to be standing and the odds are good it'll almost pay for itself in rent savings.
• On the other side of the scale, we won't usually buy shares in a company when it is valued at 100 times its profits. (Facebook excepted!) When we become part-owners in a business by buying shares, we want the price to be right for the higher risks involved.

With peer-to-peer lending, we already see that lenders are willing to accept lower interest rates for the safest options while they won't touch higher-risk opportunities unless they can get twice as much interest.

So, all else being equal, your returns are less certain, less protected and more variable if the P2P lending website has no bad-debt provision fund.

And therefore lenders, on average (but not always – like some whacky stock market investors), are likely to demand higher interest rates and higher returns for lending through them.

In addition, a bad-debt provision fund costs money to sustain, funded by the borrower. That could be extra interest being paid directly to you, rather than to a general pot that might not be needed.

So, in the long run, this should mean that even Funding Circle's high-quality A+ loans will probably have higher average rewards than a similar business with a bad-debt provision fund. As of right now, the premium you can get appears to be small on average, but I hope it'll nudge up some more.

More: read how you can dramatically boost your returns on Funding Circle's A+ loans by reading Funding Circle Lending Strategy.

Also, read more in How Much You'll Lose if Zopa's Provision Fund Fails.

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