WeB@ank - Zopa and Social Lending Thursday, January 22, 2009
One of the 3 firms showcased at the WeB@nk event this week that was hosted by Nesta was Zopa. Nearly 4 years old, Zopa [which stands for "Zone of Possible Agreement"] describes itself as a market for money. Targeted at the retail market, the platform has executed £31m of unsecured loans to date across over 7000 loans, with £12.6m booked in 2008 for 2600 loans. Their maximum loan limit is £15k and typical loans have been for cars, weddings and medical expenses - the loan purpose has to be detailed as part of the information provider by a borrower.
In supplying offers of cash, lenders specify
- the total amount on offer up to a maximum of £25,000 beyond which a lender needs a Consumer Credit Licence
- the rate they are prepared to lend at, which can be set per borrower risk category
- the maximum amount per borrower they are willing to commit e.g. no more than £100 per borrower [Zopa sets a floor of £10 minimum per borrower]
- the loan term
- the category of risk they want to invest in [Zopa stratifies its' borrowers across 5 risk categories]
- Complete a loan application
- Make monthly repayments comprising capital and interest
- Can borrow over 36 or 60 months with the ability to repay early
- Pay a loan fee of £94.25 when taking a loan
- Can borrow between £1,000 and £15,000
- provide the marketplace platform
- pool funds provided by lenders and distribute these amongst eligible borrowers
- vet lenders and borrowers against anti-money laundering criterion
- credit score borrowers
- undertake loan administration i.e. cash distribution and collection, oversee debt recovery via a third party arrangement
Zopa were at pains to stress that many people are attracted to Zopa because it puts a human face on money which they termed "Social lending", rather than the impersonal and institutionalised banking that traditionally operates. Yet as one member of the audience put it, "they made it sound like charitable work or lending for emotional/entertainment value".
Zopa did acknowledge that the flip side to social lending is that it can turn sour/personal when bad debts arise as people feel their "trust" has been betrayed. Overall Zopa has experienced 0.2% bad debts to date, and provides its' lenders with an estimate of bad debts per risk category as shown here.
One of the major selling points of Zopa is that borrowers and lenders reportedly get better rates than from banks by interacting directly. Lenders are presently getting an average of 8% after fees compared to high street savings ates of under 2%, whilst borrowers are receiving loans at 9% compared to 15%+ from a bank from unsecured loans.
I felt quite strongly that Zopa is disingenuous in making interest rates comparisons between themselves and banks for savers. When depositing with a bank you are transferring loan default risk to them and losses are borne by the bank's shareholders. Depositors also benefit from deposit protection schemes in the event of bank default. In Zopa you retain this risk. Hence an element of the rate differential has to compensate for that. In conversation after the event, their MD admitted to me that whilst the rate differential is about 6% following the sharp fall in bank deposit rates [Zopa lenders are averaging 9% less 1% Zopa fee versus average savings rates of 2%], back in the summer it was about a 2% differential.
What astounds me about this latter figure is that it indicates that Zopa lenders are clearly not making an allowance for borrower default. Whilst average historic loss rates may be only 0.2% across all lenders, those lenders who lent to defaulting borrowers will have been lost much more. More significantly, whilst Zopa claim that their credit screening process rejects a considerable percentage of borrower applicants and keeps them clear of sub-prime loans, I suspect that the deterioration in the economy is going to push up their default rates in line with the experiences of banks on similar tranches of unsecured personal debt.
My assertion regarding default risk being overlooked by lenders was further validated when I enquired about whether Zopa would consider offering credit protection insurance and Giles advised that it had been offered but there had been minimal interest in the product. Perhaps people are being overly seduced by the touchy-feely aspect of "social lending" and become too trusting or are ignorant of the risks.
Whilst savers are undoubtedly complaining about the pitiful rates currently offered on deposits, in the current environment I suspect that many people are most concerned about return of capital than return on capital, at least temporarily.
As James Gardner of Lloyds TSB (Bankervision) put it during the panel session, the real question is whether Zopa and its' kind represent a significant threat to banking and could disrupt the current model. He contended it did not and I have to concur. Whilst I believe Zopa has considerable growth potential from its' current low base and is not liable for losses on loans, I'm not convinced about its' business because
- despite having increased it's margin from 0.5% to 1%, this feels like insufficient gross margin on which to operate and develop the business. For example, at best Zopa is generating approximately £300,000 of interest revenue each year on £31m of loans, assuming all loans transacted on the platform were open, no capital repayments had been made and 1% was applicable to all of them. On top of this, Zopa will have generated just under £200,000 of borrower loan fees in 2008. Once costs are factored in e.g. staff, premises, insurances and technology, this doesn't leave much.
- Zopa isn't a regulated business at present, but were it to scale-up I believe that regulators would probably be forced to take a closer look. As James Gardner observes, were a major bank to enter the peer-to-peer lending space it would be inevitable that regulators would seek to include it as a regulated activity. At this point, its cost of operation would increase considerably putting further pressure on its' margins.
- Zopa claims that all elligible borrower applications have been funded to date, demonstrating that their supply of funds is sufficient. However this is represents a probable and material constraint on their business. The higher rates currently on offer may induce more savers to use the service but I believe that Zopa will also need to increase the average deposit several fold from the current average of £1,300, which translates into an average of 3 savers per borrower. Whilst banks have a similar situation, they can also supplement funds from wholesale markets, leverage and shareholders. None of these options are available in Zopa's current "peer to peer" model.
- Banks have considerably more experience in loan pricing than individuals and I question whether the rates presently on offer on Zopa may represent naive pricing on the part of lenders once bad debts/risk premium is taken into account. Obviously I acknowledge that bank lending rates will be higher simply to allow for bank profit and bad debt provisions, but stripping out such elements are likely to suggest higher rates should apply.
- At 6:15 AM, said...
When you go to lend money the first option you get is an easy lend screen that asks you what return you want after fee and bad debt allowance. That then places offers in the markets of your target rate plus the fee and Zopa's bad debt estimate.
So the easiest way there is to lend via Zopa automatically includes the allowance for bad debt that you're asserting isn't there.
Looking at the weekly market data spreadsheets also makes it completely obvious that people generally are including those annualised bad debt allowances.
An insurance product was considered but it received a poor reaction since it was only available for well diversified loan books and would not have been of value if the bad debt estimates are correct. You appear not to believe them so you may have been interested in the product. Otherwise it wold have been mostly of interest to those with few borrowers, who were ineligible due to that same small loan book.
Zopa matches funds to applicants before offering them a personal quote so it's inevitable that every person who proceeds with an application already had it funded. A more interesting measure is how many seek a non-personal quote using money available at 1AM and then find that the loan size they request is not available when they ask for a personal quote. That's a measure of unmet demand. Also of interest would be those who don't proceed after finding the personal quote is significantly higher than the one from the 1AM offer supply.
As a lender I seek to exploit those times of limited supply to get higher rates.
- At 10:44 AM, John Wilson said...
James, thanks for your comment and inclusion of detail that neither the Zopa MD nor the Zopa web site provided about its' workings.
I now confess to some puzzlement regarding the nature of the rates being cited by Zopa - are these inclusive of a bad debt element or not? i.e. is the 9% average quoted [after fees] before or after bad debts allowance?
I am very sceptical about the bad debt estimates given the current economic conditions - bad debt rates on unsecured personal loans will inevitably trend upwards, unless Zopa tightens its criterion even further in a similar manner to Cattles [sub-prime UK lenders], albeit they have withdrawn from lending temporarily as reported here http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article5576151.ece
Your comment on the insurance product suggest that it was structured per lender rather than for the loan book as a whole or per risk category. On this basis I can understand why it was uneconomic and available to so few lenders.
Nonetheless, by deducting the insurance tariff from the gross rate Zopa lenders received one would get a better comparable rate with the "bank rate". Whilst the insurer is seeking to make a profit which will be incorporated in their price, they have an incentive to price bad debt risk more accurately, unlike Zopa who take no risk in the process e.g. estimate errors don't hit Zopa P&L directly.
To the point on eligible borrowers receiving funding, I think we are making the same point i.e. unmet borrower demand as no funds are available in the market, which would be a constraint on Zopa's success
By way you describe it, Zopa appears not to be operating an order-driven market on both sides. Lenders make rate offers and borrowers are price takers via the quote process. The distinction here being that borrowers don't submit a rate declaring what they are willing to pay to be matched up in the market and it is lenders who set the price in the market. Hence I understand your point regarding the quote process disguising the issue of unmet demand.
It would be interesting to see what borrowers would be willing to pay to get a loan if they had to declare as such, since it seems reasonable to conclude that some of those accepting a rate quoted would have paid more because their need dictated it. This is lost income for lenders.
- At 3:28 PM, said...
The 9% is after fee, before bad debt allowances. You should read the replies to you here if you have not yet done so: http://bankervision.typepad.com/bankervision/2009/01/what-would-happ.html#comments . You may also find the FAQ section of the Zopa forum of value.
Cattles is rationing lending because it's concerned that it may have difficulty refinancing its £500 million debt facility this summer http://www.ft.com/cms/s/0/1ce04822-e5b5-11dd-afe4-0000779fd2ac.html . So it's saving cash to allow it to repay some. Has also had some delays in getting a banking license so it can take deposits to get funding that way. If Cattles was willing to split returns in a way closer to Zopa I'd be entirely happy to provide it with some funding but I expect that it'll offer normal savings account rates.
I'm not comfortable with the returns available at the moment and that seems to be the common view of those participating in the Zopa forum. Others either are or are not considering risk as much as I do, since 6.0 to 6.3% after fee and bad debt is the range of rates normally achievable in the 36 month markets. I think that's mostly money from newcomers who are asking for what they used to be able to obtain from savings accounts for much of last year.
One issue with borrowers bidding is adverse selection. Someone with no intention to repay is quite likely to be willing to bid whatever it takes to get the money. Still, I agree with you that there is money available that is not realisable with the market structure as it is. The difficulty is identifying those who would be willing to pay more and finding a way to charge them that premium. Zopa seems not to have an incentive to seek that result, since it's paid by money under management and transaction count, not investment returns.