Chief Risk Officer’s UK update – Looking at the recovery and returns

Jerome Le Luel joined Funding Circle as Global Chief Risk Officer five years ago, bringing with him more than 20 years of experience in risk management. His previous roles include Global Head of Risk Analytics at Barclays Bank and Global Chief Risk Officer at Barclaycard, where he successfully navigated their global portfolio through the 2008/9 recession.

Jerome leads a team of more than 100 risk professionals across the markets Funding Circle operates in: including data scientists, credit risk analysts and credit assessment experts.

Although the economy is still facing challenges and extra restrictions have been announced this week, there have been many positive signs over the last few months. More and more businesses have been able to reopen, customers have returned to shops, pubs and restaurants and children have gone back to schools. 

After lockdown caused the initial drop to GDP in April, this gradual return to a more normal rhythm has led to the economy growing by 8.7% and 6.6% in June and July respectively. Although many businesses are still not able to trade as normal, overall the Bank of England has found that so far the UK recovery has been more rapid than expected.¹ 

In this update I will explain how Covid-19 has so far impacted the businesses that you lend to through Funding Circle, what we predict may happen next, and how we expect this to affect your returns. The key points include: 

• Number of borrowers asking for payment plans is now below pre-Covid levels
• More than 90% of borrowers are now making their monthly payments
• Based on our modelling, we expect returns to remain positive
• However, as expected during a recession, returns will be lower than initially forecast

The vast majority of businesses you have lent to are making repayments

When the lockdown was implemented in late March, we experienced an increase in businesses that had accessed finance through the platform getting in contact to ask for payment plans. These were typically low risk borrowers that had never missed a payment before, and were very concerned with preserving cash at a time of high uncertainty.

To protect investor returns, we moved quickly to introduce a range of measures to support these businesses through this difficult period. This included significantly expanding our Collections and Recoveries team, providing payment plans to businesses where it was appropriate and facilitating loans through government loan schemes. 

Small businesses are resilient, and we continue to believe that providing payment plans and supporting them through this period is the best way to avoid credit losses and protect investor returns. By May the number of borrowers asking for payment plans began to reduce, in July this returned to pre-Covid levels, and has since then continued to trend down to below that level. 

Recently, many businesses have started to reach the end of their payment plans, and the good news is that the majority have begun re-paying again. For the loanbook as a whole, more than 90% of UK borrowers are now making their monthly repayments.

On your individual account, you may see a higher proportion of loans that are listed as late. Many of these businesses will now be making normal repayments, but have not yet caught up with the payments they missed over the last period. These will therefore be classed as late until their arrears are cleared later on in their payment plans. 

A greater initial spike, but a faster return to normal

At this stage, it is obviously difficult to tell with precision exactly how this crisis will eventually play out. However, by looking at what happened in the previous Global Financial Crisis and adjusting for what we have observed so far, we have estimated what we think is the most likely scenario.

In previous updates, we have talked about how we can stress-test our loanbook using stress scenarios provided by the Bank of England, along with a simulation tool that translates these economic scenarios into potential credit stress on our loans. 

The Bank’s 2019 stress test scenario describes a recession similar to the one seen in 2008. In the graph below, the black line shows what the model estimates credit stress would look like on our loanbook under such economic conditions: a gradual increase of credit stress over fifteen months, and then a gradual recovery over the following three years. 

Looking at what has happened so far this year, we already know that this crisis will be different. As mentioned, we already saw a sharp temporary spike of borrowers asking for payment plans when lockdown started. After this initial spike, we now expect a more spread out and milder stress that gradually reduces over time as the economy recovers – more akin to what you might see in a normal recession.

Although the future developments of the Covid-19 crisis remain uncertain at this stage, this scenario is what many lending institutions consider as their central hypothesis for now.

The orange line in the graph below shows what our model estimates based on this outlook, with the early initial spike easing to a steady recovery over the coming three years.

This simulation is our best estimate with the information currently available. It includes a number of assumptions, such as that the UK economy will continue to perform in line with current industry forecasts and that there is not a second full national lockdown as seen in spring. However, it’s important to keep in mind that there is still a lot of uncertainty in the current climate and these estimates may change. We will continue to analyse and update our models as the economy recovers. 

Overall returns remain positive

Having defined our most likely Covid-19 stress scenario, we then analysed how we expect the loanbook to perform. This has enabled us to estimate the projected returns for investors,  under stress, by annual loan cohort. The below table shows the projected returns for loans by the year they were taken out.

It’s important to note that we have always said that during a recession, depending on its severity, returns would be lower than initially predicted, and we have provided data on stress test scenarios to estimate what could happen. This year the pandemic has triggered a recession that has been unprecedented in its severity. As a result, we do expect returns to be lower than were forecast at the time the loans were taken out.

However, the good news is that we expect all cohorts to continue to deliver positive returns to investors despite the Covid-19 stress.

The figures shown are the projected lifetime annualised returns, after all loans are amortised (i.e. they have reached the end of their term and been paid down) and recoveries received. They should be seen as the end point. Depending on your individual portfolio of loans, your return may be lower than this in the shorter term, but as we make recoveries on your behalf, they will increase again. 

Loans taken out in 2017, 2018 and 2019 are most affected, whereas older loans, which are well amortised and therefore have less outstanding, are less affected. Remember, these figures are average estimates for all the loans taken out through Funding Circle. As you are lending to your own portfolio of businesses, your individual returns may be higher or lower. 

Cohort of Loans	Projected Returns2
2014	7.0% – 7.1%
2015	6.9% – 6.9%
2016	4.3% – 4.6%
2017	2.3% – 2.8%
2018	0.9% – 1.9%
2019	1.2% – 2.7%
2020	2.2% – 4.0%

Staying vigilant in an uncertain environment

Overall, we are seeing some positive signs as we navigate this unprecedented crisis. We are hearing from borrowers that the government’s business loan and furlough schemes have been extremely helpful to avoid them defaulting on their loans when their business could not operate. New entries into collections are now below pre-Covid levels, showing that beyond the initial shock, borrowers are resuming repayments as their businesses get back on track.

But we are staying vigilant. The pandemic is still very present and unpredictable, and the UK economy is severely weakened. In this context, we will continue to actively help businesses avoid financial difficulties through a broad range of options, including payment plans. We are investing significantly in expert staff and technology to achieve the best possible results for investors.

Summary: what this means for your portfolio

Throughout this pandemic, small businesses have been resilient and adapted quickly in a changing environment, and 90% are now making payments. However, they have faced significant challenges, and our belief is that short-term payment plans have and will continue to give businesses time to get back on their feet, generate revenue and subsequently repay their loans. This helps to minimise avoidable credit losses in the long-run, protecting your returns in the process.

Consequently, you will see a high number of businesses in your portfolio that are classified as late. As mentioned above, many of these will have taken an agreed payment plan and have now resumed their payments. However, they will continue to be classified as late until their arrears are cleared.

Unfortunately, as expected in a recession, some of these businesses will not be able to continue trading, and we have reduced our projected return forecasts accordingly. However, we will continue to work with businesses in difficulty, and all businesses classified as late receive frequent contact from our expanded Collections and Recoveries team. 

I hope you have found this update useful. We will continue to respond to the challenges created by Covid-19 in order to protect your portfolio, and we thank you for your support.

1. The Bank of England Monetary Policy report found that the UK recovery was more rapid than previously expected.
2. The rates shown are the annual projected returns, after fees and bad debts but before tax, that a diversified investor could earn with the Balanced lending option, by the year they were taken out. Your actual returns may be higher or lower than these projections, due to the specific characteristics of your portfolio.