Chief Risk Officer’s Update – December 2018

The economic environment has created favorable lending conditions

Investors lend through Funding Circle to small businesses in the UK, US, Germany and the Netherlands. Looking at these four economies in detail we can see that they have all recovered from the 2008 recession, with sustained growth in Gross Domestic Product (GDP) over the last four years:

1. GDP growth %, year on year

Source: Federal Reserve, ONS, OECD

In each of these markets, central banks have set historically low interest rates, making the cost of borrowing affordable and stimulating economic growth. Where interest rates have risen they have done so very gradually, to avoid triggering another recession:

2. Central bank interest rates

Source: Federal Reserve, BoE, ECB

This has resulted in strong levels of job creation and low unemployment rates:

3.Unemployment rate

Source: Federal Reserve, ONS, ECB OECD

This positive economic environment has created conditions that are highly favorable to lending. As a result, credit defaults for businesses have reduced significantly following the recession.

4. Small business insolvencies (Q1 2008 = 100)

Source: Paynet, Gov.UK, DESTATIS, CBS Statistics Netherlands

Across the US, Germany and the Netherlands consumer defaults are also at historic lows. However, the UK has seen an increase in the number of consumer insolvencies over the past two years:

5. Consumer insolvencies (Q1 2008 = 100)

Source: Federal Reserve, GOV.UK, DESTATIS, CBS Statistics Netherlands

This has been driven by a steady increase in consumer borrowing since 2013 as wages struggle to keep up with the cost of living. We haven’t seen this replicated in the UK small business space, as banks continue not to focus on small business lending. This can be seen below by the total outstanding stock of loans to small businesses, which is lower now than it was in 2011.

6. Outstanding loans to UK consumers and small businesses (£bn)

Source: BoE

However, the trends we have been seeing in the consumer space are having a knock-on effect on the overall insolvency rate of small businesses in the UK, which as we saw in graph 4, has risen slightly in recent months (although is still below pre-recession levels). For example some business owners—especially smaller ones—may be more reliant on personal credit cards than business bank overdrafts when managing the ongoing cash flow of their business.

This trend looks to be isolated to the UK, with consumer and small business insolvency levels remaining low in the US, Germany and the Netherlands.

Loan performance has been strong

Investors lending through Funding Circle have continued to earn attractive, stable returns. Across our four markets, loans taken out since 2016 are projected to deliver returns of approximately 4 – 7% per year, after fees and bad debt.

Projected returns* after fees and bad debt, all markets

Source: Funding Circle

The consistency of these returns is reflected in recent lending commitments from some of the larger investors who lend through the platform. In addition to a new £150m funding facility from the British Business Bank (the UK government’s development bank), over the past few months two well-established institutions have committed to lend $1 billion and £1 billion to small businesses in our US and UK markets respectively.

US

We have seen consistent improvement in the performance of US loans since 2016. This has been driven by two key factors: an increase in the proportion of lower risk businesses accessing finance through the platform, and the increasing maturity of our risk models, now in their fourth generation in the US.

Projected returns after fees and bad debt, US

Source: Funding Circle

We have adjusted our pricing to reflect that base interest rates are rising faster in the US than our other markets, and loans originated in Q1-Q3 2018 are currently projected to earn investors 5.8% – 7.8% after fees and bad debt.

UK

Although the credit environment for small businesses remains strong, as mentioned the outlook for consumer credit in the UK has worsened in recent years. This has impacted a small population of loans in our higher risk bands who can be more susceptible to shifting trends in the consumer credit environment. These headwinds are reflected in the projected returns for our 2016 and 2017 cohorts, which are 5.4% – 6.3% and 5.2% – 6.2%.

Projected returns after fees and bad debt, UK

Source: Funding Circle

We regularly update and improve our assessment models, leveraging more than eight years of loan performance data, and we made adjustments in recent months to account for this. These include tightening some of our credit policies and deploying our latest risk model, incorporating data directly from an applying business’s bank. The loans that have been taken out following these adjustments are projected to deliver investors returns of 6% – 7% after fees and bad debt.

Germany

Since Funding Circle acquired a business in the German market towards the end of 2015, we have seen significant improvements in loan performance; supported by the implementation of learnings and best practices from our more developed markets.

Projected returns after fees and bad debt, Germany

Source: Funding Circle

Netherlands

We expanded into the Netherlands at the same time as Germany, and we have seen similar levels of improvement over the past few years. In both markets we have developed our in-house Collections and Recoveries capabilities, and are now seeing recovery rates at similar levels to the UK.

Projected returns after fees and bad debt, the Netherlands

Source: Funding Circle

This serves to highlight the self-improving nature of lending; the more businesses that access finance through lending platforms, the stronger and more predictive risk models become. This allows us to price loans with even more accuracy.

The outlook for the economic environment is encouraging

Across all of our markets we believe that conditions remain encouraging for small businesses. In the US the economy is on a strong trajectory, stimulated by recent tax measures that have provided incentives for businesses to make investments. Although the US economy may be closer to the end of the business cycle than the start, the fundamentals remain strong and the small business credit environment is likely to remain positive in the medium term.

In the UK trading conditions remain favorable, although Brexit is creating a degree of uncertainty. We can’t predict the outcome of negotiations between the UK and the European Union, however our stress modeling (see below) shows the UK loanbook is in a strong position to weather any potential economic fallout.

The economic recovery started later in Germany and the Netherlands, so there is likely to be further to run before the end of their business cycles. Both Germany and the Netherlands are export-oriented economies; they tend to sell more goods to other countries than they buy. This means there is the potential for some exposure to the rising political and international trade tension we have seen in recent years. However, overall we remain positive about the stability of the German and Dutch small business environment over the next few years.

We are confident returns will remain resilient through a recession

A deep understanding of credit risk, and first-hand experience of managing multi-billion pound lending portfolios—particularly through the 2008 recession—has taught me that although lending is cyclical, careful monitoring and a prudent approach can provide investors with attractive returns throughout every stage of the economic cycle. When downturns happen, defaults do increase. However, it’s important to remember the vast majority of borrowers should remain financially healthy.

At Funding Circle, we rigorously prepare for changes in economic conditions. Part of this is to regularly stress test the loans in each of our markets. To do this we take a base scenario**—the projected returns from loans being originated today—and using a bespoke stress testing model, apply a number of adverse scenarios recommended by each market’s central bank. This allows us to simulate what could happen to the projected returns established in our base scenario. Although every recession is different, the results show that even in severe economic conditions investors should still be expected to experience positive returns

2018 Funding Circle stress test results

Source: Funding Circle Stress Test 2018

These results assume that no action would be taken to mitigate losses in the event of a downturn. In reality, we carefully monitor loan performance for signs of stress. If there were signs that conditions were worsening, we would make adjustments to account for some of its effects: for example tightening our assessment process, or calibrating prices on new loans. These actions should mitigate some of the adverse impact on investors’ returns.

Although we can’t predict when and how the next recession will happen, my experience tells me that we are ready. We are originating resilient loans in all of our markets, and we have the right tools in place to mitigate economic stress if needed.

We hope you have found this information useful. If you have any questions, please don’t hesitate to get in touch, and remember by lending to businesses your capital is at risk.

Jerome Le Luel

asdfad