Asymmetry of information
Peer-to-peer (P2P) lenders would make great poker players. Making difficult calls with imperfect information, reading people, making sure their stories add up.
Traditional banks have a plethora of tools at their disposal when evaluating the risk of a loan. Meanwhile, P2P lenders have to make do with what information is publicly disclosed about the borrower. No in-depth credit history – just the P2P platform’s credit risk rating. No tools for monitoring how their investments are actually used – just the borrower’s self-reported purpose of the loan. Not even a real name of a borrower – just a pseudonym.
And yet to maximise return on investment, lenders have to correctly infer the creditworthiness of their peers. And they have to bear with the default risk – even as most are far from experts in risk management.
Research-informed rules could surely help.
Default risk factors
To identify a trustworthy borrower, pay attention to the following signals provided by P2P lending platforms.
Borrower’s credit rating
By far the most influential factor for loan performance. Credit rating is determined by the platform, which bases its decision on data from an external credit rating agency. Precise details and the makeup of credit score are not disclosed to investors, but, as a general rule, low credit rating represents a history of delinquent accounts, missed payments, defaults, or a lack of credit history.
Currently, the more aggressive portfolios (with more risk) are doing better than conservative ones. But that wasn’t always the case. As recently as 2013, aggressive investors were burning more money on defaults than they were being compensated for with higher interest rates. If expectations about the economy were to sour – and there are some signs of that – today’s risk-takers might see their bottom-line turn red.
Whatever the economic outlook, the best performing portfolios (over a large sample) have at least one thing in common – they’re broadly diversified across all credit ratings. Even if you lean towards a more conservative portfolio, there are good reasons to sometimes go out of your comfort zone.
For one thing, in some situations credit rating might not reflect true risk. One particular segment of borrowers jumps to mind – young borrowers. Because credit rating depends almost solely on past repayment history, those who have no previous credit history may be miscategorised, and be willing to receive a lower rating just because it is their first loan.
Additionally, more than a tenth of FinBee borrowers – disproportionately poorly rated – take out a loan and return it (plus interest) almost immediately (in 1-2 months) in order to boost their credit scores. Because they are predominantly rated as “C” or “D” credit risk, conservative lenders never get close to them.
A simple, yet powerful measure. Expressed in percentages, it usually falls in the range of 10% to 40%, and is the second most important factor in evaluating the risk of default.
While a low debt-to-income ratio is a sign of a trustworthy borrower, a high one can be a harbinger of troubles to come. A high ratio can signal that an individual has too much debt for his income level, and will have difficulties coping with monthly payments. Meanwhile, a low ratio is linked with a higher chance of early repayment.
Although the debt-to-income ratio is important in all credit grades, it is most influential within the highest credit rating loans. That means that debt-to-income ratio is a far more accurate measure of default risk when comparing loans in the higher credit ratings than it is in the lower ones. Pay special attention, as the ratio will help you distinguish the truly trustworthy from merely solvent borrowers in A and B credit rating categories.
Loan amount, loan term and annual income of the borrower
All are somewhat-important variables to consider – even as you’re financing just a portion of the overall loan.
Not surprisingly, research suggests that the higher the loan amount and the longer the loan term – the higher the chance of a default. Therefore, as a general rule, you should prioritise smaller, short-term loans. Nevertheless, keep in mind that the effect of a high loan amount is counteracted by a higher annual income.
At the end of the day, you should consider these three factors collectively, and see whether the person can afford the loan and whether the loan conditions make sense for the borrower’s level of income.
Housing situation, marital status, occupation, length of employment, education
Far less important factors. They do correlate with the borrower’s annual income and the requested loan amount, but they are far less informative than the credit rating or debt-to-income ratio.
The research is inconclusive on this front, and it is very difficult to say with any certainty whether any of these factors affect the default risk of your particular subset of borrowers. Instead of drawing contradictory conclusions, it is far better to stick with standard financial variables to evaluate risk.
Avoid the herding effect
Finally, even with a solid foundation in risk management, you would still have to avoid the trap that even the professionals fall for – herd instinct. P2P lending markets exhibit all the traits of such herding behaviour – an irrational exuberance in following the crowd, informational cascades, preference for conformity, fear of missing out, etc.
Researchers find clear evidence that auctions with a higher participation rate attract more follow-up bids.
From the standpoint of managing risk, that is exactly the sort of logic you should avoid. The actions of other investors do not reduce the risk of default, and thus should not affect your decisions of whether to invest in a loan or not.
In other words, if other investors are choosing one borrower over some other, you shouldn’t blindly follow their lead.
Do your own research. Make up your mind on your own terms.
You will get it wrong, occasionally.
Of course, even with best risk management strategies defaults will happen. That is why it is important to choose a platform that vets each borrower individually and can minimize the default-risk before allowing investors to take unnecessary risks.
Here at FinBee, we meet each borrower individually to ensure their creditworthiness. Thus far, only 6.85% of our borrower’s loans are behind schedule for 91 or more days as of 2019. We also stand up for our investors – having recovered over 63% of loans which defaulted since 2016.
That means our investors are currently enjoying juicy returns of over 17% in 2019, even after accounting for the likely losses.
Learn more about our P2P platform at Finbee.com.