P2P default rates on the rise

The increasingly desperate search for income in a world of falling interest rates has meant that peer-to-peer (P2P) lending where investors lend money directly to firms and individuals through websites such as Zopa,RateSetter and ThinCats has exploded in recent years.More than £500m in loans were originated through RateSetter alone last year.

It has also received a lot of encouragement from the government, who see it as a way to make the financial sector friendlier to small and medium-sized firms, as well as cushioning the blow for savers. Official measures to encourage P2P lending include the introduction of the innovative finance individual savings account (Isa) earlier this year, which lets investors make P2P loans from within a tax-free saving and investing wrapper.

The idea behind P2P is both simple and extremely seductive. Instead of putting your money in a savings account and earning whatever paltry rate of interest the bank deigns to offer, you can cut out the middleman and effectively become a banker yourself. However, unlike a traditional savings account, P2P investments mean that your capital is at risk: if the people or firms to whom you lend default on their repayments, you may suffer losses and these will not be covered by the Financial Services Compensation Scheme (FSCS).

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P2P websites have tried to address this problem. First, they argue that their quality control, combined with investors spreading their money over a wide range of loans, can keep risks to minimal levels. When they first became established, the various P2P websites took great pains to emphasise their very low default rates. For example, RateSetter says that their loans made in 2011 have had a default rate of 0.59%.

However, there are concerns that this could change as the amounts lent increase and standards fall. In March, Adair Turner, the former head of the Financial Services Authority (the UK's previous financial-services regulator, which has now been replaced by the Financial Conduct Authority), warned that losses from P2P loans in the next decade "will make the worst bankers look like lending geniuses". Unsurprisingly, Turner's remarks drew a lot of criticism and derision from the P2P industry.

Indeed, several figures have argued that his failure to spot the subprime crisis meant that he had little credibility where lending or the financial system were concerned. However, the latest figures from RateSetter raise the question of whether he is sounding the alarm at the right time.

RateSetter recently reported that defaults on loans originated in 2014 already have a default rate of 2.81%, compared with an expected level of 2.1%. Since loans originated in a specific year can last for up to five years, ultimately total defaults for loans made in 2014 are likely to climb even higher.

At the moment, RateSetter diverts a certain proportion of the interest payments into a fund earmarked to cover defaults, known as the Provision Fund (Zopa also does something similar). The size of this fund is based on its own estimates of future losses plus an additional default rate of 0.5% as a buffer. If actual defaults exceed the estimates by more than the value of the buffer, investors may end up with losses.

RateSetter says it still thinks "that the Provision Fund will cover all defaults in 2014". It also says that since most defaults occur before a year, additional losses on the 2014 tranche "are expected to flatten out in future". That said, it's not obvious why loans made in 2014 should be suffering a spike in defaults, given that economic conditions have been favourable. Investors should take this as a reminder that P2P is not a riskless way to earn a bank-account-beating return.