the future of funding societies credit risk model shil mukherjee

7/24/2019 The Future of Funding Societies Credit Risk Model Shil Mukherjee

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Alternative Lending:A regulatory approach to Peer-to-Peer lending


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Alternative Lending

THE PEER-TO-PEERINDUSTRY GREW 177%

BETWEEN2012-2013

Theindustry

DOUBLESin size

every year

More than

5,000 SMEsHAVE RAISED FUNDS THROUGH ALTERNATIVEFINANCE INTERMEDIARIES BETWEEN

2011-2013

P2P lendingplatforms

are the

LARGESTFORMS OF MODERNFINANCE IN THE UK

A regulatory approach to Peer-to-Peer Lending

THE UKS LARGESTPeer-to-Peeroperators match

80 millionin loans per month

91%of the SME lending market

is dominated by the

big 5 banks

SME funding gap overthe next five years:

191BILLION

84BILLION

The US, the UK and China

MAKE UP

96%of the overall nancial return

Crowdfunding market:

OTHERS

4%UK

17%CHINA

28%US

51%

80million


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ALTERNATIVE LENDING: A REGULATORY APPROACH TO PEERTOPEER LENDING 3

Introduction

Before taking over the regulation of the consumer credit market fromthe Office of Fair Trading on the 1 April 2014, the Financial Conduct

Authority published a policy statement on its regulatory approachto firms operating online Crowdfunding platforms. As part of thegovernments plan to promote alternative forms of finance, the FCAhas adopted a balanced solution that seeks to protect both investorsand an industry that is seen to be key to the growth of small andmedium sized enterprises.

Nicholas Harding

Lending Works

1 April 2014:

FCA takes over

regulation of

Consumer Credit

from the OFT

April 2014:

FCA to publish

paper on key risks

in the market in

order to establish

intervention

priorities

1 October 2014:FCA will start

considering

applications for full

authorisation from

firms with interim

permission

1 April 2016:

Full FCA consumer

credit regime will

come into effect

replacing the

interim permission

regime

2019:

Department for

Business, Innovation

and Skills and HM

Treasury to carry out

post-implementation

review reform

2019:

FCA to complete a

review of retained

CCA conduct

requirements and

develop rule-based

alternatives

We strongly believethat the FCA regulation

is fantastic for the industryas a whole, not only will it

encourage best practice, moreimportantly, it will promotetrust and consumer security

amongst investors andborrowers.


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4 ALTERNATIVE LENDING: A REGULATORY APPROACH TO PEERTOPEER LENDING

The importance of alternativelending channels

Traditionally, UK businesses have heavily relied upon banks to meettheir funding needs. It is estimated that 91% of small and medium

sized enterprises (SME) seek funding from the UKs largest five banks.Historically, the lack of alternative funding options has proven ahindrance to such businesses.

Nevertheless, since the financial crisis, and despite

political efforts, SMEs struggle to access the

finance they need. The Breedon Report, which

examined the financing of UK SMEs, concluded

that in the next five years there will be a finance

gap of between 84 billion and 191 billion1.

Although the report did not identify a singlesolution to this problem, it established that raising

awareness about alternative finance methods

would be key.

The term alternative finance commonly

comprises any form of finance provided by non-

banking entities. It is thought that these innovative

funding methods will have a crucial role in the

creation and survival of SMEs. The government

acknowledges the importance of the funding gap

and has adopted various measures to promote

lending. Currently, it is consulting on whether to

take legislative action to help match SMEs that

have been rejected for loans with challenger banks

and alternative finance providers who are looking

to offer credit.

Amongst the alternative lending possibilities,

the Crowdfunding sector has drawn particular

attention due to its exponential growth and its

crucial role providing SMEs with access to finance.

Crowdfunding platforms provide a medium by

which businesses and individuals are able to seek

flexible financing options from an array of sources,

predominantly via online platforms. There arenumerous forms of Crowdfunding:

some are charitable donations that provide

intangible benefits; others, such as equity

Crowdfunding and Peer-to-Peer lending, do offer

financial returns.

The importance of these funding methods was

acknowledged by the Parliamentary Commission

on Banking Standards which stated that:Peer-to-Peer and Crowdfunding platforms have

the potential to improve the UK retail banking

market as both a source of competition to

mainstream banks as well as an alternative to them

() The emergence of such firms could increase

competition and choice for lenders, borrowers,

consumers and investors2.

Lending platforms were originally regulated

by the Office of Fair Trading (OFT); however,

since 1 April 2014 they are regulated by the FCA.

The Regulator shares the governments desire

to make these alternative forms of finance more

secure and accessible. Christopher Woolard, the

FCAs Director of Policy, Risk and Research

recently stated: Consumers need to be clear on

what they are getting into and what the risks of

Crowdfunding are. Our rules provide this clarity

and extra protection for consumers, balanced by a

desire to ensure firms and individuals continue to

have access to this innovative source of funding 3.

1 Breedon Report: Boosting Finance Options for Businesses2Parliamentary Commission on Banking Standards: Changing Banking for Good (57)3 The FCA outlines how it will regulate crowdfunding: http://www.fca.org.uk/news/the-nancial-

conduct-authority-outlines-how-it-will-regulate-crowdfunding


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FCAs regulatory approachto Crowdfunding

The FCAs policy statement, published in March 2014, does notpropose fundamental changes from its original Consultation Paper

(CP 13/13). Firms holding an OFT licence should have applied forinterim permission before 1 April 2014.

Those organisations that did not complete the

application by the 1 April, will need to apply for

full authorisation and will be unable to conduct

Crowdfunding activities until they are authorised.

The Regulator has decided to maintain the

polemic distinction between investment-based

Crowdfunding and loan-based Crowdfunding (or

Peer-to-Peer lending).

Investment-based Crowdfunding consists

of investing in businesses by buying unlisted

securities that are hard to value independently or

sell on a secondary market. The FCA considers

that, given the high risks that investors face by

investing in non-readily realisable securities,

they should only be promoted to individuals that

understand their inherent dangers or to those

than can cope with the potential financial losses,

that is: professional clients, retail clients who are

advised, retail clients classified as corporate finance

or venture capital contacts and sophisticated orhigh net worth investors. Those retail clients that

are not provided with investment advice will need

to pass an appropriateness test and certify that

they will not invest more than 10% of their net

investible assets in these products.

Investment-based Crowdfunding firms were

given a transition period to comply with the new

rules. While many are choosing to implement the

changes to ensure compliance immediately, they

will become mandatory from 1 October 2014.

Nevertheless, by imposing investment restrictions,

the Regulator has been accused by entrepreneurs

of taking the crowd out of Crowdfunding.

Conversely, Peer-to-Peer lending, which

consists of financing businesses and loans with

contributions from a large number of sources, has

been subject to lighter regulation.

Vince Cable

Secretary of State for

Business, Innovation and Skills

Small and medium-sizedbusinesses need access to a

diverse range of finance options,including non-bank lending. Thesenew forms of finance are still smallin scale today but they should, over

time, bring additional choice andgreater competition to the

lending market.


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New rules and capitalrequirements

The FCAs approach to Peer-to-Peer lending platforms is much lighteras they are considered to be lower risk. The Regulators rules can be

summarised as follows:

The FCA has decided to recalibrate its volume-based nancial resources requirements to reect

economies of scale in extremely large organisations. The Regulator has proposed a transition period:

Until 31 March 2017, the xed minimum prudential requirement will be 20,000. From that date,

the minimum requirement will increase to 50,000. Transitional arrangements will not apply to OFT-

regulated organisations until they become fully authorised.

Platform operators will have to create programmes that ensure loans can be managed to maturity

in case of platform failure. The Regulator has decided not to impose stringent requirements for the

arrangements that rms must have in place. Nevertheless, rms are expected to have appropriate

systems and controls depending on their customer needs and their business model particularities.

Lenders holding client money will need to apply the existing client money rules contained in the Client

Assets Sourcebook (CASS). The application of the regime will entail additional reporting requirements

for CASS medium and CASS large rms. However, Peer-to-Peer lenders will not be subject to these

measures until October 2014.

The Regulated Activities Order and the Financial Promotion Order have been amended; therefore,

lending websites and details of loans will be considered as nancial promotions. The rules requirerms to ensure investors have enough information to make informed investment decisions and that all

communications are fair, clear and not misleading. The Regulator didnt mandate specic disclosures

placing the onus on rms. These rules, considered to be essential for consumer protection, have

been applicable since 1 April 2014.

Loan-based Crowdfunding platforms will be subject to the FCAs dispute resolution rules. Moreover,

in order to assist with market monitoring, organisations will need to submit regular reports on their

nancial position, the client money held, complaints and the loans arranged each quarter.

Prudentialrequirements:

Protections incase of rm

failure:

Client moneyrules:

Disputeresolutionand reportingrequirements:

Disclosure

rules:


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It is important to note that investments via

Peer-to-Peer lenders will not be covered by the

Financial Services Compensation Scheme (FSCS).

The Regulator expects firms to disclose the lackof coverage and its consequences to potential

investors. The FCA considers that the prudential

requirements and the arrangements in case of firm

failure should be sufficient to protect investors.

Nonetheless, the possibility of including these

alternative lenders within the FSCS remit will be

reconsidered in 2016.

Lending platforms suffer from all the risks

associated with credit provision, including

money laundering and terrorist financing. The

Joint Money Laundering Steering Group haspublished draft guidance for these type of firms

relating to their compliance with anti-money

laundering regulations.

Volume-based capital requirements(Applicable from 2017)

0 to 50 million 0.20%

> 50 million to 250 million 0.15%

> 250 mill ion to 500 million 0.10%

> 500 million 0.05%

Nicholas Harding

Lending Works

Appropriate

prudential requirementsare critical for our industry.

We believe that higher capitalrequirements than those initially

proposed by the FCA couldbe beneficial; they wouldhelp prevent the failure of

businesses and increase ourcredibility.


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International approachto Crowdfunding

The Peer-to-Peer lending market remains a relative newcomer in termsof global credit provision. While growth is encouraging, particularly

in the UK, USA and China, the proportionate share of credit marketsremains small.

Market share Crowdfunding market 2013However, due to its growth potential, policy-

makers are demonstrating an increasing appetite

to regulate the sector, both to mitigate risk and

encourage customers to make use of the alternative

funding options the industry provides. Striking the

perfect regulatory balance is not easy, and while

policy approaches vary from country to country,

a certain degree of harmonisation is likely to be

necessary due to the prospective cross-border

nature of the Crowdfunding industry.

In the US, the largest Peer-to-Peer lending

market, platforms must follow an arduous

regulatory process. Each lender needs to be

regulated by the Securities and Exchange

Commission (SEC) at a Federal level, and register

the loans they originate. These businesses receive

the same treatment as a public company, therefore

they have to comply with high disclosure

requirements: their finances, loan origination

and practices are public. Peer-to-Peer andCrowdfunding activities are not permitted in

certain states, hence state approval is necessary

too. Those platforms that want to operate in more

than one state can either become a public business

or apply to each state separately.

China

US

UK

Others

Source: Iosco

28%

51%

17%

4%

As in the UK, equity Crowdfunding has certainlimitations. Sophisticated investors can only

deposit 5% of their annual income. This limit

goes up to 10% when the annual income is over

$100,000. The SEC is considering extending these

rules to retail investors.


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Conversely, China, another Peer-to-Peer giant,

has not regulated the Crowdfunding industry. The

lack of regulatory guidance and tighter monetary

conditions resulted in the failure of nearly seventyPeer-to-Peer lending websites at the end of 2013.

Although they only represent a small fraction of

the circa 1000 Peer-to-Peer platforms currently

operating in China, the collapse sparked concern

in Europe and the US. As a result, the Chinese

Central Bank assured that it will provide closer

supervision and stressed that illegal lending

practices, such as investing clients funds in

financial products, can result in death penalties.

The European Commission (EC) recently

issued a report discussing the long termpossibilities of the Crowdfunding industry to

complement traditional sources of finance. The

Commission considers that Crowdfunding

can contribute to building a pluralistic and

resilient social market economy and sustains

that burdensome and premature regulatory

action could hinder the industrys development.

The EC will conduct a detailed study in 2014 in

order to better understand national European

regulation and explore the possibility of launching

a harmonised solution.

Regulatory

regime

Description Countries

UK model Platforms need

approval from the

FCA to operate

United Kingdom

Exempt market/

unregulated through

lack of denition

P2P is either an

exempt market

or there is a lack

of denition in

legislation

Brazil, China,

Ecuador, Egypt,

South Korea, Tunisia

Intermediary

regulation

Regulates P2P

lending platforms

as an intermediary,

which requires

registration and

other regulatory

requirements

Australia, Argentina,

Canada and

New Zealand

Banking regulation Regulates P2P

platforms as banks

France, Germany,

Italy

US model Requires registrationof the platform with

the SEC and state

authorisation

United States

Prohibited Both P2P lending and

equity Crowdfunding

are banned

Japan, Israel

International regulatory regimes

Source: Iosco


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Conclusion

Initial reactions to the FCAs rules have been broadly positive, manyprecepts are a close reflection of the Peer-to-Peer Finance Association

code of conduct. Nicholas Harding, founder at Lending Works,confirmed: We strongly believe that the FCA regulation is fantastic forthe industry as a whole, not only will it encourage best practice, moreimportantly, it will promote trust amongst investors and borrowers.

The Regulator acknowledges that higher consumer

protection comes at a price. So far, it has published

two cost-benefit analyses which indicate that the

rules will result in certain companies leaving the

Peer-to-Peer industry and that compliance costs

will be permanently higher for those that survive.Increasing costs and new industry entries may result

in market consolidation.

While the estimated 840 million that will be

lent by alternative finance providers in 2014 only

represents 2% of annual UK business lending,

this amount has grown at a rate of more than

90% year-on-year. Peer-to-Peer lenders are often

described as game-changers; not only because

of the seductive rates they offer, but because both

borrowers and investors are captivated by their

speed and simplicity.

More importantly, the industry benefits from

Government support. In March, it was revealed

that Peer-to-Peer lending was to be included

within the tax-free ISA allowance. According

to one of the biggest market participants, the

announcement represents a crucial moment for the

industry. Lending platforms believe that it is a great

opportunity to lobby for increased sharing of credit

information with banks, although this would require

a considerable softening of attitudes from traditional

lenders and increased collaboration with alternative

finance providers.

The lack of competitiveness in the lending marketcauses concern among policy-makers globally. Many

countries see the benefits of supporting alternative

forms of finance. Nevertheless, the inherent

risks that Peer-to-Peer lending entails cannot be

disregarded. Although default rates in the industry

are currently low, the data can be misleading: most

of these platforms were established in the last three

years; therefore the majority of their loans have not

reached maturity yet. Market participants expect

regulation to prevent the failure of alternative

lending institutions, which would have a disastrous

reputational effect; Nicholas Harding, added:

Appropriate prudential requirements are critical

for our industry. We believe that higher capital

requirements than those initially proposed by the

FCA could be beneficial, they would help prevent

the failure of businesses and increase our credibility.


11/12


Vince Cable

Secretary of State for

Business, Innovation and Skills

Despite most lending platforms having robust

credit checking systems in place, some would like

the Regulator to be more prescriptive about the

quality of the technology and the competencies ofthe individuals running these businesses. The long

term effects of the regulatory approach adopted by

the FCA is yet to be seen, for now the future of the

Peer-to-Peer lending world is full of possibilities

which include the development of innovative

payment methods and the smart use of big data.

The rate of growth, both in value and maturity, of

the alternative lending industry is unprecedented.

The manner in which these businesses have adapted

to initial regulation paints a positive picture for the

future prosperity of a sector with a major role toplay in the Financial Services industry of the future.

We need to seemore small, innovative,

alternative banks and non-banks. There are many new

financing models which have beencreated, such as Peer-to-Peer lending,

which have taken off like wildfire.I am now beginning to encounter

companies around the countrywhich would have gone underwere it not for Peer-to-

Peer lending.

Peer-to-Peer lendersare often described as

game-changers; not onlybecause of the seductive ratesthey offer, but because bothborrowers and investors are

captivated by their speedand simplicity.


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Grant Thornton UK LLP @GrantThornton

Tarun Mistry

Partner, Financial Services

Corporate Finance

T(0)20 7728 2404

E [email protected]

Gareth Miller

Associate Director, Regulatory

T(0)20 7865 2863

[email protected]

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Financial Services

Corporate Finance

T(0)20 7865 2569

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