One of the more frequent criticisms levelled against P2P lending by sceptics is the suggestion that it exists only because interest rates are so extraordinarily low. Once rates move up, they suggest, it will be game over for the P2P movement, which in turn implies that there’s a causal relationship between extremely low interest rates and the appearance of P2P lending.

 

That might be true, but I haven’t seen any proof of it so far. It’s equally possible that there’s as much co-incidence as causation about low interest rates and the rise of P2P – after all, rates are low pretty well everywhere in the developed world but the P2P movement has shown earlier and more robust growth in the UK than in most other places. Might this be as much to do with factors such the level of consolidation in our banking system, changes in the appetite of the incumbents to lend, the approach of regulators to new entrants and the willingness of people in the UK to transact online, among many others?

 

Quite possibly – in which case, how much difference would rising interest rates make to the fortunes of the P2P lenders? After discussing this question with a number of the leading players recently, I’ve boiled these conversations down to a few key points, the most important of which is that the answer is not a question simply of the absolute level of interest rates but hinges instead on a series of factors that help to determine the balance between the supply of funds to lend and demand to borrow – much as you would expect in a market. This could turn into a long post so I’m going to split it in two and return to the subject next time.

 

Platforms’ profit margins

 

The first key issue is the spread between the cost of funds to lend and the rate that borrowers pay. Between those two figures lies the profitability of banks and P2P platforms alike. As Rhydian Lewis, CEO of Ratesetter, points out, rising interest rates tend to increase the size of that spread. Banks traditionally become more profitable during phases of rising interest rates because the rates that they charge borrowers tend to rise more quickly than the rate they pay to savers. This process widens profit margins and therefore the scope for competition, potentially favouring P2P platforms to the extent that they can make profits on a tighter spread than banks thanks to their lower overheads. So on that score, rising rates are not necessarily a big problem for P2P platforms.

 

The supply of funds to lend

 

If people can earn an attractive low-risk/no-risk return elsewhere, by putting their cash in the bank for instance, that’s what a lot of them will do. At the moment, the gap between the return people can earn from a deposit account and what they can make by lending via a P2P platform is clearly big enough to ensure a ready supply of funds. In the consumer P2P market, the premium over savings rates that people demand is fairly narrow, perhaps about 3%-4% or so, in the business lending market it’s rather more. It remains to be seen where the resistance points lie, but for business lenders on Thincats earning 10%-11%, a doubling of savings rates is unlikely to have much effect , says co-founder Kevin Caley. “If our lenders could put money in the bank and earn 4% interest on it, then it would take a lot more to persuade them to put it into something like P2P lending, but when are rates going to go up to 4%? It’s not going to be this year,” he says.

 

The question of how tight the risk premium can get before lenders pull back depends on the choices they have. For retail lenders, the main alternative will be savings products. For institutions, the range of choices is bigger but will probably include corporate bond and leveraged loan markets. If rising interest rates lead to big falls in corporate bond prices and therefore big rises in their yields – an entirely plausible scenario – these could start to look like a much more attractive relative bet than P2P lending at current rates of return. So to stay attractive to lenders, P2P returns will need to respond to changes in the returns available elsewhere: the big question is how much leeway P2P returns have before they start to look too low relative to the alternatives.

 

But enough of this for now – I’ll finish up next time with some thoughts on what rising rates might do to demand for P2P loans.

 

Update: The share price of Tungsten, the quoted e-invoicing and invoice finance provider that I wrote about a few weeks ago, has tumbled recently, partly because it needed to raise a further round of equity funding. The share sale was well supported but there seems to be considerable doubt in the market about Tungsten’s prospects and stories are emerging of high-profile backers of its IPO who are sitting on big paper losses. This is bad news for Tungsten and arguably for alternative finance more broadly – a movement that thrives on the oxygen of positive publicity can do without public mishaps like this.

 

Part 2 of Andy's blog can be read HERE.