Every time there are talks of a rise in interest rates, financial institutions go into a frenzy. The 2008 recession had forced central banks around the world to drop their rates to historical lows. But with the global economy stabilizing, the US Fed and other central banks have started tightening rates. We will be covering effects of the rising interest rates on three of the biggest P2P markets in the world: the UK, US, and China.
Last year, Bank of England (BoE) reduced the interest rate by 0.25 percent along with a sling of monetary policies to encourage growth. But in October of this year, BoE increased the interest rate, though only marginally by 0.25%. Both of these times, banks and other financial institutions immediately reviewed the mortgage and saving rates, and the effect was passed on to customers. But the change is too small to have any damaging effect on P2P lenders.
Moreover, P2P lenders do not fall directly under the scope of BoE, hence, are not immediately affected by the BoE base rate. Lender return is directly proportional to the demand and supply in the market. For the short term, P2P lenders will not be making any headline-grabbing changes to their rate structure. If the rate does end up crossing 2%, the P2P market will definitely ring up some changes in their rate structure.
Zopa, the pioneering UK-based P2P platform, was able to thrive even when rates were above 5%. But the real reason P2P gained a substantial foothold in the UK was because of the low yield environment. With saving rates below inflation, money lost its value over a period of time when held in savings accounts. This prompted people to go for P2P platforms as alternative saving options even though it had a way higher percentage of risk attached to it. If rates do reach a certain level, the lender might go for the safer option of saving accounts returns rather than the high-risk high-profit approach offered by P2P platforms. But if P2P lending is considered an investment, the yield will always be attractive for a certain class of investors.
During the last decade, the US economy endured the worst financial recession in 80 years. And to counter that, the Fed dropped the rates to 0-0.25% for an extended period of time. But with US unemployment rates at multi-decade lows, the rate has been slowly yet steadily hiked to a range between 1%-1.25%.
Impact of increase in the interest rates
Lending Club, the largest P2P platform in the United States, has mentioned in its prospectus the adverse effect hike in interest rate will have on its business
“… fluctuations in the interest rate environment may discourage investors and borrowers from participating in our marketplace, which may adversely affect our business.”
Many retail investors use the P2P platform as an investment option. Since they lend directly to the borrowers, the non-involvement of the intermediaries allows them to enjoy handsome returns as compared to returns they get for depositing into saving accounts.
As the chart above clearly depicts, a number of delinquencies are directly impacted by the increase in the interest rate. The higher the interest rates, the higher are delinquencies. Thus, the low rate environment had led to lower delinquencies. But now, there is a growing fear that a hike in interest rates will be detrimental to peer-to-peer lending platforms.
Ben McLannahan of the Financial Times believes that an increase in Fed rates can actually devastate the nascent peer-to-peer lending industry.
- Increasing default rates for peer-to-peer lending notes might trigger an exodus by institutional investors, thus triggering liquidity concerns and
- Traditional investment options would see returns revert to historical means, rendering moot the allure of higher returns offered by the p2p industry. (Source)
China is one of the biggest markets in terms of size and population. Even new regulations and the crackdown by authorities cannot halt China’s P2P market juggernaut. In March this year, it crossed $130 billion (Rmb 900bn), and it is widely expected that lending will cross Rmb 1 trillion mark this year.
With outstanding loans weighing heavy on the balance sheets of lenders, the regulatory body PBOC is worried this will lead to yet another economic recession, and that is the reason it is clamping down on the P2P industry. For the most part of its journey, the P2P industry in China has been unregulated. The sudden onslaught of regulators led to a major decline in the number of players. Case in point: There were 2,281 P2P platforms in the country, and now the number has come down to 331.
The basic interest rate is hovering around 4.35 percent. Chinese regulators believe the global economic situation is still shaky, therefore, raising the open market rate is much more appropriate than raising the benchmark rates. In February this year, PBOC raised the interest rate on open market operation to reverse repurchase agreements (repos) by 10 basis points, and furthermore, it increased the lending rates on standing lending facility (SLF). The overnight rate for the SLF loan was raised to 3.1 percent from 2.75 percent. The SLF rate acts as a de facto ceiling for interbank lending.
A change in short and medium lending rates were executed to address the rapid build-up in debt and to safeguard the economy against the consequent financial risk. Increase in interest rates along with regulatory reforms being put in place by PBOC will help the industry to grow in a safe and structured environment.
Rising interest rates pose a threat to the P2P industry as the initial adoption was triggered by the low yield offered by traditional banks. P2P lenders were able to circumvent this and offer a win-win for both borrowers and lenders. With interest rates inching up, many feel the P2P lenders will be facing higher delinquency and lower investor interest. But this does not take into account the evolution of the industry; the players have been extremely nimble and understand the predicament facing them. Many have tightened lending norms, and almost all players now have long-term institutional money on board. With credit algorithms leveraging artificial intelligence and machine learning, profitability for the nascent industry is not a distant dream. In such a scenario, interest rates offered by P2P lenders will adapt to the demand-supply ratio in the market.
Written by Heena Dhir.