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One Borrower Grading System to Rule Them All
I wrote this morning* about the latest news from European personal loans P2P lending company Bondora, which UK lenders can use to lend to borrowers in other countries.
In a moment I'll share my thoughts on Bondora's changes and there'll be a dark interlude into doctors killing patients, insanity and financial theory, which is all more closely related than you might think.
But first, in a nutshell, a quick summary of the two changes Bondora's making for those of you who missed my news article:
1. It's changing its existing system to give one of eight risk grades to all its borrowers in all countries. These are standardised across all its borrower countries, although local differences are taken into account, such as the ease with which you can recover bad debts in a given country.
2. It's updating how it sets interest rates, which will, at least initially, be based on how volatile lenders' returns (or losses) are.
That's the news. Now I'd just like to share my thoughts on these changes.
One borrower-grading system for all countries
Investors have long been able to borrow and invest internationally and that is largely made possible by investors requiring similar information and checks that everyone can understand. I'm talking about bonds (a kind of loan to businesses and governments), shares and many other investments.
But banks have never got around to creating a system for appraising ordinary bank loans across borders using a single scale, like Bondora is doing. That's why you can't apply to Deutsche Bank for a car loan and Fritz can't apply to NatWest for funds to open his barber shop.
That doesn't mean that one borrower in one country must be the same as another in another country, because a single scale can still take into account both local and individual differences. After accounting for those differences you can then slot borrowers into a grade.
It means that we can more easily compare a greater number of opportunities with a wider range of risk profiles.
Measuring risk using volatility
So we're getting a unified risk-grading system. Sounds like a good thing.
Now let's turn to Bondora's new unified risk-pricing system. In P2P lending terms that means how it estimates what interest rate should be charged for a given loan.
Before we do that, a slight diversion into the bizarre financial world and just one of its truly bizarre theories that is bizarrely popular: namely that investment (or lending) risk = volatility. Rather like a stock price that jumps up and down a lot.
To you and me (and to all the best investors in the world that I know of who have published their full investment records) risk is the possibility of your savings and investments (and loans) being able to buy you less over your chosen investment horizon than they could have done originally.
Volatility, on the other hand, is just about how things fall and rise in between. A good, calm stock-market investor doesn't give a damn if his stocks fall 10% more than average in one year if he's holding for ten years. It's the end result that counts.
Note also that I just said fall and rise. That's right, when financial theorists price risk via volatility, they don't care whether you're making or losing money. All they care about is whether you're making or losing money more violently than anyone else. Either way, it's more volatile ergo higher risk.
The only time a share investor complains that one of his stock holdings is rising too fast is because he really wants more time to buy more of the same shares at a lower price. But he doesn't say: “This is too volatile. I've taken a big risk and it didn't pay off.”
Interest rates based on volatility
Back to P2P lending and Bondora, which has said that starting soon it will initially set its interest rates using CAPM, which is a (bizarrely popular) measure focused around this same volatility.
Later it will be market forces setting Bondora interest rates, aka you, me and other lenders competing to lend to borrowers, and the supply-and-demand effect will ultimately set the interest rates.
But for now it's volatility through CAPM.
CAPM reminds me of the Hungarian doctor Ignaz Semmelweis who discovered that hand disinfection reduced death rates in operations from tens of percent to less than one percent.
On revealing the conclusive proof, Ignaz was censored by his colleagues and forced out of his profession. They were simply unwilling and unable to accept that they were wrong and had been killing their patients all their lives with their unwashed hands. So they continued to do so for a few more decades.
These sorts of incidents in professional money management are a daily, if probably less dramatic, event.
Semmelweis died in a mental institution, beaten to death by the guards. Lucikly, the authors of a substantial pile of studies showing that CAPM isn't really fit for purpose are not being villified and disbarred – just ignored.
But let's not disbar Bondora
But don't let that put you off using Bondora; there are probably a great many respected financial institutions, fund managers and others currently using volatility as a proxy for risk. Probably some of the P2P lending companies you lend through do use or have used CAPM. If you bar all companies that do it then you're going to lose many valuable resources.
Most importantly: you can still take a look at their prices and, if you're not satisfied, walk away and come back another day. Just like you can do when buying shares on the stock market. And just like a borrower can do when considering whether to take out that loan after all.
Pricing risk isn't easy. CAPM is the easiest way out for Bondora at this early stage in its new borrower-grading-and risk-pricing structure – until it passes pricing over to market forces, which is when lenders like you and I will be free to price really badly all by ourselves. Just like we sometimes do in property, on the stock market and in some P2P lending loans.
What can we do with CAPM interest rates?
While CAPM is in charge at Bondora, there are some useful ideas to take with you:
– CAPM tends to overprice higher risk, which in P2P terms means you might expect the interest rates for riskier loans to be too low for the risks involved.
– CAPM tends to underprice lower risk, which means that while lower interest rates are on offer, they could be higher than they need to be for the risks involved.
So, before we even see Bondora's renewed service, we can already, tentatively expect that we'll get a better risk-reward balance by going for Bondora's best quality loans, at least until market forces take over.
Please spread your money across lots of loans. You'll get zero use out of CAPM if you don't. Read my Candid Opinion blog on diversification from yesterday.
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