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Standing Firm Under Pressure
This is the Candid Opinion blog and now it's time to be candid about the 4thWay® Risk Ratings.
We’re proud of our scoring system and we’ll only get more proud as it proves itself and as we improve on it. The feedback we're getting from the P2P lending industry is that they think what we're doing is a really good thing.
But will our risk scores always work out?
What happens when it all goes wrong?
But consider any P2P opportunities that have more of a grey area and it becomes more urgent that our 4thWay® Risk Ratings reflect reality.
We have to accept – and we tell this to you as often as possible – that the 4thWay® Risk Ratings are not infallible and, like all risk-ratings systems, they will probably fail at some point, for some lenders.
We don’t like speaking badly of our baby, and we’re going to do our best to not let a single one of you down, but we fear that no mathematical formula can protect all lenders from losing to inflation over a five-year period.
So we’re going to hope and try to protect all of you from disappointment, but we might have to be satisfied with protecting most of you.
What we know for sure is that it will be a big shock to us whenever we are wrong. Sad and depressing. And embarrassing.
So we’re going to do everything possible to be right.
Get it right yourselves first
The 4thWay® Risk Ratings assume you spread your money across lots of loans. If you don’t, and things go wrong, that is probably not the fault of the 4thWay® Risk Ratings.
At this stage, we think, generally speaking, spreading your money across 50-150 loans is enough diversification for low-risk lending and 100 to several hundred is appropriate for higher-risk lending.
Why might the 4thWay® Risk Ratings go wrong?
But this blog is about how, when and why we might get it wrong, not you.
So we need to constantly improve.
All risk-ratings agencies do the same, but the improvements we can make in the early months and years could be far more powerful than, say, what Moody’s achieves, because the industry and our ratings are so new. Each new piece of data we can incorporate or objective improvement to methodology we make will probably have a significant impact on the quality of our scoring system.
We are reliant on the P2P lending companies
The risk scores have to be based on the information supplied by the P2P lending companies themselves. This is a strength and a weakness of the 4thWay® Risk Ratings.
This is a strength, because there is no one who will understand the risks of their own businesses better than those founders, directors and their teams of data scientists.
It is also a weakness, because they can be selective of what information they share, they might be slow to update the information (especially if it’s not in their interests) and they might downright lie.
We make adjustments for new P2P lending companies or those that have done very few loans, but otherwise we have to rely on their figures.
That’s not to say we ignore strange and disturbing signals. If we see that a P2P lending company is beginning to accept far more loan applications than previously, but it doesn’t say that it’s bad-debt rate will rise, we need to flag this as a possible warning sign. If we get lots of warning signs, or disturbing information, we might need to suspend the company’s 4thWay® Risk Rating.
That strange and disturbing information needs to be passed on to you directly – and that is regardless of whether we receive commission from that company or not. We’d rather lose commission than a shred of our reputation. That’s why our reports are candid on both the positives and negatives without holding back.
We’re starting almost from the beginning
The credit specialist we consulted to devise our 4thWay® Risk Ratings (a senior person at one of the major accountancy firms) made it clear to us that we shouldn't assume a P2P lending company is low risk because the types of loans it provides often are low risk too. And we can’t assume the opposite: that a loan type is likely to be high risk because it often is elsewhere.
Just for example, short-term property loans are often especially risky if the borrower doesn’t make any repayments at all, not even interest, until the end of the loan. Our credit specialist would typically advise against lending in such a proposition until it has a decent track record.
However, he says that if there is a very fat margin between the loan size and the value of the property, that’s different. Perhaps you might suffer a big delay in getting your money back, but the risk of losing money is greatly reduced.
So, rather than make generalisations, we will be far better off, on average, using the P2P lending companies’ own forecasts and making some small adjustments when they’re new, to allow for error or understatement, or making adjustments when they prove their forecasts are consistently inaccurate over the long run.
Improvement only through objective and calculable evidence
There’s a fair bit of data flying around that allows us to do some good scoring, we believe. Better than we had expected before we started, considering it's a new industry.
In addition, we can process the data better by constantly improving our methodology – in an objective way of course.
In both these regards, we're similar to a P2P lending company. They might have experienced people who have brought a load of useful databases and contacts with them, but they have to learn from their customers – through their results and data – how safe they really are and how to select them better.
Product and inflation risks
What we really wanted to do at 4thWay® was create a score that could take into account all types of risks, not just risks of bad debts (“credit risks”).
So we were talking about hacking and other technology risks (“product risks”), and inflation, for example. In other words, we wanted to go further than any risk-ratings agency has gone before.
But our credit specialist convinced us that was unachievable and naive. Bearing in mind we're not push overs, he has had to work hard to get his way on some points. But he was clearly right.
(On inflation, we do still give guidance on what interest rates we think you might need to earn to beat inflation in the colour code part of our risk rating, but the colour code is just an opinion separate from the mathematical score.)
What if we believe we can do better?
If we adjust our ratings for a company based solely on our beliefs, they will descend into a farce. We will become not just useless to you, but dangerous.
Worse, it would leave a big opening for P2P lending companies to persuade us that we should change the scores and our scoring system, with no sound basis for doing so.
We will gladly except any new data from the P2P lending companies or elsewhere that will enable us to make mathematical improvements, but we won't – we can't – let them talk us around.
Indeed, we have received some approaches already. We keep an “Anti-Lobbying Log” of any company that puts pressure on us (even unintentional or well-intended pressure) to change our 4thWay® Risk Ratings in its favour. We also record how we reacted to it, what the result was. I’m pleased to say we have repulsed all attempts with ease.
We'll be giving you a full report every few months on our Anti-Lobbying Log. In most cases, we probably can't reveal names of companies we spoke to, because no one will do business with us or provide data if we breach a confidence.
But we'll tell you everything we can about the approach that was made, short of revealing the identity to you. We'll also tell you the results.
Once we've got enough of your nominees for the Panel of Peers, we can create a panel and ask them to consider whether the lobbyers might have a point, so that you can be even more confident that we have your best interests completely and totally stamped over all our actions and decisions on this website.
Coming up next
I think we might already be in the position to make some calculated improvements to our scoring system or objective improvements to the methodology, and so we'll bring forward our review into it urgently.
We’re also hoping, in particular, for more data from Lending Works that will enable us to incorporate its insurance against bad debts into our risk-scoring system. This is a gaping whole in our data. Currently, Lending Works’ 4thWay® Risk Rating is probably doing it a grave injustice, even though it is already low at just 13.
Let's keep our heads
Using maths to rate risk is not perfect, since the formula and data will never be complete. And all lenders (that's you and me too) can do irrational things that make a score pretty irrelevant. But it's the best way to measure many of the risks without losing our heads or caving in to pressure.
Don’t forget to check out our highly detailed 4thWay® Insight Reports, which help you understand a great deal more about what’s happening behind the scenes, what the key strengths and weaknesses of each P2P lending company are, and our opinions about and beyond the 4thWay® Risk Ratings.
*Commission, fees and impartial research: our service is free to you. 4thWay shows dozens of P2P lending accounts in our accurate comparison tables and we add new ones as they make it through our listing process. We receive compensation from Lending Works and RateSetter, and other P2P lending companies not mentioned above either when you click through from our website and open accounts with them, or to cover the costs of conducting our calculated stress tests and ratings assessments. We vigorously ensure that this doesn't affect our editorial independence. Read How we earn money fairly with your help.