Provision Funds in P2P Lending: Protection in Case of Loan Defaults

Provision funds are designed to reduce the risk of investing in peer-to-peer lending by creating a safety buffer that P2P platforms can use to anticipate unforeseen circumstances. The primary goal is to offer investors a higher level of protection against the prospect of missing returns. From the platforms’ point of view, provision funds enhance their overall financial strength.

What Is a Provision Fund in P2P Lending?

A provision fund is a buffer consisting of money that a P2P lending platform sets aside. Normally, the money comes from regular inflows from existing borrower loans, but it can also be collected from investors’ earned interest rates on loans.

The money in the provision fund buffer is labeled for investors in case of actual capital losses arising from a defaulted loan or delayed/missed payments on a performing loan. However, investors cannot be 100% sure how much of their loss the provision fund will cover – if any at all.

A provision fund is usually reserved in cash, but can also in rare cases be disbursed in the form of other assets. The fund is stored in a special unit that is protected against operational risks coming from the platform itself or the company behind it.

How Does a Provision Fund Work?

Provision funds work by gathering a margin taken from borrowers and/or investors who pay an amount into the provision fund. 

In the investors’ case, it will generally be deducted from the interest rates they receive from the loans they have invested in. As for borrowers, the amount they will have to pay depends on their risk profile; the higher risks associated with lending them money, the higher will their obliged contribution to the provision fund be.

The above implies that a platform’s revision fund grows along with the size of the platform’s portfolio and the amount of repayments made by borrowers on the platform.

The provision fund will allegedly be paid out to investors in case of loan default. However, the level of payout is unclear since it in most cases will be administered at the discretion of the directors of each platform.

How Do Provision Funds Protect Investors’ Returns?

The provision fund becomes useful when a borrower misses out on a payment or, worst case scenario, has to give up on paying back the loan entirely. In such a situation, the provision fund can step in and reimburse investors to protect them against capital losses.

Depending on the platform and the type of provision fund, the certainty with which investors will be reimbursed varies. It will, for instance, depend on the size of the provision fund; if there are sufficient funds available to carry out the repayments.

In other words, the provision fund is not an insurance and does not provide investors with a guarantee that their lost money will be reimbursed.

How Secure Is an Investment with a Provision Fund?

Provision Funds in P2P lending does not necessarily give investors the right to reimbursement in case of capital loss. In fact, only a few provision funds are actually guaranteeing coverage of the investors’ money. Additionally, most of the provision funds in P2P lending are discretionary, meaning that they may or may not be carried out, and in case they are, investors will not know to what extent their suffered loss will be covered.

Whether investors will benefit from a provision fund or not also depends on the size of the provision fund coverage, which the article will explain further in the paragraph below. Basically, what it means is that if many borrowers default around the same time, the provision fund might not be of sufficient size to reimburse investors for all defaults.

Therefore, investors should not perceive provision funds as an insurance that will protect their returns, but merely an extra layer of security when investing in peer-to-peer lending. 

One way investors themselves can mitigate the risks associated with peer-to-peer lending is to regularly check up on the size of the provision fund, in order to make sure that their chances of actually benefiting from the platform’s provision fund are not decreasing.

Provision Fund Coverage Ratio

In order for an investor to receive repayment in case of late borrower payment or even borrower default, the provision fund buffer has to be greater than the value of expected losses. To estimate when a provision fund is more likely to carry out reimbursements to investors, you have to look at the provision fund coverage.

The provision fund coverage is a percentage that reflects the size of a provision fund. If the coverage ratio is higher than 100%, it means that the fund will protect investors from capital losses and repay them the full amount of invested and potentially lost money.

To calculate the provision fund coverage ratio, platforms will normally compare the provision fund buffer to the expected future losses on outstanding loans. As long as the result is above 100%, investors can feel relatively sure that the provision fund will cover and they will benefit from it.

Obviously, investors will have to frequently monitor the coverage ratio on the platform through which they are investing to make a continuous risk assessment.

Different Platforms Offer Different Types of Provision Funds

Not all provision funds come with the same terms and conditions; this highly depends on the given P2P lending platform. 

The table below will guide you through some P2P lending platforms and their provision funds, also called reserve funds. This overview will make it easier for investors to evaluate to what extent their investments are protected by different provision funds on different platforms.

Difference between Provision Fund and Buyback Guarantee

P2P platforms can ensure the protection of capital loss in various ways. Besides provision funds, buyback guarantee is another way of insuring yourself as an investor in P2P lending. Both provision funds and buyback guarantees aim at providing investors with a steady cash flow that will not be too affected in case of borrower default.

Whereas the provision fund relies on a tangible amount of cash or, in some cases, other highly liquid assets, the buyback guarantee is based on the promise of either the company behind the platform or the loan originators acting on the platform to buy back any loan that defaults.

One of the advantages of buyback guarantees over provision funds is that buyback guarantees will for sure be paid out in case of repayment or absolute loan default (of course, the exact terms depend on the specific platform), whereas with provision funds you have to make a claim and hope for the best.

Key Risk Indicators of a Provision Fund

All investments inevitably come with a risk of capital loss. That risk will not disappear just because you decide to invest in a platform that holds provision funds – or offer some other kind of risk mitigating maneuver.

One of the indirect risks with provision funds is that they create a false sense of security and make investors think that the platforms that offer provision funds are less risky. However, this is not the case as provision funds, in most cases, do not guarantee the protection of investors’ losses due to their discretionary methods.

Provision funds are more likely to be found on unsecured peer-to-peer lending platforms, i.e. platforms where no tangible asset or collateral can be seized in the unlucky case of borrower default. The fact that the platform is dedicated to unsecured lending is in itself an indicator of high risk. Nevertheless, in investment high risk equals high returns – with a risk of high losses, naturally.

Before investing in a platform that claims to hold a provision fund buffer large enough to cover expected future losses, you have to make sure that the provision fund coverage ratio is sufficiently high to actually reimburse investors should it become necessary. You also ought to read the platform’s terms and conditions carefully to check how the platform decides how much to repay and under what circumstances to make sure you are covered.

Regulation of Provision Funds

P2P lending is still a relatively new investment type that has become more and more popular throughout the last decade. However, due to the novelty of peer-to-peer lending, the industry is very poorly regulated, which places an even greater responsibility on the investors’ shoulders to carry out a thorough due diligence before throwing their money into a specific platform.

Nonetheless, the government in the UK has put in place a so-called Financial Conduct Authority (FCA) which has succeeded in regulating the investment and, more specifically, the P2P lending industry. The regulation – which entered into force in 2017 – demands that all lending platforms in the UK have to reserve a minimum of 50,000 GBP in funds.

This is a way of ensuring that provision funds always will consist of a substantial amount of money or other liquids. Thus, reducing the risk of presenting a poor buffer in case of loan default and not being able to repay investors.