Submission to commission on banking standards sdj 08 02 13 final

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Submission to commission on banking standards sdj 08 02 13 final

  1. 1. SUBMISSION TO THE PARLIAMENTARY COMMISSION ON BANKING STANDARDS Simon Deane-Johns Consultant Solicitor, Keystone LawThis submission offers a legal and regulatory perspective on the development of alternative financialservices to those offered by banks and traditional investment firms in the market for consumer andsmall business finance. It summarises the current crisis in the market; the advent of peer-to-peer andother alternative finance models, their differences and similarities; the regulatory barriers facingsuppliers and customers in the alternative finance industry; and the calls for proportionate reforms thatwould level the playing field which currently favours the traditional financial services industry.The Crisis in Retail Finance MarketThe UK financial system is failing to enable the cost efficient flow of funds from savers and investors toresponsible people and businesses. In particular, the UK relies on small businesses to provideapproximately 60% of new jobs, 1 yet they face a funding gap of up to £59bn over the next 5 years,within an overall finance gap of up to £190bn for the UK business sector as a whole. 2 Failure to financeentrepreneurial activity today will prolong the current period of low growth.Despite the opportunity posed by that funding gap, the UK still lacks innovation and competition in itsmarkets for consumer and business finance. 3 There are few alternative forms of debt finance andbusinesses are also failing to seek equity finance where that is more appropriate to the nature of therisks involved. 4 Over 90% of UK small businesses rely on four major banks for finance, yet those bankshave become steadily less willing and/or able to lend to the productive economy since the 2008 crisis. 51 “Business Population Estimates For The UK And Regions 2011” BIS:http://www.fsb.org.uk/pressroom/assets/statistical%20release%20bpe%202011%20edition.pdf2 “Boosting Finance Options For Business”: BIS, March 2012http://www.bis.gov.uk/assets/biscore/enterprise/docs/b/12-668-boosting-finance-options-for-business.pdf3 Boosting Finance Options For Business: http://www.bis.gov.uk/assets/biscore/enterprise/docs/b/12-668-boosting-finance-options-for-business.pdf; “Towards a Common Financial Language”, a speech by Mr Andrew GHaldane, Executive Director, Financial Stability, Bank of England: http://www.bis.org/review/r120315g.pdf; Reportof Lord Young to the Prime Minister of May 2012 “Make Business your Business: Supporting the Start-up anddevelopment of Small Business” in which many of the platforms referred to in Annex 1 of this Report are referredto with approval: http://www.startupbritain.org/resource/binary/userfiles/Make_Business_Your_Business_2.pdf)4 Boosting Finance Options For Business, at page 2.5 “Trends in Lending”, Bank of England, January 2013:http://www.bankofengland.co.uk/publications/Documents/other/monetary/trendsjanuary13.pdf SEL v1.2
  2. 2. Only approximately £1 in every £10 of the credit created by UK banks is actually allocated to firmswhose output counts towards GDP. 6 Allocating credit to productive firms is not their core activity.Notwithstanding this, the Individual Savings Account tax incentive scheme encourages consumers toconcentrate nearly £200bn of their savings in bank cash deposits (and a similar amount in a subset ofregulated stocks and shares). 7 Not only does this provide banks with an artificially cheap source offinance, as discussed below, but it also acts as a disincentive for consumers to diversify into any financialservices that do not qualify for ISAs yet more efficiently allocate both debt and equity funding toconsumers and businesses.The plunge in trust resulting from the sustained series of bank mis-selling scandals is also a significantcontributor to the crisis facing the UK retail finance market, but that is not the focus of this submission.Alternative Finance ModelsVarious new financial models and service providers are gradually emerging to challenge banks andtraditional investment firms. This submission highlights the peer-to-peer model, innovation in supplychain finance and marketplace finance in particular.Peer-to-Peer FinancePerhaps most common amongst the new financial services are online peer-to-peer finance platforms,although, despite apparently rapid growth the volume of actual funding is still very small relative to bankfunding. These platforms are online marketplaces in which most of the participants are eitherconsumers or small businesses, although some platforms are restricted to high net worth orsophisticated investors. 8 The first of these launched in the UK 2005 and at least nine others emergedduring the period to June 2012. More have launched since, or are planning to do so. In fact, 33 EU-basedplatform operators signed the recent open letter to UK and EU policy-makers referred to below. Someexamples of UK-based platforms are included in Annex 1.Each type of peer-to-peer finance platform is distinct in terms of the instrument which participantsagree on the platform, and the related credit or investment risks. These instruments range from simpleloans agreed on peer-to-peer lending platforms, to investments in debentures and shares on ‘crowd-6 “Where Does Money Come From?”, J. Ryan-Collins, T. Greenham, R. Werner, A. Jackson, New EconomicsFoundation, 2012.7 http://www.hmrc.gov.uk/statistics/isas/statistics.pdf8 Peer-to-peer finance is also often referred to as “crowdfunding”. This can be confusing. The term ‘Crowdfunding’more accurately describes person-to-person donations and rewards. ‘Peer-to-peer lending’ platforms facilitatesimple loans. ‘Crowd-investing’ platforms enable investments in either shares or debt instruments, such asdebentures and trade invoices. ‘Social investment’ enables funding for charitable or public sector projects.
  3. 3. investment’ platforms. 9 However, there are also similarities at the ‘platform level’ which aresummarised in Annex 2. Importantly, these platforms are inclusive, enabling even small lenders orinvestors to diversify small amounts of money; and enabling small businesses to access either cheaperdebt finance or equity finance where they would not typically gain access to angel investors or venturecapitalists.Critically, unlike banks and traditional investment firms, peer-to-peer platform operators do not set thekey terms of pre-packaged ‘products’ and distribute them through branches and other salesintermediaries. Instead, these marketplaces enable participants to agree directly between themselvesthe specific terms of any loan or investment; and day-to-day control over the management of funds andassets rests with lenders or investors, as the case may be, not the operator. 10 These distinctions,together with the other key characteristics summarised in Annex 2, substantially reduce or eliminate thecosts and moral hazards associated with both traditional banking and investment, as well as thoseassociated with the ‘vertical credit intermediation’ model inherent in ‘shadow banking’. 11Supply Chain FinanceBusinesses often need finance to purchase raw materials and other inputs while waiting for paymentfrom business customers who typically pay on extended terms. While large suppliers may offer creditfacilities, and some independent finance houses exist, the research cited earlier confirms that majorbanks dominate this market. Typically, they supply overdrafts, term loans, revolving credit facilities,asset finance, credit cards and factoring or invoice discounting arrangements. Often these services areobtained from the one bank, and may require all invoices to be paid to the bank or into a specific ‘lockedbox’ account.Alternative financial services are emerging in the form of equity and debt finance options discussedabove. In addition, internet technology has made it feasible to enable finance providers to compete inthe funding of single invoices or batches of specific invoices, via peer-to-peer platforms and otherintermediaries (e.g. MarketInvoice, Platform Black). However, the removal of regulatory barriers9 While currently a significant source of funding, donation-based platforms do not fall within the scope of thefinancial regulatory regime and their volumes are likely to be exceeded by volumes on financial services platforms,as has happened in the US market – e.g. compare volumes on Kickstarter, the leading US crowdfunding platform(http://www.kickstarter.com/help/stats?ref=footer) with those on Lending Club, the leading US debt-based crowd-investment platform (https://www.lendingclub.com/info/statistics.action).10 This is a requirement to avoid creating a collective investment scheme. A (more cumbersome) alternative thatdoes potentially allow the operator some control is to rely on a ‘horizontal securitisation’ model, whereby oneentity lends or invests and a second entity issue bonds or other securities and uses the proceeds to immediatelypurchase the initial loans or investment instruments. Each entity is independently regulated (especially in the caseof consumer lending). This is how US peer-to-peer platforms have been obliged to operate, although the JOBS Actmay now make the direct model feasible.11 “Shadow Banking”, Federal Reserve Bank of New York Staff Report No. 458.
  4. 4. discussed below would enable the more rapid development of alternative funding options involvinginvoices, asset finance and other forms of secured lending.Marketplace FinanceMany small businesses now sell on e-commerce marketplaces that offer a wide range of ‘back-office’business services, including marketing, order-tracking and delivery options, as well as access to a largepool of potential consumers (e.g. eBay, Amazon, Etsy). As a result, Amazon.com, for example, isreported to be enabling traders to obtain finance based on their activity on its e-commerce marketplace(albeit in the US initially), 12 while a few independent lenders, such as Kabbage, are offering financebased on traders’ activity on a range of different marketplaces (including eBay in the UK).Marketplace finance is particularly attractive because it is very closely aligned with each customer’sactual day-to-day activities and business processes, rather than being driven by the constraints of thelender’s products and internal systems and processes.Regulatory Barriers to Alternative Financial ServicesThe regulatory barriers to innovation and competition in retail financial services are most apparent inthe context of the peer-to-peer model.Of course, that model itself is not new. Since the launch of eBay in the mid-1990s the model has beenintroduced by many firms in many other retail markets. However, the model has been slow to emerge inretail finance chiefly because:(a) the financial regulatory framework prescribes limited types of financial products, suppliers, intermediaries and activities, rather than reflecting the customers’ activities and requirements;(b) this framework is reinforced by the state guarantee of bank liabilities, as well as personal tax rules and savings incentives; and(c) the silos of policy officials and regulatory authorities which correspond to each type of product, supplier and intermediary are empowered only to focus on conduct and competition within the market segments they supervise, rather than to take responsibility for how the regulatory framework and related incentives operate as a whole, or how that combination might impact competition and innovation in markets outside the regulatory sphere.The overall effect is an exclusive, rigid, self-reinforcing, officially-endorsed marketing environment inwhich small sets of incumbent suppliers and intermediaries are able to charge higher fees, make higher12 http://www.ft.com/cms/s/0/55be35f2-1093-11e2-a5f7-00144feabdc0.html#axzz28f5dRdXS
  5. 5. margins, reward staff more generously and pay more for marketing than would be the case if they wereexposed to external competition – thereby further raising the barrier to competition and innovation.All of these features in turn make the underlying regulatory framework very difficult to change (as therecent passage of the Financial Services Bill demonstrated).Some argue that new business models should flourish outside the regulatory sphere. However, thatsphere creates significant problems even for those outside its perimeter (not to mention society atlarge). It is noteworthy that the FSA’s “Perimeter Guidance Manual”, which attempts to explain “thecircumstances in which authorisation is required, or exempt person status is available, includingguidance on the activities which are regulated under the Act and the exclusions which are available”runs to 15 chapters and 616 pages. 13Barriers to Launching Alternative Financial ServicesPeer-to-peer platform operators complain that the process of launching and developing new financeplatforms has been overly complicated and expensive. The overall authorisation and launch process hastaken some leading providers up to two years. Legal advice is typically required regarding a broad arrayof potential exemptions relating to financial promotions, collective investment schemes and otherinvestment activity under the Financial Services and Markets Act (including the so-called ‘MiFID-override’), as well as offers of securities under both the Prospectus Directive and the Companies Act.Small factual differences can have seismic regulatory implications, resulting in some activities beingcompletely unregulated, some exempt on certain conditions, and some partially regulated. Thedefinition of a collective investment scheme, in particular, is a key constraint in the development ofefficient online marketplaces for invoices, asset finance and other secured lending, includingmortgages. 14In these circumstances, some operators have chosen to add greater complexity to their services thanthey would have preferred in order to fall within the more favourable regulated marketing environment.Some started out unregulated, but later found it more expedient to switch to a regulated model,occasioning yet more time and expense.Barriers Facing EntrepreneursWhile entrepreneurs are appreciative of alternative sources of finance, the fact that some crowd-investment platforms seem obliged to limit investor participation to high net worth individuals suggests13 http://media.fsahandbook.info/pdf/PERG.pdf14 These issues and reform proposals are discussed in detail in the “Briefing Paper on Proposed Amendments to theFinancial Services Bill” from Keystone Law, June 2012; as well as the “Crowd Funding Report” of the UK InteractiveEntertainment Association; and the “Ten Reforms To Grow The Social Investment Market” from Bates Wells &Braithwaite.
  6. 6. these sources might ultimately be quite limited. Such limits also prevent businesses generating customerloyalty by raising small amounts of money for small numbers of shares from many customers to financeproduct development, where the alternative would be to seek donations or pre-order goods a long timein advance.Some entrepreneurs who are seeking to raise alternative finance are confused about whether it is lawfulto use some new services, while others assume that the FSA must have acknowledged that any availableservices are operating lawfully. Others say they cannot readily decide which of the growing number ofplatforms to use in light of differences that appear to be driven more by the operator’s need to fallwithin or outside the regulatory framework rather than necessarily to deliver any substantive benefit tothe participants. As explained below, operators have launched self-regulatory initiatives to attempt todeal with at least some of these issues and generate customer confidence.Barriers Facing ConsumersConsumers face at least five significant hurdles when lending or investing directly via a peer-to-peerplatform. They need to be able to understand the credit or investment risk; to be able to diversify even asmall amount adequately; to be certain they will not be deemed to be lending or investing in the courseof a business; to forego certain tax incentives; and tolerate higher effective tax rates in the case of loansto consumers.By their nature, peer-to-peer platforms are designed to enable lenders’ and investors’ to understandcredit or investment risk and to exercise day-to-day control over the management of funds and assets.Again, the nature of these platforms presents an opportunity to spread even small sums of moneyacross many borrowers or entrepreneurs, provided that minimum participation thresholds are not settoo high. In these circumstances, consumers are confused as to why it should be comparatively easy todonate money to a project, yet harder to lend funds with interest, and highly complex to obtain a bondor even a few shares in an entrepreneurial venture they would like to support with a small amount ofmoney.It is not necessary to regulate each individual who participates on a peer-to-peer finance platform as ifhe or she is personally acting in the course of any business. All the appropriate compliance requirementscan be met by the platform, including anti-money laundering and anti-fraud checks. However, there isno consistency in what constitutes carrying on a regulated activity by way of business, so it can bedifficult for some consumers to know where they stand, particularly those with significant personalsavings to lend or invest. The ‘business tests’ differ for each of consumer credit, domestic mortgagelending and “arranging” in relation to debt or equity securities. Even an isolated transaction can satisfythe “business” test for mortgages.
  7. 7. The UK’s “Individual Savings Account” (ISA) rules enable a UK personal taxpayer to allocate up to£11,280 per annum to certain bank cash deposit accounts and a sub-set of regulated stocks and sharesand pay no tax on the interest or capital gain. 15 The Treasury estimates that “around 45% of the adultpopulation” have an ISA, 16 and that the market value of all adult ISA holdings was £391bn as at April2012, approximately half of which is in cash-ISAs. 17 Consumer Focus has found that the £158bn held incash ISA bank deposits as at 2010 was earning an average of 0.41% interest (after initial ‘teaser’ ratesexpire); that 60 per cent of savers never withdraw money from their account; and 30 per cent see theirISAs as an alternative to a pension. 18Accordingly, the success of the ISA scheme has not only come to undermine the need for savers’ andinvestors’ to diversify for their long term financial security, but it also acts as a subsidy for the providersof qualifying products, raising the regulatory barrier to competition and innovation even higher.While there are a range of enterprise tax incentives to encourage investment in start-up businesses, thefact that some crowd-investment platforms seem obliged to limit investor participation to high networth individuals puts these incentives beyond the reach of retail investors in those cases.Finally, consumers who lend to other consumers via peer-to-peer lending platforms experience adistortion in their “Effective Tax Rates”, as explained in Annex 3. In essence, bad debts accruing to theselenders are not deductible from interest income received within the platform before determining theliability to tax; and lenders must also pay tax on the interest income necessary to cover bad debts,although they do not benefit from this income. The extent of the resulting distortion rises with the levelof expected bad debt and the applicable statutory personal tax rate, and can greatly exceed it. Thiscurrently makes lending to low income earners prohibitive. Assuming lending on a peer-to-peerplatform is as desirable as lending by retail banks, any difference in Effective Tax Rates is a bad outcome.Calls to Level the Playing FieldIn these circumstances, it is unrealistic to assume that new business models will thrive without somealteration to the regulatory framework. As a result, various industry participants have been calling forclear and proportionate regulation of their platforms for some time, 19 and some operators have agreed15 http://www.hmrc.gov.uk/isa/faqs.htm16 Government response to Boosting Finance Options for Business:http://www.bis.gov.uk/assets/biscore/enterprise/docs/b/12-669-boosting-finance-options-government-response.pdf at paragraph 14.17 http://www.hmrc.gov.uk/statistics/isas/statistics.pdf18 http://www.consumerfocus.org.uk/news/consumer-focus-issues-super-complaint-to-office-of-fair-trading-about-uk-cash-isa-market19 “Briefing Paper on Proposed Amendments to the Financial Services Bill”, Keystone Law; “Crowd Funding Report”UK Interactive Entertainment Association; “Boosting Finance Options For Business”; “Ten Reforms To Grow TheSocial Investment Market”, Bates Wells & Braithwaite. “Proposals for Crowdfunding Amendments to theProspectus Directive”, Crowdfunding France.
  8. 8. self-regulation to control the most common operational risks. 20 Many platform operators also called forproportionate ‘enabling’ regulation at both UK and EU level at a summit with involving UK and ECofficials in December 2012. 21It is therefore perhaps ironic that banks still enjoy self-regulation in the context of their lendingactivities. 22 The ‘Lending Code Standards Board’ recently reported "...no breaches of the [Lending] Codeor management weaknesses were identified and no action plans were requested, indicating thatstandards of compliance and practice with the requirements of the Code are very good as they relate tomicro-enterprise customers." 23 In addition, many banks regard their card acquiring activities as fallingoutside the scope of payments regulation, even though it purports to govern the activity of “acquiringpayment transactions”. 24However, while HM Treasury announced in connection with the Financial Services Bill that peer-to-peerlending will be regulated by the Financial Conduct Authority when it assumes responsibility forconsumer credit in April 2014, there was no suggestion that the wider regulatory framework itself willchange.The Treasury has also resisted calls to extend the range of ISA-qualifying assets to include instrumentsavailable on peer-to-peer platforms on two occasions, essentially on the basis that ISAs are popular,simple to understand, relatively low risk and peer-to-peer platforms are not regulated. 25 On neitheroccasion did the Treasury appear to acknowledge or address the risks posed by the huge concentrationof funds in low yield cash deposits, or the potential benefits of enabling savers and investors to make atleast some of those funds available to consumers and small businesses at lower cost and higher returnsto compensate for higher risks.20 These include segregation of customer funds, anti-money laundering and fraud controls, fair complaints handlingand provision for the orderly administration funding instruments in the event that an operator ceases to dobusiness: see http://www.p2pfinanceassociation.org.uk/.21 Open Letter from the Peer-to-Peer Finance Industry to EU Policy-makers on the Need for a Clear RegulatoryFramework: http://thefinancelab.org/documents/Peer-to-Peer_Finance_Summit_Open_Letter.pdf22 See the Banking Code Standards Board bulletin, June 2009.23 “Themed review of compliance with the Lending Code provisions for lending to micro-enterprises”, December2012.24 See Part 1, paragraph 1(e) of the Payment Services Regulations 2009; and paragraph 8.146 of the FSA’sApproach to the FSA’s role under the Payment Services Regulations 2009.25 See fn 16; Government response to Boosting Finance Options for Business at paragraph 14; and Governmentresponse to the Red Tape Challenge for Challenger Businesses:http://www.bis.gov.uk/assets/biscore/enterprise/docs/r/12-984-removing-red-tape-for-challenger-businesses.pdfat page 13.
  9. 9. Finally, in September 2012, the Treasury resisted calls for tax relief on bad debt on the basis that: “creating an exception would add complexity to the tax system and is difficult to justify when other [unspecified] forms of investment do not qualify for bad debt relief. Moreover, the current tax treatment of P2P investors is not necessarily a barrier to further expansion, as witnessed by the impressive growth in the industry in recent years. 26Accordingly it seems clear that the Treasury is satisfied with the relatively modest scale of thealternative finance industry (despite its growth rate) and does not believe that finance provided directlyby consumers is as desirable as lending by retail banks.Simon Deane-JohnsConsultant SolicitorFebruary 2013The writer has been invited to make this submission on the basis of his general experience, gained as asolicitor specialising in retail financial services, e-commerce and IT. Clients include online peer-to-peerfinance platforms; non-bank lenders; e-money issuers and payment service providers. However, his viewsare based on his general knowledge and experience, and are not necessarily those of any client.Experience relevant to this submission include the writer’s role as General Counsel of Earthport, one ofthe first e-wallet payment services; and as General Counsel (and a co-founder) of Zopa, the first peer-to-peer lending marketplace from 2004-2008. He has advised on the launch of numerous other innovative,non-bank retail financial services and consulted to Amazon.com and WorldPay (formerly the acquiringarm of RBS). He advised on the launch of the Peer-to-Peer Finance Association and has responded topersonal invitations for submissions to the Breedon Taskforce on small business finance, the CabinetOffice “Red Tape Challenge”, and certain Peers in connection with the Financial Services Bill. In December2012 he co-organised the Peer-to-Peer Finance Policy Summit with the Finance Innovation Lab. Thewriter is also Chairman of the Media Board of the Society for Computers and Law and a member of theInteroperability Board of Midata, the UK government programme to enable consumers and smallbusinesses to access their transaction data in computer-readable form.26 Government response to the Red Tape Challenge for Challenger Businesses, at page 13.
  10. 10. Annex 1 Examples of UK-based Alternative Finance Platforms 27Personal loansZopaRatesetterStudent loansProdigy FinanceBusiness loansFunding CircleThin CatsInvoice discountingMarketInvoicePlatform BlackSocial project loansBuzzbankEquity investmentCrowdcubeSeedrsCrowdBnkBankToTheFutureDebt investmentAbundance GenerationTrillion FundForeign exchangeKantox27 Neither the mention nor failure to mention a platform is intended to suggest that the operator in anyway endorses the contents of this paper, or that the platform is not operating lawfully.
  11. 11. Annex 2 Key Characteristics of Peer-to-Peer Finance Platforms1. An electronic or digital platform based on internet technology, enabling low cost business operations and customer access to transaction data via secure ‘my account’ features;2. Typically, the platform operator is not a party to the instruments on its platform and segregates participants’ funds from the operators’ own funds – accordingly, the operator has no credit or investment risk or balance sheet risk, and no temptation to engage in regulatory or tax arbitrage;3. Very small amounts can be subscribed or lent (typically a minimum of £10);4. Finance is drawn by each single recipient from many lenders or investors at the outset, avoiding the need to split a single loan or debenture into many bonds through securitisation at a later point in time, with all the risks that entails (i.e. mispricing 28 and mistaken calculations of capital reserve requirements 29).5. Similarly, each lender or investor may diversify their funds by financing many different people or businesses on a range of different terms at the outset, again avoiding the need for securitisation as a mechanism for enabling investors to access different interest rates, maturities or borrower types.6. The one-to-one legal relationship between borrower and lender or investor (or their successors) is maintained for the life of each instrument via the same technology platform (with a back-up available), so that all the performance data is readily available to participants, enabling cost- effective and efficient risk monitoring, collections and enforcement activity; and7. Low cost operations and lack of balance sheet exposure enables platform operators to charge customers significantly less in fees and leave more of the profit margin with participants than banks or investment funds. 3028 “Shadow Banking”, Federal Reserve Bank of New York Staff Report No. 458.www.ny.frb.org/research/staff_reports/sr458.pdf29 http://www.fsa.gov.uk/pubs/guidance/gc11_12.pdf30 “Bank staff costs take bigger share of pot”, Financial Times, June 5, 2012: www.ft.com/cms/s/0/d4fe3186-ac0d-11e1-a8a0-00144feabdc0.html#axzz1xI6Uo3tc
  12. 12. Annex 3 Quantifying the Non-Deduction of Bad Debts Tax Distortion For Loans to Consumers 31Overview of this Annex1. Firstly Effective Tax Rates (ETRs) are described. Secondly the issue of Non-deduction of Bad Debts is laid out. Next the resulting ETRs are presented and explained, using a common rate of return.Effective Tax Rate Method2. Effective Tax Rate (ETR) methodology helps illustrate the scale of any distortion caused by the tax regime on income from capital. ETR methodology of this type is usually quoted as having its genesis in the work by King and Fullerton (1984): The taxation of Income From Capital. Their work has been developed and applied by many in the years since. In this note only a relatively simple version of the calculation is needed as only personal income tax applies.3. Put simply the “tax wedge” is the return to the lender before deducting tax (but after other costs), less the return after deducting tax (and costs). The ETR is the tax wedge divided by the return to the lender before deducting tax (but after other costs). Without a tax distortion, the ETR will equal the lender’s statutory tax rate (e.g. 40% for higher rate taxpayers) 32. Ideally ETRs on equally desirable investments will be the same and the tax regime will not harmfully distort the choice faced by investors making those investments.The Bad-Debt Deduction Issue4. Assume the expected return to lenders via a person-to-person lending platform (“Platform”) is the rate of interest paid by borrowers less a 1% management fee and the expected level of bad debts. Ideally this would also be the return subject to the lender’s personal tax rate. Where high street banks are the intermediaries this is the case. The ETR would then be 40% if the lender was a higher rate (HR) taxpayer, 20% if they were a basic rate (BR) taxpayer, and so on. No tax distortion would arise either between lending via high street banks and via the Platform, or within the Platform’s markets of varying risk. This would be a good outcome.31 This material for this Annex was provided by a private investor who does not wish to be identified.32 The effective tax rate is perhaps more intuitive as it will equal the statutory tax rate (assumed to be 40% for thepurpose of this analysis) in the absence of distortion. But if there is a distortion the change in the ETR also dependson the level of return (i.e. level of interest) chosen to illustrate the problem. Since this level of return chosen isalways one of analytical judgement, slight variation in the ETR measure arising from differences in such judgementcan cause unnecessary confusion. The tax wedge on the other hand is, at least in this case, dependent on the levelof expected bad debt and the lenders personal tax rate only. Having specified these, the tax wedge has theadvantage of being stable whatever the overall level of return set. In practice both are usually considered whenassessing tax distortions to capital returns.
  13. 13. 5. But bad debts accruing to Lenders via the Platform are not deductible from interest income received within the Platform before determining the liability to tax; and lenders must also pay tax on the interest income necessary to cover bad debts, although they do not benefit from this income. As a result, a significant tax distortion to exists. The extent of this distortion is quantified by the ETRs shown below. The ETRs can greatly exceed the statutory rate; the ETR rising with the level of expected bad debts, and with the applicable statutory personal tax rate. Assuming lending on a Platform and by retail banks are equally desirable, any difference in their ETRs is a bad outcome.Results6. Table 1 below shows how the tax distortion increases with the risk of bad debt. Each column from left to right gives a step in the calculation.7. Firstly a suitable benchmark interest rate needs to be chosen. If we assume a Platform is a small player and interest rates over markets of varying risk are set by high-street banks, the return after all costs (bad debts and fees) but before personal tax should be broadly the same. So this analysis firstly assumes the return net of the Platform’s 1% fee and of expected bad debts is the same for all a Platform’s credit/term markets.8. The level of return after costs but before tax should be one that lenders could get in their alternative investment choice. The level has been set at 5%, it being broadly what might usually be achieved in long term savings accounts in retail banks.
  14. 14. Table 1: ETRs assuming a common return after costs but before tax, HR lendersBenchmark rate of interest 5.0% iafter costs before taxMarginal Personal Tax Rate 40% t Without Distortion With Distortion Rate Addition ExpectedMarket Fee Charged to Tax Effective Net al Tax Total Tax Effective Net Bad Debts Borrower Wedge Tax Rate Return on Bad Wedge Tax Rate Return Debt (1) (2) (3) (5) (6) (7) (8) (9) (10) (11) =i+(1)+(2) =i*t =(5)/i =i-(5) =(2)*t =(5)+(8) =(9)/i =i-(9) 3 Year Loans 1 1% 0.5% 6.5% 2% 40% 3.0% 0.2% 2.2% 44% 2.8% 2 1% 1.0% 7.0% 2% 40% 3.0% 0.4% 2.4% 48% 2.6% 3 1% 2.9% 8.9% 2% 40% 3.0% 1.2% 3.2% 63% 1.8% 4 1% 5.2% 11.2% 2% 40% 3.0% 2.1% 4.1% 82% 0.9% 5 1% 5.0% 11.0% 2% 40% 3.0% 2.0% 4.0% 80% 1.0% 5 Year Loans 1 1% 0.4% 6.4% 2% 40% 3.0% 0.2% 2.2% 43% 2.8% 2 1% 0.8% 6.8% 2% 40% 3.0% 0.3% 2.3% 46% 2.7% 3 1% 2.3% 8.3% 2% 40% 3.0% 0.9% 2.9% 58% 2.1% 4 1% 4.2% 10.2% 2% 40% 3.0% 1.7% 3.7% 74% 1.3% 5 1% 3.1% 9.1% 2% 40% 3.0% 1.2% 3.2% 65% 1.8%9. The table shows the additional tax wedge rises to just over 2% in the worst case of 3 year loans in the risk category ‘C’. That doubles the tax take, and the ETR is 82%. But the table also shows that in this market the net return to a HR taxpayer is only 0.9% after tax. It could be assumed HR taxpayers are effectively priced out of this market, and a number of others with large ETRs. The case for BR taxpayers is shown in Table 1A.
  15. 15. Table A1: ETRs assuming a common return after costs but before tax, Basic Rate lendersBenchmark rate of interest 5.0% iafter costs before taxMarginal Personal Tax Rate 20% t Without Distortion With Distortion Rate Addition ExpectedMarket Fee Charged to Tax Effective Net al Tax Total Tax Effective Net Bad Debts Borrower Wedge Tax Rate Return on Bad Wedge Tax Rate Return Debt (1) (2) (3) (5) (6) (7) (8) (9) (10) (11) =i+(1)+(2) =i*t =(5)/i =i-(5) =(2)*t =(5)+(8) =(9)/i =i-(9) 3 Year Loans 1 1% 0.5% 6.5% 1.0% 20% 4.0% 0.1% 1.1% 22% 3.9% 2 1% 1.0% 7.0% 1.0% 20% 4.0% 0.2% 1.2% 24% 3.8% 3 1% 2.9% 8.9% 1.0% 20% 4.0% 0.6% 1.6% 32% 3.4% 4 1% 5.2% 11.2% 1.0% 20% 4.0% 1.0% 2.0% 41% 3.0% 5 1% 5.0% 11.0% 1.0% 20% 4.0% 1.0% 2.0% 40% 3.0% 5 Year Loans 1 1% 0.4% 6.4% 1.0% 20% 4.0% 0.1% 1.1% 22% 3.9% 2 1% 0.8% 6.8% 1.0% 20% 4.0% 0.2% 1.2% 23% 3.8% 3 1% 2.3% 8.3% 1.0% 20% 4.0% 0.5% 1.5% 29% 3.5% 4 1% 4.2% 10.2% 1.0% 20% 4.0% 0.8% 1.8% 37% 3.2% 5 1% 3.1% 9.1% 1.0% 20% 4.0% 0.6% 1.6% 32% 3.4%

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