1. SUBMISSION TO THE PARLIAMENTARY COMMISSION ON BANKING STANDARDS
Simon Deane-Johns
Consultant Solicitor, Keystone Law
This submission offers a legal and regulatory perspective on the development of alternative financial
services to those offered by banks and traditional investment firms in the market for consumer and
small business finance. It summarises the current crisis in the market; the advent of peer-to-peer and
other alternative finance models, their differences and similarities; the regulatory barriers facing
suppliers and customers in the alternative finance industry; and the calls for proportionate reforms that
would level the playing field which currently favours the traditional financial services industry.
The Crisis in Retail Finance Market
The UK financial system is failing to enable the cost efficient flow of funds from savers and investors to
responsible people and businesses. In particular, the UK relies on small businesses to provide
approximately 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 finance
entrepreneurial 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 its
markets for consumer and business finance. 3 There are few alternative forms of debt finance and
businesses are also failing to seek equity finance where that is more appropriate to the nature of the
risks involved. 4 Over 90% of UK small businesses rely on four major banks for finance, yet those banks
have become steadily less willing and/or able to lend to the productive economy since the 2008 crisis. 5
1 “Business Population Estimates For The UK And Regions 2011” BIS:
http://www.fsb.org.uk/pressroom/assets/statistical%20release%20bpe%202011%20edition.pdf
2
“Boosting Finance Options For Business”: BIS, March 2012
http://www.bis.gov.uk/assets/biscore/enterprise/docs/b/12-668-boosting-finance-options-for-business.pdf
3
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 G
Haldane, Executive Director, Financial Stability, Bank of England: http://www.bis.org/review/r120315g.pdf; Report
of Lord Young to the Prime Minister of May 2012 “Make Business your Business: Supporting the Start-up and
development of Small Business” in which many of the platforms referred to in Annex 1 of this Report are referred
to 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. Only approximately £1 in every £10 of the credit created by UK banks is actually allocated to firms
whose 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 to
concentrate nearly £200bn of their savings in bank cash deposits (and a similar amount in a subset of
regulated stocks and shares). 7 Not only does this provide banks with an artificially cheap source of
finance, as discussed below, but it also acts as a disincentive for consumers to diversify into any financial
services that do not qualify for ISAs yet more efficiently allocate both debt and equity funding to
consumers and businesses.
The plunge in trust resulting from the sustained series of bank mis-selling scandals is also a significant
contributor to the crisis facing the UK retail finance market, but that is not the focus of this submission.
Alternative Finance Models
Various new financial models and service providers are gradually emerging to challenge banks and
traditional investment firms. This submission highlights the peer-to-peer model, innovation in supply
chain finance and marketplace finance in particular.
Peer-to-Peer Finance
Perhaps 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 bank
funding. These platforms are online marketplaces in which most of the participants are either
consumers or small businesses, although some platforms are restricted to high net worth or
sophisticated investors. 8 The first of these launched in the UK 2005 and at least nine others emerged
during the period to June 2012. More have launched since, or are planning to do so. In fact, 33 EU-based
platform operators signed the recent open letter to UK and EU policy-makers referred to below. Some
examples 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 participants
agree on the platform, and the related credit or investment risks. These instruments range from simple
loans 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 Economics
Foundation, 2012.
7
http://www.hmrc.gov.uk/statistics/isas/statistics.pdf
8
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 facilitate
simple loans. ‘Crowd-investing’ platforms enable investments in either shares or debt instruments, such as
debentures and trade invoices. ‘Social investment’ enables funding for charitable or public sector projects.

3. investment’ platforms. 9 However, there are also similarities at the ‘platform level’ which are
summarised in Annex 2. Importantly, these platforms are inclusive, enabling even small lenders or
investors to diversify small amounts of money; and enabling small businesses to access either cheaper
debt finance or equity finance where they would not typically gain access to angel investors or venture
capitalists.
Critically, unlike banks and traditional investment firms, peer-to-peer platform operators do not set the
key terms of pre-packaged ‘products’ and distribute them through branches and other sales
intermediaries. Instead, these marketplaces enable participants to agree directly between themselves
the specific terms of any loan or investment; and day-to-day control over the management of funds and
assets 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 the
costs and moral hazards associated with both traditional banking and investment, as well as those
associated with the ‘vertical credit intermediation’ model inherent in ‘shadow banking’. 11
Supply Chain Finance
Businesses often need finance to purchase raw materials and other inputs while waiting for payment
from business customers who typically pay on extended terms. While large suppliers may offer credit
facilities, and some independent finance houses exist, the research cited earlier confirms that major
banks 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 are
obtained from the one bank, and may require all invoices to be paid to the bank or into a specific ‘locked
box’ account.
Alternative financial services are emerging in the form of equity and debt finance options discussed
above. In addition, internet technology has made it feasible to enable finance providers to compete in
the funding of single invoices or batches of specific invoices, via peer-to-peer platforms and other
intermediaries (e.g. MarketInvoice, Platform Black). However, the removal of regulatory barriers
9
While currently a significant source of funding, donation-based platforms do not fall within the scope of the
financial 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 that
does potentially allow the operator some control is to rely on a ‘horizontal securitisation’ model, whereby one
entity lends or invests and a second entity issue bonds or other securities and uses the proceeds to immediately
purchase the initial loans or investment instruments. Each entity is independently regulated (especially in the case
of consumer lending). This is how US peer-to-peer platforms have been obliged to operate, although the JOBS Act
may now make the direct model feasible.
11
“Shadow Banking”, Federal Reserve Bank of New York Staff Report No. 458.

4. discussed below would enable the more rapid development of alternative funding options involving
invoices, asset finance and other forms of secured lending.
Marketplace Finance
Many 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 large
pool of potential consumers (e.g. eBay, Amazon, Etsy). As a result, Amazon.com, for example, is
reported 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 finance
based 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’s
actual day-to-day activities and business processes, rather than being driven by the constraints of the
lender’s products and internal systems and processes.
Regulatory Barriers to Alternative Financial Services
The regulatory barriers to innovation and competition in retail financial services are most apparent in
the 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 been
introduced by many firms in many other retail markets. However, the model has been slow to emerge in
retail 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 in
which small sets of incumbent suppliers and intermediaries are able to charge higher fees, make higher
12
http://www.ft.com/cms/s/0/55be35f2-1093-11e2-a5f7-00144feabdc0.html#axzz28f5dRdXS

5. margins, reward staff more generously and pay more for marketing than would be the case if they were
exposed 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 the
recent passage of the Financial Services Bill demonstrated).
Some argue that new business models should flourish outside the regulatory sphere. However, that
sphere creates significant problems even for those outside its perimeter (not to mention society at
large). It is noteworthy that the FSA’s “Perimeter Guidance Manual”, which attempts to explain “the
circumstances in which authorisation is required, or exempt person status is available, including
guidance on the activities which are regulated under the Act and the exclusions which are available”
runs to 15 chapters and 616 pages. 13
Barriers to Launching Alternative Financial Services
Peer-to-peer platform operators complain that the process of launching and developing new finance
platforms has been overly complicated and expensive. The overall authorisation and launch process has
taken some leading providers up to two years. Legal advice is typically required regarding a broad array
of potential exemptions relating to financial promotions, collective investment schemes and other
investment 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 being
completely unregulated, some exempt on certain conditions, and some partially regulated. The
definition of a collective investment scheme, in particular, is a key constraint in the development of
efficient online marketplaces for invoices, asset finance and other secured lending, including
mortgages. 14
In these circumstances, some operators have chosen to add greater complexity to their services than
they 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 Entrepreneurs
While 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 suggests
13
http://media.fsahandbook.info/pdf/PERG.pdf
14
These issues and reform proposals are discussed in detail in the “Briefing Paper on Proposed Amendments to the
Financial Services Bill” from Keystone Law, June 2012; as well as the “Crowd Funding Report” of the UK Interactive
Entertainment Association; and the “Ten Reforms To Grow The Social Investment Market” from Bates Wells &
Braithwaite.

6. these sources might ultimately be quite limited. Such limits also prevent businesses generating customer
loyalty by raising small amounts of money for small numbers of shares from many customers to finance
product development, where the alternative would be to seek donations or pre-order goods a long time
in advance.
Some entrepreneurs who are seeking to raise alternative finance are confused about whether it is lawful
to use some new services, while others assume that the FSA must have acknowledged that any available
services are operating lawfully. Others say they cannot readily decide which of the growing number of
platforms to use in light of differences that appear to be driven more by the operator’s need to fall
within or outside the regulatory framework rather than necessarily to deliver any substantive benefit to
the participants. As explained below, operators have launched self-regulatory initiatives to attempt to
deal with at least some of these issues and generate customer confidence.
Barriers Facing Consumers
Consumers face at least five significant hurdles when lending or investing directly via a peer-to-peer
platform. They need to be able to understand the credit or investment risk; to be able to diversify even a
small amount adequately; to be certain they will not be deemed to be lending or investing in the course
of a business; to forego certain tax incentives; and tolerate higher effective tax rates in the case of loans
to consumers.
By their nature, peer-to-peer platforms are designed to enable lenders’ and investors’ to understand
credit 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 money
across many borrowers or entrepreneurs, provided that minimum participation thresholds are not set
too high. In these circumstances, consumers are confused as to why it should be comparatively easy to
donate money to a project, yet harder to lend funds with interest, and highly complex to obtain a bond
or even a few shares in an entrepreneurial venture they would like to support with a small amount of
money.
It is not necessary to regulate each individual who participates on a peer-to-peer finance platform as if
he or she is personally acting in the course of any business. All the appropriate compliance requirements
can be met by the platform, including anti-money laundering and anti-fraud checks. However, there is
no consistency in what constitutes carrying on a regulated activity by way of business, so it can be
difficult for some consumers to know where they stand, particularly those with significant personal
savings to lend or invest. The ‘business tests’ differ for each of consumer credit, domestic mortgage
lending and “arranging” in relation to debt or equity securities. Even an isolated transaction can satisfy
the “business” test for mortgages.

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 shares
and pay no tax on the interest or capital gain. 15 The Treasury estimates that “around 45% of the adult
population” have an ISA, 16 and that the market value of all adult ISA holdings was £391bn as at April
2012, approximately half of which is in cash-ISAs. 17 Consumer Focus has found that the £158bn held in
cash ISA bank deposits as at 2010 was earning an average of 0.41% interest (after initial ‘teaser’ rates
expire); that 60 per cent of savers never withdraw money from their account; and 30 per cent see their
ISAs as an alternative to a pension. 18
Accordingly, the success of the ISA scheme has not only come to undermine the need for savers’ and
investors’ to diversify for their long term financial security, but it also acts as a subsidy for the providers
of 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, the
fact that some crowd-investment platforms seem obliged to limit investor participation to high net
worth 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 a
distortion in their “Effective Tax Rates”, as explained in Annex 3. In essence, bad debts accruing to these
lenders 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. The extent of the resulting distortion rises with the level
of expected bad debt and the applicable statutory personal tax rate, and can greatly exceed it. This
currently makes lending to low income earners prohibitive. Assuming lending on a peer-to-peer
platform is as desirable as lending by retail banks, any difference in Effective Tax Rates is a bad outcome.
Calls to Level the Playing Field
In these circumstances, it is unrealistic to assume that new business models will thrive without some
alteration to the regulatory framework. As a result, various industry participants have been calling for
clear and proportionate regulation of their platforms for some time, 19 and some operators have agreed
15
http://www.hmrc.gov.uk/isa/faqs.htm
16
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.pdf
18
http://www.consumerfocus.org.uk/news/consumer-focus-issues-super-complaint-to-office-of-fair-trading-
about-uk-cash-isa-market
19
“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 The
Social Investment Market”, Bates Wells & Braithwaite. “Proposals for Crowdfunding Amendments to the
Prospectus Directive”, Crowdfunding France.

8. self-regulation to control the most common operational risks. 20 Many platform operators also called for
proportionate ‘enabling’ regulation at both UK and EU level at a summit with involving UK and EC
officials in December 2012. 21
It is therefore perhaps ironic that banks still enjoy self-regulation in the context of their lending
activities. 22 The ‘Lending Code Standards Board’ recently reported "...no breaches of the [Lending] Code
or management weaknesses were identified and no action plans were requested, indicating that
standards of compliance and practice with the requirements of the Code are very good as they relate to
micro-enterprise customers." 23 In addition, many banks regard their card acquiring activities as falling
outside the scope of payments regulation, even though it purports to govern the activity of “acquiring
payment transactions”. 24
However, while HM Treasury announced in connection with the Financial Services Bill that peer-to-peer
lending will be regulated by the Financial Conduct Authority when it assumes responsibility for
consumer credit in April 2014, there was no suggestion that the wider regulatory framework itself will
change.
The Treasury has also resisted calls to extend the range of ISA-qualifying assets to include instruments
available 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 neither
occasion did the Treasury appear to acknowledge or address the risks posed by the huge concentration
of funds in low yield cash deposits, or the potential benefits of enabling savers and investors to make at
least some of those funds available to consumers and small businesses at lower cost and higher returns
to compensate for higher risks.
20
These include segregation of customer funds, anti-money laundering and fraud controls, fair complaints handling
and provision for the orderly administration funding instruments in the event that an operator ceases to do
business: 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 Regulatory
Framework: http://thefinancelab.org/documents/Peer-to-Peer_Finance_Summit_Open_Letter.pdf
22
See the Banking Code Standards Board bulletin, June 2009.
23
“Themed review of compliance with the Lending Code provisions for lending to micro-enterprises”, December
2012.
24
See Part 1, paragraph 1(e) of the Payment Services Regulations 2009; and paragraph 8.146 of the FSA’s
Approach 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 Government
response 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.pdf
at page 13.

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. 26
Accordingly it seems clear that the Treasury is satisfied with the relatively modest scale of the
alternative finance industry (despite its growth rate) and does not believe that finance provided directly
by consumers is as desirable as lending by retail banks.
Simon Deane-Johns
Consultant Solicitor
February 2013
The writer has been invited to make this submission on the basis of his general experience, gained as a
solicitor specialising in retail financial services, e-commerce and IT. Clients include online peer-to-peer
finance platforms; non-bank lenders; e-money issuers and payment service providers. However, his views
are 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 of
the 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 acquiring
arm of RBS). He advised on the launch of the Peer-to-Peer Finance Association and has responded to
personal invitations for submissions to the Breedon Taskforce on small business finance, the Cabinet
Office “Red Tape Challenge”, and certain Peers in connection with the Financial Services Bill. In December
2012 he co-organised the Peer-to-Peer Finance Policy Summit with the Finance Innovation Lab. The
writer is also Chairman of the Media Board of the Society for Computers and Law and a member of the
Interoperability Board of Midata, the UK government programme to enable consumers and small
businesses to access their transaction data in computer-readable form.
26
Government response to the Red Tape Challenge for Challenger Businesses, at page 13.

10. Annex 1
Examples of UK-based Alternative Finance Platforms 27
Personal loans
Zopa
Ratesetter
Student loans
Prodigy Finance
Business loans
Funding Circle
Thin Cats
Invoice discounting
MarketInvoice
Platform Black
Social project loans
Buzzbank
Equity investment
Crowdcube
Seedrs
CrowdBnk
BankToTheFuture
Debt investment
Abundance Generation
Trillion Fund
Foreign exchange
Kantox
27
Neither the mention nor failure to mention a platform is intended to suggest that the operator in any
way endorses the contents of this paper, or that the platform is not operating lawfully.

11. Annex 2
Key Characteristics of Peer-to-Peer Finance Platforms
1. 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; and
7. 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. 30
28
“Shadow Banking”, Federal Reserve Bank of New York Staff Report No. 458.
www.ny.frb.org/research/staff_reports/sr458.pdf
29
http://www.fsa.gov.uk/pubs/guidance/gc11_12.pdf
30
“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. Annex 3
Quantifying the Non-Deduction of Bad Debts Tax Distortion
For Loans to Consumers 31
Overview of this Annex
1. 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 Method
2. 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 Issue
4. 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 the
purpose of this analysis) in the absence of distortion. But if there is a distortion the change in the ETR also depends
on the level of return (i.e. level of interest) chosen to illustrate the problem. Since this level of return chosen is
always one of analytical judgement, slight variation in the ETR measure arising from differences in such judgement
can cause unnecessary confusion. The tax wedge on the other hand is, at least in this case, dependent on the level
of expected bad debt and the lenders personal tax rate only. Having specified these, the tax wedge has the
advantage of being stable whatever the overall level of return set. In practice both are usually considered when
assessing tax distortions to capital returns.

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.
Results
6. 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. Table 1: ETRs assuming a common return after costs but before tax, HR lenders
Benchmark rate of interest 5.0% i
after costs before tax
Marginal Personal Tax Rate 40% t
Without Distortion With Distortion
Rate Addition
Expected
Market 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. Table A1: ETRs assuming a common return after costs but before tax, Basic Rate lenders
Benchmark rate of interest 5.0% i
after costs before tax
Marginal Personal Tax Rate 20% t
Without Distortion With Distortion
Rate Addition
Expected
Market 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%