Posted: 1st September 2017
First published by Thomson Reuters during August 2017
Since March 2009, the Bank of England base rate has been at 0.5 percent or below; it is at a historic low of just 0.25 percent. This period has allowed households to access cheaper personal finance and mortgage deals.
The Bank of England (BoE) has commented that consumer borrowing is growing "particularly rapidly", with consumer credit (which includes credit cards, car loans and second mortgages) up nearly 11 percent in the last year; the fastest growth for 11 years.
There is, however, a growing number of voices – including the BoE, Financial Conduct Authority (FCA), Financial Ombudsman Service (FOS) and some debt charities – raising concerns about the level of personal debt households have accrued during this period. This group cites the potential risks to households in repaying this debt – which will be even more difficult should interest rates begin to rise or lines of credit are withdrawn or amended.
A portion of the consumers taking advantage of the increasingly available credit are young families, who may not have experienced a base rate greater than 0.5 percent, and may have grown accustomed to high levels of debt and low interest rates. A vital consideration for these households is whether they have assessed the impact of a mortgage rate rise on their finances or a period where credit is harder to access.
A 1 percent rise on a 25-year repayment mortgage of £200,000 would see typical monthly repayments increase by £108. If the BoE base rate turned towards the levels seen prior to the financial crisis (5.25 percent in February 2008), mortgage repayments on the same 25-year repayment mortgage of £200,000 could increase by approximately £596 a month. Of course, this will not happen overnight, and whilst the second example is extreme, it is an indicator of what a different economic landscape may bring with it.
Given the above, and the risk to customers, the FCA's attention is increasingly turning to early identification of consumers in financial difficulty, putting the emphasis on firms to employ appropriate mitigation techniques. How can firms assure themselves that they are offering credit on a sustainable basis?
Can firms do more?
Whilst consumers are responsible for ensuring they are living within their financial means, it is not just consumers who should be considering levels of debt and the potential implications of interest rate rises. Firms providing credit have based their business models on the successful repayment of this credit, or repayment by a significant number of these consumers. Many customers in arrears, or significantly high levels of debt, places pressure on the viability and profitability of lenders and, of course, the outcomes being provided to customers.
If information around lending and the contingency support in place for customers in difficulty is not sufficient, this can have wider impacts on brand advocacy and trust. Despite the primary onus for affordability being on the customer, it is essential that firms have distinct and defined policies that articulate how customers in difficulty should be supported. But what should this entail?
In recent publications, the FCA has made it clear that firms must consider both the creditworthiness of a customer and the affordability of the credit given what the firm knows about the customer's circumstances. An assessment solely focused on a customer's creditworthiness may not be enough to reliably prevent instances of customers falling into difficulty. To this end, the firm must also consider whether the customer will be able to repay the credit in a sustainable manner over the course of the agreement (or for running-account credit, over a reasonable period).
The impetus is on firms to develop their own approach to assessing affordability, considering the nature of their target customer base, the level of risk attached to the credit and any external factors (such as interest rate rises) which could impact a customer's ability to meet repayments.
The proposed rules in the FCA's recent consultation paper state that a firm does not need to estimate or establish the customer's income (or disposable income) where it can demonstrate that it is obvious – in the specific circumstances – that the credit is affordable. However, affordability is only likely to be obvious where the amount of credit is small, any risks associated with the credit are low and the applicant is a prime customer.
Without an advanced view of a customer's individual circumstances, firms may struggle to have absolute confidence in the customer's ability to make repayments. Verifying whether potential applicants can afford the credit is vital to firms' levels of assurance, as well as the eventual outcome achieved by the customer. Firms should be looking to understand customers' ability to pay both at current interest rate levels and in the event of any future rate changes by evaluating income, debts, expenditure and other outgoings.
Even where lending decisions have been responsible, not all future events can be predicted, and there will be times that customers get into financial difficulties during the course of a credit agreement. How firms treat customers who suffer financial difficulties is an important area of focus for the regulator.
How can firms set themselves up for success?
There are a number of areas that firms can test to ensure responsible lending and the fair treatment of customers entering financial difficulty, including;
Tone from the top
Boards embracing the need to support customers in financial difficulty will ensure their firms are significantly better placed to deal with it. Making sure all levels of the firm are aware of the organisation's customer-centric values is a key element of the firm's strategy for managing arrears customers.
Given the FCA has proposed clearer expectations with regards to the assessment of creditworthiness and affordability, firms will need to consider both aspects in the context of their own unique customer bases and business models.
Staff training and awareness
Staff must be supported to understand the business's expectations with regards to early arrears identification. This goes further than the firm's policies and regulatory obligations, although a true understanding of these is also vital.
Context for the importance of supporting customers in genuine financial distress should be provided, helping the business to illustrate how and why it expects its staff to uphold its values. As well as this, can the unique, individual risks the firm and its customers are exposed to be used to establish potential warning signs of financial difficulty – and what are staff required to do when they encounter these 'red flags'?
The FCA's Occasional Paper 20 offers commentary around indicators of financial distress.
Staff members' ability to identify customers falling into arrears, discern vulnerability and treat all customers fairly could have some role to play in the view of their individual performance.
Matching suitable products to consumers' circumstances and monitoring staff to ensure they are continuously delivering on this requirement can prevent detriment from crystallising in the customer base. As well as this, balanced incentives for identification of customers experiencing difficulties could allow for earlier intervention and lead to better outcomes.
Active discussion of how firms can support customers entering financial difficulty
When a customer is identified as having significant potential to fall into arrears or experience financial difficulty, the firm should establish a consistent, documented method for discussing their circumstances with them. Part of this is ensuring customers' awareness of the forbearance options available (as well as explaining the possible implications of each of these on their future suitability for credit).
Policy and process review
Do test and review responsible lending and arrears handling policies to identify and address any risks or gaps. Policies and procedures should be reviewed in the context of FCA's concerns and the evolving regulatory environment for firms to assure themselves that they are well prepared for any scrutiny.
As with all regulatory initiatives, the customer, the outcome they achieve and their ability to access and interact with vital financial services is at the heart of this issue.
The benefit to firms of enhanced (and more active) treatment of customers in financial difficulty is clear; firms' customer-centric approaches will feed directly into better outcomes for customers, which in turn will promote trust and advocacy. By more effectively supporting customers through some of the genuine difficulties that life brings, firms can create more sustainable and long-term relationships with their customers.