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High-cost lending: Balancing control and sustainability

Alex Ellerton Alex Ellerton

“The only thing worse than being talked about is not being talked about.”

Oscar Wilde’s infamous proverb is unlikely to be one that payday lenders will be inclined to endorse. Indeed, as long as the debate surrounding high-cost, short-term credit (HCSTC) has existed, the view from government and regulators of those that provide such facilities has been less than savoury. Lending practices and the potential vulnerability of the target customer base have received negative media coverage, which has often depicted the industry as unethical. Yet, with 3.1 million UK adults using high-cost loans or having had one in the previous 12 months, the sector remains a lifeline to many who may not have access to alternative (or affordable) mainstream credit.

With Britons’ personal debt pile hitting a record £213 billion and following a sharp rise in complaints relating to unaffordable lending, the Financial Conduct Authority (FCA) has issued a Dear CEO letter to payday lenders encouraging them to proactively compensate customers where the firm has failed to undertake a creditworthiness assessment that meets FCA expectations.

The HCSTC industry has been subject to regulatory scrutiny for a number of years and, try as it may, is beginning to drown in a deluge of complaints from claims management companies (CMCs) looking for alternative sources of income now that the PPI-sourced revenues are drying up. However, maintaining the balance between regulatory expectations, provision of a fit-for-purpose product set that satisfies customer demand and managing legacy issues retroactively is proving increasingly challenging. Indeed, as the very sustainability of the sector is challenged, evolution is no longer optional.  

The FCA's focus on HCSTC started in 2014 when it assumed responsibility for consumer credit from the Office of Fair Trading. Among the measures it focused on to more closely regulate the sector were: price caps, rollover limits and a restriction in the number of times payday lenders could attempt to collect payments from borrowers' bank accounts.

Since then, the regulator has dedicated significant resources to the protection of vulnerable customers, as shown in the 2018-19 Business Plan. The latest development is the publication of a policy statement (PS 18/19) with amended rules and guidance on assessing creditworthiness and affordability.

The FCA’s approach in the Dear CEO letter builds on the work undertaken during the PPI complaints handling exercise, but also reflects apparent concern regarding the long-term viability of specialist lenders in a challenging marketplace.  The letter emphasises the need for firms to adopt a proactive approach to remediating areas in which recurring issues have been identified.

This is in line with the advice we give our clients and is a result of working across different financial services markets in response to a range of thematic redress exercises. The benefits of proactive remediation are countless; in this sector, doing the right thing without being prompted by the regulators can be a true differentiator. Moreover, the costs of redress and remediation under duress may far exceed those associated with proactive exercises.

The findings derived from remediation and redress programmes are an invaluable tool to identify and address areas of concern; the so-called ‘future fix’. Such exercises should be used to inform the development of new governance, controls and risk management practices, which will become increasingly important as the Senior Managers and Certification Regime (SMCR) is rolled out more widely across the industry.

End-to-end analysis (from product development, through sales, complaints and, if applicable, redress) can drive more sophisticated scenario planning to enable the deployment of preventative measures and contingency solutions in a more timely manner. Moreover, developing more flexible and effective infrastructures, particularly where complaints handling is concerned, will prove fundamental to the long-term sustainability of HCSTC lenders and the products they currently offer. Similarly, strategically investing in the better identification of vulnerable customers (using more than credit risk analyses) will simultaneously reduce credit risk and enhance reputational standing through demonstrably responsible lending.

While the proactive remediation of past shortcomings is essential, we believe that preventing poor outcomes in the first instance, both for customers and credit providers, sits at the heart of a responsible and sustainable business model. Indeed, the financial burden of complaints handling, in addition to redress and remediation exercises, will be the key drivers behind prospective exists in the marketplace.

The FCA is increasingly concerned by ‘disorganised exits’, emphasising the prospective volatility of firms harbouring historic failings that may require redress beyond their means. Into this picture, we should factor the high-level prudential requirements set out in the FCA’s Threshold Conditions, which will restrict firms’ ability to trade on through capital erosion. While deposit takers have more extensive resources, continued regulatory and economic pressures will threaten the efficacy of such products and the business models supporting them within a world of non-bank lenders.

CMCs’ role in the redress framework is double-edged. Advocates will argue that CMCs contribute to the protection of consumers, whilst detractors will question their commercial model, practices and their lead generation methods. What is undeniable is that they have played a leading role in the increased volume of complaints payday lenders have had to handle. CMCs will be under the FCA’s regulatory scope from April 2019. While we expect that further regulatory scrutiny and measures will improve the service they provide, ample time remains for a negative effect on the HCSTC industry to be felt before the regulation becomes effective.

With all the negative connotations attached to HCSTC, the more positive aspects of these providers are often overlooked. Yet, in a challenging economic climate, short-term credit is a service that remains a vital lifeline for millions of borrowers, many of whom borrow and repay without difficulties. The risk profile of such facilities will always be reflected in the comparatively high-cost of borrowing. Nonetheless, it is worth noting that many of the products in question remain cheaper than unarranged overdrafts, yet payday lenders suffer higher default costs than banks.

Comparatively, regulation of this sector is in its infancy. Further controls with more demonstrable focus on outcomes are a welcome progression that will facilitate the delivery of a more viable product to consumers. However, at present, this is a fragile market place and evolutionary work is only just beginning. Regulators and firms alike must recognise that proportionality, based upon the relative risks within this customer demographic, will be crucial to delivering responsible lending and a sustainable business model. The need for a proactive approach now applies equally to backward looking redress and remediation exercises, and to an evolution in ‘future fit’ lending practices, complaints handling processes and business models.

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HCSTC regulator demands

The FCA has required that regulated entities:

  • assess their lending activity to determine if their creditworthiness assessments are compliant
  • inform the regulator if they are unable to meet financial commitments due to remediation costs
  • take remedial action and consider proactive redress when deficiencies are found
  • make appropriate provisions for any remediation required
  • review their policies and procedures to ensure they comply with amended rules and guidance on assessing affordability in consumer credit (PS18/19).

Points of action:

  • Refine strategy and governance: Consider the strategic objectives of the business and/or function, ensuring practices are responsible, proportionate and transparent, with a governance model to reflect and maintain these aspirations
  • Reinforce accountability: Embed end-to-end accountability, ensuring product development and sales processes reflect regulatory requirements, risk exposures and customer vulnerabilities, while reinforcing and promoting responsible lending
  • Proactively remediate: Instigate proactive redress and remediation exercises to address past shortcomings, thus demonstrating a commitment to good customer outcomes and reinforcing reputation through responsibility
  • Evolve the business model: Draw on findings from proactive remediation exercises to evolve HCSTC business models and infrastructures, optimising controls, product development processes and complaints handling
  • Actively shape the sector: Commit to playing a positive role in shaping the sector, contributing to regulatory evolution, countering disruptive influences and repairing reputational perceptions

To find out more on how we can assist with redress and remediation matters contact Alex Ellerton.