The cost-of-living crisis means demand for consumer credit is increasing, but customer delinquency is also expected to increase, potentially bringing working capital issues for firms. Jarred Erceg looks at implications for consumer credit firms, particularly lenders to sub-prime and near prime sectors.
The reasons for the cost-of-living crisis are well-documented. Inflation is currently 9%, the highest rate for 40 years. Energy costs are a key contributor with average gas and electricity prices increasing by 53.5% and 95.5% respectively year on year. Fuel prices are also at record levels. Food inflation rose to 4.3% in May, up from 3.5% in April, the highest since April 2012.
Meanwhile, according to the ONS, real wages (wages adjusted for inflation) fell by 1.2% compared to 12 month ago. As a result, more people are having to rely on credit to finance their everyday living costs. Bank of England figures released in May show that consumer lending rose by £1.6 billion in February and £1.3 billion in March, the highest borrowing over a two-month period since early 2019.
How have market changes impacted customer delinquency?
Although demand for lending is high, consumer-credit firms are also having to manage an increase in customer delinquency. According to the FCA, around 25% of the UK population have low levels of financial resilience, a number which has largely been stable since the beginning of 2020, but is now rising as financial pressures push up demand for consumer credit, especially in the sub-prime sector.
Consumers in lower income brackets are known to be disproportionately affected by inflationary pressures – expenditures most exposed to inflation constitute a greater proportion of outgoings for financially vulnerable groups. For example, energy-related costs (housing expenses and transport fuel) make up to 40% of disposable income for lower income groups relative to 20% for the average household. A survey of lenders by the Bank of England in Q1 2022 showed that lenders expect an increase in defaults on unsecured loans. This could have significant implications for all businesses in the consumer-credit sector, but will potentially have significant impact in the sub-prime sector. How will higher customer delinquency impact a firm’s lending criteria and ability to recover balances owing?
Considerations around affordability and vulnerability assessments
The FCA has explicitly stated that they don't want firms to lower affordability standards in the current climate. It's more important than ever to ensure that affordability processes are robust enough to only extend credit to those who can afford to repay it – but with costs rising so fast, this can be hard to identify.
The financial upheavals faced by many over the past two years, together with the fast-moving macro-economic environment make a customer’s track record of affordability less relevant when looking at future affordability. For example, labour shortages are hitting some industries more than others - do some sectors have less pay-bargaining power than others and could this influence their vulnerability to inflation? Consumer credit firms must be alive to this. Also, where automated-decision making is used for credit decisions, the data behind algorithms may need to be updated or reviewed to check it's still relevant or fit for purpose in the current environment.
Identifying vulnerability remains crucial. In this climate, people’s financial situation can deteriorate quickly. Lenders need to ensure their processes capture newly vulnerable customer groups, so they remain compliant with their regulatory obligations and do not expose themselves to unaffordable or irresponsible lending complaints.
Capturing BNPL in affordability assessments
A key part of assessing affordability is capturing a consumer’s borrowings with other providers. The popularity of buy-now-pay-later (BNPL) and explosion of providers makes that increasingly challenging. Citizen’s Advice have found that more people are using BNPL to cover everyday spending rather than discretionary purchases, and that those receiving universal credit are twice as likely to use it.
BNPL firms are not yet regulated and are therefore not obliged to share data around their users’ borrowings with Credit Reference Agencies (CRAs). The leading BNPL provider in the UK has voluntarily started reporting customer debts to CRAs from June 2022, and while others BNPL firms may follow, this could take time. It's also unlikely that historic BNPL loans will be reported to CRAs, giving lenders less information on past credit habits.
Until BNPL is fully regulated – final FCA rules and implementation are now not expected until 2024 – and reporting is more consistent across the sector consumer-credit providers may not be able to have a full picture of a consumer’s borrowing, which is likely to have implications when assessing affordability.
FCA focus on consumer credit
The FCA has recently issued two Dear CEO letters for consumer credit lenders, illustrating their concern around the sector.
On 6 May, the FCA issued a letter amid concerns that ‘firms may exploit the cost-of-living crisis to promote their services, and that increased demand may result in unsustainable and often unaffordable lending’. In particular, the FCA has concerns about the quality, presentation, and oversight of financial promotions. On 16 June, the regulator outlined their expectations around treating borrowers fairly, in particular embedding the vulnerable customer guidance .
Both letters ask firms to consider the potential harm for consumers should they be mis-sold products. This focus on outcomes for the consumer is one of the key tenets of the new Consumer Duty. Although final rules are not yet confirmed, the FCA explicitly states that they aren't waiting for the Duty to come in before they act to improve consumer outcomes. The regulator will be proactively applying their rules to ensure that consumer credit firms act to promote fair outcomes for consumers.
For example, are your customers using products designed for short-term borrowing for their long-term borrowing needs? Is that leading to persistent debt?
In a recent speech the FCA stated that too often firms have failed to meet expectations on affordability, including relending. This is borne out by the proportion of complaints about unaffordable lending that the FOS has upheld – still greater than 60%, and the redress liabilities that firms have incurred.
What do consumer credit firms need to do?
In such a challenging environment, consumer credit firms - especially sub-prime lenders - should ensure they have re-considered impairment and provisioning across their portfolios.
- Where firms rely on customers’ repeat lending, what will be the knock-on effect of increased delinquencies?
- Will increased delinquencies and associated effects impact a firm's funding arrangements, including compliance with covenants?
- Firms should ensure that all statutory notices are issued as required to ensure there are no issues when seeking to recover non-performing loans
Firms need to have appropriate forecasting models in place, which can be used to stress-test a firm’s resilience in different scenarios to provide greater clarity on triggers that may lead to underperformance. Firms that are proactive and take a customer-led approach will be best placed in shoring up their financial robustness.
For more insight, contact Jarred Erceg.