The cost-of-living crisis is driving up demand for consumer credit. But concerns around default rates, affordability assessments and identifying vulnerability are also on the rise. Will Stagg and Jarred Erceg give an overview of the issues facing the consumer credit sector this year.

Latest consumer finance figures show consumer credit new business was 13% higher in 2022 than 2021. The number of consumer credit providers is shrinking, however. Major players such as Wonga, QuickQuid, PerfectHome, Loans at Home, BrightHouse and SafetyNet have left the market. Morses Club has scaled back lending, Provident Financial has closed its consumer credit division and Amigo has taken a significant break from undertaking new lending while the firm undergoes restructuring.

With budgets squeezed by the cost-of-living crisis, the sector is having to contend with shifts in consumer behaviour, an increase in delinquency rates and growing regulatory oversight. Here are the key issues for the consumer credit sector in 2023.

Higher delinquency rates

The cost-of-living crisis has led real wages (excluding bonuses) to fall by 3.1%, one of the largest falls seen since comparable records began in 2001. While this has translated to increased demand for consumer credit, it is also expected to contribute to higher delinquency rates. The Bank of England’s quarterly credit conditions survey shows that default rates on unsecured lending increased in Q4 2022 and that lenders expect them to increase again in Q1 2023, along with more defaults on credit cards and other loans.

Those in lower income brackets are more affected by inflationary pressures so the impact on the sub-prime credit sector could be significant, but high levels of delinquency will have implications for all businesses in the consumer credit sector.

Identifying newly vulnerable customers

Research by the FCA in October 2020 showed that 27.7 million adults had characteristics of vulnerability, a 15% increase on pre-pandemic levels. Since then, consumers have seen pandemic-related government support withdrawn and been buffeted by the cost-of-living crisis.

Identifying vulnerability remains crucial but harder than ever in such a fast-changing economic environment. People’s financial situations can deteriorate quickly. Consumer credit providers need to ensure their processes capture newly vulnerable customer groups so they remain compliant with regulatory obligations and don't expose themselves to unaffordable or irresponsible lending complaints.

Affordability assessments

The Financial Conduct Authority (FCA) has explicitly stated it doesn't want consumer credit firms to lower affordability standards in the current climate. Maintaining robust affordability assessments is hard, however, as financial upheavals faced by many since 2020, coupled with fast-rising costs make a customer’s track record of affordability less relevant when looking at future affordability.

The popularity of buy now pay later (BNPL) makes capturing a consumer's borrowings with other providers increasingly challenging. Some larger BNPL firms are sharing this data. But until BNPL is fully regulated and required to share data with credit reference agencies (not expected until 2025), and reporting is more consistent across the sector, consumer credit providers may not have a full picture of a consumer’s borrowing. This brings implications when assessing affordability.

Consumer complaints and redress

Another major challenge involves complaints about irresponsible lending and corresponding redress liabilities, often driven by complaints management companies. While the number of complaints to the Financial Ombudsman Service (FOS) has fallen from the high levels seen in 2020/21 (in part due to the schemes of arrangement proposed by firms in the sector), the FOS still received over 19,000 new complaints about historic unaffordable lending in 2021/22, showing this remains an important issue. 

The FCA started regulating the sector in 2014 but the FOS imposes stricter consumer protection standards on loans prior to that date, giving rise to potential historical redress liabilities. The impact of a large number of retrospective claims is considerable: redress payments (including an additional eight per cent statutory interest) or loan balance readjustments need to be made. The cost involved in the claims management process, including system and platform developments and staff training, is significant. Consumer credit firms must also pay fees of £750 per complaint referred, regardless of the outcome.

Such costs can affect resources and liquidity and have been a major contributing factor to the demise of firms in the sector, for example, Wonga and Loans at Home.

Schemes of arrangement

Recently, consumer credit firms have used schemes of arrangement to compromise redress claims. This has been driven by a desire to crystallise historical redress liabilities. Instant Cash Loans successfully implemented the first of these in 2019. In July 2021, the High Court sanctioned Provident Financial's scheme. And, following an initial unsuccessful attempt in 2021, Amigo had its ‘New Business Scheme’ sanctioned in May 2022. Most recently, Morses Club proposed its scheme in December 2022, although on 7 March the FCA announced it would oppose the proposed scheme at the sanction hearing, due to concerns over the funding required for the compensation fund.

Although a costly process, a scheme of arrangement can provide finality for firms in respect of their redress liabilities and, compared to an insolvency, can improve consumer outcomes. Once legacy redress issues have been eradicated, future debt or equity raises become much more attractive to potential investors.

Increasing regulatory oversight

The consumer credit sector remains in the regulatory spotlight. In May 2022, the FCA issued a ‘Dear CEO’ letter outlining concern that firms in the sector may "exploit the cost-of-living crisis to promote their services, and that increased demand may result in unsustainable and often unaffordable lending". The regulator has used similar letters to remind firms of their obligations, particularly around treating customers fairly and regulatory expectations towards vulnerable customers.

Consumer credit firms also need to focus on complying with the FCA’s operational resilience requirements, implementing the Consumer Duty and ensuring they meet regulatory expectations around wind-down planning.

Working capital challenges

Given the macroeconomic headwinds, consumer credit firms are likely to experience an increase in requests for forbearance now, as well as rising default rates. Liquidity for such lenders must be tightly managed to forestall potential working capital issues.

Where firms rely on repeat lending, the knock-on effect of higher default rates can be magnified. Management needs to consider whether increased delinquencies will impact a firm’s own funding arrangements, including compliance with covenants.

At a corporate level, many consumer credit firms have taken on more debt to meet liquidity concerns and deal with increased operational costs. Higher interest rates are also putting pressure on cash flow. Granular cash flow forecasting should be undertaken on a weekly basis to ascertain whether firms have enough liquidity to get them through the next 12-24 months. Management also needs to plan for any debt facilities due to mature in the short to medium term.

Growth of buy now pay later

The BNPL sector is a large and fast-growing market. It is due to come within the regulatory perimeter – HM Treasury consulted on draft legislation in February 2023 – but final rules from the FCA aren't expected until 2025. However, the FCA has proposed that:

  • current rules on creditworthiness assessments should be applied to BNPL agreements
  • rules on how BNPL firms treat customers in financial difficulty should be introduced
  • customer complaints should be referred to the Financial Ombudsman Service (FOS).

Many BNPL firms have already started this process. The sector still needs to navigate significant change, however – implementing affordability assessments and processes to identify vulnerability, including tailoring the customer journey appropriately.

Firms also need to develop workable solutions with credit reference agencies, allowing a consumer’s BNPL debt to be viewed by other credit providers as part of their affordability assessments.

The sector remains vulnerable to the impact of redress claims, including the risk of retrospective redress claims.

For more information and guidance, contact Will Stagg or Jarred Erceg.

Financial services restructuring and insolvency

The financial services sector is a diverse, dynamic and competitive marketplace.

Financial services restructuring and insolvency

The financial services sector is a diverse, dynamic and competitive marketplace.