On 31 July, the FCA published its long-awaited consultation paper “Assessing Creditworthiness in Consumer Credit”, which seeks to clarify what the regulator expects of firms when assessing creditworthiness and affordability. The FCA believes this is in line with its commitment to improved transparency (as set out in its 2017 Mission) and that it will make it easier to supervise the consumer credit markets.
Since taking over the regulation of consumer credit in 2014, the FCA has employed an army of economists and researchers to grapple with how best to pursue its operational objective of securing an appropriate degree of protection for borrowers of consumer credit, against the backdrop of an economy that is still largely fuelled by debt. It is aware that it must balance the protection of consumers with the risk that its rules restrict the availability of credit and increase the overall cost of borrowing, which, in turn, could have an impact on the economy. The FCA is keen to stress, therefore, that:
- it does not think that the basic approach to creditworthiness needs any fundamental change. It is based around high-level principles with an emphasis on proportionality;
- outcomes matter more than process, and firms can satisfy themselves on affordability in different ways; and
- given that the consumer credit market is so broad and varied, it is not appropriate to prescribe in detail particular checks firms should make, or specific information they should obtain or verify, either generally or in particular sectors.
So, have the FCA proposals achieved greater clarity without making changes to the existing approach to creditworthiness? Unfortunately we think not.
Proposed new rules
The FCA’s proposed approach to affordability checking across the entire consumer credit market (both pre-contract and before significantly increasing the amount of credit or credit limit) can be summarised broadly as set out below:
- Firms must have policies and procedures which document their affordability assessment approach in writing that are approved by senior personnel. The effectiveness of those policies and procedures must be kept under periodic review via robust governance and control.
- Firms will need to identify and establish parameters for the cohort of customers or product(s) where no income and expenditure assessment will be required. This should be limited to “prime” customers (i.e. those with good credit history and no financial difficulties) where the cost and amount of credit is “relatively low”. No guidance is given on what is meant by “relatively low”.
- For any customers who are not “prime”, or where the cost and amount of credit is not “relatively low”; firms must take individual income into account by looking at the person’s debt to income ratio. Household income must not be taken into account. Firms will need to establish parameters as to when it is appropriate to estimate income (e.g., if the applicant’s employment status is known, if the firm has previous application data or access to current account information). If it is inappropriate for a firm to estimate income (because the firm does not have sufficient evidence already), firms will have to request details from the individual. It will generally not be sufficient to solely rely on a statement of income without independent evidence (e.g. supplied by a CRA or a third party) unless the costs and risks are very low (in which case the firm should be able to substantiate this). Firms should take into account security of income and whether retirement is imminent.
- Firms will need to identify and establish parameters for when it is “obvious” that a customer’s non-discretionary expenditure (such as expenditure on mortgage and utilities, dependents etc) is unlikely to have a material impact on affordability.
- Unless it is obvious that a customer’s non-discretionary expenditure is unlikely to have a material impact on affordability, firms must take non-discretionary expenditure into account in deciding whether an individual has sufficient disposable income to afford the loan. Firms will need to establish parameters as to when it is appropriate to estimate non-discretionary expenditure (e.g. by using reasonable assumptions from statistical data to estimate a maximum amount or a range). It will generally not be appropriate to estimate non-discretionary expenditure if the firm knows (or should be aware) that the individual’s circumstances are significantly different from the statistical norms.
What has changed?
Focus on individual income
The FCA has proposed that, when assessing affordability, firms should only consider whether repayments can be made wholly out of individual income, ignoring household income entirely. The potential impacts of this are considerable. For young people living with their parents and for stay-at-home parents, in either case with low or no incomes, it would appear that access to any credit which does not have a “relatively low” APR, will be restricted as it will simply not be possible to demonstrate that these individuals have sufficient income on their own to repay their loans.
Excluding low or non-earning individuals from being able to access credit on their own (unless, presumably, they have a guarantor) even where the household income is demonstrably good, represents a departure from existing industry practice. We think this may have wider impacts on society – for example pressurising partners to have joint accounts, potentially disenfranchising stay-at-home parents, or acting as a disincentive for young people in terms of building their credit rating.
Not permitted to take into account the existence of security
Currently, the rules are that firms must not base their affordability assessments primarily or solely on the value of security. The FCA proposal is that this becomes a requirement that, when considering affordability risk, the firm must not take into account at all the existence of any form of security.
For rent-to-own and hire-purchase providers (such as car finance providers offering PCP), the asset is not officially “security”, but we think that the intended effect is the same. These firms have always taken into account the value of the asset being financed, and the fact that the borrower can give it back if the lending becomes unaffordable. We suspect that under the new rules, these factors would need to be disregarded.
This could create significant challenges for point-of-sale hire-purchase providers, where speed of decisioning is key to the business model – whether in an online or a face-to-face environment. While the FCA may be happy to see a drop in PCP lending, the potential impact on the wider economy should be properly considered.
Need for data analysis and rigorous regular review
The FCA expects firms to have an audit trail justifying each decision. The most efficient way of doing this is to “front-load” the work by establishing parameters and using software and data analytics tools. For established banks and large lenders this may mean no more than a few tweaks to existing systems.
However, for new entrants to the market, for smaller lenders, and for brokers to whom credit and affordability assessments have been outsourced, this represents a challenge, not only in terms of cost, but also in terms of competitiveness. If firms have less data, they will be less able to estimate income and expenditure, so they will need to ask for more information and their credit decisions will take longer. This will also impact online point-of-sale lenders whose priority is to integrate their credit assessments into the sales process.
Again, therefore, there are potential knock-on effects on small firms and market entrants and on the wider retail market that need to be considered.
Osborne Clarke comment
In seeking to increase transparency and clarity on what is a sufficient affordability assessment, it was, perhaps, always going to be an impossible task for the FCA to avoid increased prescription, even if that has not been the intention.
The FCA has clearly applied focus on what can be done to predict financial distress and how to help customers avoid it, relying heavily on data modelling and analytics. What is not clear from this consultation paper is whether the FCA has applied an equal amount of focus to the potential ramifications of for the market and the economy as a whole if it introduces the new rules that it has proposed.