There are approximately three million consumers who currently use high-cost credit. These are generally the most vulnerable customers with low and variable income and unpredictable expenditure, who may need but cannot access credit. The Financial Conduct Authority (FCA) therefore finds itself in a difficult balancing act – ensuring that consumers who need credit will be able to access it, but also ensuring that those customers aren’t left with unsustainable and unaffordable levels of debt.
The Woolard Review, which was published on 2 February 2021 and reports for the FCA on change and innovation in the unsecured credit markets, considers the alternatives to high-cost credit and measures that can reduce reliance on it. Although it does not make any changes to FCA regulation, the review sets out 26 high-level recommendations for the FCA and the government.
Credit unions and CDFIs
The report considers the potential for credit unions and community development finance Institutions (CDFIs) to provide alternative financing to high-cost credit.
For credit unions, a notable issue is legislation that caps the annual percentage rate, or APR, they can charge at around 42.5% in Great Britain, and just 12.9% in Northern Ireland. Given sub-prime rates are often in the high double digits or more, the legislation prevents credit unions from servicing this market sector. Accordingly, the report recommends that the Credit Unions Act 1979 and Credit Unions (Northern Ireland) Order 1985 are updated to expand the variety of products that credit unions can offer. The quid pro quo for this is likely to be more stringent governance and regulatory oversight.
This is not a new recommendation – the government first sign-posted reform to credit unions in its spring 2020 Budget. While the laws are in need of updating, it is questionable how far credit unions can go in servicing the subprime market. Credit unions are membership organisations serving small communities with specific objectives, and often with a focus on branch presence and face-to-face services. Even if legislation is updated, many unions will not want to depart from their existing operating models. So, while they would be a useful addition to the subprime market, they don’t quite fit the bill for general low-income customers needing to obtain a loan at short notice for unexpected expenditure.
CDFIs are also community based lenders, but specialise in lending to individuals and businesses who find it difficult to access mainstream credit. CDFIs are funded by governmental grants and philanthropic support (rather than deposits), but struggle with high overheads and low loan value, making it difficult to attract capital to lend. The review recommends further work to explore ways to increase CDFI lending capacity, such as subsidies and investment incentives.
Barriers to entry
Even with reform, there is a limit to how much lending capacity credit unions and CDFIs can provide. The review therefore recognises the importance for mainstream lenders to serve the sub-prime market. There are barriers to entry though – the review notes that lenders are put off by subprime given the regulatory and reputational risks and argues that mainstream lenders' expertise and economies of scale are essential to driving competition, innovation, consumer choice and improved outcomes in this area.
The regulatory and reputational risks are just a matter of perception, the FCA concludes. Consequently, there is no proposal to change its regulatory approach. Instead, the review recommends discussions between the FCA, the Treasury, Fair4All Finance and mainstream lenders (who, with their economies of scale, can viably lend to subprime), to find ways to overcome these barriers and/or incentivise subprime lending.
This will likely be an uphill battle for the FCA. The review does not address the main barrier to mainstream lenders participating in the subprime sector, which is that doing so at a profit is extremely difficult. With high default rates and the costs cap in place, there is a reason why several payday lenders have been driven out of the market. Furthermore, for mainstream lenders, there is often little commercial justification to offering these kinds of product as a "loss leader", given the reduced potential for cross-selling.
Reliance on high-cost credit
In addition to looking at alternatives to high-cost credit, the review considers demand-side measures that could reduce the need for it.
In that respect, the review sees promise in products that help consumers to improve their credit scores, allowing them to access cheaper credit. Some of these products rely on the provision and repayment of small credit lines to build credit scores, though consumer groups see these as a pathway to debt. The FCA has already reviewed these products in its Credit Card Market Study without finding specific harms, but the review recommends further analysis into their effectiveness. If they are not effective, the FCA will likely prohibit them from being marketed as "credit building". In addition, the review recommends including credit-builder products in future cohorts of the FCA's Sandbox programme.
One cause for consumers ending up with inappropriate credit products is consumer awareness. Take-up of professional advice in this area is minimal, and many consumers either do not know what alternative lending products are available, or may dismiss mainstream (lower cost) products out of hand for fear of being rejected. The review recommends that the FCA works with Fair4All Finance to identify barriers to consumer awareness, including removing any regulatory barriers. This could include amending the scope of regulated credit broking to allow firms to provide information about alternative credit products without an FCA licence.
Finally, the FCA identifies social policy issues as a driver for credit demand. Without overtly criticising these measures (it's not the FCA's place to do so), the review concludes that further analysis is needed to identify the impact that different social policies (such as Universal Credit) have on demand for high-cost credit. While the review talks about the importance of consumer awareness, it is a shame that it does not take the opportunity to comment on the need for better education about financial products and how they work.
From an FCA survey of more than 7,000 people during the pandemic, it is estimated that 12 million people in the UK have low financial resilience, meaning they may struggle with bills or loan repayments. Arguably, financial resilience is expected of people, but few have been given the tools or skills to understand what that even means. With fintech innovations happening all the time, it is hard for anyone to keep up with all of the types of product on offer, let alone consumers with low financial resilience.
There are some clear steps recommended by the review, such as updating the laws that govern credit unions, incentivising CDFI funding and providing greater clarity on what information firms can give to consumers without constituting regulated credit broking. Beyond these, it looks as though the review will lead to more detailed review exercises amongst key stakeholders to explore issues that increase demand for high cost credit, or that prevent the supply of alternatives.
We will be publishing further Insights covering the other key themes of the Woolard Review.