“A typical credit check is backward looking. It relies on the future looking much like the past. So, if your customer has not had much debt and a history of meeting their obligations in the past then the assumption is that they will continue to do so in the future... I hope you can see why a backward-looking credit check isn’t enough. Will the customer be able to repay without causing them wider financial difficulties?”
Speech given by Jonathan Davidson, Director of Supervision – Retail and Authorisations at the FCA, at Credit Summit, London – 15th March 2018
The Financial Conduct Authority (FCA) has taken up the mantle of affordability and creditworthiness in line with its business commitments of upholding transparency in the financial system. Having introduced policy statements 17/27 in July last year, it has published feedback on the proposals this summer, with a view to initiating the rules on 1st November of this year.
The policy statements introduce some clear changes in how lenders must work with their consumers, most notably, establishing the concept of “affordability” into consumers creditworthiness.
So what is creditworthiness and how does the idea of exploring affordability change the role of a lender when an application is received?
The consultation into affordability was prompted by concerns about the harm, or potential harm, that could befall consumers through poor lending practices, and consumers being granted credit they cannot afford to repay.
The term “affordability” was introduced by the Office of Fair Trading (OFT) in 2011 but has come to prominence now that the regulation of the finance sector has passed to the Financial Conduct Authority. Following the prominently cited behaviour of some pay day lenders, the subject of consumers ability to pay has come to the fore.
Within the consultation, the FCA wanted to clarify a number of major factors. These were:
- The distinction between affordability and credit risk
- The criteria for deciding the proportionality of assessments
- The role of income and expenditure information
- Their own expectations of firms’ policies and procedures
The FCA has deliberately not been prescriptive in its recommendations to establish affordability and creditworthiness within firms. As we have seen with other areas of financial services regulation, such as on rules concerned with Anti-Money Laundering (AML) and Counter-Terrorism Financing (CTF), they are focused solely on outcomes. This, then, gives firms a lot of leeway in how they approach the new recommendations, provided they can justify their assessments to regulators.
At its most simple, creditworthiness assessment is the process undertaken by lenders to establish whether the credit requested by the customer is affordable for the consumer, and what level of risk it poses to the lender. These two sides of the same coin come together to establish consumers overall creditworthiness.
The FCA will require all firms to be in a position to establish creditworthiness and affordability, and have policies and procedures to ensure robustness. These policies must take into consideration the principal factors for consideration listed above, and be signed-off by senior management. They must further be reviewed on a periodic basis.
Affordability is then, the part of a credit application that concerns itself with the financial health of the consumer, rather than the lender.
The FCA has outlined a new definition of affordability, outlining the risk to the consumer of not being able to afford the repayments. This introduced a number of new ideas that have not been seen before, including the removal of presumption that an ability to pay back past loans or debts means that they will be able to repay future debt.
Lenders therefore have to take into consideration what may happen in the future – as far as they are able. They may ask themselves questions such as whether the applicant is likely to remain in the same job and at the same salary? Can the applicant still repay should there be a change in interest rates?
The role of salary becomes very important because of one change that the FCA has made, which is that unless they have intimated otherwise, the assumption is that all applicants will repay credit direct from income made through salary. Lenders should also consider whether a borrower may find themselves having to borrow further to keep up with repayments, and finally consider whether the repayments could have a significant impact on the customer’s overall financial situation.
The FCA has been keen to promote the concept of proportionality within the new guidelines. A loan for £100 for example, does not require the same scrutiny as one for £10,000.
As the FCA guidelines make clear, most firms are already considering the prospect of affordability within the context of being responsible lenders and are building it into their assessments. They did however stress that there has been evidence of “under-compliance” when it comes to the rules, and that the FCA found some firms had a culture of running procedures that are unnecessarily “ineffective or prohibitive.”
Good for consumers and lenders alike
Few reading this will have failed to notice that one of the largest pay-day loan company’s, Wonga, has gone into administration. The company, which was once tipped for a stock market floatation and valued at around £1 billion, has entered administration after suffering a deluge of customer compensation claims. Many of these centred on legislation passed in 2015 that outlawed some of the more excessive rates of interest passed on by lenders to consumers – at one stage Wonga offered interest rates on its loans of 5,853%, before reducing this to a “high” of 1,500%.
What the example makes clear is that many pay day lenders were not considering the issue of affordability when offering loans to consumers. A simple Google search unveils numerous horror stories of consumers offered loans that were all but impossible for them to repay.
The Financial Conduct Authority has positioned the new requirements to illustrate that irresponsible loan offerings are poor business practice. The company’s that will thrive are those responsive not just to their own credit risk scores, but also those that take into consideration the financial health of their customers.
The FCA has crossed a proverbial tightrope in drafting the new requirements.
The levels of consumer debt are nearly as great as they were in 2008 prior to the Great Financial Crash, and today, as Jonathan Davidson pointed out in his speech to Credit Summit, nearly 20% of 25-34 year old’s have no savings, 36% had been overdrawn at some point in the last 12 months, while the volume of self-employed people has risen 1.5m in the UK since 2000, with a further 900,000 on zero hours contracts.
In drafting the new requirements to ensure that lenders take into consideration the affordability of the loan for the consumer, they have protected the wellbeing of the financial credit system by ensuring it is responsible lenders who consider the wellbeing of their customers who will benefit.