The FCA consultation distinguishes between two main areas of risk when assessing consumer credit: credit risk and affordability risk. We look at the proposed changes to creditworthiness assessments.
In its 2015/2016 Business Plan, the FCA raised concerns of bad practice by some consumer credit firms which provided credit to consumers who could not afford it. Some consumers suffered financial distress as a result of this bad practice (by one measure, 17% of consumers with outstanding consumer debt suffered from moderate to severe financial distress).
The FCA has launched a new consultation to clarify the rules on assessing creditworthiness (PDF) to address perceived industry confusion.
What is the FCA creditworthiness survey?
The consultation follows a survey by the FCA earlier in the year on how firms approach consumer creditworthiness. Key findings from this survey include:
- 96% of firms use Credit Reference Agencies (CRAs), with many firms using multiple CRAs
- 74% of firms take individual income into account with 10% never doing so and 7% only in marginal cases
- 69% of firms always take individual expenditure into account and 36% of firms consider household expenditure. 6% never consider either of these and 9% only do so in marginal cases
- Of the firms that take expenditure into account, only 41% always or usually verify this.
Credit risk v affordability risk: what's the difference?
The FCA consultation distinguishes between two main areas of risk when assessing consumer credit. The first, ‘credit risk’, is defined as the risk to lenders that the consumer will not repay the debt.
'Affordability risk' on the other hand is the risk faced by consumers that they will not be able to afford to repay. The two of course overlap considerably. The FCA, however, is principally concerned about where the credit risk indicates the credit will be profitable for the lender, while the affordability risk shows that it may not be affordable for the consumer.
What rules are changing?
The FCA is proposing to update its rules on creditworthiness in CONC to clarify the FCA's requirements for assessing consumer creditworthiness. The current rules are high-level and largely principles based. The FCA’s proposed changes are therefore intended to improve firms' understanding of correctly assessing creditworthiness, rather than prescribing a set process. Key changes to CONC include:
The meaning of affordability: the FCA proposes to clarify that consumer creditworthiness includes the affordability of the borrower (not just credit risk to the lender). Firms will need to consider whether the credit will be affordable for the consumer by satisfying themselves that the consumer will be able to make the repayments:
- as they fall due over the life of the agreement
- wholly out of income (unless a contrary intention is indicated, in which case the firm will be required to satisfy themselves of other criteria)
- without the consumer having to borrow to meet the repayments or fail to meet other financial commitments
- without the repayments having a significant negative impact on the customer’s overall financial situation.
Income and expenditure: the FCA acknowledges the fact that for ‘prime’ consumers (i.e. consumers with good credit history), it is not always necessary to consider the customer’s income to determine their affordability. For other consumers, however, the FCA expects firms to consider their income and expenditure. The amended rules will not prescribe how income should be accounted, only that it must be 'reasonable in the circumstances' and that it will not generally be sufficient to rely on the borrower's statement of income. The assessment of income must also take into account any likely material deductions as well as non-disposable income.
Proportionality: the amended CONC rules will require that assessments of creditworthiness are proportionate to the individual circumstances. In determining proportionality, firms will need to consider the following factors:
- the type of credit
- the amount and duration of the credit
- the frequency and amount of instalments
- the total amount payable
- the total charge for credit and the annual percentage rate of charge
- whether interest rates and charges are fixed or variable
- other potential costs
- other potential consequences of non-payment
Policies and procedures: all policies and procedures for determining creditworthiness will need to be kept in writing and set out the principal factors which the firm will take into account. These policies will need to be approved by the firm's senior personnel or governing body. Firms will be required to periodically review their policies to ensure their effectiveness and compliance with CONC.
P2P lending and other types of credit: CONC 5.5 concerning P2P platforms will be updated so that the platform will be required to make creditworthiness assessments in a similar fashion. The creditworthiness assessment will also be required where there is a significant increase in the amount of credit (filling an anomaly in the current rules). Other types of credit specifically targeted by the consultation include open-end and running-account credit (from credit cards) and guarantor loans.
What are the next steps?
Respondents have until 31 October 2017 to provide the FCA with feedback to this consultation. A policy statement together with final rules and guidance will then follow in the first half of 2018.
Our final thoughts
At a time of increasing consumer credit, the Bank of England warning of a credit bubble requiring banks to set aside up to £11.4 billion of extra capital in the next 18 months, the Bank and FCA focussing on PCP car finance and with stories of loan sharks and pay day loans regularly in the media, it is perhaps unsurprising that creditworthiness is on the FCA’s radar. The FCA's proposed amendments strike a healthy balance between not being overly prescriptive whilst giving firms greater guidance to make reasonable and proportionate assessments of the affordability risk to consumers.
It is perhaps a soft, principles-based approach to addressing the inherent conflict of credit risk (where a borrower looks profitable) and affordability risk (where they may suffer financial distress if lent to).
In the context of 96% of firms using CRAs for creditworthiness assessments, this conflict was the crux of Andrew Vorster’s challenge at Money2020 to the likes of Experian and Citi. To paraphrase from memory one of the most contentious and passionate public challenges to the financial services norm we’ve seen: Credit scores - no one asked if you want one, no one told you when you got one and even then they didn’t tell you what it is. Instead, you have to ask and pay to see it, yet a three-digit number has a serious impact on your finances, career and your life. Credit scoring is opaque, for the benefit of lenders’ profits and broken.
So it waits to be seen whether the FCA’s softer approach will address the problem of financial distress for many consumers in light of increasing criticism of the lending industry or whether further FCA involvement – potentially harder, more direct, enforcement – will be deemed required in the interest of consumer protection.