On 4 July 2017, the Prudential Regulation Authority (“PRA”) released a statement on consumer credit (“Statement”), following a review of consumer credit lending (“PRA Review”). The review included the examination of PRA regulated firms’ underwriting practices for credit cards, unsecured personal loans and motor finance. As readers will be aware, there has been a good deal of press coverage regarding concerns over increased consumer lending and the rising average level of household debt. The fear is that “risky” lending is on the rise,taht consumers won’t be able to manage their debts if interest rates increase and commission based products could be leading to an increase in the (mis) selling of unsuitable products.
The PRA website confirms that the PRA Review was carried out following “a continued period of material growth in consumer credit, a lowering of pricing and extensions of interest-free offers” and the Statement records the issues which are seen to arise for the PRA regulated firms which provide the consumer credit referred to in the paragraph immediately above. As set out in the introduction to the Statement, those firms will shortly be contacted by the PRA, with a request that they respond to the Statement and the information provided by them will assist the PRA in determining firm specific supervisory action and will be shared with the Financial Conduct Authority.
What the PRA Review found
In brief, the PRA Review found:
- There was evidence of weakness in some aspects of underwriting;
- The resilience of consumer credit portfolios is reducing due to the combination of continued growth, lower pricing and some increased lending into higher risk segments;
- Assessment and pricing for risk has been influenced by historically low arrears rates;
- Firms are not necessarily considering the impact of consumer indebtedness and consumer’s future ability to repay debt when assessing lending risk;
- There is a large degree of variation between firms in respect of risk management practices and controls in respect of consumer credit products;
- In respect of credit cards, many firms are attracting new consumers by offering 0% promotional offers. This includes applying the uncertain Effective Rate Accounting standards to those offers. In addition, if the model assumption used by the firm when calculating the offer turns out to be optimistic (because of unpredicted changes in consumer behaviour), that firm could be facing a loss if the offer made was only likely to be marginally profitable;
- In respect of unsecured personal loans, the rapid reduction in interest rates for consumer lending means that the firms will be left with less income to absorb potential future losses;
- In respect of motor finance, the fast expansion of Personal Contract Purchase (“PCP”) deals exposes lenders to the risk of the vehicle’s residual value – in PCP deals, lenders offer a guaranteed future value for the vehicle, which is usually in the range of 85% to 95% of the expected future value of that vehicle. This exposes the lender if there is a significant downturn in the used car market.
Issues for PRA Regulated firms
The PRA Review made it clear that firms are “the first line of defence against the risk of losses on these exposures”. In light of this, the PRA will be requesting evidence from all firms with “material exposure” to consumer credit as to how they will ensure the following:
- That a firm’s credit scoring process adequately captures medium term risk (including consideration as to whether credit scoring models should build in an approach to “new generation” borrowers, who do not have experience of a high interest rate environment);
- That “stress-testing” approaches do not under estimate potential downturn risk – current arrears multiplier models may be unsuitable and it might be wise to predict the absolute level of arrears in stress when taking a view as to risk;
- That loss leader segments are to be explicitly reported and monitored;
- That, at the cut off point for new business, consideration is given as to whether a “prudent add-on” should be applied, meaning that default rates could be higher than provided for by an assumption, before new business becomes loss making;
- That a consumer’s total level of all debt is be taken into account during the underwriting process;
- That firms’ risk appetite, MI and governance frameworks are sufficient to oversee consumer credit portfolios;
- In respect of credit cards and in particular 0% offers, that they can justify the assumptions used when forecasting new business and in particular, how the potential volatility of customer behaviour referred to above will be managed;
- They can provide evidence of underwriting assessments and pricing of unsecured personal loans which take into account the total amount of debt a consumer has; and
- In respect of motor finance, the guaranteed future value of a vehicle (as referred to above) is set in a “prudent” manner.
These issues have been summarised from the Statement, the full copy of which can be found here: http://www.bankofengland.co.uk/pra/Documents/publications/reports/prastatement0717.pdf
What the future holds
In addition to the PRA seeking the evidence outlined above from PRA Regulated firms, The Bank of England will also be bringing forward its assessment of “stressed losses on consumer credit lending in the Bank’s 2017 Annual Cyclical Scenario stress test for the major firms”. In addition, the PRA will work with firms who have high exposure to consumer credit but were not captured by the Annual Cyclical Scenario stress test to review firm’s resilience to the 2017 stress scenario and to provide appropriate feedback to firms.
The risk here is that, if firms do not address the issues highlighted in the PRA Review and the Statement, they are potentially engaging in risking lending practices. This could leave them open to claims from consumers in negligence and/or for breach of contract, should consumers encounter difficulties with their borrowing and allege that they should not have been sold the consumer credit products they have entered into. In addition, consumers may be left with risky products which they cannot afford to repay in the future. And there is the possibility of regulatory investigaiton and disciplinary actions
Firms should therefore look to comply with PRA requests for evidence and should ensure that they have considered how to comply with the issues outlined in the Statement, as summarised under the heading “Issues for PRA Regulated firms” above.