Tomorrow we will be welcoming around eighty delegates to our conference – Creating Trust in Financial Services. Those delegates will be drawn from a broad range of stakeholders, including Government, the FCA, financial services providers, FinTechs, debt advice agencies and organisations involved in the commissioning or delivery of financial support. Together, we will reflect on why trust in financial services is important, and what new approaches could be taken to foster it.
As we approach that debate, CfRC Director, Damon Gibbons, sets out his thoughts concerning the issue of trust in today’s system of consumer credit lending and regulation.
Trust and the economy
At least some level of trust is essential for a modern economy to operate effectively. There is a longstanding literature which identifies trust as critical in enabling exchange (of labour, goods and services) over time. If we didn’t have trust, we wouldn’t work in lieu of wages being paid; we wouldn’t order anything over the internet, and we wouldn’t even accept currency issued by the Bank of England. For a quick read about the importance of trust, try this article in Forbes magazine from 2010.
But whilst some of level of trust is essential, we don’t trust others completely. We might work for a month in advance of wages, but we also want a contract which we can enforce if payment isn’t forthcoming. It follows that we therefore need to have trust in the wider system – of law and regulation – so that we can also enforce that contract if necessary. The level of trust we have in both the other party to an agreement and that wider system determines both whether we do business at all, and how we do it – whether it is on a handshake or with detailed legal advice. And how much we are prepared to take on trust is also related to what is at stake (the level of possible gains and losses) and the frequency (and therefore built up experience) with which we do business with other people.
Trust and consumer credit
With respect to consumer credit, lenders throughout the ages have always considered advancing credit to be a risky business. That is certainly true. Some borrowers may try to abscond with the money. And, although the vast majority enter into agreements in good faith, many of these (and for a multitude of reasons often beyond their control) may not pay back on time.
Assessing the likelihood of default is therefore a major preoccupation for lenders, and in today’s system, credit information services have therefore become extremely important as the mechanism through which lenders obtain information about a borrower’s identity; address; liabilities, and payment history. In principle the system reduces the risk for lenders – they can use it to assess a borrower’s financial situation and assess their ‘creditworthiness’.
However, it is important to recognise that much of the information that is being reported through this system – ‘missed payments’ and ‘defaults’ in particular – are defined by lenders themselves. It is the lending industry which sets the terms on which borrowers are to be judged. This means that lender expectations, whether reasonable or otherwise, form the basis of risk itself.
It is possible for lenders to manipulate borrowers into becoming ‘higher risk’ than perhaps would otherwise be the case. For example, products can be structured (sometimes deliberately, sometimes not) in ways which make it difficult for borrowers to maintain compliance with the contract. We need only to think of the typical payday loan prior to the introduction of the price cap in 2015, where repayment of the full amount was required within one month. Given the profile of borrowers it was certain that many would struggle with this contractual requirement, but its existence provided an opportunity for lenders to offer ‘roll-overs’ – which led to the charging of interest on interest – or for them to generate additional revenue from default fees. The actual risk of complete non-payment by payday borrowers was low because most provided lenders with Continuous Payment Authority to take money directly from their bank accounts. However, the risk of borrowers failing to meet the contractual terms that lenders put in place was high.
There are many other examples of how lenders can create risk within the system.
They can fail to properly assess the affordability of a loan at the outset – effectively setting people up to fail.
They can also set up repayment schedules which are difficult for people to manage: the traditional requirement for credit to be repaid on a set date in the month doesn’t sit easily with the increase in insecure employment that has occurred in recent years. It is likely that many missed payments are the result of a failure of lenders to move away from their own preferred cash-flow arrangements and develop products with the repayment flexibility that borrowers need. How lenders view those missed payments will vary, but many have developed products which take advantage of borrowers (‘behavioural pricing’) rather than help them.
Simply feeding in more binary (has paid on time/ hasn’t paid on time) data into the current system – for example from rent or Council Tax payment records – only further limits the flexibility lower income households have to manage their budgets and is not a solution for those whose risk has, in many cases, been created by the existing system itself.
Increasing the risk of customers in these ways can be profit maximising for lenders both individually and as a group – at least in the short-term.
Firstly, products can be repriced to reflect the greater ‘risk’ of borrowers defaulting; secondly, reporting regular, albeit often minor, infringements of the contract reduces the likelihood of people going elsewhere by limiting their access to other forms of credit; and thirdly, when combined with the widespread marketing of the importance of maintaining ‘credit scores’, it creates a ‘fear factor’ and has a ‘disciplinary effect’ on some borrowers, making it more likely that they will continue to make payments even if they cannot realistically afford to do so.
An alternative approach
Tomorrow’s conference provides an opportunity for a wide range of stakeholders to discuss whether this system is something we really want to continue with. If we agree that the current system is heavily lacking in trust and is busy with the creation, rather than the reduction of risk, we should start thinking about how a future system could be built which seeks to reverse this.
Providing borrowers with greater payment flexibility might be a good place to start, and we will be reporting further on our Rent-flex pilot with Optivo Housing Association – which has highlighted the benefits of this approach – at the conference. But product and service design issues go beyond just repayment schedules, and we need to think about how we can test out new approaches involving the co-design of products and services with end user groups so that these become ‘fair by design’. Government, social investors, and the FCA could facilitate this by providing a challenge fund to support the development of new products and services and giving access to the regulatory sandbox for trials to take place.
But intervention to change the current credit scoring system is also required. Data concerning missed payments is not currently balanced by information as to the cause, nor informed by data on the response that the lenders gave to their borrowers which may be contributing to a longer-term deterioration in the customer relationship and payment record. Changing the reporting requirements in these respects could drive considerable improvements in collections practice.
And much greater thought is needed about how we can ensure that interventions by debt advice and financial health support agencies (into which there is considerable public investment) can be used to improve the credit scores of borrowers. Many people who experience financial problems are provided with assistance and support, and they are likely to change their financial behaviours as a result. However, the advice and support interventions that they receive are not currently given any weight within the credit referencing system or by lenders in their subsequent risk assessments. This creates a barrier to their rehabilitation to more mainstream credit markets.
We could also seek to use data in a way which helps borrowers as well as lenders. Whilst lenders have access to increasingly detailed data about borrower behaviours, there is virtually no data made available in return which might make it easier for customers to find lenders that have their best interests at heart.
Finally, we need the regulator to lead by example: providing much greater transparency about the evidence on which it has based its decisions (whether rule changes or the design of redress schemes) together with a consultation on how it will measure and report on the impact of its interventions moving forwards.
We look forward to discussing these, and many other possible ideas, to improve levels of trust between lenders and borrowers and in the wider consumer credit system with delegates at the conference tomorrow!