Are you lending (ir)responsibly?

Irresponsible lending is a challenge that has existed in the credit market for years and remains a driver of harm capable of pushing consumers into hardship. This blog looks at some of the reasons behind this risk and sets out examples of good practices that firms operating this business model should consider.

The risk of irresponsible lending. A challenge that has existed in the credit market for years and, despite focus by firms and the regulator, remains a driver of harm capable of pushing consumers into hardship.

The credit market has continued to evolve over the years to meet the varying needs of consumers, including during the early months of the pandemic when lenders sought to implement temporary guidance, offering forbearance and support to those in need of help. At the same time, the market has witnessed an increase in buy-now-pay-later (BNPL) lending – which itself will be subject to stricter rules – in part driven by customers who may not appreciate this is a form of credit.

Lenders are facing challenges, having to change their strategies to address shortfalls in assessing affordability and getting comfortable with the dual concept of creditworthiness, which encompasses a firm’s willingness to lend and a customer’s ability to comfortably cover repayments. This can be a difficult ask, requiring subjective judgment especially when interpreting regulations such as the Financial Conduct Authority’s (FCA) new Consumer Duty.

The current environment is particularly hard, with rising interest rates and inflation adding strain to consumers, not just those who may be exhibiting varying characteristics of vulnerability.

The last few years have seen the FCA turn the spotlight onto the lending market through “Dear CEO” and portfolio letters. It is clear that the FCA expects firms to improve responsible lending standards, which is fundamental for firms to evidence good customer outcomes, which is a key tenet of the new Consumer Duty.

5 key thoughts on what good looks like

Jonathan Davidson, previously the Director of Supervision – Retail and Authorisation of the FCA, stated that “A firm whose business model is predicated in selling products to customers who can’t afford to repay them is not acceptable, nor is it a sustainable long-term strategy”. This statement remains pertinent now, particularly when considering the current economic environment and strains that businesses are facing. How, then, to avoid this risk?

1) Target the right market for your product

The regulator’s previous business plan (2021/22) stated that “consumers should be able to access affordable products and make informed decisions to meet their borrowing needs”. This is also a focus in the FCA’s current plan (2022/23) and should be considered at the forefront of every lending decision and be well embedded into the framework of any regulated lending strategy. This expectation from the FCA is that for lenders to provide good service and achieve good outcomes, they must first get the customer journey right and sharpen their view of a customer’s affordability.

With the introduction of the Consumer Duty, this element of the customer journey will be ever more important, as businesses will need to challenge themselves on whether the customer has been provided with sufficient information to understand the product available in order to make a well-informed decision. But also, the firm must identify if the right products are available for the target audience in order to demonstrate that a good outcome is reached for the customer based on their financial objectives.

2) Take greater responsibility for decisions

Know when to say yes before pressing lend. That also means knowing when to hold back from lending to someone who exhibits signs they may not be able to afford the repayments in the future, which might require asking challenging questions as part of the decision-making process. When thinking about this, reflect on the Consumer Duty requirements where the regulator highlights the need to be alert to foreseeable harm.

We’ve seen some lenders in the retail space start to incorporate this, such as changes in mortgage policy to tighten the lending criteria given inflationary pressures and the rising costs of living.

When considering the tools at your disposal to formulate a decision to lend, over-reliance can often be the root-cause for a firm adopting a false sense of security with its own processes. Credit Reference Agency (CRA) data is one of the most utilised pieces of information that is woven into the lending criteria but, looking at this in isolation or placing too much weight on this metric amongst other factors could become a driver of an irresponsible lending decision. Processes should be reviewed by firms including how all information at their disposal can be used to make the right lending decision.

3) Governance – know what is going on throughout the organisation

Governance is important to the proper management of risk. Key aspects of the governance structure should be clearly defined, for example:

• Responsibility for overseeing the affordability risk strategy and appetite;
• Accountability within roles; and
• Segregation of duties.

In addition to this, end-to-end oversight means having appropriate, accurate, and timely reporting. This allows the business to better understand its performance and where improvements may be needed to reflect current and future threats to good customer outcomes. Firms may face challenges with the following:

• First and second line controls testing, monitoring, and assurance;
• Defining Management Information (MI)/Key Performance Indicators (KPIs) for meaningful reporting;
• Reviewing and challenging the appropriateness of the affordability framework, including the use of automation in lending decisions; and
• Setting risk triggers/Key Risk Indicators (KRIs) that alert the firm on when to act and making appropriate changes based on these.

Where firms engage with intermediaries or other third-parties within the supply chain, they should have effective oversight of how they impact on the customer journey. Where these firms play an important role in distributing products and connecting consumers with the right service providers, effective oversight on these entities not only enables firms to monitor whether their customers are receiving sufficient support and information to achieve their financial objectives, but also enables firms to act at pace to respond to actions taken by other market participants. This includes taking action to notify the FCA where they become aware of another firm in the distribution chain that is not complying with FCA rules, such as those introduced recently in the Consumer Duty. Technology can also be used to increase the effectiveness and efficiency of this process, for example, Deloitte’s OneView Third Parties solution.

4) Internal infrastructure – build the foundations

Policies and procedures are key for all firms. They form the foundation of consistent risk-based frameworks within the first and second lines of defence. Firms can have challenges with:

• Key decisions and rationale of using certain assumptions (such as affordability assumptions from CRA data, Loan-to-Income (LTI) ratios, income-to-indebtedness ratios, expenditure allowance estimates for non-essential vs essential living costs, etc.);
• Clear interaction between policy documents (e.g., links between policies on affordability and vulnerable customers); and
• Defining end-to-end business processes and customer journeys.

Embedding risk-based policies and procedures throughout the organisation and regularly reviewing them to make sure they are up to date with the latest regulatory developments is key. Further, proactive assurance and testing to evidence that they are producing good customer outcomes and operating effectively have an important part to play.

5) Review and feedback. Would I take out a loan from me?

An essential part of any governance framework is for organisations to learn quickly from mistakes and update processes where relevant. This should include both internal (i.e., self-evaluation, root-cause analysis, lessons learned exercises) and external (i.e., customer) feedback.

To be able to do this, a business needs quality MI which accurately reflects the real-time lending decisions being made. In a period of high inflation and changing interest rates, poor decisions can be made, or harm can arise, when data becomes stale. MI should support management in identifying trends that require action, such as where complaints data (supported by arrears data) indicate that a customer is struggling to maintain repayments and the credit agreement may no longer be affordable. Such cases would require the firm to engage with the customer to re-evaluate their circumstances as necessary to avoid the risk of harm. In such cases, firms should remain mindful that the FCA may well request evidence of rationale for lending decisions, so it is important to keep clear records of this.

Consider as well that the Consumer Duty requires Boards to assess at least annually whether their processes drive good customer outcomes. In times of stress, be prepared to increase the cadence of such reviews.

In summary

Affordability risk is an important issue and, with the current socio-economic environment, it is important to act now so that:

• Affordability assessments are being appropriately and consistently undertaken;
• Customer needs and circumstances are taken into consideration including foreseeable changes to circumstances and vulnerability; and
• Lenders have appropriate oversight over dealers/brokers.

And remember: even affordable loans can become unaffordable, but businesses need to be alive to this risk by asking themselves where could a loan be foreseeably unaffordable?