Assessing creditworthiness in consumer credit: FCA publishes final rules and guidance

13th August 2018

The results of a large-scale survey by the Financial Conduct Authority (FCA) in 2017 indicated, among other things, that: 75% of UK adults had one or more consumer credit products or loans in the previous 12 months; 4.1 million people were “in difficulty” because they had already failed to pay domestic bills or meet credit commitments in three or more of the previous six months; and 50% of UK consumers showed one or more characteristics of potential vulnerability [1].

Against that backdrop, and the FCA’s wider scrutiny of the consumer credit sector, the FCA consulted in the second half of 2017 on proposed changes to its rules and guidance on assessing creditworthiness in consumer credit, with a clear focus on affordability. Final rules and guidance were published on 31 July 2018 [2] and come into force on 1 November 2018. Consumer finance specialist Jeanette Burgess considers the changes and what they mean for lenders.

Background

The FCA indicated back in 2015 that it would be looking at affordability more closely. Its 2017 consultation followed a survey of the practices of 70 firms across 12 credit sectors [3], which concluded that most firms considered they were compliant in assessing affordability but would welcome greater clarity of the FCA’s expectations. The consultation was published in response to evidence both of under-compliance with the rules but also of firms having procedures which might be unnecessarily costly or restrictive – both possibly due to misunderstandings.

The new rules and guidance do not represent a fundamental change of approach. The key changes seek to clarify the existing rules and guidance in the Consumer Credit Sourcebook (CONC) on responsible lending and post contractual requirements. While the FCA acknowledges that creditworthiness assessments are not an exact science, it expects firms to have effective processes in place aimed at eliminating lending that is foreseeably unaffordable. It wants firms to make a “reasonable assessment, not just of whether the customer will repay, but also of their ability to repay affordably and without this significantly affecting their wider financial situation”. At the same time, it wants to “avoid being too prescriptive, as this could have harmful unintended consequences, including for the cost and availability of credit. We want firms to take a proportionate approach, taking into account the costs and risks of the credit for the individual consumer”.

So, what does this mean in practice, and how have the FCA’s proposals changed following the consultation?

Implementation date

The FCA originally proposed transitional provisions allowing firms to make assessments under existing CONC rules where an application process had started when the new rules came into force, provided the process was completed within one month. Industry respondents expressed concerns about the proposals and considered that a longer period would be appropriate due to the technical changes needed. As a result, the FCA decided to delay implementation until 1 November 2018, with no need for transitional arrangements.

The basic requirement

CONC 5.2A outlines the basic requirement. As under the existing rules, firms must make a reasonable assessment of creditworthiness before entering into a regulated credit agreement or significantly increasing the amount of credit or the credit limit. The rules do not prescribe exactly when an increase is significant, but clarify that a number of separate increases, which may be insignificant individually, could amount to a significant increase, triggering a further creditworthiness assessment. The assessment must be based on sufficient information which the firm is aware of at the time of the assessment and which has been obtained, where appropriate, from the customer, and where necessary from a credit reference agency (CRA). The information must enable the firm to carry out a reasonable assessment (more on this below…).

In a change from the original proposals, the new rules make it explicit that a firm must not proceed unless it has carried out a creditworthiness assessment in accordance with the rules and had proper regard to it in respect of affordability.

Distinguishing between ‘credit risk’ and ‘affordability risk’

The FCA expects firms to consider more than just the credit risk to themselves when assessing creditworthiness. The new rules clarify that creditworthiness includes both credit risk to the lender and affordability risk to the borrower. A loan might be profitable for the lender, but is it affordable for the borrower? Firms are free to use a variety of methods and processes to assess credit risk and affordability – manual, automatic or both.

In relation to credit risk, the proposed draft rules referred to the risk that the customer would not make “one or more repayments” under the agreement by the due date. Some respondents were concerned at the implication that credit risk should be assessed by reference to missing a single repayment. The FCA says that this was a misunderstanding of its proposals, and the reference was to cover the situation where credit may be repaid by a single bullet payment rather than instalments. It has removed the reference to “one or more”, and added new guidance to clarify that there may be circumstances in which the risk that one repayment will be missed or will be late is relevant to the creditworthiness assessment. It accepts that this will not always be the case. The FCA has also clarified that “repayments” do not include an option-to-purchase fee under a hire-purchase agreement and, while the final rules now refer explicitly to ‘credit risk’ as an element of creditworthiness, the FCA says that it did not want to fetter how firms assess that risk.

There is a new definition of ‘affordability risk’ – the risk to the customer of not being able to make repayments under the agreement in accordance with CONC 5.2A.12R. When considering affordability risk, firms must not take into account the existence of, or the intention to provide or request the provision of, any guarantee, indemnity, or other form of security. If the customer intends to repay wholly or partly from savings or assets, the firm must take into account the purpose the customer holds them for, if they will be available to pay the debt and what impact this will have.

In relation to CONC 5.2A.12R, the FCA originally proposed that repayments should be out of the customer’s own income, unless they clearly intended to repay using savings or other assets. Many respondents to the consultation raised significant concerns that this could increase financial exclusion and, as a major departure from current industry practice, could have a significant impact on firms’ processes (with the associated cost implications). Recognising these concerns, and acknowledging that its proposals could have impacted negatively on certain groups, the FCA rowed back from its original draft. The new rules provide that firms will be able to take account of other income, including from other household members, where they reasonably expect this to be available to the borrower for repayment of the credit. The FCA expects firms relying on this provision to be able to demonstrate, if challenged, that it was reasonable for them to expect that the income would be available to make the repayments. Where another person’s income is taken into account in the assessment, account should also be taken of that person’s non-discretionary expenditure (more on this below…).

The roles of income…

The new rules and guidance also shed some light on an issue which has caused lenders a few headaches – how far they are expected to go in identifying and verifying income and expenditure.

There is no requirement to determine/estimate income where the firm can demonstrate that the loan is obviously affordable, or where the customer has indicated clearly an intention to repay wholly using savings or other assets. This is unlikely to apply in most cases. The burden will be on the firm to demonstrate, if challenged, that the absence of a material affordability risk was obvious.

The requirement is for a firm to take reasonable steps to determine the amount, or make a reasonable estimate, of the customer’s current income, and to take it into account.

Where it is reasonably foreseeable that there is likely to be a reduction in the customer’s income during the term of the agreement (or during the likely duration of the credit where the agreement is open-ended), which could have a material impact on affordability risk, the firm must take reasonable steps to estimate the amount of the reduction, and take it into account. A firm can only take into account an expected future increase where it reasonably believes on the basis of appropriate evidence that the increase is likely to happen during the term of the agreement (or during the likely duration of the credit where the agreement is open-ended).

An estimate of the customer’s income may include a minimum amount or range, provided that any assumptions on which the estimate is based are reasonable in the circumstances. In an addition to the original proposals, the new guidance specifies that income can include income other than salary and wages.

It is important to note that it is not generally sufficient to rely solely on a statement of current income from the customer without independent evidence, for example information supplied by a CRA or third party documentation supplied by the third party or the customer. The original proposals referred simply to a “statement of income”, but the FCA has amended this to “statement of current income” to provide further clarity.

…and expenditure

Income and expenditure are inextricably linked, and so if a firm is required to assess income, it must do the same for non-discretionary expenditure unless, again, it is obvious that it is unlikely to have a material impact on affordability risk.

The guidance specifies that non-discretionary expenditure includes payments needed to meet priority debts and other essential living expenses and other expenditure which it is hard to reduce to give a basic quality of life, and payments the customer has a contractual or statutory obligation to make (for example, under a mortgage contract or credit agreement). The FCA recognises that some obligations may be shared with another person, or arrangements may have been made for their payment (for example, through a debt management plan). In an addition to the original proposals, the new guidance now provides for both scenarios to be taken into account as appropriate.

Where it is reasonably foreseeable that there is likely to be an increase in the customer’s non-discretionary expenditure during the term of the agreement (or during the likely duration of the credit where the agreement is open-ended), which could have a material impact on affordability risk, the firm must take reasonable steps to estimate the amount of the increase, and take it into account. A firm can only take into account an expected future decrease where it reasonably believes on the basis of appropriate evidence that the decrease is likely to happen during the term of the agreement (or during the likely duration of the credit where the agreement is open-ended).

An estimate of the non-discretionary expenditure may include a maximum amount or range, provided that any assumptions on which the estimate is based are reasonable in the circumstances.

When determining/estimating non-discretionary expenditure, a firm may take into account statistical data unless it knows or has reasonable cause to suspect that the expenditure is significantly higher than that described in the data, or that the data is unlikely to be reasonably representative of the customer’s situation.

An analysis of the size of the customer’s debts compared to income may form part of a creditworthiness assessment where it is proportionate to the individual circumstances of the case, having regard to the factors listed in CONC 5.2A.20R, which takes us on to proportionality.

Proportionality and an outcomes-based approach

The FCA’s approach is to set high-level principles where firms should use their judgement to determine what is appropriate in the circumstances, having regard to the nature of their products and customers and the costs and risks involved. CONC 5.2A.20R provides that the extent and scope of the creditworthiness assessment, and the steps that the firm must take to satisfy the requirement that the assessment is a reasonable one, based on sufficient information, are dependent upon, and proportionate to, the individual circumstances of the case.

CONC 5.2A.20R to CONC 5.2A.25G set out rules and guidance in relation to the factors that should be taken into account in an individual case when deciding how much information is sufficient for the purposes of the assessment, what information is appropriate and proportionate to obtain and access, and whether and how the accuracy of the information should be verified. The rules include a list of factors to which firms must have regard when deciding what steps are needed to make the creditworthiness assessment a reasonable one. Having listened to the concerns raised by some industry respondents about the factors determining proportionality, the FCA has clarified that they may pull in different directions and it is for firms to assess how they apply in their own case. It has also clarified that firms may, where appropriate, have regard to the intended purpose of the credit.

Firms should have regard to information which they are aware of at the time the assessment is carried out that may indicate that the customer is in, has recently experienced, or is likely to experience, financial difficulties, or is particularly vulnerable. The reference “is likely to experience” did not feature in the original proposals but has since been added by the FCA. Firms may have regard, where appropriate, to information obtained in the course of previous dealings (although it should be considered that the information might be outdated and require updating).

The volume and content of the information that must be taken into account, and the steps that must be taken (if any) to evaluate that information and confirm its validity, will depend on the level of affordability risk arising out of the agreement. Factors affecting the level of risk (no longer referred to in the guidance as “key” factors) include the actual or potential cost of the credit and the total amount payable in absolute terms and relative to the customer’s financial circumstances, where known. In reality, this means that sub-prime lenders are likely to be required to go much further than prime lenders, for smaller sum loans, possibly leading to a point where it becomes uneconomic to provide loans to sub-prime customers.

Chapter 3 of the Policy Statement accompanying the final rules and guidance addresses some common misconceptions and provides a range of examples to illustrate how proportionality may affect a firm’s policies and procedures for assessing creditworthiness, including affordability.

Specific rules for certain types of lending

Specific rules and guidance apply in relation to certain types of lending, including open-end and running-account credit, guarantor loans and peer-to-peer lending.

In relation to running-account credit, the lender must assume that the customer draws down the entire credit limit at the earliest opportunity and repays by equal instalments within a reasonable period. The final guidance clarifies that while firms should, in considering what a reasonable period is, have regard to the typical period of repayment of a fixed-sum loan for an equivalent credit amount, the FCA is not mandating this as the basis used. It says that it is open to firms to make alternative assumptions regarding the length of the period of repayment, where these are reasonable in the circumstances. The FCA has also acknowledged concerns expressed by many industry respondents that requiring assumptions about likely further drawdowns and repayments would create unnecessary complexity and deliver little benefit. The new rules now provide that if, after considering the individual circumstances of the particular customer of which the firm is aware at the time the creditworthiness assessment is carried out, it is reasonable to make further assumptions about the timing and amounts of drawdowns of credit and repayments over the duration or likely duration of the credit, then the firm must do so and the assumptions must be reasonable ones.

In relation to guarantor loans, in addition to assessing the borrower’s creditworthiness, firms are required to consider the potential for the commitments in respect of the credit agreement to have a significant adverse effect on the guarantor’s financial situation. Lenders do not have to undertake an identical assessment for the guarantor as for the borrower, but must undertake a reasonable assessment, based on information obtained from the borrower, the guarantor and, where necessary, a CRA.

Focus on policies and procedures

CONC 5.2A.33R prescribes the requirements in relation to firms’ policies and procedures for creditworthiness assessments. Among other things, they must: establish, implement and maintain clear and effective policies and procedures which enable them to carry out assessments and which set out the principal factors they will take into account when carrying them out; set out the policies and procedures in writing and have them approved by the governing body or senior personnel; access and periodically review the effectiveness of their policies and procedures and the firm’s compliance with both them and its obligations under CONC 5.2A; take appropriate measures to address any deficiencies; and maintain a record of each transaction to demonstrate compliance. Firms are not required to keep a record where an application is declined, but may wish to do so to evaluate the effectiveness of their policies and procedures. Firms using automated processes are expected to have appropriate policies and procedures in place to ensure they can adequately manage any associated risks. The same applies if the firm relies to a significant extent on data or information from CRAs or third parties [4].

WM Comment

The new rules and guidance are to be broadly welcomed. The FCA has listened to industry concerns, in particular regarding implementation, proportionality, and the ability to take household income into account. The result provides lenders with a framework and greater clarity around what is expected of them, while calls from some consumer organisations for more prescription have been resisted, leaving lenders with the flexibility and discretion to decide what is appropriate in any given case, which is a positive step. The new rules do not represent a significant departure from current practice.

It is essential that lenders consider and adhere to the requirements in relation to policies and procedures. In light of the FCA’s outcomes-based approach, the ability to provide a sound audit trail will be key.

Lenders should focus on an holistic approach tailored to their products and customer base but which considers each customer’s financial situation individually. For high-cost-short-term credit, sub-prime and vulnerable customers this will inevitably involve a degree of manual assessment. While the concept of affordability is not new, lenders to these markets may see more potential customers failing creditworthiness assessments as a result of the increased focus on affordability risk.

If you require assistance in relation to any of the issues discussed in this briefing, including reviewing and updating existing policies and procedures ahead of 1 November 2018, please do not hesitate to contact Jeanette, who will be very happy to help.

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[1] Understanding the financial lives of UK adults: Findings from the FCA’s Financial Lives Survey 2017
[2] Assessing creditworthiness in consumer credit – Feedback on CP17/27 and final rules and guidance
[3] Assessing creditworthiness in consumer credit – Summary of research findings July 2017
[4] As part of its consultation, the FCA asked for respondents’ views on issues around the use of credit information including the role played by CRAs in the provision of data, products and other analytics to inform lenders’ creditworthiness assessments. It will use the responses to plan the scope of its credit information market study in early 2019.