Introduction

The UK’s widely reported “cost-of-living" crisis is likely to provide further disruption in the retail lending market when firms are assessing affordability and supporting customers in financial difficulty. Whilst the full impact of COVID-19 to household income and affordability is masked in part by the impact of Government Support Schemes, the pandemic challenged long-held assumptions around household expenditure. With some expenditure such as transport and leisure dropping overnight, and surges in other things such as energy due to time spent indoors, the ability to rely on the habits of the past to predict the spending of the future was immediately disrupted.

From a Conduct Risk perspective, this backdrop, but also other events such as Brexit, rises to energy costs, national insurance, and council tax increases has generated a toxic mix of economic challenges which is placing pressure on individual consumer spending habits and affordability. The speed of change, and the range of factors mean that customers are facing financial pressure now, with more to come. Furthermore, the impact of this crisis will not hit all customers at the same time, and in the same way. There are a number of factors which may distort the ability of firms to predict how and when they may need to manage customers as a result of this. For example, in some cases, COVID increased household ability to save, therefore increasing the ability to cope with an expenditure shock in the short-term. In addition, whilst the cost of energy has increased overnight for some, some customers are still locked into long-term energy deals and therefore it is only as/when these deals end, that this picture may start to become clearer. We are also entering a period of lower energy usage and therefore costs due to seasonal usage may further mask the impact in the short to medium term.

Pressure on affordability can impact both the ability to lend to customers, but also the extent to which you may need to offer forbearance for those already struggling. Furthermore, it is almost certain to increase the number of customers that may fall into financial difficulty. The FCA has already outlined their concerns to the industry in a recent speech here.

This is an evolving and fluid situation in which both the industry and customers are still determining the full impact in the short, medium, and long term. As we look to understand this in more detail over the coming months, we have outlined below some no regret actions we believe firms can take right now to mitigate the risk of customer harm because of this ongoing pressure on affordability.

Customers Seeking to Borrow

Employment in the UK remains high; However, it is expected that wage increases will not keep pace with rising prices over the coming months and years. Whilst the increase in prices will be manageable for some, there will be an increased number of households, whose budgets have already been stretched, that are expected to struggle. With many economic forecasters expecting interest rates to reach 2% by the end of 2022, this is likely to create further pressure on longstanding borrowers who are used to, or have only known, an ultra-low interest rate environment. Given the reliance on data models to support affordability decisions, there is a risk that firm’s affordability processes do not react quickly enough to such “overnight” changes. The level of governance in place to review and update these models means firms cannot amend their lending criteria quickly enough to mitigate risk of harm to consumers.

No Regret Actions

  • Implement an approach to increase the number of marginal affordability cases which are referred for a manual underwrite to determine whether a future increase in the cost of essential goods and/or services would adversely impact on affordability.  
  • Determine whether there needs to be any manual adjustments applied to the existing expenditure models and assumptions as a tactical solution whilst the expenditure model is reviewed. For instance, applying an additional uplift to key areas of concern such as fuel and energy to reflect volatile market conditions, and potentially more blanket increases to other household expenditure to reflect the slower but increasing impact of inflation.
  • Provide additional training to underwriters to identify expenditure items that are considered below current average levels of expenditure and ensure they are challenging the customer position more closely.
  • Increase the level of Quality Assurance checking that is undertaken of lending applications where there are higher risk lending characteristics, and the household affordability could be impacted by more immediate challenges to cost-of-living.
  • Review current affordability models, including the use of ONS, open banking and behavioral data, to ensure that any potential price rises are accurate and representative of the cost of living within the UK for an average household based on their household composition and location.
  • With interest rates expected to continue rising, continue to regularly review the stressed interest rate methodology and ensure that this is sufficient to meet any future rise in interest rates.

Customers in Financial Difficulty

The cost-of-living crisis will undoubtedly see increased inflows into collections or pre-arrears teams. As we saw during COVID we expect that this will be across several different customer cohorts, including some who weathered the storm of COVID, but their savings are now depleted or are not necessarily over indebted. The expenditure pressures outlined above however means financial resilience is much lower and the ability to sustain payments (or clears arrears) is significantly reduced.

Whilst we typically see more robust assessments of affordability for new business, in collections and pre-arrears the situation is much more varied and will depend on whether the financial difficulties are short or long-term.

No Regret Actions

  • Firms should ensure that they do not have any policies or processes that prevent customers accessing support or forbearance when they are in pre-arrears, such as waiting for the customer to miss a payment before they will discuss options.
  • In establishing the impact of the cost-of-living crisis more direct questions should be posed to customers either through traditional telephony interactions as part of the Income and Expenditure assessment (I&E), but also included in self-service and digital journeys. These should look to establish whether the inflationary pressures are likely to lead to longer term affordability issues which may require the lending to be restructured or whether the issues are anticipated to be short-term and can be dealt with through appropriate forbearance. These include (but are not limited to):
  • Energy bills: Has your monthly payment recently increased? When does your current deal end?
  • Fuel costs: Does the fuel cost in the I&E (if applicable) represent your average costs based on current fuel prices? Have you had to modify your driving habits because of the price increases?
  • Childcare costs: have childcare costs increased as employees start to return to the office following the easing of COVID restrictions?
  • Day-to-day living: Are you reliant on your credit card(s), overdrafts, or other credit to pay for essentials like food?
  • Day-to-day living: Have you cut back on essentials or turned the heating off to reduce your household expenditure?
  • Borrowing: is your current mortgage on a fixed or variable rate?
  • Income: Are there likely to be any changes in your household income in the next three to six months?
  • Review your capacity planning. Conversations will need to be longer and more detailed to ensure the above items are considered thoroughly. This will impact your capacity to serve so make sure you have the resources available to allow you to do this. We expect that there will be an increased demand from both collections inflows but also customers wishing to engage at the pre-arrears stage who may require a more holistic conversation.
  • Furthermore, given requests for help may come from customers without experience of financial difficulties, they may not come through the traditional Bank contact channels, for example, debt charities. Consider how flexible your resource and communication models are to ensure there are no barriers to support, which may prevent a situation from worsening.
  • An additional challenge is that the fuel crisis is not the only headwind expected in 2022:
  • In April, Council Tax and National Insurance increased for most people, which may result in inflows from the start of April. Some customers may receive a £150 rebate to help with fuel costs and National Insurance will reduce for some people in July, but this may only serve to delay inflow and not all households will receive this;
  • The next Bank of England Base Rate announcement is expected in May. Should it align to increase predictions, customers on a variable rate product may start to move into financial difficulties if the increase is beyond their affordability. Similar behaviors can be expected in Q3 and Q4 in line with subsequent announcements; and
  • In October, the energy price cap is expected to rise further, hitting customers when their energy usage will be at its highest.
  • Consider if models or analytics can be used to identify at-risk customers and use that to drive proactive contact strategies to reach out to customers most likely to be impacted by the cost-of-living crisis.
  • Consider if your approach to fees and/or breathing space may need to be adjusted to provide adequate forbearance to those hit hardest.
  • Consider if your collections toolkit has the right range of forbearance options to deal with these customers and is administered with the right level of flexibility.

Conclusion

The last two years have meant that firms have needed to adapt and flex to respond to fast-moving global, economic, social, and political changes, this situation is no different. We know that the data available from the last two years is unlikely to be a strong predictor of the future. Therefore, firms will need to act now to be more tactical in how they empower colleagues to assess affordability or support customers in financial difficulties.