Banks lend people money they can’t afford to pay back because it’s profitable.
That needs to change.
There is a growing level of concern that people are taking on too much debt. Bank chiefs have called growing credit card debt a ‘ticking time bomb’, the Times’ splashed on potential mis-selling of car finance, and the Bank of England and Financial Conduct Authority have raised concerns that households are borrowing too much.
That concern has been prompted by sustained high levels of borrowing. As today’s figures from the Bank of England show, consumer borrowing, while slowing slightly in March, continues to grow at over 10% year on year. Total borrowing now stands at £197.4 billion the highest level since 2008.
Annual growth rate of household debt
Often overlooked is that, on aggregate, that growth is not necessarily a problem. In the UK people have around £190 billion worth of consumer credit but £700 billion in savings accounts alone. Together we are well in the black. The problem is the distribution of that debt — some people have debt they can’t afford.
At Citizens Advice we see the impact of that every day. Last year we helped more than 350,000 people manage debts they couldn’t afford. Including helping people with 141,000 credit card issues, 116,00 with personal loan issues, and 51,000 with overdrafts issues.
The FCA’s concerned that the high growth of debt will mean more people struggling to pay back their debts. The Bank of England’s concerns, while less related to the personal impact of that debt, are still linked to its distribution. Primarily they are concerned that if too many people can’t afford to pay back their debts it will pose a risk to the stability of financial institutions.
But why do people take on unaffordable debts?
Traditionally, when we look at who has unmanageable debt, we think about the circumstances of the borrowers — why did they borrow that money? But we also need to ask why banks lend it. At a simple level there is a good incentive for banks to make sure they only lend people money they can afford to pay back — if they don’t the bank makes a loss.
The reality is more complex, recent research by the Financial Conduct Authority, in their investigation of the credit card market, and by the Competition and Markets Authority, in their investigation of the personal current account market, show that customers in financial difficulty are as, if not more, profitable than those who stay on top of their debts.
The credit card market
In the credit card market, the FCA found that more than 5.5 million people were in problem debt in 2014. More than 2 million people were in arrears, and 3.7 million were either in persistent debt or making ‘systematic minimum repayments’.
Particularly striking was the number of people who were in problem debt for three or more years. Looking only at the people who remained in the same type of problem debt, they found that 1.7 million people had been struggling with their credit card debt between 2012 and 2014.
The FCA’s findings highlight two problems. First that large numbers of people are taking on unaffordable credit card debt. And second, that lenders aren’t doing enough to help people manage that debt when they get into financial difficulty. The chart below, which is from the same research, shows why.
People in problem debt, other than those in severe arrears, where they are likely to default on their debt, are very profitable. The return on lending, across both high risk (red) and low risk (orange) customer groups is roughly the same for customers in problem debt and not in problem debt.
Return on lending by customer group in the credit card market
The current account market
The CMA found a similar situation in their investigation of the current account market. Roughly 45% of active current accounts used an overdraft in 2014 and around a quarter used an unarranged overdraft. In total people paid £1.7 billion in arranged overdraft charges and £1.2 billion in unarranged overdraft charges.
Consumers who use an overdraft pay a high price for their debt. In 2014, there were over 500,000 instances where customers paid more than £100 in unarranged overdraft charges in a month, and over a million instances where customers paid more than £75.
Like credit card debt, large numbers of people have persistent overdraft debt. In 2014 16% of overdraft users were in their overdraft for more than 8 days a month on average, 12% were in it for more than 15 days.
For banks, there is little incentive to help those customers manage their debt. As shown in the chart below, taken from the CMA’s market study, heavy overdraft users are the most profitable customer group — with the exception of the 9% of accounts with very high balances. Someone in their overdraft for 15 days a month on average is worth £40 a month to banks.
Average revenue per account by customer account useage
So what can be done?
The normal response to unaffordable lending is to create rules against it. The FCA are planning to publish a piece of work on how creditworthiness is assessed over the summer which will likely focus at how well affordability rules in the UK work.
That approach is most clearly seen in the mortgage market where, for instance, only 15% of customers are allowed to borrow more than 4.5 times their income.
The approach for unsecured lending is currently less clear cut. While lenders do have to make sure someone can afford their debt, there are not hard and fast rules for how they do that.
Clear rules on affordable lending are important. But, given that consumers with unaffordable debts are very profitable, controlling that lending is likely to be challenging. A more effective approach would be to incentivise banks to lend more affordably.
A step in the right direction?
The FCA’s recent recommendation for the credit card market, that people should be offered an affordable mechanism to repay their debt after they have been in problem debt for three years, could be a step in the right direction.
However, for the remedy to work it has to do two things. First it must mean there is an additional incentive on lenders to get their initial lending decision right. Second, it needs to incentivise lenders to help people pay back their debt before they are required to offer them forbearance.
Specifically, any losses a lender suffers from providing an affordable repayment mechanism need to outweigh the gains made from a customer who remains in financial difficulty over a long period of time. If it doesn’t, high levels of unaffordable borrowing will continue.
Too often it is the behaviour of borrowers that gets criticised when thinking about problem debt. But, as noted by Martin Wolf, the Financial Times’s chief economics commentator, ‘Excess borrowing by fools would have been impossible without excess lending by fools: creditors and debtors are joined at the hip.’
Currently when banks lend people money they can’t afford, they are simply responding to incentives.
Those incentives need to change.
