Comments from ACCA to the Financial Conduct Authority (FCA)
August 2014
The ACCA recommended the imposition of a price cap in the HCSTC market in its response to the FCA’s December 2013 consultation on the regulation of consumer credit and wholeheartedly supports the Treasury’s decision to confer a duty to cap prices in this market on the FCA.
We believe the general approach taken by the FCA in developing its proposals for the price cap is sound. The quality and extent of the analysis undertaken is impressive and is clearly the result of much hard work and careful thought. The FCA’s existing proposals for a 0.8% per day Initial Cost Cap (ICC), 100% Total Cost Cap (TCC), £15 default fee cap and interest accrued post default at 0.8% per day, however, are too high. We believe there is considerable scope to lower the price cap, reduce the percentage relating to the TCC and to lower the default fee cap. This will be of greater benefit to consumers while still allowing firms to operate profitably.
The consultation paper appears to suggest there is an unavoidable tension between two of the FCA’s strategic objectives:
We do not accept that these two objectives conflict. The competition objective clearly states that competition should be promoted only if it is ‘effective...in the interests of consumers’.
In the HCSTC market competition has not worked in the interests of consumers because, at the moment, the market is highly concentrated and because consumers are not sensitive to price. There are currently no plans to change the level of market concentration despite the fact this is partly due to a prior decision to allow the takeover of one large player by another (OFT 2011). There are plans to improve price competition by implementing the Competition and Markets Authority’s (CMA) recommendations (for example, the introduction of a price comparison website).
It is not clear that competition will work well for consumers in the HCSTC market even when the CMA’s recommendations are fully implemented. The potential for businesses to finance each other and for unaffordable loans to create demand for further loans (ACCA 2014) imply that lending businesses may grow symbiotically rather than competing with each other. Further, there is little evidence that competition alone is capable of producing good outcomes in credit markets (Perkins 2013), particularly for the near- and sub-prime borrowers who typically use HCSTC (Federal Reserve 2007). The FCA’s existing proposals represent a compromise between the need to protect consumers and the desire to minimise the number of firms exiting the market. We believe the compromise is too heavily skewed towards mitigating the risk of firm exit.
We recommend that the FCA amend its proposals to a 0.6% per day ICC, 75% TCC, £5 default fee cap and a cap on interest accrued post default of 0.03% per day – in line with lenders’ average cost of capital of 10% per annum calculated by the FCA (FCA 2014b, p 92). We also ask the FCA to conduct a full and thorough review of the entire market when it reviews the impact of the rate cap in January 2017. As there is currently no group of consumers who clearly benefit from the use of HCSTC we believe the FCA should be open to the possibility that, should the price cap prove ineffective in protecting consumers, the most appropriate course of action may be a complete ban on these types of products.
We support a lower cap for six main reasons:
1. Further reducing access to HCSTC will be of more benefit to consumers
We agree with the FCA that the price cap will improve outcomes for borrowers in two ways: by tightening underwriting criteria, i.e. discouraging lenders from lending to borrowers of low creditworthiness and by reducing the cost of loans for those borrowers who continue to receive them. We examine the impact of lowering the cap from 0.8% per day to 0.6% per day on both groups in turn.
Previous research into the costs and benefits of access to HCSTC has been inconclusive, with equal numbers of studies concluding borrowers are better off both with and without such products. The FCA’s analysis is a much needed addition to existing literature and shows,
“4.30 ...there is clear evidence that HCSTC use causes harm to borrowers who just qualify for HCSTC loans (i.e. have relatively low credit scores).” (FCA 2014a)
and that,
“4.32 The analysis suggests that the harmful effects of HCSTC are lower for borrowers with a better credit score, but they do not disappear.” (FCA 2014a)
Further the FCA found,
“HCSTC loan denial does not cause use (of) illegal lenders. Of 2,000 consumers sampled in the consumer survey, less than 2% stated they borrow from an illegal lending (sic). Comparison of those narrowly successful and narrowly unsuccessful in their HCSTC application shows that those narrowly unsuccessful are slightly more likely to consider borrowing from an unlicensed lender, but this difference is not statistically significant.” (FCA 2014b, p 161)
Borrowers of all levels of creditworthiness experience negative effects following the use of HCSTC in its current form and lack of access to HCSTC does not appear to increase the likelihood of recourse to illegal lending. Perhaps surprisingly, the FCA found that even borrowers with relatively high credit scores experienced negative effects from HCSTC use. At present no group of borrowers is clearly benefitting from access to HCTSC, therefore, there is no reason to favour any particular underwriting cut-off (i.e. level of cap) over another. A lower cap increases the benefit to consumers.
Table 1 offers a comparison of the FCA’s estimates of the static impact of setting the ICC at different levels (holding the TCC and default fee caps constant at 100% and £15 respectively). An ICC of 0.8% implies 11% of borrowers who currently access HCSTC will no longer be served while an ICC of 0.6% increases this proportion to 19%.
Table 1 – Static impact of ICCs at different levels
ICC Level (100% TCC, £15 default) |
Unique Individuals NOT served (000s) |
% No longer accessing HCSTC |
0.40% |
851 |
39.69% |
0.50% |
600 |
27.99% |
0.60% |
404 |
18.84% |
0.70% |
310 |
14.46% |
0.80% |
231 |
10.77% |
0.90% |
185 |
8.63% |
1.00% |
129 |
6.02% |
Baseline |
2144 |
|
Source: FCA2014b, Table 9, p 69 |
|
|
It is important to note that these are static impacts – they do not take into account the dynamic responses of firms which we believe will be considerable – therefore the numbers of borrowers excluded are almost certainly overstated.
The characteristics of the additional borrowers excluded at 0.6% are also important. Figure 1 shows that according to the FCA’s analysis, the probability of default for first time borrowers excluded by moving the ICC from 0.8% to 0.7% is 31% and for those excluded by moving the ICC from 0.7% to 0.6% it is 27%. These are high levels of default but we believe the level of default on first time loans associated with an ICC of 0.6% fits better with the requirement that lenders conduct robust affordability assessments (discussed in more detail below).
2. The effect on repeat borrowers of a lower ICC
As things stand, HCSTC loans have negative effects on all who use them. The negative effects are smaller for borrowers with higher credit scores. However, it is hoped that prices can be reduced to the point at which these negative effects will be outweighed by the short term benefits of access to credit. This is by no means a certainty; prices will still be very high following the imposition of the cap. A 0.6% cap makes it more likely that HCSTC will be of benefit to borrowers than a 0.8% cap.
In fact, many longer loans are currently generating less than 0.8% revenue per day in the absence of a rate cap, the FCA found,
“5.14 The current median revenue per day per loan for the 11 firms in our modelling sample is...0.6% for loans longer than 60 days.” (FCA 2014a)
Using the information in Figure 3.1 of the FCA’s consultation paper we estimate that 20% of loans are longer than 60 days, for the borrowers taking these loans a 0.8% cap would be largely irrelevant. For the 31% of loans which are 32 days or longer we estimate that the median revenue per day is also below 0.8% (FCA 2014a, Figure 3.1, p 16). Only a lower price cap has the potential to improve the position of these borrowers.
The ICC specifically should be as low as possible. Regardless of how products are advertised or intended to be used HCSTC borrowers tend to end up borrowing frequently and being indebted for long periods of time. Existing business models are reliant on repeat lending for their profitability and borrowers are now taking an average of 6 loans per year (FCA 2014a) up from 3.5 in 2010 (Burton, 2010). Repeat borrowers are at most risk of detriment and most in need of protection. The TCC only applies to the initial loan and subsequent rollovers. The FCA will monitor levels of repeat borrowing but currently has no plans for hard limits on the number of loans borrowers can take per year. This means a borrower using a line of credit or repeatedly refinancing with short breaks between loans could face a very high TCC without technically hitting either the 100% TCC cap currently being proposed or the 75% TCC cap we are advocating.
A borrower who takes 11 x £260, 30 day loans with a 3 to 4 day break between each loan, for example, will pay £686.40 in interest or 264% without breeching the 100% TCC cap. This example is equally representative of a borrower using a line of credit who makes 11 distinct ‘draws’ in a year. Under a 0.6% ICC this scenario would result in the borrower paying £514.80 or 198%, still a large sum but a saving of £171.60 or 66% compared to a 0.8% cap.
3. The FCA’s analysis overstates the long term viability of the high-street HCSTC market
The use of existing business models as a baseline presents a problem: there are two markets, high-street and online, for HCSTC in the UK with firms operating in these different markets employing significantly different business models with a different cost base. One of the principal purposes of the price cap is to allow lenders to cover essential operating costs but to discourage lenders from lending to borrowers of low creditworthiness by reducing the amount of revenue available to cover losses due to defaults. However, the essential operating costs faced by high-street lenders are significantly higher than those faced by online lenders. The application of the same price cap to both markets, therefore, subjects high-street lenders to a more stringent underwriting constraint than that faced by online lenders. A uniform price cap also means high-street firms are more likely to be unable to cover costs and exit the market than their online counterparts.
In order to equalise the amount of underwriting risk high-street and online lenders will be permitted to take and to minimise the risk of firm exit from the high-street market it would be necessary to implement two price caps, a lower one in the online market and a higher one in the high-street market. However, we agree with the FCA that having different price caps in the high-street and online would create opportunities for ‘gaming’ the cap and is a highly undesirable scenario (FCA 2014a, p 37).
The FCA’s existing proposals for a 0.8% per day Initial Cost Cap (ICC), 100% Total Cost Cap (TCC), £15 default fee cap and interest accrued post default at 0.8% per day represent a compromise designed to accommodate both the online and high-street markets. We believe the compromise is too heavily skewed towards accommodation of the high cost base associated with high-street lenders’ existing, unprofitable business models.
In attempting to compare hypothetical future HCSTC markets with and without the rate cap it is important to consider the possibility that high-street providers may no longer be able to operate even in the absence of a rate cap. These lenders are currently generating an average 0% (CMA 2014) or negative (FCA 2014a) return on their HCSTC operations. The imposition of a price cap within the range of levels under consideration will certainly not improve profitability. If the ‘writing is on the wall’ for the high street business model the rate cap could arguably be set at a level which precludes the provision of HCSTC through this channel without being judged to have impeded competition.
We believe that, even in the absence of a cap, high-street profitability will continue to decline and that there is a very real possibility that many or even all firms will exit the high-street market in the near term for the following reasons.
First, as regulatory scrutiny has increased and limits on rollovers and the requirement to assess affordability have been enforced a number of firms have exited the market. Most notable among these is Cheque Centres which was previously the second largest player; other recent exits include Albemarle and Bond and The Cash Store.
Second, the withdrawal of the cheque guarantee card led to a large jump in interest rates on the high-street from £12-£18 (Burton, 2010) to £25-£30 per £100 borrowed for a month. Combined with high-street lenders’ high cost base higher default losses have made HCSTC provision unprofitable for some firms (for example, H&T) resulting in their exit from the market.
“The withdrawal of the cheque guarantee card has seriously affected lenders’ ability to manage risk. Although some long‐established customers can still borrow against cheques with only bank statements to back them up, lenders have had to find other methods for new customers.” (University of Bristol 2013)
Third, the online market is growing rapidly and increasing numbers of high-street borrowers are crossing over to the online channel. The FCA’s data show that,
“...for those consumers whose first use of HCSTC was through a high‑street lender in Q1 2012, 24% subsequently use an online provider.” (FCA 2014a, p 38)
This contrasts with the Office of Fair Trading’s findings in 2011 that there was almost no cross-over between the two markets (OFT 2011). As increasing numbers of high-street borrowers switch to online borrowing this may present an ‘adverse selection’ problem for high-street lenders in the future as higher credit quality borrowers are more likely to be digitally included. The creditworthiness of the pool of high-street borrowers may well fall to a level where no lender can operate profitably.
If this does happen then high-street borrowers will still lose access to HCSTC but online borrowers will have been needlessly exposed to the higher costs and greater detriment associated with a higher cap. In trying to understand the relative importance of the risks to these two groups it is important to consider the numbers of borrowers involved. According to the CMA, 83% of borrowers have taken out a loan online compared with 29% on the high-street and 12% who have used both channels. This equates to around 1.1-1.2m people who borrow either just online or both online and in the high-street each year and between 220,000 and 250,000 who borrow exclusively in the high-street (based on FCA estimates of 1.46m (pre-cap) and 1.3m (post-cap) borrowers accessing HCSTC each year).
4. The FCA’s analysis overstates the risk of firm exit from the online market
The FCA’s static analysis of the risk of firm exit is very conservative and does not allow for the dynamic responses of firms to the price cap. The online HCSTC market is very concentrated partly because regulatory uncertainty over the past two years has discouraged new entrants to the market. There may be some ‘pent-up’ supply i.e. firms that will look to enter once the regulatory landscape is more certain. Large US firms such as World Acceptance Corporation and ACE Cash Express would appear to be well placed to enter the market if opportunities exist once the regulatory landscape is more certain (Wonga.com 2013). There are significant efforts being made to improve the delivery of HCSTC alternatives through workplace lending spearheaded by the Chartered Institute of Payroll Professionals (CIPP). It should be noted that as 60% of private sector employees work for SMEs many people are at significant risk of falling outside the scope of these kinds of schemes.
Firms themselves are confident they can adapt their business models to the new cap both by increasing revenues to the maximum allowable under the cap and by cutting costs (see, for example, Cash America, 2014, p 7). On the revenue side it is important to note that online instalment and longer term products, those greater than 60 days in duration, are already being provided with median revenue per day of 0.6% (FCA 2014a).
On the cost side, we believe advertising, marketing and acquisition costs will be reduced. These costs currently make up an average of around 19% of total costs for the online firms surveyed by the FCA. We question whether this level of spending does anything to increase consumer welfare and therefore whether such a high level of spending should be included in baseline considerations for a price cap. A recent survey conducted by Stepchange found that 32% of people contacting the charity for help were being ‘bombarded’ with marketing calls by payday loan companies, receiving an average of 10 such calls per week (Stepchange 2014). Making these calls costs money and results in little benefit for consumers.
Revenue per borrower (who continues to be served) per year is forecast by the FCA to fall by around 35% as a result of the price cap. Lead purchase costs and marketing spend are directly influenced by the revenue increases they can be expected to generate (see, for example, theories of Return on Marketing Investment and Customer Acquisition Cost/Customer Lifetime Value) it seems reasonable to suppose that, all else being equal, a 35% drop in average revenue will result in a 35% drop in advertising, marketing and acquisition spending.
We believe there will be further downward pressure on this category of costs for the following reasons. First, the exit of a number of firms from the online market in response to the price cap will increase the supply of leads and put further downward pressure on lead costs. Second, advertising and marketing spend is likely to be further reduced by legislation as a result of Lord Mitchell’s bill to restrict television advertisements for payday loans.
Product life cycle factors may also lead to a natural reduction in the level of advertising and marketing spend and in default costs as the payday loan market is maturing. This is evidenced by the increased reliance on repeat customers who are typically cheaper to serve.
5. Using a 0.6% cap to enforce Affordability Assessments
A 0.6% cap goes further in terms of codifying the Affordability Assessment which is an important consideration if competition is to be fostered. Leaving the Affordability Assessment as the subject of ‘numerous meetings’ or the requiring the employment of a ‘Skilled Person’ favours large firms who are better able to afford such measures and discourages smaller and more innovative firms. Lowering the cap brings the level of underwriting risk firms will be able to take more closely into line with the requirements of the Affordability Assessment. It also improves the affordability of loans by making them cheaper. A lower cap would give firms greater certainty that compliance with the price cap is likely to be synonymous with the FCA’s expectations regarding Affordability Assessments.
6. Default fees, interest accrued post default and the TCC
We believe the default fee cap should be set as low as possible. The FCA’s analysis shows that default fees make a very small contribution to total revenue, restricting them therefore has little impact on supply and competition (see, for example, FCA 2014b Figure 18, p 56, reproduced in Figure 2 below. Percentage reduction in revenue plotted against different levels of ICC is almost identical for different levels of default fee cap, indicating that the level of default fees themselves have little impact on revenue.) However, the impact on individual borrowers can be significant; default fees increase the risk of the cross subsidisation of strategic defaulters, who do not pay them, by ‘good’ borrowers, who do pay them.
We believe default fees should reflect the cost of collections activity rather than acting as a mechanism through which the default costs of poor underwriting decisions can be clawed back. The FCA has calculated the average cost of collections to be around 2% of all costs for online firms and even lower for high-street firms (see FCA 2014b, Figure 13, p 37 and Figure 14, p 38).
Interest accrued post default should also reflect the true cost of the debt remaining outstanding for longer than anticipated. We believe the appropriate benchmark for this is lenders’ cost of capital (calculated by the CMA and FCA as around 10% p.a.) rather than the original high rate specified in the HCSTC contract.
We also favour a 75% TCC over a 100% TCC as this reduction does not have a dramatic impact on the risk of firm exit, according to the FCA,
“5.55 We modelled the impact of a range a range of total cost caps on firms’ revenues, profits, number of borrowers served and value of loans. Our modelling suggests limited changes to the risk of exit between 75%, 100% and 200% caps, but a total cost cap of 50% would significantly increase the risk of large firms exiting. Taking into account a margin of error, 75% appears too close to levels at which more large firms could exit, which could significantly reduce access.” (FCA 2014a, p 41)
As discussed above, we believe the risk of firm exit is overstated and that a lower TCC serves to reduce the negative consequences of prolonged indebtedness and interest accrued post default. This is particularly important measure if distressed borrowers, with large and multiple loans, are to be protected.
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Wonga.com (2013), ‘Response of Wonga Group Limited to the Competition Commission’s Statement of Issues of 14 August 2013’, 23 September, accessed 21 August 2014.