The question of how to provide reliable, affordable short-term credit for citizens and communities with low incomes and poor credit scores has long been a difficult and complex public policy issue. There are real moral dilemmas about who should be able to borrow money and how this access should be provided. The routes through which many low income people currently borrow money are far from optimal. Their small-scale, short-term, immediate borrowing needs are often met by a highly commercial high-cost credit provider – such as payday lending – as they unable to access cheaper, mainstream financial products. Advertising and asymmetric information also play key roles.

Payday lending The changes the FCA has introduced since taking control of the regulatory regime have had a major impact on the payday lending industry. Indeed, the industry today is markedly different from the headline grabbing one of two years ago. A number of lenders already exited the market in 2014 - estimates suggest 25-30% of providers, and more continue to do so, opting not to apply for full FCA authorization. To-date, around 50 firms have received full FCA authorization to offer high-cost short-term credit (compared to 240 firms operating two years ago), among which are the larger ones, such as Wonga, Sunny and Quick Quid who have the means to adapt to the new reality. The other major adjustment is on product offering. Very few firms are now offering single payment loans, as they are largely unprofitable under the new pricing regime. Instead, larger instalment loans spanning a number of months are under offer. Guarantor loans, where family and friends guarantee the loan are another growth area. They generally offer a lower interest rate than payday loans as the perceived risk on default is less.

Many of the new firms and new products are building on the innovation brought to the market by the likes of Wonga. One such new entrant is Provident Financial Group’s Satsuma. Launched in 2013, self-branded as “best in class” on price (costing £40/£100 borrowed compared to Quick Quid £72), loan amount (up to £1000), flexible repayment terms (monthly and weekly), and no hidden costs (such as missed payment fees). Like the majority of online lenders, Satsuma is targeted at younger borrowers, in full-time employment who need short term loans to manage their lives and afford discretionary purchases. In this way it complements the Provi’s more traditional face-to-face doorstep loan (the loan that comes to you), serving the less credit worthy customer. Provident has also launched a pilot guarantor loan product, offering larger sums of money over a longer period to borrowers whose own credit record is wobbly, but where a friend or relative provides a backup guarantee on repayments. Another new entrant to the online short term credit market is Uberima. Uberima offers interest-charge only loans, i.e. no other charges, of up to £1000, with flexible repayment terms. Uberima loans undercut Wonga by around 25% on cost.

According to the Consumer Finance Association (CFA), one of the main trade associations for online short term credit lenders, at the end of 2015 approximately 80% of loan applications are being rejected and lending volumes are down by 70%. This largely reflects tighter affordability checks such that only those with good credit records are granted loans. For those who are denied a loan, a CFA/YouGov poll found more than a quarter said they failed to pay some form of bill or credit repayment, a tenth used an unauthorised overdraft at a bank, and others delayed the planned purchase. A small percentage said they had borrowed from an unlicensed lender, and a very small percentage (2%) turned to a credit union. According to some observers (Policis, CFA) there is a real danger that some new on-line market entrants will be operating illegally outside UK regulation. Their view is that many customers are unlikely to check the legitimacy of a lenders licence and they will not know who they are dealing with. This is the contemporary version of the loan shark, and draws on experience in the USA where there has been a rise of illegal activity in those states with the most restrictive regulation. Monitoring the activity of illegal lenders is a new challenge, and calls for action by government, the regulators and the justice sector.

Loan sharks, of the traditional sort, are still active in the UK. According to the illegal money lending team (England), around 300,000 households borrow from illegal lenders. There is no typical profile of a borrower, but they are generally located in low income neighbourhoods, have bank accounts (95%) and a high level of debt (owing on credit cards, council tax, door-step loans, utility bills, previous overpayment of benefits, rent-to-own, payday loans, rent and phone bills). As such, they have few alternative sources of credit when money is needed for everyday expenses such as food and clothing. Loan sharks are generally known to family and friends, and are regarded as part of the community. The impact of involvement with a loan shark can go well beyond financial extortion to physical and mental distress, at its most acute leading to suicide. Immigrant populations are particularly vulnerable to loan sharks as they have yet to establish residence and other requirements, necessary to interact with the formal credit sector.

Credit Unions have long been viewed as one of the most effective ways to provide basic financial services to un/under-served populations, both promoting saving and offering affordable credit. In Scotland, an Affordable Credit Working Group which brought together a wide range of stakeholders with the view to improving access to fair, affordable short-term credit in Scotland recently came to the same conclusion. The Working Group published “Gateway to Affordable Credit” in the spring 2016, stating that “we believe that the solutions to widening the availability of affordable credit lie in growing our credit union and CDFI sectors”. The report goes on to say “Scotland is ideally placed to lead the UK in identifying and testing solutions to deliver more affordable credit on a viable basis, at scale.” Similarly, this was the proposition of the Archbishop of Canterbury three years ago when he spoke out against Wonga and the payday lending industry. Out complete the bad with good. One thing the Archbishop has appreciated is the slow gestation inherent in growing the credit union/community finance sector as a serious alternative, often saying that ten years will be needed. This would seem to be a realistic time frame, given the significant challenges facing the sector: vision, leadership, fragmentation (small autonomous entities, non-collaborative trade bodies), capital, technology, product and service innovation, capacity and skills. Progress in the past two years is nonetheless quite  promising with the DWP financed (plus Barclays and Lloyds) credit unions expansion project beginning to deliver much needed infrastructure support to participating credit unions. In addition to this there is considerable innovation elsewhere in the credit union sector, and a sub-set of credit unions are on a trajectory to become full service, modern financial institutions. This is good news for both current and future users of credit unions. But there are points of concern. The customer base that will benefit from credit union expansion and modernization. Indeed, it is unclear whether the offering will attract the largely financially excluded, or – more likely - those in employment and with a stable financial profile who prefer credit unions over mainstream banks for ethical reasons. For sure, the credit unions themselves need this customer base to be financially sustainable and to be relevant in the 21st century.

At the local level, there are a number of good initiatives such as Sheffield Money, the city’s new one-stop shop which provides joined up money and debt advice together with access to loans (from credit unions and CDFIs), credit for white goods, and savings and bank accounts from the “better” banks. Birmingham’s Fair Money works along similar lines as an on-line multi-agency service. London Capital, Leeds and Pollock Credit Unions all offer payday like short term loans, and Street UK and Northern Money provide sizeable lending services in the Midlands and the north respectively. Lendlocal is a peer-to-peer platform connecting people with spare cash to people who need a loan, brokering the money through credit unions and CDFIs.  Fair for You, a competitor to Brighthouse, offers more reasonable finance for household goods via an on-line platform (see below).

Other areas where there are exciting developments are with credit scores and price comparison sites. On the former, Pariti provides on-line tools, guidance and access to low cost loans, and offers  a different approach to credit assessment, building on positive debt reduction steps. Price comparison websites, purpose built for customers of short-term credit and with poor credit scores are beginning to emerge in response to the CMA recommendation (e.g. FairMoney.com). A particularly interesting development is the use of metrics other than APR to compare the cost of borrowing short term.

But this is not to suggest all is well. New market entrants (such as Fair For You) are finding that credit rating companies often misrepresent the credit histories of many people, typically those with complex histories. Inconsistent reporting, mislabelling defaults where debts have been settled, and duplication of debt from the same source are a sample of the errors that are recorded.  

Rent-to-Own. Like most forms of high cost borrowing in the UK, the Rent to Own (RTO) sector has experienced huge growth following the onset of the recession, establishing itself as ever present on the high streets of our more deprived towns, cities and communities. It enables over 400,000 households, almost exclusively with low incomes and reliant to some degree on benefits, to take out expensive credit to spread the cost of purchasing consumer goods from furniture and large household items (cookers and washing machines) to electrical items (such as TVs and computers). It has proven to be recession proof, more than doubling in size over the last five years since the onset of the economic crisis. The market is dominated by three just providers, with BrightHouse, by far the most well recognised and largest firm. The business model relies upon costly hire purchase arrangements whereby the customer has a credit agreement but does not actually own the goods outright until the last payment. Therefore, in addition to the huge cost of purchasing the products, falling behind with RTO repayment means customers face losing goods, which can put undue pressure to prioritise such payments. A number of other unfair practices have also been highlighted - all shown to compound the debt trap for many low income families.

By way of offering an alternative a number of social businesses (such as Fair for You) have been launched, trying to address some of these consumer detriment issues. These assemble a range of local stakeholders together with suppliers of household goods and affordable credit lines, combining some of the more positive characteristics of the RTO model that appeal to consumers but delivered in a way that designs out some of the more harmful aspects. By doing so, these alternatives are able to generate significant cost savings for low income customers and thus help to avoid paying a poverty premium for their essential goods. It is early days for these alternatives and they face a number of big challenges to reach scale and make a tangible impact.

Government policy and regulation (Q13)

Regulation, done well, can protect consumers and make markets work for consumers. Recent changes to consumer credit regulation are a good example. The responsibility for regulating the consumer credit sector was transferred to the FCA in 2014. This heralded a major change from the light touch used by the OFT. The FCA has a different approach and philosophy to the OFT and is more willing to intervene in markets (for now). The FCA’s authorisation process is much tougher than the OFT’s licensing approach. There are now meaningful conduct of business rules which determine how firms should behave and treat consumers. The FCA has much greater resources to scrutinise the business models of firms much more intensively during authorisation, undertake more intensive supervision of firms, and enforce against breaches of regulation.

The introduction of a tough charge cap on payday lending was a landmark decision for contemporary regulation. In addition to providing additional consumer protection by constraining unscrupulous lenders to target vulnerable consumers, it allows non-profit lenders such as credit unions to compete more fairly against aggressive payday lenders. Historically, non-profits have been crowded out of the market by payday lenders who could deploy huge marketing and advertising budgets - generated from exploitative business models. Capping the charges on payday loans should constrain the ability of payday lenders to win and maintain market shares so clearing space for alternative lenders. 

But whilst we have seen real progress in the payday lending market, major problems remain in the wider consumer credit market, harming consumers and acting as barriers to non-profit lenders who want to offer consumers a fairer deal. For example, the credit card and overdraft markets are not working for financially vulnerable households. Millions of vulnerable credit card borrowers face an uphill struggle trying to manage over-indebtedness. Consumers in the high risk credit card market are at risk of unfair practices and high charges from four providers who dominate this market. High unauthorised overdraft charges continue to harm vulnerable consumers struggling to make ends meet. Unfortunately, the CMA recently decided not to recommend a regulated charge cap on overdraft charges leaving consumers vulnerable.

A recent report on the rent-to-own (RTO) sector[2] shows the huge consumer detriment in the RTO market with consumers paying a high cost to own basic consumer goods. Such issues have placed the industry firmly under the spotlight of policy makers and the regulator. Falling under the Financial Conduct Authority since 2014, a process of authorization is ongoing, paying particular attention to affordability assessments, arrears handling and forbearance, and price transparency. The ‘big three’ have all been given authorization. The only substantial new requirement is the appointment of an independent ‘Skilled Person’, effectively a self-policing provision. Compared to the treatment of the payday lending industry, this is a very mild regulatory stance. However, the FCA did impose a redress scheme in March 2016, against Buy As You View, requiring close to £1 million payment to 59,000 customers for arrears payments.

We believe that the FCA should apply tougher regulatory interventions to stamp out unfair charges and practices in credit card and overdraft markets, and to apply the same approach adopted for the payday lending market to the RTO sector. But we need to be realistic. The CMA’s weak conclusions may hinder the ability of the FCA to apply tough regulatory interventions such as capping unfair charges in the credit card and unauthorised overdraft markets[3].

What does this all mean for non-profit lenders such as credit unions? The clampdown on payday lending has created a real opportunity for non-profit lenders to offer the short-term, convenient credit consumer something they need and want. But there is concern about the regulatory framework in which credit unions operate. As a small part of the financial services landscape, their treatment is a delicate balance of fair attention to consumer protection and over regulation. Although sector-specific regulation was introduced in 1979 it was only the 2011 Legislative Reform Order that gave credit unions the scope to widen activities, allowing them to liberalise the common bond, enrol community groups and businesses as members, to pay interest on savings (as well as a dividend), and to charge for a limited range of additional services. However, the cap on interest rates remains, now sitting at 3%/month. In 2014, regulation of credit unions moved to the FCA and the PRA. The FCA is still finding its way with credit union regulation, and guidance around (customer) affordability and vulnerability is proving challenging for some new market entrants/potential innovators, who find the FCA over protective and imposing considerable costs on their businesses. 

Fintech (Q14)

FinTech developments have the potential to significantly improve the financial health of lower income households. For example, the use of technology to deliver automated lending online has enabled credit unions to better meet customers’ increasingly high expectations and compete more effectively with the competition. It has streamlined procedures that make it far simpler for the member but that also reduce both the time taken for a decisions from days (or in some cases weeks) to hours and the unit costs of administering a loan through operational efficiencies. As a result it has helped attract new and more diverse members that are younger and often with higher household incomes, expand lending portfolios both in terms of new loan products and lending levels but also enabling more informed decisions that has reduced bad debts. 

However, a number of barriers remain to be addressed if this potential is to be realized. Barriers fall into three groups[4]:

Regulatory barriers: with high levels of public concern about the practices of payday and other lending targeted to low income groups, regulators are understandably subjecting new business models to greater scrutiny and have established tougher rules for financial services providers in the sector. However, there is also a need to ensure that regulation does not stifle innovation which is of benefit to consumers. There is a need for regulators to be pro-active by providing safe harbours or regulatory sandboxes to allow innovators to experiment. There is also a need to encourage the development of common infrastructure for the community finance sector, enabling the pooling of liquidity, and provide access to the payments system.

Financial barriers. The UK has a sophisticated investment environment with a wide variety of possible funding sources. However, there is frustration that when it comes to developing products and services targeted on the needs of lower income households, much of the investment is short-term and subject to changing priorities. The case for blended finance can be made to help ‘lubricate’ the sector, and the recently created Access Foundation is an important initiative.

Organisational barriers. While non-profits and community finance organizations have in-depth knowledge of low-income households, FinTech firms have the technical expertise. There is a natural partnering arrangement to be sought here, although differing cultures needs to be overcome.