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The Doubly-Excluded: consumer credit regulation in the UK

Following the financial crisis of 2007-09, mainstream banks in the UK withdrew from the riskiest segment of the consumer lending market, in part because of pressure from the regulatory authorities to reduce the risk profile of their asset book. The supply of prime credit was reduced. Meanwhile demand for sub-prime credit grew significantly, both because the number of those excluded has risen and because slow wage growth and reductions in welfare benefits increased the credit needs of those who were already excluded (Consumer Finance Association, 2015).

New supply of sub-prime credit was provided by a range of lenders, including pawnbrokers, high-street and online payday lenders (sometimes known as High-Cost Short-Term (HCST) credit providers), home credit providers; and, to a lesser extent, by community finance institutions and credit unions.

Stories of predatory lending practices, illustrated by examples of vulnerable individuals over-burdened with debt repayments, became regular features in the UK media. A campaign against payday lenders gained momentum, with support from high profile politicians, church leaders and community groups. The providers of HCST credit were vilified - sometimes with justification - but the reasons for the growth in demand for credit were not seriously examined.

In response, the Office for Fair Trading (OFT) was asked to report on the way in which consumer credit was regulated, which it did in December 2012 (Office of Fair Trading, 2012). In January 2013 the Public Accounts Committee (PAC) of the House of Commons discussed the OFT report. The government had already decided to move the regulation of consumer credit to the newly established Financial Conduct Authority (FCA). The question that was posed by the PAC, and others, was whether this was sufficient; or whether additional regulation should be introduced in the UK. The government, in response, commissioned some academic research.

The research was duly published (Personal Finance Research Centre, University of Bristol, 2013) and the government responded, saying that it would clamp down on irresponsible practices, especially advertising, and work with industry bodies to improve compliance with voluntary codes of practice. In addition the government gave the FCA the power to impose a cap on the cost of credit in the future, if they deemed it appropriate (Department for Business Innovation and Skills, 2013).

The campaign against payday lenders intensified until, in November 2013, the government changed course, announcing that it would legislate to force the FCA to exercise its power to impose a cap on the cost of credit. The FCA took over responsibility for consumer credit in April 2014 and in July issued a Consultation Paper, setting out its proposal to impose a cap, which was implemented in January 2015 (Financial Conduct Authority, 2014). In addition the FCA introduced a new regulatory regime for all providers of HCST credit.

The price cap has three elements:
- an initial cost cap of 0.8% per day
- a 15 cap on default fees
- a total cost cap of 100%
It follows that in future borrowers must never pay more in interest charges and fees than they initially borrowed. The price cap covers HCST credit providers, but excludes credit agreements secured by a mortgage, charge or pledge (including pawn-brokers and car log-book loans), home credit loan agreements, and loans provided by community finance companies.

While community finance lenders were excluded from the rules on the interest rate cap, they were included in the new, wide-ranging regulatory regime. This has created enormous cost pressures for the community finance sector. It is not so much the rules themselves, many of which are unarguable, but the time and cost required to create systems that demonstrate compliance. It is not doing the right thing that is difficult, but collecting evidence that the right thing has been done.

In a recent report on the global micro-finance sector, the Centre for the Study of Financial Innovation noted that Regulatory Risk ("the risk that microfinance services will not develop because of a lack of appropriate prudential supervision and regulation") was ranked the 5th highest risk by investors, but among regulators themselves it was ranked a lowly 18th (Centre for the Study of Financial Innovation, 2014). This discrepancy reminds us that while investors and practitioners find regulation burdensome and expensive, regulators see themselves as a force for good.

For as long as there has been a market for sub-prime consumer lending there has been debate about how best to provide appropriate protections for borrowers without driving lenders out of the market place altogether. In 1938, Rolf Nugent of the Russell Sage Foundation, wrote that the two important questions to ask about any form of cap on the cost of credit are these:

"Are the marginal borrowers who would be eliminated from loan service by a lower maximum rate better or worse off by virtue of their inability to borrow? Can the state enforce its desire to prevent these marginal applicants from borrowing, or will they merely be compelled to pay the higher charges demanded in an illegal market?" (Nugent, 1938, p. 210).

The two questions remain highly pertinent to the UK today.

The FCA's self-assessment of the likely consequences of its new regime was that:

most of the lenders are only marginally profitable and the price cap will force them out of the market. The three largest lenders, who account for 72% of the market by revenue, are all profitable and will remain so once the price cap is in place.
those consumers who are still eligible for high cost credit will get cheaper loans, but around 11% of consumers will no longer be able to get loans. These people (around 160,000) will, the FCA claims, be better off for not taking out loans and are unlikely to seek loans from illegal lenders; (Financial Conduct Authority, 2014)

We do not yet have sufficient evidence to say whether these predictions will turn out to be true. The prediction of market consolidation seems credible, whereas the prediction of better outcomes for consumers seems much less persuasive.

It is clear than many smaller lenders are leaving the market and that the supply of capital to the HCST market is declining. The Consumer Finance Association estimates that between 2013 and 2015 lending fell by 70% with around 80% of loan applications now rejected. The number of HCST providers has fallen from around 240 to between 30 and 40 (Consumer Finance Association, 2015). We have not yet reached the endgame that the FCA predicted, with only three online and one high street lenders remaining, but we are heading in that direction.

The new regulatory framework has led to a further segmentation of the consumer credit market in the UK with the sub-prime sector now divided into two groups: near-prime, who remain profitable for the HCST lenders, and true sub-prime, who do not. To avoid media criticism and regulatory pressure around the treatment of customers, the HCST credit providers who remain in the market are now focussed on borrowers with better credit scores. By doing so they are able to avoid the reputational problems of dealing with the most vulnerable customers, while maintaining their margins by lending to those with relatively strong credit histories.

One new entrant to the home-credit lending market (which is not covered by the price cap) circulated an investor presentation in July 2015, which estimated that the market for sub-prime credit in the UK has grown to around 12 million adults (i.e. almost a quarter of the adult population). This reflects the retreat of the mainstream lenders from "risky" consumer lending. By pushing up the prices of its un-capped products - those which are excluded from the new regulatory regime - this company anticipates rapid growth in its lending book and its market share, and is forecasting returns on equity of around 20% - 30%.

A report by BIS from 2010 estimated that the number of people in the UK using illegal lenders was 310,000 (up from 165,000 in 2006), which represented 3% of households in the lowest income quartile and 6% of residents from the most deprived housing estates. The report argued that illegal lending thrives in a credit vacuum and was unlikely to go away, given the strength of demand. The size of the illegal market was estimated to be around 700m per annum (Department for Business Innovation & Skills, 2010). By comparison, total consumer credit in the UK is around 170bn, of which the HCST credit market accounts for around 5bn. Lending by credit unions is only 650m and lending by community finance institutions around 50m (Alexander, et al., 2015).

The market opportunity for community finance lenders is growing and changing. Those who are "doubly excluded" tend to be those with the worst credit histories and those whose ability to pay back a loan is hardest to ascertain. These are often the most vulnerable borrowers, for which reason they are also the most expensive customers to serve well. It seems doubtful that these "doubly excluded" - those who are now denied access to credit both by the mainstream lenders and by the sub-prime lenders - will be better off in a world with a smaller supply of legal credit, whose providers are now moving towards the safer ground of prime and near-prime lending. Community finance companies certainly provide a better option, but there are few of them and their capacity to grow is constrained, both by lack of capital and by the need to divert more and more resources towards regulatory compliance.

It should come as no surprise that tough new regulation has led to:

1. market concentration, as the costs of entry to the existing market-place for new players is raised;
2. product innovation, which allows new entrants to capture market-share by introducing new products that side-step regulation; and
3. higher costs for lenders, which are passed on to borrowers either in the form of higher prices or through poor customer service.

This was not the intention of those who campaigned for greater regulation of the HCST market; nevertheless, this is what they have achieved.

There is wisdom in the old English saying that "the road to hell is paved with good intentions".


Alexander, N., White, D. & Murphy, T., 2015. Meeting the Need for Affordable Credit, Dunfermline: Carnegie UK Trust.

Centre for the Study of Financial Innovation, 2014. Microfinance Banana Skins, 2014, London: CSFI.

Consumer Finance Association, 2015. Credit 2.0 A commentary on borrowing and spending in the 21st century, London: Consumer Finance Association.

Department for Business Innovation & Skills, 2010. Interim Evaluation of the National Illegal Money Lending Projects - Summary, London: Policis.

Department for Business Innovation and Skills, 2013. Government Response to the Bristol University Report on High Cost Credit, London: Department for Business Innovation and Skills.

Financial Conduct Authority, 2014. Proposals for a price cap on high-cost short-term credit, London: Financial Conduct Authority.

Nugent, R., 1938. The Changing Philosophy of Small Loan Regulation. Annals of the American Academy of Political and Social Science, Volume 196, pp. 205-210.

Office of Fair Trading, 2012. Regulating Consumer Credit, London: National Audit Office.

Personal Finance Research Centre, University of Bristol, 2013. The impact on business and consumers of a cap on the total cost of credit, London: Department for Business Innovation and Skills.

© Mark Hannam January 2015