Responsible Lending and Affordability

In our lending and affordability series we explore some of the key challenges for firms in getting this right – considering regulatory requirements and expectations, the customer perspective, testing and monitoring, and future development opportunities.

We all know that firms need to lend responsibly. But what does “responsible” actually mean, and why is it important?

Clearly, firms have a regulatory obligation to lend responsibly but for some there are business and ethical considerations to make as well. The approach that each individual business takes to responsible lending should be centred around putting the customer first, considering the specific needs of their particular customer base and target market, from point of sale through to the time when a customer exits the relationship.

Getting responsible lending right and establishing affordability is critical to demonstrating that you are a responsible lender and that you enable and support retail customers to pursue their financial objectives – to both the FCA and your customers. The ongoing impact of the rising cost of living on consumers and the FCA’s heightened expectations under the Consumer Duty mean there has never been a more important time to do so.

Lets not forget that lending responsibly has considerable downstream benefits, including reduced numbers of customers entering arrears, lower volumes of bad debt and recovery costs alongside the avoidance of regulatory sanction.

To lend responsibly firms need a responsible lending framework supported by a strong organisational culture.

What does good look like?

“We want firms to make a reasonable assessment, not just of whether the customer will repay, but also of their ability to repay affordably and without this significantly affecting their wider financial situation”

The foundations of responsible lending is a framework which:

• Considers both creditworthiness and affordability.
• Creditworthiness is only the likelihood of someone repaying based on analysis of a wider population and past trends (e.g. credit scores).
• Affordability looks at someone’s current, and to some extent future, financial position to make an informed decision about their ability to repay.
• Is proportionate to the risk of the customer as well as the firm. Most firms will need to establish some form of Net Disposable Income (NDI) - how much disposable income you expect the customer to have after paying priority bills and covering essential expenditure - to gain a view of a customer’s affordability. How detailed and exact this assessment is will depend on the risks of your product and customer base.
• For example, a firm offering point-of-sale credit to prime customers operates a largely automated process which involved asking all applicants for personal information and employment status. The firms checks the applicants credit score and indebtedness indicators, and models expected expenditure using ONS data. In cases where the firm feels it is obvious the credit will be affordable, no further checks are made (e.g. customer is in full-time, contracted employment, has perfect credit history, and low levels of indebtedness).
• The firm still need to be able demonstrate it was reasonable to assume affordability was obvious if challenged.
• Underpinned by clear rationale for checks and calculations undertaken and how they support the delivery of responsible lending
• Considers the needs of your customer and target market and how it supports them in achieving their financial objectives (whilst avoiding foreseeable harm)?

Affordability should not just be an additional process added to the sales journey – it must be reflective of the firm’s strategy, culture, and objectives and as such be subject to robust oversight. By regularly testing and monitoring the framework, firms will be able to demonstrate the delivery of good customer outcomes through the lending journey. An annual desktop review of the framework won’t be enough – firm’s should be testing the outcomes received by customers via customer outcomes testing on an ongoing basis, regularly monitoring key data points and metrics which indicate the framework is operating as expected, and validating that any models and assumptions remain true and operate as designed.

Information, particularly when provided by the customer, must be probed or validated. Firms should consider how best to use the right mix of customer declaration, external data, and internal customer data to form a view on a customer’s NDI.

The use of external data, such as credit bureau affordability data and ONS expenditure statistics, allows firms to automate processes but this can be problematic for some customers with non-conventional circumstances (e.g. rely on other people’s income, use multiple bank accounts).

Internal data, such as previous repayment history, lending history, indicators of vulnerability, and previous income and expenditure declarations, ought to be considered when assessing affordability.

Including assumptions around a customer’s potential future circumstances can help firms determine a more accurate view of their affordability in the long term. This does not have to be trying to understand every possible scenario that a customer could encounter, but it should be proportionate to your business.

Ultimately, firms must look to paint as complete a picture as possible of a customer’s financial situation from both a creditworthiness and affordability perspective.

KPMG in the UK has specialists with extensive experience with Responsible Lending frameworks and affordability assessments, ranging from supporting firms with design, development and implementation, all the way through to testing whether assessments perform as expected and are delivering good outcomes to customers. If you would like to hear from one of them or require specific support with Responsible Lending and/or BAU activities, please do not hesitate to get in touch.