Create responsible lending journeys

What is responsible lending?

Lenders are responsible for evaluating a customer’s creditworthiness before entering into a loan agreement. However, different circumstances demand a tailored approach to each customer.

The FCA has published rules and guidance on the activities that consumer credit lenders are expected to follow within the Consumer Credit sourcebook, CONC chapter 5 (CONC 5). There are three general concepts that form the core of its responsible lending guidelines – lending should be affordable, suitable and sustainable.

What is affordability, and how is it assessed?

CONC establishes that credit commitments must not “adversely impact the consumer’s financial situation” (CONC R5.2.1 (2)).  An affordable loan is one that can be repaid without undue difficulty, from a proportion of a customer’s disposable income. Credit providers must perform an affordability check to assess if the product is right for the customer. The complexity arises when establishing monthly income and expenditure.

Analysing income data

Monthly salaried workers typically have income that is consistent and predictable, but for others (e.g. self-employed, weekly paid, contract or gig workers) earnings vary. Each group needs to be assessed differently to properly deduct the consistency and reliability of their income.

Currently,  the most reliable method for gathering income data when performing an affordability check is to request a payslip or a bank statement. However, physical documentation presents a substantial operational and customer experience challenge as today customers are expecting an answer in minutes, and will materially impact application conversion.

The emergence of Open Banking offers a new and exciting opportunity to lenders.  Learn more about how it benefits lenders and customers here.

Analysing expenditure data

Lenders must also establish non-discretionary (essential) and discretionary expenditures.  It’s worth exploring if realistic reductions in discretionary spending could be made if necessary.  Expenditure can be assessed by asking a customer to complete an income and expenditure form. However, while thorough, this approach will increase friction in customer journeys, reducing conversion.

Alternatively, in lower-risk circumstances, expenditure can be roughly assessed by looking at the Office of National Statistics (ONS) data that shows the customer’s life circumstances (eg. marriage status, number of dependents, etc.).

Lenders should establish the right approach for each customer.

What is suitability, and how is it assessed?

Suitability assessment looks at whether the credit product is appropriate for the applicants’ specific needs and circumstances.  An area of very active focus by the FCA in the UK consumer credit market has been on the use of unstructured debt in circumstances where structured debt is the appropriate solution. 

Unstructured debt (overdrafts, credit cards, short term loans, lines of credit) allow customers quick and easy access to extra funds to manage income and expenditure fluctuations.  However, this is typically interest-only credit, or at least require low monthly capital repayments.  The lack of repayment plans creates significant risk of customers falling into cycles of perpetual debt.  None of these products should be used to fund larger or longer term credit needs.

What is sustainability, and how is it assessed?

Sustainability is an assessment of the risk that a customer’s credit commitment, while affordable today, will continue to be affordable.

While you cannot predict the future, you can consider the risk of a customer being unable to sustain long term repayments.  More unpredictable earnings increase the risk, as does elevated existing long-term credit commitments.

The consequences of any changes to a customer’s circumstances should also be considered – a default on a second charge mortgage would create a much more negative outcome than falling behind on an unsecured personal loan.

Sustaining repayments through additional borrowing is unacceptable and should be considered a primary indicator of vulnerability.

Sustainability risk is mitigated by reducing the proportion of monthly disposable income required to meet monthly commitments.  Reducing the amount by extending term needs to be done carefully.  Is the extended period of customer indebtedness in their best interests?

Ensure responsible lending by orchestrating personalised digital journeys.  Discover SaaS journey orchestration.

What systems does a lender need?

There are three essential enterprise systems that every lender needs:

Loan management system

As the heart of all consumer credit businesses, its purpose is to manage the lifecycle of the credit product, starting from loan funding to repayment collection.

These systems are complex, amortising and re-amortising customer credit balances, handling all the operational activities within a lender, meeting all regulatory requirements regarding the management of the customer debt, and accounting for funds.  What loan management systems do not is assess who to lend to.

Decision engine

Traditionally used to undertake classic credit risk assessments, they are effective at analytically predicting the probability of an outcome through modelling multiple quantitative inputs.   Decision engines and other statistical methods have a role to play in assessing customer circumstances.  However, to do so requires their deployment much wider than simply delivering a credit risk score.  It requires multiple models, each of which demands different data inputs.

So, decision engines quantify risk into a number.  Classically in credit risk, a cut off is established – a number below which credit is declined.  When it comes to customer assessments a more nuanced approach is needed. One that can use model outputs to drive continued engagement with the customer.

Customer onboarding

Historically, when credit risk has been a lender’s primary focus, the customer onboarding journey has been a single application process that every applicant follows.  As assessment requirements have grown, this ‘one size fits all’ approach has proven to be inadequate, and the binary world of the “good” applicant and the “bad” applicant has added another cohort, the “maybe” applicant – someone who passes credit rules but whose circumstances have not been sufficiently understood.

Introducing human assessment of the ”maybe” cohort increases cost and time, and reduces conversion.  Simply declining any “maybe” applicant can significantly reduce addressable markets.

Lenders’ technology architecture must support the customer assessment strategies that their product and market require, both today and to adapt to the ever-changing demands of the future.

Evidencing responsible lending

FCA’s Principle 2 (Skill, care and diligence) and Principle 3 (Management and control) are the founding principles of the UK financial regulatory regime.  In practical terms, they mean that lenders must have systems in place to ensure they understand what is happening in their business and continually monitor and adjust their decision making to improve customer outcomes.

Firms must be able to evidence that any given customer assessment was suitable and proportionate by keeping well-detailed records.  Recording the overall assessment strategy that was applied at the time would be insufficient.  The specific details of the assessment must also be available to evidence that the strategy was followed.

Do lenders also need to assess for vulnerability?

Lenders must assess customers for an elevated risk of vulnerability and evidence that it does not prevent lending responsibly by performing vulnerability checks.

Protecting vulnerable customers is a core ideology of the FCA.  FG21/1 “Guidance for firms on the fair treatment of vulnerable customers” outlines four types of vulnerability –

  • Financial resilience – How healthy are their financial circumstances and are they able to meet short term financial shocks?
  • Life events – Are life events such as redundancy, bereavement or divorce creating increased financial risk?
  • Health – Do health issues (e.g. illness, disability, visual impairment, addiction) create customer risk within the application process or the ongoing use of the credit product?
  • Capability – Does the customer understand what they are signing up for and how to use the product?

Lenders need to look at indicators of vulnerability – both behavioural and changing financial circumstances.  Open Banking can support this assessment.

Once an elevated vulnerability risk is identified, lenders must establish mitigation processes to reduce the risk materialising.  These processes will vary depending on the customer’s circumstances.

How we can help

To get responsible lending right, you need a deep understanding of your customers.  Lending journeys must be fast to adapt and be tailored to each customer, in a more granular way than ever before.

Orchestrating digital lending journeys with PrinSIX can transform your lending.

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Fast-track your knowledge of best practices in responsible lending

Book a call with PrinSIX CEO, Julian Graham-Rack to discuss how to overcome the challenges of lending. Previously the CEO of a UK lending provider, he is a recognised subject-matter expert on responsible lending practices.

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