HLP Compliance Blog

What & Why? Financial Distress

HLP Compliance Blog, Gavin Earnshaw

Predicting ‘Financial Distress’ is like anything in life; predictions are sometimes right, often wrong and can come from flawed assumptions or data. But such a prediction is something that the Financial Conduct Authority (FCA) has been mulling over recently, and the results give an insight into their thinking.

Debt plays a crucial role; be it to allow people to manage temporary cash-flow shortfalls (think short-term insurance contracts, such as house insurance) to spreading the cost of large purchases, such as property. Many people manage their debt adequately, making repayment a priority and meeting their obligation as agreed.

But for some the story is different. Their debt becomes associated with financial distress.

So, what is financial distress? What proportion of people with debt experience this financial distress and what are their socio-economic characteristics? If we can answer these questions we can go some way to prevent such distress in the first place.

This is the question the regulator has pondered recently and the findings are interesting.

They say that, while firms cannot predict which exact individual will suffer financial distress in the future, the research shows it appears possible to consider, on average, whether cohorts of individuals with a set of characteristics are especially vulnerable to future financial distress, and therefore whether lending to them may be predictably unaffordable and harmful.

They found that the ratio of consumer credit debt relative to income, known as the debt to income (DTI) ratio, has a strong relationship with financial distress. People with higher debt relative to income experience greater financial distress. A person’s current DTI ratio is a strong predictor of whether individuals are likely to experience financial distress approximately two years in the future. 10% of people with the highest DTI ratios are much more likely to suffer financial distress in the future than those with lower DTI ratios.

All this suggests that the regulator thinks that affordability assessments, taking into account existing debts, is the way for lenders to manage customer loans. The MMR brought such assessment into the mortgage market and will continue to hold back lending to some individuals. It remains to see how this will manifest itself in terms of financial distress. The true effect will be seen when interest rates rise. Apparently we are still some time away from this, so only time will tell.

This focus by the regulator shows a forward thinking approach. Not always popular and often maligned for their intervention, but if these rules can prevent your customers from suffering financial distress then that will create a happier customer base. Multiply that effect across the industry and we may well prevent the level of financial shock that we saw 8 years ago.

So next time you consider an affordability assessment that appears frustratingly limiting you could consider this point. Acting in the customers best interest can sometimes mean delivering bad news. Better a reality check now than serious financial problems in the future.

You can read the FCA’s findings in full in Occasional Paper Number 20: Can we predict which consumer credit users will suffer financial distress? here.

Read more:

Compliance Q & A, 8th September, 2016.

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