Lending in the cost-of-living crisis: new thinking for affordability assessments

We all know that there’s a cost-of-living crisis. Beyond the worrying headlines, it’s now considered by many to be a short-lived economic recession. It’s vital for UK lenders to get to grips with the impact it’s having on their existing and new lending – and put in place strategies and processes to work with the most severely affected customers and businesses.

The priority for lenders is to understand current and future consumer affordability. It’s clear this is directly impacted by the current economic situation, so all lending decisions should be made with clarity of an individual’s unique financial situation – both now and in the future.

Let’s take a look at the biggest factors at play, what this means for making affordable lending decisions and what actions lenders should be taking now.

Inflation, government support and affordability

The typical measures of economic health, such as unemployment and GDP, don’t yet reflect the negative pressures being piled on UK consumers and businesses. This is because supply-side challenges and the Ukraine conflict have both caused record high inflation rates. Inflation is currently running at 9.4%¹, the highest level since 1982. This high rate is mainly fuelled by increased energy costs, which in turn mean higher transport and production costs across virtually all industries. Estimates in the media suggest the average household is now £44 per week worse off than 1 year ago² and it’s expected to get worse before it gets better.

The government has acted to support the most impacted segments of the UK population with a series of measures³: the energy bill rebate provides up to £550 per household, £650 cost-of-living payments for those on benefits, £300 pensioner cost-of-living payments, £150 disability cost-of-living payments, an increase in the national insurance contribution threshold to £12,570, a 5p cut in fuel duty and freezes on other duties. These measures will provide some help for consumers, but will it be enough?

Reliable data sources and affordability assessments

One concern with current models is that they use data and assumptions from a more stable economic period. It’s historical data with a varied lag period. Usually, the past is a good predictor of the future – until something unexpected comes along, as we’re seeing at the moment.

Affordability assessments that estimate consumer expenditure tend to be based on limited sources of data and rely mostly on survey data or sweeping assumptions. Collecting expenditure information directly from the consumer for unsecured lending is one way to go. Beyond that, the Living Costs and Food Survey (LCF)⁴ is typically used as a good basis to estimate essential expenditure. It’s not one-size-fits-all though, and there are multiple years of data and different types of data that may be used by each individual lender, resulting in different outcomes and decisions. The increased scrutiny that has come about because of the current economic climate means that lenders are starting to ask whether this data is sufficiently accurate. Does it reflect what their customers are experiencing in real life today and what they’re likely to experience in the future?

Let’s take an example from the most recent survey data available – the ‘Family Spending in the UK: April 2019 to March 2020’, published March 2021⁵. The average annual electricity and gas costs⁶ across all households was £1,196. This compares to a cheapest fixed rate tariff of £1,970 as at May 2022⁷. Ignoring differences in consumption and size of household, this equals an increased expenditure of £775 per annum or £65 per month. Of course, this is before any additional price cap increases that may come into force later in 2022.

Finding the right approach for sustainable, affordable lending

So, what’s the best way for lenders to account for changes in consumer expenditure when we’re making lending decisions? Can we see into the future when assessing income and expenditure? There are many different answers to these questions depending on your market, risk segment and perceived risk.

Consumer lending is a visibly and directly impacted area with relatively mature affordability assessments. So, it’s reasonable to think that lenders can take account of these changes and start using new expenditure assumptions and calculations when we make lending decisions. As a minimum, lenders will be adjusting their essential expenditure assumptions to take account of known energy price increases, food inflation and higher fuel costs. But this isn’t a one-off exercise. It’s also important to factor in regular reviews based on the latest available data and forecasts whenever we’re reviewing affordability strategies.

Some lenders may wish to undertake a complete review and overhaul of their approach with the following questions in mind:

1. Is the right data captured directly from the consumer?
2. Are we using the best and most accurate data available across both income and expenditure calculations?
3. Does our calculation take account of known or expected changes to a consumer’s income or expenditure?

This list is not exhaustive. The unprecedented level of market changes and increased consumer pressure means lenders must question their behaviours, actions and strategies if we want to maintain sustainable and affordable lending.

What’s the future for lending and how can Experian help?

The Financial Conduct Authority has already written to the chief executives of more than 3,500 firms to remind them of their regulatory obligations⁸, further reinforcing the need to act, with the predictions of a short-lived recession in the coming months.

Whether you’re using bureau-based solutions or have developed your own in-house models, our team of consultants can help you understand how Experian’s combination of economic expertise and depth of affordability solutions for consumer lending can help your business.

To speak with one of our consulting team, contact us.

Sources

[1] Consumer price inflation, UK: June 2022, Office for National Statistics
[2] Asda says some shoppers asking cashiers to stop at £30, BBC News
[3] Overall government support for the cost of living: factsheet, Gov.uk
[4] Living Costs and Food Survey, Office for National Statistics
[5] Living Costs and Food Survey: technical report data tables, Office for National Statistics
[6] Family spending workbook 1: detailed expenditure and trends (Table A6, 4.4), Office for National Statistics
[7] Retail price comparison by company and tariff type: Domestic (GB), Ofgem
[8] FCA tells lenders to support consumers struggling with the cost of living, Financial Conduct Authority