In December 2018, the Financial Conduct Authority (FCA) published its final consultation on the high cost of credit in the Overdraft market – CP18/42. This follows on from a series of reforms within the lending industry aimed at protecting consumers, and in particular those in financial difficulty, from disproportionate credit charges. In this blog, Nevan explores the significance of these reforms from three perspectives: regulatory, business and reputation.
What are the proposed reforms within the Overdraft industry?
The FCA want firms to address the high level of fees and the complexity inherent within overdraft products. They are proposing a ban to all fixed fees for overdrafts (other than ‘refused payment fees’) and adopt rules to ensure that the difference in pricing between arranged and unarranged overdrafts is not excessive with any differences aligned to the cost of service. To facilitate better comparison of overdraft lending to other forms of credit the policy demands simple, single interest rates expressed as an APR.
Furthermore, the FCA want firms to do more to identify overdraft customers who are showing signs of financial difficulty, and to put processes in place to help them to reduce overdraft usage. Included in these reforms is a series of recommendations on how to address the low level of awareness and engagement on the cost of borrowing via overdraft facilities.
How significant are the changes?
The regulatory intervention was described by the FCA as its biggest in the sector for a generation. The FCA chief executive, Andrew Bailey, said: “These changes would provide greater protection for the millions of people who use an overdraft, particularly the most vulnerable. It is clear to us that the way banks manage and charge for overdrafts needed fundamental reform …”
Upon closer inspection, it is clear that this regulation has important and far-reaching implications for personal current account providers from a series of different perspectives:
- Regulatory: firms need to ensure they tackle the biggest intervention for a generation well
- Business: there are clear commercial implications as fee revenues shrink
- Reputation: responses to the regulation will have reputation at significance for banks
Firms must initiate a review of their overdraft policies, pricing and strategies to understand what amendments, if any, will be required to achieve compliance.Under the new rules, pricing must be simple and comparable to alternative credit products which means a consistent APR per product throughout a customer’s tenure, irrespective of their circumstances.
The fixing of APR and removal of fees places greater reliance on using risk-based pricing at application point to optimise profitability. The importance of the overdraft decision and the limit assignment is now elevated as exposure value is a risk mitigant in the absence of fees and pricing tiering. Banks will need to enhance their overdraft application risk based pricing framework and review their behavioural scoring and affordability assessments to ensure limits are being assigned correctly.
The ultimate objective will be to offset revenue losses by re-adjusting for risk through pricing without losing profitable customers to competitors. This may mean tightening unarranged overdraft policy and providing alternative lending options to those customers that regularly use this form of credit.
Current accounts sit at the cornerstone of a customers financial status, and so press attention is likely to be focussed on banks’ responses, with the hearts and minds of consumers potentially at stake. Analysis to understand customer behaviour and the impact on balance sheet metrics are important but they will need to be considered alongside a softer approach that considers the importance of long-term reputation alongside short-term revenue implications.
How could this effect wider banking processes and models?
Whilst pricing and customer retention may be the immediate focus, it is important to anticipate downstream impacts. The removal of daily fees and potentially lower interest rates on unarranged overdrafts there could be less incentive for customers to repay overdrafts timely which could increase the incidence and duration of past due behaviours.
The changes will have serious implications for revenue recognition models and could affect definitions of default for credit risk models and volumes in stage 2 under IFRS 9, all of which could have significant implications for the banks. Forecasts and stress tests must now incorporate the perceived impact from these changes to overdrafts.
This may extend beyond current accounts as credit cards and personal loans provide more logical lending alternatives. Depending upon the materiality of the impact on defaults and past dues a re-development of IRB, IFRS 9 models and operational scorecards might be a future requirement. With adjustments to APRs and changes in customer behaviour, Effective Interest Rate (used to discount in IFRS 9) estimates are likely to require a recalibration.
These reforms will undoubtedly shake-up the overdraft market. With a deadline of December 2019 in place, we recommend that banks must begin their preparations immediately. Pricing analytics and what-if scenario testing will be pivotal to informing any changes to bank’s strategies and policies, with commercial impacts weighed up against reputation considerations.
As aspects of these reforms are part of the regulator’s wider initiative of increasing competition in the UK banking market, firms must anticipate the competition’s next move alongside their own strategy.
The new rules, if acted upon swiftly, present an opportunity to attract new customers although conversely a wrong move could lead to a bank losing their most profitable customers and market position.