Down but by No Means Out: UK Consumer Lending Six Months Into the COVID-19 Crisis

At the onset of the COVID-19 crisis, fears were rife of global financial crisis (GFC)-style wholesale disruption to consumer lending. The key drivers were expected to be a combination of (i) increasing credit risk and defaults; (ii) substantial reduction in availability of funding; and (iii) loss of lender appetite to issue new loans given extreme uncertainty in the outcome of both the health crisis itself, governments’ response to it and the resulting economic downturn.

Six months later, all these issues have been realised to some extent. However, the industry’s mood is mainly one of tentative calm mixed with continued concern, rather than outright retreat or, worse, panic. In this Executive Insights, we consider why this is and the industry’s prospects for the coming months.

Defaults and credit risk — government interventions less problematic than expected

Government guidance requiring payment holidays to be granted for three months for unsecured lending was a shock for lenders, both in and of itself and operationally, especially given the challenges of the sudden need to work remotely. 

All lenders were severely tested by the volume of forbearance requests — in many cases, their processes and staffing levels were simply not geared up to deal with the situation. Given regulatory guidance to ensure that individuals in trouble were given help, some had little choice but to say ‘yes’ to the great majority based on a sometimes cursory inspection of their individual merits. A substantial number of requests were granted as a result, albeit with significant variation between lenders. Some industry participants suggest that as many as 50% of these were simply consumer preference for taking a payment holiday rather than genuine need. But whatever the real reasons, a substantial reduction in full payment of loans was the result.

Figure 1 shows monthly loan repayment amounts, split between MFIs (monetary financial institutions — essentially deposit-taking banks and building societies) and other consumer unsecured lenders. 

This chart shows that, following steady if somewhat volatile growth over the past five years, there was a substantial peak-to-trough reduction in lending repayments following the onset of the crisis, of the order of 25% for both MFIs and specialist lenders.

Although undoubtedly very material, the payment reductions were less than lenders originally feared. A leading industry hypothesis is that many consumers who had both mortgages and unsecured loans chose to take a mortgage holiday, following which their unsecured payments appeared very affordable, so they chose to continue to pay the unsecured loans in full rather than accrue more interest to pay later.

The chart also shows that, for both types of lender, there is early evidence of recovery, which appears to have been somewhat stronger for specialist lenders than MFIs. This improvement happened more quickly than expected. Anecdotal evidence indicates that performance since the end of July 2020 (at the time of writing, the latest date for which data is available) has continued to improve, thanks to lenders being better prepared to deny unjustified requests and less consumer demand than in the ‘first round’.

There has been significant variation among lenders within this overall trend, and on average repayment levels are still well below pre-COVID-19 levels, but some lenders have indicated that as many as 80% of forbearance customers have returned to full pay. In particular, fewer consumers than expected took advantage of the extension of the government-driven forbearance programme from three months to six months. 

A further boost to repayment performance is expected when government-driven forbearance ends, which lenders hope will close most of the gap. But the extent of this cannot be known in advance, especially as it is not certain that people currently on furlough, many of whom will have utilised forbearance measures, will have jobs to return to once these schemes end. Estimates in the industry vary from 10% to 50% of furloughed jobs not returning — even at the lower end, this would be a significant increase in unemployment, which would be reflected in repayment rates. 

Despite this relatively positive message the current situation remains problematic: Current repayment levels are not sustainable, and (close to) full recovery is required to repair P&L accounts and maintain access to funding (see below). Furthermore, the increasingly likely scenario of a second wave of COVID-19 could further extend forbearance and/or furlough periods, leading to more uncertainty and pressure on repayments.

Funding — robust so far, but government actions are key to future availability

Our previous article on the consumer lending market emphasised the importance of funding to the performance of the sector and its key components. 

Deposit funding has remained very robust, especially for major banks and building societies, due to a ‘safety first’ flight to quality for retail investors’ savings. Market participants expect this to continue, despite low interest rates and better stock market performance than initially appeared likely.

Bank-issued term and revolving funding have also largely remained robust. Many lenders have tripped covenants on their facilities, but funders have in most cases taken a measured and supportive approach, especially to lenders with robust track records who, but for COVID-19, were and would be performing well. It has been fairly common for funders to restrict criteria for new lending and limit quantities, but on the whole they have encouraged lenders to resume new business where prudent and feasible, as lenders would otherwise enter de facto run-off and their income would gradually decline towards levels incapable of supporting the debt. 

Bank funders were initially fearful of the impact of the government-driven three-month forbearance programme being extended to six months, due to roll-up of interest and associated lower income/higher unemployment expectations challenging affordability of payments. But, as noted above, recent credit/repayment performance has been better than expected. In this context, credit committees have not yet in general directed reduction of funding banks’ exposure to unsecured consumer lending. However, as the prospect of a second wave of COVID-19 and further extensions to government programmes comes closer, simply assuming that funders’ positivity will continue would be premature.

For capital markets-driven funding, debt markets were largely ‘closed’ for a brief initial period, including securitisations and bonds. However, these have recently recovered, and with pre-existing facilities relaxing some of the restrictions introduced at the start of the crisis, and some new securitisations (for example, by Blue Motor Finance), it has been possible to price forward flow deals again.

Finally, block funding for new lending was reduced following the onset of the crisis, especially by non-UK domiciled blockers; however, although still closed for some challenged existing customers, blockers have resumed funding for new customers with a robust track record or prospects.

Almost six months on, funding for lenders has proved to be more robust than in the immediate aftermath of the GFC, and also more robust than feared following the onset of COVID-19. But significant uncertainty remains in terms of both the underlying COVID-19 health crisis itself and its impacts on government policy and the macro-economic environment. As with credit performance, it would be rash to assume that the crisis has passed.

Lenders remain open for new business 

The initial response to COVID-19 was a marked reduction in new lending volumes. Many lenders chose to process applications and honour loan offers made prior to the onset of the crisis, but otherwise closed entirely. Some were so operationally overwhelmed by forbearance requests that they had to focus solely on serving existing customers’ needs rather than processing new applications. This was exacerbated by the sudden need for a large proportion of staff to work from home, and lenders’ (entirely appropriate) focus on the health and safety of their staff versus growth in new business.

The results in terms of gross consumer unsecured lending are shown in Figure 2.

The chart shows that MFIs reduced new unsecured lending by over 40% in April and May versus February and March, with a corresponding reduction of over 50% by other consumer lenders. A significant recovery in new lending volumes is also evident by the end of July (at the time of writing, the most recent data available): In the case of MFIs, this recovery represents c.75% of the April-May contraction; for other consumer lenders, new lending had recovered almost all of the lost ground.

Anecdotal evidence from loan brokers, who deal more with non-MFI lenders, is supportive of these broad trends. Following the immediate onset of the crisis, more than half of specialist lenders withdrew from active participation, but by the end of the summer the majority were open for business, at least on a restricted basis, with lending volumes trending towards normality. However, public statements from major banks indicate continued caution, in line with the weaker, if still very significant, bounce-back shown here.

So what is the cause of this difference between the two types of lenders? Our preliminary view is that this comes down to differing funding models and capital requirements. 

For MFIs, deposit raising remains a ready source of funding following the post-COVID-19 flight to quality and, unlike other funding sources, it exerts no direct time pressure to ‘get going again’. MFIs must also provide substantial levels of capital against doubtful debts and loans in default, so they are naturally more cautious about taking on riskier lending, especially given the rapid recognition of such risk required under IFRS9. Under these conditions, a retrenchment in credit appetite is logical. 

MFIs are also cognisant of the need to update underwriting and capital models to reflect a generally higher expectation of defaults versus recent history, driving further risk aversion. Some have already taken this step and others will follow, albeit that regulators have not so far rushed them into doing so. 

Specialist lenders have benefited from some of the demand which MFIs no longer serve. This ‘trickles down’ to represent a new and, relative to their average customers, lower-risk tranche of demand (a mechanism examined in more detail in a previous article). Specialist lenders have also contracted their credit appetite at the riskier end, but the effect is off-set by this new source of business.

In aggregate, this has resulted in some significant changes to MFIs’ and other consumer lenders’ books (see Figure 3).

This chart shows that, consistent with their reduced levels of new lending, MFIs overall have reduced exposure and, as of the end of July, were still doing so. In contrast, there is early evidence of specialist lenders looking to resume growth in their books, which our recent discussions with industry participants have indicated has continued in August and the early part of September.

Overall supply has therefore diminished, but not disastrously so: Most creditworthy consumers looking for an unsecured loan can still find one, albeit they may need to search more widely than before, and provide more information or accept less favourable terms. As a result, the use of open banking by consumers to prove their creditworthiness is rising, and the range of mainstream lenders incorporating this data into their underwriting processes is increasing, as anticipated in our article in May. 

In an effort to meet demand without taking excessive risk, lenders are making long-term improvements by increasing the granularity of previously broad assumptions in terms of risk profile of certain professions (e.g. hospitality and travel) or types of employment (e.g. contractors or those where bonuses are a significant part of earnings). 

Conclusion

The performance and prospects for unsecured lending present a more positive picture than feared six months ago, and one that is still improving. The anticipated business failures and lender distress have not yet happened at scale — specialist investors and book acquirers looking for low-priced bargains are still on standby, and most consumers are still being served. 

However, there is still significant caution around all major market aspects, caused by uncertainty about an increasingly likely second wave, the end of government furlough and forbearance schemes, and the broader policy and macro-economic environments. 

This uncertainty, and the accompanying volatility, are here to stay for the foreseeable future, but there will be substantial opportunities for agile and responsive players.