Harper Wright, the financial
capability manager for Bank of America, and Capco’s principal
consultant Francesco Burelli, discuss the challenge of tackling
over-indebtedness in the UK. A new era of high consumer debt in the
country has lent extra momentum to the FSA’s Treating Customers
Fairly agenda.

Total consumer debt now exceeds £1.34 trillion ($2.7 trillion)
in the UK. More UK consumers than ever are resorting to bankruptcy
or Individual Voluntary Arrangements (IVAs) to resolve their debt
problems. Rising interest rates are making levels of debt more and
more unsustainable for consumers in many countries. In the UK these
trends have led a number of authors to write about a rising level
of “over-indebtedness”.

But what exactly is “over-indebtedness”? Is it a simple ratio of
debt to income or assets, or something else? Is it a question of
“how much” or are there other factors that need to be

The sad truth is that many consumers either do not know how to use
credit correctly or ignore their personal financial situation with
disdain. Borrowing is seen as a right, and if a lender is willing
to grant the credit line, the borrower assumes that they can afford
it. This attitude has been worsening as banks have been pushing for
more lending so as to grow their asset book and meet the yield
growth expectations of shareholders.

Over the past few years the two main messages contained in most
consumer credit marketing campaigns have been “go ahead and treat
yourself” and “all you need to worry about is the APR – look at our
low introductory rate”. Only in recent months, after having been
hit by increasing levels of bad debt, UK banks have started
revising policies, tightening lending criteria and clearing their
books by moving dubious outstandings into early collections.

The UK regulator, the Financial Services Authority (FSA), has set
the deadlines of March and December 2008 by which time firms must
be able to evidence that they have systems in place to test whether
customers are being treated fairly by consistent business
practices. Regulation tends to have a prescriptive nature, but
differing from common regulatory practices, the FSA’s Treating
Customers Fairly (TCF) is regulation in principle only.

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This means that financial institutions have been left open to
develop their own interpretation and responses to the legislation.
Thus far, the two major lines of response to TCF have been the
re-papering of terms and conditions of lending products and an
increased demand for consumer education. A 2006 FSA study pointed
out that many consumers are vulnerable “as a result of risks which
they are not protected against, either through poor choices or
simply lack of awareness”.

Similar to consumer education initiatives launched by the European
Commission and other national governments and regulators, the FSA
launched a programme which aimed to provide financial education to
university students and schoolchildren in an effort expected to
cover the majority of UK secondary schools in the next three

But is school training in the cumulative dynamics of compounded
interest rates going to solve the over-indebtedness issue and
ensure that borrowers are treated fairly by their banks? Such a
programme will undoubtedly increase awareness with respect to the
total debt an individual could or should burden themselves with but
there is another dynamic at play.

A fundamental, critical

The free and easy approach to credit granting by lenders and
borrowing by consumers has led many to totally ignore the
fundamental and critical link between the useful life of the item
being financed and the repayment term. For big ticket items such as
houses or cars, consumers still make this connection. The house
will still be around in 30 years, so a long term mortgage is
reasonable. However, consumers will purchase items on a credit card
and then make minimum payments. This means that the finance period
could have a term longer than many mortgages. Low minimum
repayments allow borrowers a great amount of flexibility but at the
same time can be a possible trap for the unwary when high revolving
credit card balances or bank overdrafts are consolidated into long
term lines of credit to ease the pressure on consumers and to
enable banks to provide more short term credit.

By succumbing to this temptation, the borrower will likely finance
many purchases beyond their useful life. If the decisive factor in
determining the term of a consolidation loan is affordability,
rather than the useful life of the items being financed, the
borrower has started on the slippery slope towards a reduced
standard of living in the future.

Even worse, freeing up additional short term credit can begin the
cycle again for many borrowers. Warning bells should start ringing;
although in real life the borrower is often unaware of any
potential problem and most lending and debt consolidation practices
are ignoring this issue.

An example of irresponsible lending or failing to comply with TCF
could be defined as “knowingly financing a good or service beyond
the useful life of that item”. Accepting or creating an obligation
that commits part of future income to pay for something that is no
longer benefiting the consumer implies a lowering of that
consumer’s standard of living and possibly facilitating financial
trouble in the medium term.

Perhaps debt consolidation loans, which often extend the term of
finance beyond the useful life of the original items, should be
accompanied by counselling or education for the borrower to ensure
that they do not overextend themselves yet again. Both lenders and
borrowers need to think very carefully about “how long – i.e. term”
as well as “how much – i.e. amount”. Both factors are critical in
complying with the principles of Treating Customers