Short-term, reactive measures fail to address the underlying causes of bad debt, say Keith MacDonald and Órla Murphy. They look at the current state of play and explain a method to identify and stop potential debtors
In June of last year the Bank of England stated that “Britain’s record debt mountain could threaten the country’s financial stability”. This rather disturbing statement has been echoed recently by financial institutions, consumer groups and the media.
Over the past year we have been inundated with facts and figures that highlight the gravity of the UK’s debt situation. Between 2000 and 2005 personal debt increased by a staggering 87 per cent to more than £1.1 trillion. Such a situation positions the UK as the most indebted nation in Europe, head and shoulders above its nearest counterpart Germany.
Analysis of growth in personal debt since 2000 reveals some startling facts:*
• Secured lending on homes has soared 92 per cent to £947 billion
• Credit card debt has increased 76 per cent to £56.3 billion
• Consumer credit lending has jumped 66 per cent to £191 billion
APACS estimates that consumer debt in the UK is growing at the rate of £1 million every four minutes, and this trend shows little sign of abating.
However, debt levels themselves do not necessarily represent a problem. If debt is manageable, it can encourage economic growth, but recent trends indicate that this is not the case.
Indeed, it appears that the increasing personal debt figure is contributing to an increasingly worrying bad-debt situation. During the first six months of 2005 high street banks wrote off almost £3 billion in bad debt, with this figure estimated to soar to £11 billion by year-end. In this article we investigate the causes for this rise in bad-debt levels, and potential strategies for lenders to address the problems.
Causes of bad debt
There is no single reason why personal debt in the UK has exceeded a record £1 trillion, and why related bad-debt levels have gone up. It is the result of a combination of both economic and behavioural factors:
• Aggressive marketing of lending products: in a competitive credit environment lenders adopted aggressive sales campaigns, most particularly of credit cards and personal loans, frequently targeting higher-risk customers.* For example, in anticipation of the Christmas spending frenzy, lending institutions, each year, distribute approximately 100 million pre-approved credit card application forms c Lax approach to risk-scoring and profiling of customers: a previously high rating of consumer confidence and the desire to extend the customer base saw institutions adopt less than rigorous risk assessment of customers. Broad marketing campaigns, such as the example highlighted above, mean that high-risk customers are as likely to receive pre-approved credit status as their low-risk counterparts
• Consumer behaviour: no longer a nation of savers, consumers in the UK are investing less and spending more. A bout of low credit interest rates and a general scepticism towards the stock market and pension industry have all contributed to this shift in mindset
• High interest rates: while not at the heights of the late 1980s, interest rates have crept up over recent years. Consumer spending, having grown continuously during a period of low interest, did not immediately tail off as rates began to rise. It is only in recent times that consumers have begun to cut back on spending
• Relaxing of personal bankruptcy rules: in 2002 the government took some of the sting out of the tail of declaring personal bankruptcy. Previously bankrupt customers are now eligible to open bank accounts and take out credit cards after one year instead of the much longer three years. As of September last year personal bankruptcies had increased by 31 per cent on the previous year to almost 45,000
• Poor personal financial control and protection: often it is poor personal discipline and lack of knowledge that causes debt problems. For example, making minor savings in insurances (e.g. third-party rather than comprehensive car cover) could be enough to push someone into delinquency should an incident occur
Evidently, lenders are beginning to feel the pinch of bad debt on their financial results. However, it is not just their profitability that is being affected; there are other adverse factors causing concern. For example, capital requirements are becoming more onerous, and the integrity of many institutions’ lending practices has been called into question.
It is not just the lenders that are burdened with the effects of our debt mountain. Other groups bearing the bruises of a deteriorating debt situation are the credit advice bureaux and counselling services.
The National Debtline is inundated with calls and struggling to manage the ever-increasing volume. During the weeks immediately proceeding Christmas approximately 12,000 consumers called seeking advice, of which calls two-thirds went unanswered. With other credit advisory services witnessing the same trend in call volume it is becoming progressively more difficult for indebted consumers to seek the advice and guidance they so need. How should lenders respond? The pressure is on for lenders to respond to the debt crisis. There are a number of options available to them, some of which we have listed and rated below. This is not intended as an exhaustive list; rather it covers some of the more topical approaches under consideration by many lending institutions.
Each of the options has been rated against four criteria:
• Addresses underlying issues of bad debt: an option is marked more favourably in accordance with each of the criteria it meets to mitigate underlying factors of the bad-debt situation. These include improving customer financial education
and awareness, and tailoring of products to meet customer risk profile (i.e. a reduction in blanket marketing)
• Revenue-generation: if an approach can garner revenue for the lender, i.e. income specifically related to the lending product/option (e.g. late payment fees, increase in interest rates) it is scored higher based on its ability to bring in revenue consistently
• Reduction in cost of bad debt: in addition to the loss of payments due to customers defaulting, lending institutions must put aside provisioning funds in anticipation of accounts turning delinquent. If an option can increase a customer’s likelihood of meeting payments and/or reduce the cost of provisioning, it is marked favourably
• Positive customer impact: options that punish the customer or burden them with additional costs are viewed negatively. If a strategy can deliver benefit to the customer, e.g. advising the customer on better financial management practices, then it is scored highly
From our diagram it is clear that no option can deliver favourable results across all criteria. Based on its long-term vision of targeting the reason for bad debt, its ability to reduce provisioning and its promotion of customer education, pre-delinquency management (PDM) can provide a beneficial option for lenders and consumers alike. Ironically, this is a strategy that many lenders have not fully explored or invested in to date.
Pre-delinquency management
PDM is a proactive approach to determine which customers or accounts currently in order may turn delinquent in the near future. Lenders use customer behavioural data and risk scores to determine which customers should be contacted.
Empowered with this knowledge lenders then have the ability to look at each customer individually and speak with them to fully understand their situation. Only then, if the customer is receptive to it, advise or suggest the most appropriate remedial actions for that customer.
The premiss of this approach is educating customers, making them aware of their spending habits and their consequences, and providing counsel on how to help customers reverse the situation. Unlike some of its counterparts identified above PDM does not seek to extract payment, sell other products or lumber the customer with more costs. The overriding objective of PDM is to empower the customer.
PDM can be implemented as a strategy to target bad debt on a single product (e.g. credit cards) or across multiple products (e.g. credit cards, personal loans, mortgages) to build a more informed customer view. Similarly, it can be strengthened by a parallel adoption of other strategies. For example, a lender that engages in PDM and has a collaborative agreement with other lending institutions to share data will be in a much more powerful position to determine the true risk of a customer. Therefore, the lender will be able to select the most appropriate option to prevent that customer’s account from turning delinquent.
Benefits and challenges
Beyond its obvious benefits of creating a more financially aware set of customers and cutting provisioning costs, PDM can realise other advantages:
• Stronger customer relationships: in an era of diminishing loyalty where customers can be lured away by more attractive and competitive product offerings from other institutions, it becomes increasingly important to retain customers. Contacting and helping customers, without a hidden sales agenda, forges a better customer relationship. As trust and integrity increase, customers are less likely to switch allegiance
• More informed marketing campaigns: exclusion of PDM-eligible accounts from marketing campaigns will reduce the risk of mis-selling and irresponsible lending. The remaining account population should prove a less risky pool of potential candidates
• Avoidance of negative media attention: some of the approaches adopted by lenders, such as Barclaycard’s decision to increase interest rates, have evoked a negative media response and engendered anger among the credit advisory groups. PDM’s customer-orientated approach is viewed as a positive and proactive approach by lenders to work towards a long-term solution to the bad debt situation PDM, as with any strategy, comes with its own set of challenges. We have highlighted some of the hurdles we faced initially and how, if not managed, they could impede its success:
c Developing a single customer view: a challenge in itself, this holy grail of forming a view of a customer across products is vital to understanding customer behaviour and risk if PDM is to be implemented across multiple lending products. Many lenders are still in the process of building this view, so an implementation of PDM may have to be restricted to one product
• Operating model: defining the appropriate criteria, or triggers, to determine which accounts are on the verge of delinquency and the subsequent application of appropriate remedial actions is vital. In the absence of such robust rules customers may be contacted or advised incorrectly, leading to frustration and concern
• Customer engagement: to engage a customer in what can sometimes be a sensitive topic of conversation requires operators to develop an open yet non-intrusive set of conversational skills. Development of this consultative approach to customer engagement is vital to get customers to reveal why they may be experiencing financial difficulty. Where operators do not have these skills, training is crucial to foster a positive customer experience and create a successful call outcome
• Call centre operations: from previous experience of call centre operations the optimum time to call customers is during the evening or weekend when they have more time to converse. This rule of thumb is not unique to PDM so conflict of resources may arise PDM is not a panacea for bad debt. It is an option that, unlike some other approaches, not only focuses on benefiting the lending institution, but can actually help the consumer.
Date: 25th, March, 2006
ADVICE TO READERS
While this website is checked for accuracy, we are not liable for any incorrect information included. We recommend that you make enquiries based on your own circumstances and, if necessary, take professional advice before entering into transactions.
Enter your postcode here to find out how much your property is worth, based on Land Registry data.
RSS Feed
Delicious
Digg
reddit
Facebook
StumbleUpon