Stress testing for human beings

Speaker: Charles Randell, Chair
Event: Gleneagles Pensions & Savings Symposium
Delivered: 27 September 2019
Note: this is the speech as drafted and may differ from the delivered version

Highlights:

• Bank regulators test the resilience of the system to future economic downturns – for conduct regulators, it’s the human impact which also matters
• The system needs to support savers to make good decisions in good times and bad.
• Affordability and appropriate arrears handling vital for a fair consumer debt market.

Stress testing is one of the most important post-crisis reforms.  

No one can predict with certainty when the next recession is coming, but we know there will be another one at some stage. Perhaps not for many years – you won’t get any forward guidance from me.

So, every year Bank of England supervisors subject the major banks to a hypothetical stress test scenario, based on a set of severe but plausible assumptions about a future economic downturn. Bank of England policy committees then examine and publish the results, looking through 2 lenses: first, whether the banking system as a whole has the capital and liquidity it needs to provide credit to the real economy through the downturn; and secondly, whether any of the individual banks within the system needs to take action to strengthen its financial position to withstand the downturn. The results of the 2019 stress test will be published in the next few months.

But for a financial conduct regulator there’s a third, equally important lens we need to look through when we’re thinking about an economic downturn: the human impact.  Both the system and individual banks can be capitalised well enough to deal with their credit and investment losses in a downturn, but behind those losses will be millions of people in real distress.

Monetary and fiscal policy can each play a big role in determining the extent of this human impact – but monetary and fiscal interventions aren’t necessarily unlimited. Social policy can play a role, even where monetary or fiscal policy can’t. And financial regulation has a role to play as well.

So the Financial Conduct Authority, like other public authorities, must try to be ready for a downturn when it comes.

Today I want to outline the potential impact of an economic downturn on people in the UK, given the current state of their financial lives; to discuss the roles of the various authorities in responding to their needs; and to outline some of the choices with which policymakers may be faced. I also want to reinforce the FCA’s expectations about what financial firms should be doing, right now, regardless of when the next downturn comes.

Financial lives

There are a number of surveys about people’s finances in the UK, including the FCA’s own Financial Lives survey.

It’s a mixed picture. Although the number of people with unaffordable debt has been on a downward trend, there are still a lot of people who have very little financial resilience, as a result of high debt, low savings or both.

Debt can help people to spread unexpected expenses or spend money on assets or services which improve their welfare. But unaffordable debt becomes a persistent drain on their financial wellbeing. That’s why the FCA requires firms to assess whether their customers are taking on debt which is affordable[1].

Although the number of people with unaffordable debt has been on a downward trend, there are still a lot of people who have very little financial resilience, as a result of high debt, low savings or both.

Around 26 million UK adults have unsecured debt, such as short-term loans. The average amount of unsecured debt among these adults is nearly £10,000. As I say, debt can improve people’s welfare if it’s being used for the right purposes and is affordable. But around 8.3 million people are defined as ‘over-indebted’ because keeping up with domestic bills and credit commitments is a heavy burden or they have missed paying domestic bills or credit commitments in 3 or more of the last 6 months.  

Although tighter affordability rules[2] mean that homeowners are not as exposed to mortgage debt as they were going into the last recession, there are nevertheless still over 800,000 UK households who have mortgage debt of more than 4 times their household income. Some of these borrowers may be more vulnerable to an income shock than others.

And savings are low, so many people lack resilience to deal with financial shocks, let alone support their needs when they retire. Approximately a third of UK adults have less than £2,000 of cash savings, and 1 in 8 has no cash savings at all. 

At the same time as the saving rate has been falling, there have been major changes in people’s pension arrangements. In 2017 nearly 40% of adults below state pension age had no pension provision at all beyond the state pension they will eventually receive.  Auto-enrolment has significantly improved this position since then, and hopefully encouraged an important savings habit. But gone are the days of pension schemes for many private sector workers which guarantee to pay a percentage of the worker’s final salary. Most private sector workers today carry the full risk that the investments in their pension schemes don’t grow and won’t fund the retirement income they hope to have. And corporate or private pension scheme members can now take out cash from their schemes and invest it themselves, even if that means giving up a regular guaranteed payment. 

Now it’s important to emphasize that although saving is weak, the debt picture we see is better, at an aggregate level, than it’s been at times in the past – including when we went into the last recession. But some people have argued that the next recession may look very different from the last. In particular, they’ve argued that in a future downturn more people may lose their jobs than in the last recession, and of course unemployment is a key driver of debt distress and falling savings. Whether that’s right or not - I’m certainly not the right person to predict.

The human impact of a stress test

As I’ve made clear, the Bank of England’s annual stress test uses a severe but plausible scenario designed as a strong test of the banking system and the banks within it, but it’s not a forecast of what the next recession will look like, let alone of when it will occur. So for the FCA as a conduct regulator, it’s a useful way of thinking about how to prepare for a future recession but no more than that.

Under the latest stress test scenario, unemployment rises to 9.2 per cent, house prices fall by 33 per cent, and the stock market falls by 41 per cent.  That seems both severe and unlikely but not impossible – as it should be for the stress test to serve its purpose.

In this scenario, many people would be unable to pay their existing unsecured debts. And they and others would lose access to further credit; if they have been relying on credit to pay for their everyday needs they would be in crisis. 

Mortgage arrears would also rise, feeding through into increased repossessions. Although lenders should be adequately capitalised to continue lending to the real economy, some lenders might choose to sell their distressed debt portfolios.

Homeowners who have been relying on using their home to help fund their retirement could find their numbers don’t add up any more.

Those who had lost their jobs would also cease to benefit from employer contributions to their workplace pensions. Member contributions to workplace pensions would reduce.

And if asset prices fell as the scenario assumes they will, those who have chosen to exercise their pension freedoms and decide how to invest their pension assets and when to draw them may be shocked to see the value of their assets go down. From what we know of human behaviour, it’s likely that some of them will want to sell, crystallising a loss at what may be the bottom of the market.

Policymakers’ roles and choices

As policymakers think about a future downturn, what should they do?

Debt

First, thinking about the impact of a downturn underlines the fact that we at the FCA need to maintain our focus on the market for unsecured credit. Since we took over the regulation of consumer credit in 2014, we’ve made some big interventions in this market to stamp out some of the worst excesses we found. Capping payday lending and rent-to-own charges; clamping down on harmful repeat lending by doorstep and catalogue lenders; requiring credit card providers to intervene and help customers in persistent debt; and simplifying the way banks charge for unarranged overdrafts, which we expect to reduce their cost. And we’ve also focussed on affordability, requiring lenders to sharpen up their practices in this area and ordering redress where they’ve fallen short.

But even if we keep up our focus on affordability, the simple fact is that lenders normally assess the affordability of credit on the assumption that the borrower keeps their job. It’s difficult to see that this market could work any other way. A spike in unemployment would mean an increase in firms’ arrears. We would need to ensure that firms handle arrears in accordance with our rules, but if there were a severe downturn then clearly we wouldn’t be able to mitigate its impact on our own. 

We would need to work with Government and with other authorities to look at a range of responses in the area of financial services. For example, an increase in debt arrears would mean an increase in demand for debt advice. It’s not easy to increase the supply of good quality debt advice quickly, and it needs to be funded. Both those tasks lie outside the FCA’s direct remit but they are critical in mitigating harm which we care about.

And we hear from the debt advice charities that public sector debts – such as council tax – as well as utility and mobile phone bills, are a big part of the problem debt they deal with. In a recession, the response would need to include all creditors.

The Government is introducing breathing space to help people struggling with debt to have time to take the advice they need and work out what’s best for them.  There’s also a proposal to introduce a statutory debt repayment plan at a later stage which can bind in all creditors. 

Since we took over the regulation of consumer credit in 2014, we’ve made some big interventions in this market to stamp out some of the worst excesses we found.

Finally, the issue of consumers struggling with their mortgage repayments might become even more pressing in a downturn. We are changing our rules to make sure that consumers who are up-to-date with their mortgage payments are not unfairly prevented from switching to better deals.  But lenders need to treat those consumers unable to afford their mortgage fairly and compassionately even if they are under strain from an increase in arrears. And while we will use our powers to supervise authorised mortgage administrators, we’ve recently drawn attention in our Perimeter Report to the fact that we can’t offer the same level of protection to consumers whose mortgage is bought by an unregulated firm as those who have mortgages with regulated firms.   

But even with all of these measures, in a severe downturn our society would face the challenge of an increase in the number of people who could not meet their bills. This challenge goes far beyond our remit at the FCA.

Pensions and investments

Turning to pensions and investments, the FCA needs to consider the support which consumers would need if a recession led to falls in the value of their investments, pressure to access pension savings for everyday living expenses and bigger gaps in new retirement saving. 

As I’ve said, we know that some people will be in danger of selling their investments at the bottom of the market and they will need to be guided to act in their long term best interests. This is particularly important for the investments of people who have retired or are nearing retirement and who have little or no opportunity to rebuild their retirement savings, but it matters for all savers.

Some final salary pension scheme members with short term financial pressures may be tempted by unscrupulous advisers to take transfers from their pension schemes when they shouldn’t – as we have seen before. So we need to continue to work with the Pensions Regulator and the Money and Pensions Service to ensure that people get the right advice and guidance and that we hear quickly about pension scams and inappropriate advice. Moving swiftly to deal with the scammers and skimmers, and alerting the public through initiatives like ScamSmart.

And people’s confidence in further pension saving may be shaken so that they reduce their saving or stop it altogether. We already see too many people who are not saving enough. All policymakers will need to consider how to support further retirement saving and guide savers to the best long-term investment choices. 

Of course, these risks are exacerbated if people go into a recession with retirement savings which are invested inappropriately. Such as putting all their eggs in one high risk basket, like a minibond or peer-to-peer lending platform. For most individual savers, spreading risk and keeping costs down are the right way to invest, and unlisted and illiquid investments like these should have little or no place in their savings plans. They are more likely to be badly affected in a recession.  

And reducing costs will become even more important as people’s savings reduce. 

So we must maintain our focus on ensuring that better value, well diversified investment products are available and signposted, both in the accumulation and decumulation phase of people’s retirement plans. And we must continue to work with Government on ensuring that savers don’t invest money they can’t afford to lose in unlisted, illiquid and high cost investments.

Finally, it’s important that we use our ongoing evaluation of the Retail Distribution Review and Financial Advice Market Review to assess whether the advice market will deliver what consumers need, including in a downturn.

Expectations of firms

Thinking about a future downturn is as important for firms as it is for us at the FCA and for other authorities and policymakers.  

We are already supervising firms’ approach to our debt affordability and arrears handling requirements and taking enforcement action against firms which fall seriously short – supervision and enforcement have been transformed since we took over regulation of the sector five years ago. But supervisory action, redress and enforcement are not good outcomes for firms or consumers. The best outcome is for firms to to comply, treat customers appropriately and avoid the financial and reputational costs of redress and enforcement. Enforcement which would come at a time when our Senior Managers Regime makes the accountabilities of each member of a firm’s senior management very clear. 

We are also supervising investment advisers to ensure that they give suitable advice, and taking action against firms which promote unsuitable investments, particularly those which are unlisted, illiquid, risky and costly. Be in no doubt that we will take enforcement action in cases of serious misconduct, and will work to ensure that bad actors don’t subsequently re-enter the regulated financial services industry.

We must maintain our focus on ensuring that better value, well diversified investment products are available and signposted, both in the accumulation and decumulation phase of people’s retirement plans.

The spotlights shining on the suitability of products and arrears handling for consumers in a downturn would also shine on firms’ treatment of small businesses. We know all too well from the last recession what can happen, and Senior Managers need to focus on these issues right now.

All consumers, including the customers of well-run firms giving suitable advice, would be concerned about the impact on their savings and investments and would look to firms to give them the support they need. Providing the right support is consistent with the principle that firms pay due regard to the interests of their customers and treat them fairly. 

The Bank of England’s stress tests have demonstrated that the financial system is now strong enough to support the real economy through a severe recession. But while the system is financially secure, many people are not. So as a financial conduct regulator, we need to think about what an economic downturn means for the human beings which the system is there to serve.

Whenever an economic recession comes, we will use the tools we have to mitigate its effect on people’s debt, savings and investments. But if it came now, it would hit at a time when many people have low financial resilience. And our tools are limited, and would need to be used as part of a much broader monetary, fiscal and social policy response.

So we are continuing our focus on firms’ compliance with our requirements on affordability and arrears handling, and guiding savers to the right options for their savings. We expect firms to focus on these issues too, and have a low tolerance for firms who fall short of our standards in these areas.

We don’t know when the next economic downturn will come, but thinking about its impact 
is an essential part of being a forward-looking regulator.