Multi-firm review of consumer credit firms and non-bank mortgage lenders

The firms we reviewed operated in a variety of different sectors ranging from insurance premium finance to financing retail sales of consumer goods and services. In the main, we found firms had a good understanding of the sector in which they operated. However, they did not always consider all the risks that could affect their business. 

Good practice

• We found most firms had a good understanding of the credit risk they undertook with effective credit assessment of borrowers. 
• Firms which were part of larger groups used group resources such as finance and treasury support to help with monitoring of their own financial position and achieve economies of scale. 

Areas for improvement

• In the absence of specific regulatory requirements for capital and liquidity, we found some firms had not considered or set their own financial risk metrics for adequate levels of capital and liquidity.
• While we found that most firms had considered credit risk, some had not considered other risks, such as interest rate risk or liquidity risks.
• We found some firms that operated with a number of business partners including Appointed Representatives (AR) had no quantitative assessment of the risks posed by these partners ie, principals considering the risks posed by ARs. We encourage firms to develop methodologies to quantify the risk associated with oversight of AR risk as appropriate. For further information on Effective Appointed Representatives Oversight, please see our recent publication, Principal firms embedding the new rules for effective appointed representative oversight: Good practice and areas for improvement.

We saw a variety of approaches to monitoring risks and providing management information to the management team or governing body.

We expect firms to consider forward-looking financial projections and strategic plans, under both business-as-usual and adverse circumstances that are outside their normal and direct control. We also expect them to ensure they have adequate financial resources to deal with those risks. Our expectation is that there is appropriate oversight and challenge from the firm’s management team.

Good practice

• We found examples where the Board/management team had set a clear risk appetite, outlining their desired risk profile and the types of risks the firm was willing to accept. For example, the firm does not want arrears to rise above a certain level and sets a range of warning level triggers prompting it to take action as arrears levels increase.
• Some firms had undertaken robust business planning, produced forecast financial statements that clearly showed their regulatory capital position and reported performance against these forecasts.
• Some firms had actively considered the levels of liquidity required to run their business and set their own triggers or buffer levels to allow early warning of potential issues.
• We saw examples of well-developed risk management and oversight processes at some larger firms. A number of firms operated a three lines of defence approach and, where necessary, used external support. 
• We found one example of a compliance team with a clear mandate to ensure adequate oversight of ARs and risk management. One firm also highlighted emerging trends such as the move from an AR to an introducer-appointed representative model.

Areas for improvement

• Many firms, including principal firms with ARs, did not have a clearly articulated view of what level of financial resource they considered to be adequate and at which points they would become concerned. Without this, it is difficult to create an effective risk management framework or ensure that corrective actions are taken at the right time. 
• Some firms relied only on more basic financial statements and discussing these at committee meetings to make decisions. Some firms focused on the level of sales and arrears levels but had limited financial data to identify any strain on the balance sheet. 
• We found some firms which were part of larger groups relying too heavily on their group for financial monitoring and regulatory reporting. In some instances, this group-wide reporting led to poor visibility of individual entities’ financial positions. This meant these firms were not aware of their capital or liquidity positions and so could not identify potential issues, determine compliance with their regulatory requirements or take action to address issues quickly.
• Many firms did not have a process, or time set aside, for identifying new and emerging risks. This left them slow to respond to changes and challenges in the market. 
• A number of firms did not have any mechanism in place to review interest rate risk, meaning they took longer to react and make necessary changes. 

Most firms had an inadequate approach to stress testing and there was a lack of adequate wind down planning.

Good practice

• We saw some examples where firms considered interest rate risk and had carried out stress testing to identify the impact on margin and profitability of changes in the cost of funding and the rate charged to borrowers on loans.
• Some firms with variable rate lending had considered the impact on arrears levels of passing on interest rate rises in full. These firms were assessing the full impact of the change in the environment on the business, rather than looking at single metrics in isolation. 
• Some firms in this sector take advantage of natural hedging where both lending and funding can be fixed and matched for the duration to minimise interest rate risk.

Areas for improvement

• Many firms had an underdeveloped approach to stress testing which meant that they were under-prepared for changes in economic conditions. We encourage firms to undertake scenario-based stress testing, which focuses on all the risks that are relevant to their business.
• Some firms did not have a robust framework in place to identify their future funding needs or identify when they could come under liquidity stress. We expect firms to consider the risk of this happening and to put in place measures to address this should it occur.
• The changing economic conditions during this review resulted in pressure on some firms in getting funding. Assessing their funding requirements and considering the availability of funding (funding gap analysis) should be an important consideration for firms to help identify financial resilience risks. This is also valid for firms that lend out on a short-term basis or have any form of group level support.
• Most firms had seen an increase in arrears in loan repayments. However, they had made limited commensurate increases in loan loss provision or consideration of ring-fencing capital where accounting provisions did not fully reflect the rise in arrears.
• We saw an example where a firm relied on a credit modelling approach to assess the risk but used a fixed probability of default, despite a broad range of borrowers and products on offer.
• Overall, there was a lack of adequate wind down planning undertaken by firms.

We saw a number of firms that had considered the changing economic conditions and had adapted their processes in an effort to minimise potential harm to their business and to customers.  

Good practice

• We found firms that had undertaken robust business planning and produced forecast financial statements that clearly showed their regulatory capital and liquidity position.
• We observed some robust risk assessments. This included analysis of asset quality, expected and unexpected losses, the impact of market changes, operational risk and concentration risk.
• We found some firms had actively considered the levels of liquidity required to run their business and had set their own triggers or buffer levels to allow early warning of potential issues.

Areas for improvement

• Smaller firms were often understandably reliant on a single source of external funding but, in several cases, did not identify this as a risk. Growth plans often did not consider the levels at which diversifying funding sources might become a viable option.

We saw examples of well-developed risk management processes at some larger firms. Several firms operated a three lines of defence approach and utilised external support where necessary.  

Good practice

Risk appetite 

• We found examples where the Board/management committee had set a clear risk appetite outlining their desired risk profile and the types of risks the firm was willing to accept. 
• We saw some evidence of the assessment of financial resources needs being balanced against growth objectives.
• Some firms had developed their agreed risk appetite into individual triggers and set buffers for key financial measures. For example, a firm which did not want liquidity to fall below a certain level and had set a range of warning level triggers to act as prompts to take action as levels fall.
• Some firms with strong risk measures in place were able to update their product offering to cope with cost-of-living pressures and high interest rates, while continuing to provide services to consumers. However, other firms took actions with potentially significant impact without fully understanding the consequences because they were unable to model the impact of their actions on their firm.

Funding risk  

• We saw larger firms using complex and diversified funding arrangements, including combinations of warehousing, securitisation and forward flow arrangements. These firms managed the funding risk from these arrangements reasonably well. 
• We saw some firms actively diversifying against funding risk including a variety of funding sources and a spread of renewal dates. 

Interest rate risk  

• We saw the use of gap analysis to understand mismatches in duration/repricing risk alongside stress testing of margins to gain a more comprehensive understanding of the business’s interest rate risk exposure. This type of analysis usually corresponded with swifter action to manage the impact of the interest rate rises in 2022/23. 
• When using gap analysis we saw some firms starting to use more flexible intra-group funding arrangements to manage repricing risk. However, it was not always clear whether this was creating new interest rate risk exposures elsewhere in the group or taking advantage of surplus cash within the group.  

Areas for improvement

• Many firms did not have a clearly articulated risk appetite in place. Some firms subject to a capital requirement from the MIPRU handbook considered this amount to be materially lower than their own risk appetite but were unable to articulate what their own capital requirement should be. Without this, it is difficult to create an effective risk management framework or make time-critical business decisions.
• Some firms exclusively relied on and monitored risk measures imposed by external parties such as funders or securitisation covenants. It is important that management teams also establish their own risk appetites, then put in place mechanisms to measure performance against them. 
• Many firms did not have a clear understanding of the impact of interest rate changes on their businesses and were slow to respond to rising interest rates. This had a material negative impact on profitability. 
• Firms with primarily floating rate loan books did not proactively monitor interest rate risk, as they consider themselves hedged against this risk. Firms should consider the second order consequences of interest rate changes, such as changes in consumer behaviour that may harm the firm’s financial resilience.

The recent increases in interest rates negatively affected a number of the firms in the review. Firms should have been monitoring wider economic conditions and understood the impact of interest rate changes.     

Good practice

• We saw examples of well-developed stress testing. These used multiple scenarios against a range of factors, including demand for products, loan performance, house prices and the impact of interest rate changes.
• Some firms were using credit risk modelling that was forward looking, not just considering prior loan losses but using experience as a predictor of potential future losses. This enabled firms to spot trends and take actions to both protect themselves and their customers.
• We saw examples where firms had considered potential issues with their business partners, such as external funders exiting the market and the impact on their liquidity to run their businesses and had established alternative funding sources should the need arise.
• We saw some firms which had considered measures to increase their regulatory capital position as a result of their stress testing. This included restricting dividend payments or raising additional capital.  

Areas for improvement

Stress testing  

• We observed that stress testing was often limited and did not cover the firm’s risk profile. Some firms stressed a fall in lending but did not have scenarios for rising arrears or interest rates. As set out in FG20/1, we expect that firms use stress scenarios that are severe but plausible and relevant to their circumstances. 
• We observed a firm exploring alternative funding options because it could not get sufficient securitisation funding at short notice. Firms should develop appropriate early warning indicators to deal with the issues that such a challenge could create. 
• We found some firms that had not put in place contingency funding plans setting out adequate strategies and proper implementation measures to address potential liquidity shortfalls. There is more guidance available in MIPRU 4.2D.
• Most firms had seen an increase in arrears in loan repayments, but there was limited commensurate increase in loan loss provisioning or capital set aside.

Wind down planning 

• We found a general lack of wind down planning. Some firms considered this to be only an issue for their funding providers. We recognise that the security held by funding providers is likely to give them a very significant stake in a wind down situation. However, we expect firms to consider their own responsibilities and plan to ensure that they take actions to minimise the impact of firm failure, on both customers and markets, at the appropriate time.