Predicting which consumer credit users will suffer financial distress

24 Aug 2016 By Carl Packman, Research and Good Practice Manager

A recent report authored by John Gathergood, Associate Professor Economics at the University of Nottingham argues that individual debt levels in relation to income levels – otherwise known as the Debt-to-Income Ratio – is the best indication for whether someone is more or less likely to suffer financial distress.

The Occasional Paper, published by the Financial Conduct Authority and titled “Can we predict which consumer credit users will suffer financial distress”? stimulates an ongoing debate about creditworthiness and the complexity of assessing a borrower’s ability to repay what they’ve borrowed, an important issue for firms, regulators and other policy makers concerned with responsible lending.

Gathergood raises the issue that debt, and especially consumer credit debt, is commonly viewed in negative terms.  This negative view of debt comes from its association with financial distress, but we know that in reality, many borrowers use credit products for income smoothing and also take on personal debt in anticipation of greater future prosperity.  The research in this report therefore looks specifically at how we define financial distress. More specifically, it looks at the correlations between consumer credit use and financial distress, and when or with what products, this distress is most likely to occur.

Using Office for National Statistics’ Wealth and Assets Survey data Gathergood asks, “is it possible to predict the consumers who are at high risk of suffering financial distress in the future”? In the report Gathergood uses a number of different measures to answer this question. For example, he uses more objective measures such as levels of arrears, number of credit products held, and types of credit products used; and subjective measures such as self-reported financial distress. After analysing the data, Gathergood argues that a person’s current ratio of consumer credit debt relative to income (known as the Debt-to-Income ratio) is the strongest predictor of whether individuals are likely to experience financial distress. This means that rather than seeing the stock of outstanding consumer debts as an indicator of financial distress in itself, we need to instead look at the individual debt levels in relation to one’s income levels.

Financial distress: objective versus subjective measures

The research found that median consumer credit debt, according to the Wealth and Assets Survey, is is £1,900. This figure, however, is skewed by the fact that the top 10 per cent of individuals (ranked by consumer credit debts) hold at least £10,300 in consumer credit debts, representing in excess of 2.5 months of household income before tax: a significant amount of debt.

But what we should be looking for, according to this research, is the precise ratio between debt and income that indicates a likelihood of financial distress. To this end, Gathergood reveals an issue that is a very live topic for debt advice agencies: the exact number of people who are considered to be in financial distress in the UK. Gathergood notes that using a narrow definition of financial distress based on arrears reveals, just 2 per cent of individuals with outstanding consumer credit debt would be considered to be in financial distress. However, using a broader measure of financial distress, (i.e. individuals self-reporting that they are in distress), 17 per cent of individuals would be in this position. Gathergood points out that it is these more subjective measures which advice agencies were more likely to trust when assessing whether an individual is in financial distress.

This poses a number of questions: given the gulf between what Gathergood calls the narrow, objective measure of financial distress and the broader self-reported measure, does this say anything significant about how the financial health sector should measure financial distress? More specifically, given that funding for advice should, ideally, follow demand for such advice, is the onus upon agencies to demonstrate why self-reported measures of financial distress hold as much weight as the objective measures such as debt arrears?

Financial distress, even where it is self-reported, has a material difference on the life of an individual, so even if a debt advisor was to turn around to someone and tell them their debts did not meet a set of narrow and objective criteria of what distress should look like, that does not make the debtor’s financial life, and how they manage it, any easier.

While Gathergood finds “a consistent pattern of individuals in greater financial distress reporting higher anxiety”, what we cannot yet accurately measure is the extent to which financial distress is having a material effect on other parts of our lives. For example in 2015, PwC in the US found that one in five employees report issues with personal finances being a distraction at work and 37 per cent saying that at work each week, they spend three hours or more thinking about or dealing with issues related to their personal finances.

Subsequently, one particular conversation this paper should spark between industry and the third sector, is the extent to which worrying about one’s finances, and the impact this has on their wider lives, is as serious a concern as any other measure of financial distress, whether or not it tallies up to the narrow measure of financial distress Gathergood talks about.

This also raises a point about how agencies measure financial distress. To give an example of why this is needed, Gathergood mentions that 17 percent of people self-report as having financial distress – this is the equivalent of 2.2m people. Additionally, the Money Advice Service (MAS) in their Indebted Lives research found that 8.8m people – 18 per cent of the adult population – are considered over-indebted. It’s important to highlight here that MAS’ definition of financial distress included all bills, including to creditors. The Occasional Paper – correctly, given its remit – was limited to only credit commitments.

Given that this paper is an exploration of what a creditor should be looking for to inform them of a potential applicants’ creditworthiness, all commitments are necessary to consider – and the debt-to-income (DTI) ratio is a measure that can include all commitments, not just outstanding consumer credit debts.

In sum, it may be of general interest for lenders, as well as advice agencies, to know that 2 per cent of individuals with an outstanding consumer credit debt are recorded as suffering financial distress by an objective measure. Gathergood’s finding that the top 10 per cent of individuals by Debt to Income ratio are much more likely to suffer financial distress than other individuals is incredibly useful all round, as is the finding that financial distress is less likely to be predicted from ‘life events’ than Debt To Income ratios (though the occurrence of ‘life events’ was higher among those in financial distress).

Finally, it is also worth knowing that a greater number of individuals will fall into the category of financial distress when we widen the net of commitments.

What the report means for advice agencies

  1. The report confirms that financial distress can vary by financial product type, with some higher cost products being more likely to cause financial distress in certain consumers;
  2. It confirms that debt relative to income is an important measure of someone’s financial health, as opposed to just looking at the stock of debt alone;
  3. It confirms that ‘life events’ are helpful to explain future financial distress but are not the only factor to consider, particularly where individuals are experiencing chaotic lives in general;
  4. Self-reported financial distress – which Gathergood points out is very important to debt agencies – is no less a strong indicator as objective reports of financial distress and must be taken very seriously, particularly where it has a material impact on other issues such as anxiety and life satisfaction;
  5. It confirms the view that data for creditworthiness is not perfect, but should not be interpreted as saying all data is credit data: there is a difference between data that can be collected on an individual and good data;
  6. In spite of the figures found in the research of this paper, ability to pay a consumer credit debt is not the same as having a financial life without complications and all commitments must be taken into consideration in the Debt To Income ratio – useful for both lenders and advice agencies alike.