Business, Innovation and Skills CommitteeWritten evidence submitted by Ingacity Limited

PAYDAY LOANS, ROLLOVERS AND AFFORDABILITY: THE FCA MUST APPOINT SKILLED PERSONS

Summary

1. Ignacity Limited provides consultancy services to City firms. In the course of our work, we have looked at a payday lender’s proposition to a Private Equity Stockbroker. Some of what we found may be relevant to evidence given to the BIS Committee on 5 November 2013.

2. The central proposition is that once the payday lenders become interim authorised on 1 April 2014, the FCA should use its powers under S166 of the Financial Services & Markets Act to appoint Skilled Persons (paid for by the interim authorised firm, not the FCA) to investigate and report on the economics of each payday lender, its risk assessment processes and its reward and remuneration structure.

3. This is the only way in which the FCA can achieve reasonable certainty as to whether a payday lender can make money out of “affordable” lending and as to whether its employees, agents and others it pays are not being rewarded for blithely disregarding the FCA requirements to achieve higher pay through reckless lending.

The Economic Significance of Rollovers

4. The payday lender that we looked at candidly admitted that it was unable to make a profit on loans repaid promptly. This is entirely consistent with our experience over the economics of providers of mezzanine and bridging finance for construction and similar products—these lenders cover their operating, legal and related costs (including cost of capital) on loans that are repaid on time or earlier but make substantial profits out of extra charges and higher interest rates when loans have to be extended.

5. “Profit” on a loan is the difference between the revenue received and the costs incurred. The revenues are of course fixed and fairly easy to determine. But the cost is far from determinant. There are numerous definitions of cost and this enables a lender to generate a wide range of numbers for the cost of lending, say, £100:

(a)A lender will typically have a number of fixed costs—for instance, the cost of premises (with further scope for variation if the premises are owned rather than rented). One would exclude these from the marginal cost of making extra loans—as one would IT and other overhead costs. But these costs do have to be met and a calculation of average costs should include them.

(b)There is considerable scope to massage the figures for costs by, for instance, allocating legal and other costs largely towards the rolled over loans—thus excluding them from the cost of the initial loan.

(c)A particular issue arises over the cost of capital. It is again fairly easy to ascertain the cost of loan capital and to make a calculation to apportion that cost. But if a lender largely relies heavily on equity finance, unless dividends (and retained profits) are attributed to loans the cost of capital will be reduced and the profitability of loans inflated.

6. There are accounting standards that apply to Financial Accounts. These have come to replace professional judgment—so that “true and fair” has come to mean “calculated in according to the rules”. This one may contrast with the earlier approach adopted in particular by the Scottish profession—that a professional was an individual who formed his (we would today add) her judgment on the basis of integrity and experience. For a Scottish accountant, “true” was defined as Aquinas defined it: an adaequatio mentis ad rem, a notion captured by the expression “get one’s mind round an issue”.

7. Even rules are of course bent on occasion. Accounting standards are no exception. Auditors are human and do not wish to lose audit work that pays the mortgage. They are vulnerable to pressure from their clients. Accounting Standards do not provide a complete defence against the fallibility of human nature. As Hobbes (Leviathan, Chapter XI) observed:

For I doubt not but, if it had been a thing contrary to any man’s right of dominion, or to the interest of men that have dominion, “that the three angles of a triangle should be equal to two angles of a square,” that doctrine should have been, if not disputed, yet by the burning of all books of geometry suppressed, as far as he whom it concerned was able.

8. In areas where there are no rules, diligent and supervised inquiry is necessary. An effective method is scenario planning—working out the profit a lender would make if every loan were repaid on time, and then a succession of scenarios to ascertain how many loans need to be rolled over to achieve levels of profit. As noted, some care is required to ensure that all costs are included. It is as we shall see below crucial that the people who do this work are appointed by the FCA and answer to the FCA.

Use of FCA S166 Powers

9. The FCA cannot have provided in its budget for the authorisation process for an investigation of the business models of the payday lenders—it is charging only £10,000 for each application. It cannot safely rely on the payday lenders to provide a trustworthy assessment on such a crucial area. The FCA must arrange for investigations to be made.

10. So this is an area in which the FCA could usefully use the powers it has under Section 166 of the Financial Services & Markets Act (“FSMA”) to appoint a Skilled Person. The Skilled Person is usually a Firm (a legal person) rather than an individual (a natural person). The FCA has an approved list of firms that have the requisite skills to write a report. Authorised firms can be required to appoint and—importantly—pay for a Skilled Person. The FCA can and does require firms to pay Skilled Persons up front. All the payday lenders will be authorised firms (under the interim authorisation arrangements) from 1 April 2014. The FCA can require each of them to appoint its nominated Skilled Person to prepare and deliver to the FCA an analysis of the economics of the payday lender. This will not impact significantly on its own budget as the payday lenders will be meeting the costs directly.

11. Such an analysis can be used to determine whether the payday lender is operating an acceptable business model. If it is not operating an acceptable business model, it will not meet the FCA’s Threshold Conditions—the minimum standards for authorisation. Under such circumstances, the FCA is obliged by FSMA to decline it authorisation.

Lending when a Borrower cannot Afford to Repay

12. The BIS Committee was blithely told that nobody would lend if they did not believe that they would be repaid. This misrepresented the true position.

13. Lenders are in fact taking a calculated risk on the number of borrowers that will default. The interest rate charged is set at a level that cannot be justified save on an expectation of a level of default. So it is integral to the strategy of the payday lenders that they do lend to some borrowers who will be unable to repay their loans. They may not be able to identify them individually but they are lending to some people who cannot pay back.

14. It is probable—I would say certain—that some, probably most and maybe all payday lenders will systematically underestimate or ignore the risk of moneys not being paid back. One consequence will be a laxity in checking affordability. The following factors encourage reckless lending:

(a)Any split between the interests of funders and lenders. I use the term “funders” rather than owners because there is a greater likelihood of risks of default being disregarded if the payday lender has significant debt funding. Servicing those debts requires the lender to lend. If it is committed to paying, say, 12% on debentures issued to raise £1 Million, it has to find £10,000 a month. It can only do that by lending. So one all too easily gets into a situation in which the lender will definitely be forces into a loss if it does not lend but might escape this if it does lend. There is thus an incentive to take an optimistic view on defaults.

(b)Any risk of the firm making an overall loss, which would call into question its ability to pay dividends or profit share. Everyone not on fixed salaries but dependent on profit share or dividends again has a strong incentive to disregard risks of default.

(c)This is of course particularly the case when there is a bonus or other payment system that rewards volume of lending not volume of repayments. Even if the persons responsible for compliance and risk assessments are not themselves given inappropriate financial incentives, it is impossible to overstate the personal and psychological pressures brought on compliance and risk officers who say “no” too often. If we have learned nothing else from the collapse of HBOS and the Coop disaster we should have learned that.

(d)If a payday lender is so structured that the cost of default falls on outside funders but the rewards of lending go to those involved in lending, then the incentives for reckless lending are immense.

15. There is a real possibility that by making reckless loans a payday lender will be able to massage its balance sheet. Each extra loan (or charge levied but not collected) will add to the lender’s assets as well as its profits. If a payday lender advances £160 with a requirement to repay (say) £200, that transaction immediately generates a nominal profit of £40 which flows through to the net assets of the lender. But it is only a nominal profit, and the impact on cash is to reduce the cash held by the lender by £160. The Lender will only actually have £40 extra when (if) the loan is repaid. The FCA should require regular publication of cash flow on a website so that all interested parties can see what is going on.

The FCA needs to use its S166 Powers here as Well

16. The remedy for this situation is to require each payday lender applying for full authorisation to appoint (and pay for) a Skilled Person to assess its processes for managing risk, the organisational structure of the lender and the financial incentives.

17. The FCA should further use its powers to make rules governing remuneration to outlaw any reward system that incentivises volume of lending rather than volume of repayment. However that will not be sufficient. First, the rules governing remuneration notoriously do not capture the payments made to partners in hedge funds. Neither will they capture anyone with a partnership arrangement with a payday lender. Second, they do not cover dividends and owing to the favourable tax treatment of dividends one may expect a number of interesting arrangements in the payday lending sector. It follows that the FCA must appoint Skilled Persons to investigate what is going on in each lender and to identify any perverse incentives, that is to say any incentives that encourage reckless lending.

18. It may well be that the consequence of this is that a number of payday lenders will be unable to satisfy the Skilled Person that they can eliminate perverse incentives. It may well be that the business model of some lenders is such that they simply cannot afford not to achieve a volume of lending that is incompatible with any realistic affordability criteria. In that case the FCA must refuse those lenders authorisation and require them to wind down their operations in a short time period.

A Perverse Incentive to the FCA

19. I should draw attention to a danger of a perverse incentive to the FCA in all of this. The FCA is proposing that each payday lender pays a fee of £10K when it applies for authorisation. The larger lenders will, if authorised, become liable for annual fees that will be much more substantial. This creates a perverse incentive to the FCA to authorise applicants. While I have a high opinion of Lesley Titmuss (whom I first met when she was an undergraduate at Oxford and I was a NATO research Fellow and Junior Dean of another Oxford college). However I do not think it sensible to have perverse incentives in the FCA’s fee structure, not least because it makes it harder for the FCA to reduce such incentives in regulated firms. I also do not see why the FCA should be made the target of criticism—and it certainly will be—if it is forced to use the fees paid by the rest of the financial community to subsidise payday lenders.

Conclusion

20. The FCA is proposing to charge each payday lender a fee of £10,000 to process its application for authorisation. That is simply not enough to finance the essential investigations into the business model and structure of an applicant to determine whether it will be economically viable if it complies with proposed FCA rules (eg on affordability and rollover) and to determine whether its financial structure and its reward systems are compatible with responsible lending.

21. It may be that the FCA is willing to cross-subsidise the processing of applications. If so this should be made explicit and the FCA be required to publish (at least to the BIS Committee) a budget that demonstrates that the cost of thorough investigation of applicants will not be an impediment to the utmost rigour and diligence. If the FCA is not willing to do so, it should give an undertaking to the BIS Committee and hence to the House of Commons and people of this country that it will impose Skilled Persons on each and every payday lender that holds an interim authorisation on 1 April 2014 so that it can rapidly obtain a detailed and thorough report on the business models and reward systems of each applicant.

22. If there is no investigation before authorisation, firms will be authorised that will simply be unable to comply with FCA rules to protect vulnerable lenders. It is very much harder for the FCA to remove an authorisation than to refuse an application.

6 November 2013