FCA’s Analysis: Can a consumer’s financial distress be predicted?

The FCA have published, in August 2016, an Occasional Paper which analyses the typical features and characteristics of consumer credit users who are likely to suffer financial distress.

Individuals with outstanding consumer credit debts hold, on average, consumer credit debts equivalent to 14% of their gross annual individual income or 12% of their household income. Ranking individuals by the ratio of their consumer credit debts relative to income (DTI ratio), the study finds that the top 10% of individuals with outstanding consumer credit debts, who hold approximately a third of total debt balances, have consumer credit debts that are over 38% of their gross annual individual income or 31% of their annual household income. These debts are equivalent to over 3.1 months of individual income or 2.5 months of household income before tax.

Using a broader measure of financial distress the paper estimates that 17% of individuals with outstanding consumer credit debt, or 7% of those holding a consumer credit product, face moderate or severe financial distress. This is a large number of individuals, approximately 2.2 million and compared to other individuals, those in financial distress are typically younger, with lower income and higher DTI ratios. They also have noticeably worse self-reported measures of well-being.

Accordingly the research concludes that DTI ratio is a strong predictor of future financial distress, even after controlling for ‘life events’ that may cause financial distress, such as becoming unemployed. The top 10% of individuals by DTI ratio are much more likely to suffer financial distress than other individuals. And those who hold the majority of their debts in higher-cost products are substantially more likely to experience financial distress than holders of other forms of credit, such as personal loans.

This research shows the risks of financial distress vary predictably depending on an individual’s circumstances. Individuals in financial distress are typically younger, with lower income, less likely to be employed and exhibit higher debt-to-income ratios than individuals who are not in financial distress but do have consumer credit debts. The paper suggests that affordability policies should be tailored to the products that people apply for and to applicants’ circumstances, especially by considering their DTI ratio.