Response to consultation Paper on draft Guidelines on loan origination and monitoring.
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The definitions of ‘the three lines of defence’ at paragraph 75 are at odds with the well-established ‘three lines of defence’ standard used by firms in the UK. The use of the same terminology in the EBA guidelines may cause some confusion on which approach to use.
As regards the substance of paragraph 75, there is potential for overlap between the second line of defence’s responsibility for controls of the credit risk taking and management process with the duties of the first line.
In the UK, the first line of defence has ownership, responsibility and accountability for directly assessing, controlling and mitigating risks for the firm; whereas, the second line of defence monitors and facilities the implementation of effective risk management practices. The third line of defence is usually made up of the internal audit function.
As currently drafted, the reference to the third line cited in the guidelines is geared towards a bank’s credit risk and would therefore not be appropriate for non-banks.
More broadly, as a result of these rules, lenders would need to invest a significant amount of time to cross-reference the proposed guidelines with their internal committees and policies. This could take some firms a lot of time to put into effect, especially where organisational structures are more complex.
The concept of a ‘single customer view’ (SCV) cuts across the sophisticated models employed in the credit industry which are based on automated decision-making. In practice, there may be a series of different SCVs that illustrate the financial position of the borrower. We would welcome further clarification on the definition of this model.
Paragraphs 85 and 86 go further than the UK regime (contained within the FCA’s Consumer Credit Sourcebook (CONC)), in that it introduces an affordability assessment for corporate lending (given that this falls under loans to professionals), which is currently exempt from regulation. The key criteria for credit risk by this category of lenders, much of which is of high value, should remain the client’s propensity to default. Paragraph 85 also requires firms to have a “comprehensive view of all of the borrowers credit commitments”, which may not always be possible for the lender to ascertain in practice.
The ‘plausibility’ check specified in paragraph 88 assumes a level of human intervention, which does not work for the many firms that use automated credit decisioning. This check will add a layer of manual processing and risks firms having to duplicate their efforts, which could lead to a significant drain on available resources and increased costs for consumers.
Separately, the specific requirements for lending to consumers as enshrined in paragraph 91 and Annex 2 will presumably require written evidence which goes against the FCA’s recent changes to creditworthiness and affordability assessments which are predicated on proportionality. Such a prescriptive approach will likely raise the cost of credit and increase financial exclusion. It does not allow for sufficient flexibility to vary the affordability criteria according to, for example, product type, lending channel or amount of borrowing.
The list of information to be collected from consumers in Annex 2 is overly prescriptive and requires records to be kept that are not part of the normal UK credit granting process such as evidence of tax status or evidence of the insurance of collateral.
Where there is a novation of an agreement, for example from an individual’s own company to a sole tradership or to a larger partnership, many funders will not undertake a full affordability assessment as in many cases the risks to the funder are likely to be substantively similar as before the novation. This can be for many reasons including the same guarantor, the same directors being behind the business, or a similar type of business. This makes compliance with paragraph 95 superfluous.
Sometimes, after a loan book has been sold, customers may request novation from the new lessor. The new lessor may opt not to undertake full creditworthiness assessments on this process for the reasons stated above. This is a proportionate decision which ensures the customer can continue to benefit from the finance provided. If the new rules impose a requirement for greater creditworthiness assessments of these customers, it may discourage the sale of loan books and make novation, and the flexibility it provides to some customers, more difficult.
Paragraphs 98 and 99 are also overly-prescriptive, notably the introduction of metrics, such as debt-to-income ratio, that in the UK mortgage market, have been replaced by a regulator-prescribed, sophisticated affordability model based on disposable income. The impact will therefore be to constrain lending. Further clarity is required on how the conflicting approaches between the proposed guidelines and national models will operate together in practice.
The concept of ‘sensitivity analyses’ (implying several actions by the lender) in paragraph 101 will be onerous, particularly for smaller value loans and gives no flexibility for the lender to exercise discretion. For example, balloon payments which are a feature of personal contract purchases (PCPs) in the UK are priced into this model, whereby the consumer is given a guaranteed future value. Furthermore, assessing the borrower for a reduction of income goes far beyond conventional practice in the UK and could be extremely difficult to both evaluate and explain to a customer.
The ‘sensitivity analyses’ in respect of secured lending (paragraph 114) are also burdensome and go far beyond the normal criteria for assessing Buy-to-Let mortgages and construction finance in the UK. The reference to the marketability of a property may be impossible to meet as not all properties are marketable.
The guidelines do not make any allowance for credit to be granted on the basis of a future increase in income, including a loan to finance higher education, as per the FCA’s rules (CONC 5.24.16).
Paragraph 123 applies the requirements for analysis of the borrowers’ financial position to leasing. A clear definition of “leasing” is not provided – for example whether this refers only to finance leases or to both finance and operating leases. It is also unclear how this will affect non-bank leasing. As stated above, this could create a two-tier system.
The question of where Buy-to-Let agreements sits within the guidelines is unclear. Paragraph 113 classifies these as consumer loans but they can also be offered to limited companies, in which case they would be classed as professional loans. We would welcome further clarity on this.
As a general point, we suggest that the EBA use the model developed for securitisation exposures (see p. 16). This would set out clearly which asset classes are within scope of the guidelines and which parts of the guidelines apply to which assets. This would also need to specify that if a Member State did not regulate a particular product type then this would be outside scope of the guidelines.
The requirements are particularly problematic because they impose regulation on what is currently part of a commercial judgement. It would be particularly damaging to innovation and prevent firms introducing new models which usually operate at a loss initially.
If the matrix of prices described in paragraph 189 was applied to loans at an individual level it would be impossible to implement. Firms publish these matrices but the main basis is to ensure a positive rate of return (some loans will be above the bar, others below it).
Paragraph 187d conflicts with credit risk strategy for consumers which firms base on demographic groups rather than by product category.
Removal of automated valuations would also increase costs for consumers, who often bear the cost of valuations associated with many mortgage products. The need to take time off work, to open up a house to a valuer adds to even further inconvenience for borrowers. Taking speed, cost and convenience together, the requirement for a surveyor valuation would add considerable friction to the remortgage process and could result in consumer harm if, as a result, borrowers chose to remain on uncompetitive products with their existing lender – which could lead to some consumers ending up as potential ‘Mortgage Prisoners’. The guidelines do not appear to acknowledge the sophistication of existing practises within this market and could significantly increase application processing times.
The requirements for moveable property also introduce new unworkable duties. Leasing firms usually rely on members of staff to assess values of the assets they fund. They will have in-depth knowledge of the products they fund, especially in the case of vendor finance provided by equipment manufacturers. For example, a manufacturer of a very specific type of agricultural equipment, that also offers funding, is likely to be best placed to identify the future value of that equipment. Paragraph 225 (e) appears to suggest that anyone involved in valuation should be independent of the funder.
Overall, the monitoring framework reinforces many of the issues raised in our response, notably that the lack of flexibility in guidelines would hinder innovation, harm competition and disincentivise smaller lenders. It also potentially conflicts with existing FCA rules requiring consumer lenders to take steps to encourage customers to pay more, such as under the credit card persistent debt rules in CONC 6.7.27R to CONC 6.7.40G, irrespective of whether this increases the credit risk in the relevant portfolio.
5. What are the respondents’ views on the requirements for governance for credit granting and monitoring (Section 4)?
We would welcome a more forward-looking approach from the EBA. The guidelines are drafted on the assumption that all firms in scope use archaic credit risk underwriting processes, when many have automated these processes for decades. The tone of the guidelines is old-fashioned in nature and could restrict innovation.6. What are the respondent’s views on how the guidelines capture the role of the risk management function in credit granting process?
The FCA’s Senior Managers and Certification Regime makes clear (SYSC 6.1) that non-banks must manage their compliance obligations but not to the same degree as for banks.The definitions of ‘the three lines of defence’ at paragraph 75 are at odds with the well-established ‘three lines of defence’ standard used by firms in the UK. The use of the same terminology in the EBA guidelines may cause some confusion on which approach to use.
As regards the substance of paragraph 75, there is potential for overlap between the second line of defence’s responsibility for controls of the credit risk taking and management process with the duties of the first line.
In the UK, the first line of defence has ownership, responsibility and accountability for directly assessing, controlling and mitigating risks for the firm; whereas, the second line of defence monitors and facilities the implementation of effective risk management practices. The third line of defence is usually made up of the internal audit function.
As currently drafted, the reference to the third line cited in the guidelines is geared towards a bank’s credit risk and would therefore not be appropriate for non-banks.
More broadly, as a result of these rules, lenders would need to invest a significant amount of time to cross-reference the proposed guidelines with their internal committees and policies. This could take some firms a lot of time to put into effect, especially where organisational structures are more complex.
7. What are the respondents’ views on the requirements for collection of information and documentation for the purposes of creditworthiness assessment (Section 5.1)?
The application of section 5 to non-banks will amplify the concerns set out in our response to questions 7, 8 and 9 and will, in particular, adversely impact smaller lenders (including those offering credit at the point of sale), digital start-ups and app-based lenders.The concept of a ‘single customer view’ (SCV) cuts across the sophisticated models employed in the credit industry which are based on automated decision-making. In practice, there may be a series of different SCVs that illustrate the financial position of the borrower. We would welcome further clarification on the definition of this model.
Paragraphs 85 and 86 go further than the UK regime (contained within the FCA’s Consumer Credit Sourcebook (CONC)), in that it introduces an affordability assessment for corporate lending (given that this falls under loans to professionals), which is currently exempt from regulation. The key criteria for credit risk by this category of lenders, much of which is of high value, should remain the client’s propensity to default. Paragraph 85 also requires firms to have a “comprehensive view of all of the borrowers credit commitments”, which may not always be possible for the lender to ascertain in practice.
The ‘plausibility’ check specified in paragraph 88 assumes a level of human intervention, which does not work for the many firms that use automated credit decisioning. This check will add a layer of manual processing and risks firms having to duplicate their efforts, which could lead to a significant drain on available resources and increased costs for consumers.
Separately, the specific requirements for lending to consumers as enshrined in paragraph 91 and Annex 2 will presumably require written evidence which goes against the FCA’s recent changes to creditworthiness and affordability assessments which are predicated on proportionality. Such a prescriptive approach will likely raise the cost of credit and increase financial exclusion. It does not allow for sufficient flexibility to vary the affordability criteria according to, for example, product type, lending channel or amount of borrowing.
The list of information to be collected from consumers in Annex 2 is overly prescriptive and requires records to be kept that are not part of the normal UK credit granting process such as evidence of tax status or evidence of the insurance of collateral.
Where there is a novation of an agreement, for example from an individual’s own company to a sole tradership or to a larger partnership, many funders will not undertake a full affordability assessment as in many cases the risks to the funder are likely to be substantively similar as before the novation. This can be for many reasons including the same guarantor, the same directors being behind the business, or a similar type of business. This makes compliance with paragraph 95 superfluous.
Sometimes, after a loan book has been sold, customers may request novation from the new lessor. The new lessor may opt not to undertake full creditworthiness assessments on this process for the reasons stated above. This is a proportionate decision which ensures the customer can continue to benefit from the finance provided. If the new rules impose a requirement for greater creditworthiness assessments of these customers, it may discourage the sale of loan books and make novation, and the flexibility it provides to some customers, more difficult.
8. What are the respondents’ views on the requirements for assessment of borrower’s creditworthiness (Section 5.2)?
The EBA’s background to the draft guidelines emphasises proportionality but deliberately excludes creditworthiness assessments of consumers from this, which will adversely impact, for example, lenders’ ability to serve the market for small value loans. In contrast, the FCA has taken more pragmatic view which recognises the diversity of the credit market.Paragraphs 98 and 99 are also overly-prescriptive, notably the introduction of metrics, such as debt-to-income ratio, that in the UK mortgage market, have been replaced by a regulator-prescribed, sophisticated affordability model based on disposable income. The impact will therefore be to constrain lending. Further clarity is required on how the conflicting approaches between the proposed guidelines and national models will operate together in practice.
The concept of ‘sensitivity analyses’ (implying several actions by the lender) in paragraph 101 will be onerous, particularly for smaller value loans and gives no flexibility for the lender to exercise discretion. For example, balloon payments which are a feature of personal contract purchases (PCPs) in the UK are priced into this model, whereby the consumer is given a guaranteed future value. Furthermore, assessing the borrower for a reduction of income goes far beyond conventional practice in the UK and could be extremely difficult to both evaluate and explain to a customer.
The ‘sensitivity analyses’ in respect of secured lending (paragraph 114) are also burdensome and go far beyond the normal criteria for assessing Buy-to-Let mortgages and construction finance in the UK. The reference to the marketability of a property may be impossible to meet as not all properties are marketable.
The guidelines do not make any allowance for credit to be granted on the basis of a future increase in income, including a loan to finance higher education, as per the FCA’s rules (CONC 5.24.16).
Paragraph 123 applies the requirements for analysis of the borrowers’ financial position to leasing. A clear definition of “leasing” is not provided – for example whether this refers only to finance leases or to both finance and operating leases. It is also unclear how this will affect non-bank leasing. As stated above, this could create a two-tier system.
9. What are the respondents’ views on the scope of the asset classes and products covered in loan origination procedures (Section 5)?
The inclusion of lending to ‘professionals’ within the guidelines sets a dangerous precedent of regulation for what is supposed to be non-mandatory guidance. No evidence for the need to include leasing within the guidelines is presented (indeed except for regulated customers, leasing is not considered to be “lending money” by the FCA under their complaint-handling (DISP) rules).The question of where Buy-to-Let agreements sits within the guidelines is unclear. Paragraph 113 classifies these as consumer loans but they can also be offered to limited companies, in which case they would be classed as professional loans. We would welcome further clarity on this.
As a general point, we suggest that the EBA use the model developed for securitisation exposures (see p. 16). This would set out clearly which asset classes are within scope of the guidelines and which parts of the guidelines apply to which assets. This would also need to specify that if a Member State did not regulate a particular product type then this would be outside scope of the guidelines.
10. What are the respondents’ views on the requirements for loan pricing (Section 6)?
The loan pricing measures appear to be designed to bring together prudential and consumer protection measures. However, these serve different purposes and should therefore not be treated as part of a ‘one size fits all’ model.The requirements are particularly problematic because they impose regulation on what is currently part of a commercial judgement. It would be particularly damaging to innovation and prevent firms introducing new models which usually operate at a loss initially.
If the matrix of prices described in paragraph 189 was applied to loans at an individual level it would be impossible to implement. Firms publish these matrices but the main basis is to ensure a positive rate of return (some loans will be above the bar, others below it).
Paragraph 187d conflicts with credit risk strategy for consumers which firms base on demographic groups rather than by product category.
11. What are the respondents’ views on the requirements for valuation of immovable and movable property collateral (Section 7)?
The requirements set out in paragraph 195 present a significant threat to existing business models based on automated valuations at the point of loan origination for immovable property. As currently drafted, these guidelines state that desktop or drive-by valuations can only be taken where the properties in question do not share similar characteristics to the ones already valued or revalued by the valuer. The implication is that, where this is not the case, a physical visit to the property would be required for every mortgage application that is granted.Removal of automated valuations would also increase costs for consumers, who often bear the cost of valuations associated with many mortgage products. The need to take time off work, to open up a house to a valuer adds to even further inconvenience for borrowers. Taking speed, cost and convenience together, the requirement for a surveyor valuation would add considerable friction to the remortgage process and could result in consumer harm if, as a result, borrowers chose to remain on uncompetitive products with their existing lender – which could lead to some consumers ending up as potential ‘Mortgage Prisoners’. The guidelines do not appear to acknowledge the sophistication of existing practises within this market and could significantly increase application processing times.
The requirements for moveable property also introduce new unworkable duties. Leasing firms usually rely on members of staff to assess values of the assets they fund. They will have in-depth knowledge of the products they fund, especially in the case of vendor finance provided by equipment manufacturers. For example, a manufacturer of a very specific type of agricultural equipment, that also offers funding, is likely to be best placed to identify the future value of that equipment. Paragraph 225 (e) appears to suggest that anyone involved in valuation should be independent of the funder.
12. What are the respondents’ views on the proposed requirements on monitoring framework (Section 8)?
At paragraph 234, the proposed rules on the credit risk monitoring framework make reference to a SCV. As noted above, there may be some challenges for firms seeking to implement this as different approaches may be used in practice.Overall, the monitoring framework reinforces many of the issues raised in our response, notably that the lack of flexibility in guidelines would hinder innovation, harm competition and disincentivise smaller lenders. It also potentially conflicts with existing FCA rules requiring consumer lenders to take steps to encourage customers to pay more, such as under the credit card persistent debt rules in CONC 6.7.27R to CONC 6.7.40G, irrespective of whether this increases the credit risk in the relevant portfolio.