Rise in consumer defaults!
In recent news, the rise in consumer default rates has the Bank of England (BoE) as well as the high street banks concerned about the health of the UK economy. The BoE has attributed this to the rising cost of living that is outpacing the increase in wage growth. However, this only considers the short term problem and does not properly address the larger underlying picture.
Last month I wrote a piece called the “Irrational borrower” which examined why so many consumers decide to take out costly short-term credit to pay for goods rather than save the money themselves and forgo the interest. The main conclusion from this is that we all desire instant gratification when it comes to purchasing goods and as such have a lack of self-control. Therefore, many consumers feel they need a “nudge” to help them save money. This behavior leads to many consumers prematurely exhausting their regular income and then resorting to high-cost credit to feed their purchasing needs.
In recent years the FCA has made leaps forward to attempt to reduce the number of consumers getting into financial distress and to limit irresponsible lending, by increased regulation on credit products. This has shown to be somewhat effective, however, as we have seen with the rise in default rates this year, this doesn’t solve the problem but merely slows it down. In my opinion that continued stridentcy in regulation by the FCA will only make it harder for consumers to gain access to credit and will not alter human behaviour when it comes to our own spending habits. As such a reduction in supply rarely leads to a reduction in demand, therefore any increase in regulation that limits access to credit for some consumers is likely to lead to the growth of more illegal sources of finances to fund spending.
A paper published by the the American Real Estate Society (P. Elmer and Steven Seelig) with the rather unwieldy name “Insolvency, Trigger Events, and Consumer Risk Posture in the Theory of Single-Family Mortgage Default” also found that insolvency is a “primary motivation for default” and that “adverse shocks to income and house prices, but not interest rates, also affect default and insolvency through the erosion of personal wealth.” This demonstrates that if government can encourage consumers to save a larger proportion of their income we may see a reduction in consumer defaults through saving not regulation.
So what might be a better approach?
There are plenty of ways government can increase consumer savings. One thing that has been introduced recently is that banks in the UK are now offering cash prizes on savings accounts. Halifax now offers 3 winners a top price of £100,000 each month just for saving with the bank. This comes after Shawn Cole, a professor at Harvard Business School, co-wrote the study of “Can Gambling Increase Savings? Empirical Evidence on Prize-linked Savings (PLS) Accounts”. The study showed that banks in South Africa that offered prize draws on savings accounts achieved a 38% increase in annual savings and “that large prizes generate a local “buzz” which leads to an 11.6% increase in demand for PLS at a winning branch.” In a separate study Cole's separate study “Financial Training for Mine workers in South Africa” Cole found that by also providing financial training to mine workers, they planned their expenses better and even cut spending on gambling and social activeities.
By merely enforcing more stringent regulation without increases in consumer savings programs or financial education, we may see increases in illegal lending due to the shortfall in the supply of money being picked up by illegal lenders. Though the right regulation can be effective, I believe that the UK government should continue to increase and promote savings programs with one of the aims being to lower the number of consumers entering financial distress, which in turn would provide a more stable growing economy.