Consumer Credit Fundamentals

Size: px

Start display at page:

Download "Consumer Credit Fundamentals"

Madlyn Ramsey
6 years ago
Views:

1 Consumer Credit Fundamentals

2 This page intentionally left blank

3 Consumer Credit Fundamentals Steven Finlay

4 Steven Finlay 2005 Softcover reprint of the hardcover 1st edition All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1T 4LP. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act First published 2004 by PALGRAVE MACMILLAN Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N.Y Companies and representatives throughout the world PALGRAVE MACMILLAN is the global academic imprint of the Palgrave Macmillan division of St. Martin s Press, LLC and of Palgrave Macmillan Ltd. Macmillan is a registered trademark in the United States, United Kingdom and other countries. Palgrave is a registered trademark in the European Union and other countries. ISBN ISBN (ebook) DOI / This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. A catalogue record for this book is available from the British Library. Library of Congress Cataloging-in-Publication Data p. cm. Includes bibliographical references and index

5 To My Wife Sam

6 Contents Preface Acknowledgements xii xiv 1 Introduction The rise and rise of consumer credit Consumer credit defined Boon or bane? Working with credit Chapter summary Suggested sources of further information 11 2 The History of Credit Ancient origins The Greek experience The Roman Empire The early Church to late Middle Ages The Reformation A modern philosophy of credit From Victorian necessity to the First World War Between the wars The modern age The impact of technology Chapter summary Suggested sources of further information 31 3 Products and Providers The features of credit agreements Secured or unsecured credit Amortized or balloon credit Fixed sum or running account credit Unrestricted or restricted credit Two party or three party credit agreement The cost of credit Credit products Mortgages Personal loans (installment loans) Retail credit (retail loans) 38 vi

7 Contents vii Hire-purchase Card accounts Charge accounts Revolving loans Mail order catalogue accounts Overdrafts Pawning (pledging) Payday loans and cheque cashing services Productive and consumptive credit Credit products permitted under Islamic 46 (Shari ah) law 3.5 Credit providers Banks Building societies (savings and loan 48 companies) Finance houses Credit unions Utility companies Pawnbrokers Government agencies Licensed moneylenders (home credit 50 companies) Unlicensed moneylenders Prime and sub-prime lending, mainstream and 51 non-mainstream lenders 3.7 The demographics of credit in the UK Credit usage Credit provision Chapter summary Suggested sources of further information 57 4 The Economics of Credit and its Marketing Sources of income Arrangement and account management fees Interest charges Late payment fees, penalty charges and 61 early redemption fees Insurance Merchant and interchange fees Costs of credit provision Cost of funds Bad debt and write-off (charge-off) 69

8 viii Contents Provision Fraud Infrastructure and overheads Advertising and promotion The special case of mail order 80 catalogues Offers and incentives Retention and attrition Cross-selling and up-selling A credit card example Chapter summary Suggested sources of further information 90 5 Credit Granting Decisions The creditworthy customer The application for credit Judgemental decision making Credit scoring Using the score to make decisions Choosing the outcome period Comparing judgemental lending and credit 104 scoring 5.6 The case against credit scoring Enhancing credit scoring systems with 108 judgemental decision rules (policy rules) Organizational policy Data sufficiency Expert knowledge Legal requirements Pricing for risk Credit scoring models of profitability Behavioural scoring The impact of credit scoring Chapter summary Suggested sources of further information Credit Reference Agencies The evolution of credit reference agencies Public information County court judgements, 119 bankruptcies and repossessions The Electoral Roll 119

9 Contents ix 6.3 Private information Shared customer account data Credit searches Credit Industry Fraud Avoidance Scheme 122 (CIFAS) Gone Away Information Network (GAIN) Notice of correction Derived information Geo-demographic and socio-economic 123 data Credit scores Performing a credit search: matching applicant 125 and credit reference data No trace cases Previous addresses, linked addresses and 127 joint applications Third party data The role of credit reference agencies in credit 130 granting decisions 6.7 Using credit reference data to reevaluate 131 existing customers 6.8 Infrastructure requirements for credit reference 132 agency operation 6.9 The myth of complexity The credit reference agency business model US credit reference agencies Other national situations Secondary uses of credit reference data The impact of credit reference agencies Chapter summary Suggested sources of further information Credit Management Recruitment The credit granting decision process Setting the terms of business Shadow limits Application fraud Account management Account cycling and statement 157 production

10 x Contents Transaction authorization and transaction 158 fraud Customer or account level management? Collections Collections strategies Designing collection strategies and 165 action paths 7.4 Debt recovery Write-off, the sale of debt and legal action The business functions responsible for 167 credit management Marketing Credit Operations IT Legal, and accounting and finance Chapter summary Suggested sources of further information Ethics in Lending The role of ethics in financial services Ethics a theoretical overview Utilitarianism Kant s ethical theory Higher moral authority Natural law, virtue and human rights Ethics in practice The charging of interest Interest or usury? Jeremy Bentham s Defense of Usury The principle of reasonable return A right to credit? The use of personal information in credit 191 granting decisions 8.7 Over-indebtedness and responsible lending Chapter summary Suggested sources of further information Legislation and Consumer Rights The Consumer Credit Act Credit licence Requirements for a legally binding 199 credit agreement

11 Contents xi The right to cancel Advertising Credit tokens Early settlement Charges for delinquency Court action to recover debt Repossession of goods under hire-purchase 205 and conditional sale agreements 9.2 Bankruptcy The road to bankruptcy After a bankruptcy order has been granted The Data Protection Act The right of subject access Data controllers and data processors The right to prevent direct marketing Automated decision making Dealing with repayment difficulties 212 a borrower s perspective 9.5 Chapter summary Suggested sources of further information 214 Appendix A: The Calculation of Interest and APR 215 A.1 Simple and compound interest 215 A.2 Calculating interest for fixed term amortizing 216 loans and mortgages A.3 Calculating interest for credit cards 218 A.4 Calculating APR 219 A.5 Example interest and APR calculations 222 Appendix B: A Brief Note on the Construction of Credit 226 Scorecards B.1 Credit scoring data sets 227 B.2 Pre-processing (data preparation) 227 B.3 Reject inference 229 B.4 Assessing the performance of credit scoring 229 models B.5 Operational issues 230 B.6 Suggested sources of further information 231 Notes 232 Bibliography 234 Index 241

12 Preface Like many people I have a mortgage. Last year I bought a new fridge freezer and it made sense to take the interest-free repayment option and leave the money earning interest in the bank, rather than paying for it there and then. The last time I bought a car there was no discount for cash like the good old days, but if I had taken the company s motor finance plan then they would have cut me a deal. When I do my grocery shopping I use the credit card supplied by the supermarket to gain the extra loyalty points on offer, and I ll even use my credit card to buy a 50 pence newspaper if I go to the newsagent and find I don t have any cash. I m a typical individual living in a world where credit is prevalent across almost every aspect of consumer society. Was credit always so pervasive? Between 1985 and 2004 the amount of personal debt in the UK more than quadrupled in real terms, and today more people use more credit in more ways than ever before. Yet credit is not just a modern phenomenon, and the nature of the credit we use today is little different in principle from that used by the Babylonians, Greeks and Romans thousands of years ago. What has changed is the speed, sophistication and convenience of the credit experience brought about through the application of modern technology. Is credit a good thing? The arguments about the pros and cons of credit have raged since antiquity, with references to its use and misuse in many ancient texts including the Bible, the Qu ran and the Torah. Aristotle argued against the unnatural nature of interest-bearing credit while others, such as the eighteenth-century philosopher and social commentator Jeremy Bentham, argued for the right of each person of sound mind to borrow under whatever terms they saw fit without undue restriction or legislation an argument widely accepted by modern economists. Today, there is often an undercurrent of us versus them. The consumer is represented by the media as the underdog, enslaved to debt by the financial services industry in its never ending drive for profit. Yet it is difficult to see how western societies, particularly the UK and US, could manage without consumer credit in something resembling its current form. We live in a state of tension. On the one hand credit provides the ability to buy goods and services when we want them, and provides a xii

13 Preface xiii cushioning effect against short-term economic downturns, allowing spending to continue until conditions improve. On the other hand, debt has caused a huge amount of misery and unhappiness. Around 5 percent of the UK population has been taken to court at some point in their lives by unpaid creditors, and every year tens of thousands of people are forced to leave their homes as their properties are repossessed or they become bankrupt as a final desperate answer to their debt problems. The issue that we need to address as a society lies in balancing these opposing forces. The benefits of a liberal financial services framework need to be weighed against the protections required to safeguard the well-being and livelihoods of the populace in a manner we have come to expect in a modern civilized society. Despite the widespread use of credit and almost daily coverage in the media, the literature relating to consumer credit issues is patchy, and there is much ignorance about one of the world s largest industries. What material does exist is often specialized and focussed towards specific aspects of the subject. There is very little that comprehensively introduces consumer credit in something approaching its entirety. Therefore, this book has been written to fill what I perceive as a gap. My objective has been to provide a broad contextual and cross-disciplinary introduction to consumer credit, covering its history, the types of credit available, how credit is granted and managed, the legal framework within which commercial lenders must operate, as well as consumer and ethical issues. I have also tried to provide a text that, while having been written from a UK perspective, contains much that is relevant to consumer credit markets around the world. This is a tall order, but I hope I have been able to provide sufficient information for it to be of worth to anyone with an interest in the subject. Steven Finlay, May 2005

14 Acknowledgements First and foremost I would like to thank my wife Sam, and my parents; Ann and Paul, all of whom contributed from their own areas of expertise and devoted much of their time towards reading early drafts of the manuscript. My thanks also to Professor Robert Fildes of Lancaster University for his comments, input and guidance. I would also like to thank Dr Ian Glover of Experian, Dr Mohammed Salisu of Lancaster University, Professor John Presley and Dr Keith Pond of Loughborough University, Nathen Finch of the National Pawnbrokers Association and Mark Rowe of Pentest Limited for their help. Finally, there are numerous others to whom I am indebted in one way or another for their help and support, and my thanks goes to all of you. xiv

Consumer Credit Fundamentals

Consumer Credit Fundamentals Also by Steven Finlay THE MANAGEMENT OF CONSUMER CREDIT Theory & Practice Consumer Credit Fundamentals Second Edition Steven Finlay Steven Finlay 2009 Softcover reprint of