What EU regulators should do to limit over-indebtedness

This article is part of a new joint SPERI-Finance Watch series on “Untold stories of personal debt in Europe” to which different guest authors contributed.

For years, consumer credit and its overuse have been identified as key elements contributing to the financial vulnerability of households across Europe. Life accidents (such as unexpected unemployment, illness, issues related to aging, death of a close relative, single parenthood responsibilities etc.) put households that lack sufficient savings at risk of over-indebtedness.

In 2008, the consumer credit market was regulated at EU level through a Directive (DIR 2008/48/EC), known as the Consumer Credit Directive or CCD. The Directive sets out a legal framework for consumer credit, which was intended to strengthen consumers’ trust by creating an environment where they are sufficiently protected. Eleven years on, the European Commission is evaluating the impact that this Directive has had in protecting and safeguarding citizens, particularly the most vulnerable ones. The result of the analysis – expected by April 2020 – will allow the newly appointed Commission to consider whether improvements need to be made.

Finance Watch, together with its members who actively work on financial inclusion and consumer credit issues, identifies key areas and principles that should be reconsidered to tackle the negative impact that dangerous financial products still have on European citizens.

The risk of credit emerges from market failures rooted in the lack of options that debtors have in relation to their creditors, especially when vulnerable (e.g. poor, unemployed, ill, socially marginalised, etc.) This unbalanced power relation can lead to:

• Exploitative, unscrupulous or irresponsible lending practices
  • For instance, when the terms and conditions of the credit are significantly different from mainstream practices – and where the most vulnerable people have little alternative but to agree.
• High cost credit
  • Vulnerable debtors are often considered ‘riskier clients’ because of their financial fragility. The costs (e.g. higher rates and multiple fees) that they face are significantly higher than the average on the mainstream market, illustrating that “being poor is expensive.”
• Complex credit contract terms and conditions
  • When vulnerability is combined with poor financial literacy, borrowers run the risk of not understanding the weight of liabilities or the way the product should be properly used to avoid penalties and extra costs.
  • Fragile borrowers might also be deceived by misleading teaser rates that apply only for a short period of time, after which higher costs are introduced.

Recommendations from a customer protection perspective

Prevention is better than cure: A fair and sound assessment

To help tackle such issues, several measures could be put in place, such as a mandatory and adequate personal budget analysis (income and expenditures), or adjusted offers (in amount and in duration) based on evaluations of the on-going credit and debt situation. In addition, when the financial capacity and creditworthiness assessment indicates that a potential debtor would likely be unable to repay their debt, their credit application should be turned down.

Processes and practices following a negative assessment of creditworthiness also need to be reconsidered. Indeed, vulnerable consumers have no capacity to negotiate nor exert their free will: their financial distress puts them in a weak position. Decisions on whether to grant credit should be transparent, and they should be accompanied by clear indications on how to improve budgeting practices.

The revised Directive should also specify that the lender has the duty to refrain from granting credit when the result of the creditworthiness assessment is negative. Furthermore, the purpose (or aim) of the credit should be noted in the contract.

The reviewed Consumer Credit Directive should establish a clear distinction between the creditworthiness assessment and the credit risk assessment. It should require that all credit intermediaries have the same level of liability when it comes to carrying out these assessments. This should become mandatory for all authorised credit intermediaries, including those who have less than 50% of their core activity focused on providing credit, as is the case for car sellers, supermarkets, etc. Adequate supervision and sanctions are also necessary. Finally, the remuneration of intermediaries carrying out these assessments should be aligned with responsible lending principles.

The creditworthiness assessment, when properly done, is the best way to implement responsible lending. The assessment should identify the remaining amount of the budget (incomes from which unavoidable day-to-day expenditures have been deducted) that can be used for credit repayment. At the same time, the assessment must also allow the credit provider to adjust the credit offer in amount, duration and cost, so that it is affordable for the customer.

Transparency of information to escape the labyrinth of debt

Debtors should be made fully aware of their rights within the EU. At present, empirical evidence and scholars such as Caroline Metz in her (upcoming) contribution to this series, show that notifications and communications to debtors are often unclear, in particular when the debt has been sold to a credit servicer. Clear and accurate information should be made available when a debt is notified – meaning that the debt itself, and all the associated rights and obligations, are transferred from the original creditor to a third party, who assumes responsibility to collect the debt. This should include additional information to support the debtor, such as – for instance – useful contact details and access to legal and debt advice, the latter being crucially important in solving over-indebtedness issues.

A shot at redemption in the hands of the EU Regulator 

Another important aspect is to harmonise insolvency proceedings that concern the restructuring, insolvency and discharge of debt. Finance Watch encourages the harmonisation of insolvency proceedings and the so called ‘second chance’ for entrepreneurs. A common principle for personal bankruptcy would indeed reduce barriers to EU cross-border investment, which may be related to differences between EU Member States’ restructuring and second chance frameworks. Ultimately, it would also increase investment, indirectly growing job opportunities in the single market. It would allow individuals to get back on their feet without a negative credit history, which might impede them from applying for new credit to – for example – start a small business or develop an existing one.

To conclude, it is paramount to bear in mind that over-indebtedness is a multifaceted issue that can hit individuals, households or entrepreneurs at different moments in their lives. Therefore, when combined with other dimensions of vulnerability (job insecurity, illness, single parenthood, aging issues, etc.), debt issues significantly increase individuals’ fragility and endanger their resilience to life shocks. The debt trap can become a vicious circle that is hard to escape. EU regulation should provide citizens – both households and entrepreneurs – a concrete possibility for a ‘second chance’ and for a fresh start from the chain of over-indebtedness.

Olivier Jérusalmy, Senior Research and Advocacy Officer at Finance Watch