Consumer Credit Directive and financial sustainability

The new European Community directive on credit agreements for consumers (CCD – Consumer Credit Directive) approved by the European Council, represents a new and important challenge for consumers and financial institutions.  The directive introduces some important principles based on “responsible lending”. On the one hand, the CCD places greater emphasis on consumer protection by imposing a number of new and more stringent duties on lenders. 
 
​A series of obligations for lending institutions regarding the information supplied to consumers both in advertising and in the precontractual phase have been ratified in order to help the consumer in their search for the best offer.  Anyone entering into a credit agreement will have the right to withdraw from the contract within two weeks without giving any reason, and will be required to pay the amount due in advanced and minor compensation. 

On the other hand, the directive places a duty on lenders to assess the creditworthiness of the consumer prior to entering into the credit agreement, based on sufficient information supplied by the consumer and, where necessary, obtained through the consultation of relevant databases.  This part of the directive is aimed at protecting both the credit applicant and the creditor. In the case of the consumer, the credit analysis looks at the level of indebtedness, so that this does not lead to over-indebtedness and therefore into a state of personal financial problems.  From this point of view, once lenders have assessed the applicant, they must be able to develop services which are designed to better advise the consumer on the most appropriate credit product.  Regarding creditors, they will be led to adopt the most advanced tools for credit risk analysis, which should also include elements of debt which are outwith purely banking debts.

The new directive is inserted into a consumer credit market which is still very fragmented and differentiated within the European Union. It aims to harmonize the rules and operating procedures in order to assure greater transparency, efficiency and competition to EU consumers in a single market.  The objective of the European legislator is to sustain and increase consumer confidence, and to increase the 1 percent share of cross-border consumer credit out of the total credit granted, thus creating a true single market in this sector.

The analysis of financial sustainability
Changes in the attitude of consumers, who are ever more aware and mature when acquiring credit, the CCD and external factors related to the current economic framework, have triggered research on financial sustainability and made “responsible lending” an ever more central issue for financial institutions.

In the assessment of retail customers, credit risk remains an essential parameter, but it is not the only one.  In order to optimize management of the retail portfolio, it is necessary to integrate the traditional credit scoring and rating indicators with new assessment tools, with the aim of adopting an approach which is truly able to estimate both the expected risk and level of sustainability of the prospect and/or acquired customer.

CRIF Decision Solutions – a CRIF Group company specializing in decision support solutions for credit and financial marketing – has studied and improved new methods of assessing the risk of over-indebtedness which takes a series of factors into consideration, the most important being:
  • the growing competition between operators which leads to the use of advanced decisional tools aimed at increasing lending targets, while looking to prevent any rise in the risk level of the portfolio;
  • the need for financial institutions to protect themselves from the real reputational risk when the credit granting process does not satisfy the necessary transparency criteria and is not consistent with an assessment of the actual debt sustainability carried out by the institution;
  • the need to overcome the slowness with which traditional risk control tools adapt to rapid changes in supply and demand. In fact, rating systems are structurally unsuitable to capture abrupt changes in the market, as well as unexpected changes in the economic cycle;
  • the opportunity to interpret changes in the lifestyles of households affected by economic turmoil and, consequently, uncertainty in the international macroeconomic scenario which has once again been shaken by repeated crises in the real estate credit market.
Starting from these requirements, CRIF Decision Solutions has developed an innovative approach which is based on the construction of a synthetic sustainability index.  This index is derived from household budget data, from which it is possible to estimate the pattern of possible household savings, which could be used to cover future financial commitments and which are translated by the model into a sustainable monthly installment.  The inference model of the sustainable monthly installment has the objective of producing a quick and accurate assessment of the effective disposable income of the customer, by taking into account the composition, the location, and the ingoings and outgoings of the household as well as the overall level of indebtedness which can be found in the credit bureau.

A sustainability model: an example of application in the Italian market

CRIF Decision Solutions analyzed a sample of around 150,000 Italian households, both consumers and SMEs, and it was found that about 80% of the customers who applied for credit were characterized by good financial sustainability, based on the data stored in the CRIF credit reporting system, EURISC.  EURISC is the only credit reporting system in Italy which is representative of the retail segment of the market, with 70 million credit lines and a significance rate of 93% for natural persons. Despite the fact that in March 2008 a slight decrease in the index was noted compared to December 2006, the empirical evidence gives a positive signal of the ability of Italian households to maintain financial equilibrium.

The following graph shows the distribution of default rates observed on a sample of about 65,000 households following the assessment of their financial sustainability: the creditworthiness assessment being equal (as expressed by the categories of CRIF Credit Bureau Score), after 12 months the customers who presented a high risk of financial strain on the basis of the sustainability indicator show doubled default rates with respect to customers who, on the basis of the sustainability indicator, have reached a solid balance in their household budget.

The sustainability indicator is an advanced tool for the segmentation of the retail customer portfolio, which effectively helps in the choice of credit limit, loan term and the most suitable type of product for the customer, by quantifying a sustainable monthly installment over the medium-term.
Finally, in line with the requirements of the Consumer Credit Directive, the ability to give the customer an indication of the installment which is most sustainable and compatible with their lifestyle promotes the consultancy role of the financial intermediary and facilitates a dialogue based on the principles of transparency and objectivity. The sustainability measurements help the final consumer to think in terms of cash flow, to focus on the principal ingoings and outgoings, to draw up an analytical budget in order to rebuild the standard of living of the household, and above all to make the choice of taking out credit ever more considered and mindful.