Early Settlement Rebates-further Analysis

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Early settlement rebatesfurther analysis

Summary

1.

2.

3.

4.

This working paper sets out some further analysis of the implications for home credit

of early settlement rebates and their regulation. It builds on the analysis contained in

two earlier working papers published alongside Emerging Thinking.1

We look first at the rebates paid for early settlement of home credit loans and

whether the statutory minimum rebate, as required by the Consumer Credit (Early

Settlement) Regulations 2004 (the 2004 Regulations), represents a fair value for

home credit customers and lenders.

We have seen no evidence that home credit lenders have failed to comply with the

2004 Regulations.2 We note further that the 2004 Regulations were designed to

apply to a wide range of consumer credit agreements and not just to home credit

loans. The purpose of our analysis is not to assess whether home credit lenders are

failing to comply with the 2004 Regulations, nor whether the 2004 Regulations are

appropriate, in general, across the consumer credit sector. Rather our objective has

been to evaluate the widespread practice by home credit lenders of offering rebates

which comply with the minimum required by law, but are no more generous to

customers than this.

Our analysis suggests that there is little justification in either principle or in practice

for home credit lenders to retain up to four or eight weeks charges as a result of the

2004 Regulations permitting a deferred, rather than the actual date of settlement, to

be used in the rebate calculation. We can see no justification for home credit lenders

1Renewal Loansand The Consumer Credit (Early Settlement) Regulations 2004.

2

One home credit lender submitted an opinion from Counsel expressing the view that its current approach to rebates compliedwith the 2004 Regulations.

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to retain a larger amount for loans of longer than one year, than for loans of less than

one year. These findings are robust to a range of assumptions about the cost

structure of home credit. By contrast, the unadjusted actuarial formula3 appears to

fall within our illustrative range of possible underlying costs for the purposes of

calculating a cost-based rebate.

5.

6.

7.

We then consider the degree to which this issue is relevant to a competition inquiry.

In principle, low rebates could adversely affect competition by increasing switching

costs and adding to incumbency advantages. However, it not clear that these effects

are currently having a strong adverse effect on competition. Other incumbency

advantages appear more substantial.

Finally, we explore whether rebates might be higher if other advantages enjoyed by

incumbent lenders were reduced or if price competition intensified. We conclude that

they might, although we consider that price competition is more likely to focus on

headline prices than on rebates. We also noted that, in these circumstances, better

rebates might be paid when customers renew a loan with an existing supplier

compared with when they settle a loan early in order to switch to a competitor.

Section 1: Introduction

A high proportion of home credit loans settle ahead of term. 4 Most customers who

settle early will pay a higher ex post interest rate than the headline APR on the loan.

In the working paper on renewal loans, we estimated that renewals account for over

one-third of new loans issued. While some renewal loans take place on or after the

3As set out in the 2004 Regulations, but treating the actual settlement date as the settlement date for the purposes of the

calculation rather than some deferred date.4For example, Provident estimated that [] per cent of its home credit loans were settled early. Early settlement is also

common in other consumer credit markets: for example research conducted by Mori for the DTI in 2003 found that 48 per cent

of HP customers and 41 per cent of personal loan customers had paid off a previous agreement early. Source: Consumerawareness of credit issues: research study conducted for DTI, September 2003.

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contractual term, the majority of renewals appear to take place before this date 5 and

other loans are settled early without renewal. The total balances outstanding on

early settlements are substantialwe estimate that between 150 million and

200 million in outstanding balances are refinanced through renewal loans each

year.

8.

9.

Competition between home credit suppliers over the terms of rebates appears

muted. Customers understanding and awareness of the detailed terms on which

early settlement takes place are likely to be low, particularly when taking out an initial

loan.6 There appears to be little incentive for suppliers to offer a better deal at early

settlement than the rebates required by law and relatively few do. Only two of the

large suppliers offer rebates that are more generous than the statutory minimum for

customers who are renewing loans.7 To our knowledge, no large supplier offers

more generous rebates than the statutory minimum to customers who settle a loan

early for any reason other than renewals. Rebates offered by most suppliers are a

small percentage of the balances outstanding at early settlement.8

In the absence of vigorous competition over the terms of early settlement, the price

paid by many customers for early settlement of home credit loans is set according to

by the minimum rebates determined by statute. If this statutory minimum

underestimates the fair value of a rebate, this will to result in harm to those

consumers that settle early. If the statutory minimum rebate overestimates the fair

value of a rebate, this will result in a cross-subsidy in favour those customers who

5Renewal Loansworking paper, paragraph 56.

6We note that under the Consumer Credit (Agreements) (Amendment) Regulations 2004, suppliers are now required to provide

three examples of what an early settlement figure would look like at one-quarter, one-half and three-quarters of the way througha loan. This provides some additional information to customers at the outset of a loan about the likely size of an earlysettlement rebate, for loans redeemed at those stages.7Mutual offers a refinancing discount for customers who renew a loan with them. They told us that this did not bring them

business benefits but was part of their organizational culture. [] uses the actuarial formula set out in the regulations but doesnot defer the settlement date by four weeks. Some smaller suppliers also offer better terms than the statutory minimum. We

were told by one small supplier that they had on one occasion gained some extra custom by paying a larger rebate than others.8Renewal loansworking paper, paragraph 62.

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settle early, as lenders seek to recover the cost from other customers or in other

ways.

10.

11.

12.

13.

The rest of this paper examines the implications of early settlement rebates and their

regulation on home credit. Section 2 assesses the extent to which early settlement

rebates represent a fair balance between home credit lenders and customers. In

Section 3, we explore the extent to which any shortfall between rebates paid on early

settlement of home credit loans and fair values of rebates can be considered to be

either a cause or a consequence of a lack of competition.

Section 2: Are rebates fair?

In this section, we consider whether rebates paid by home credit suppliers represent

a fair balance between borrowers and lenders. We start by discussing conceptual

issues about what constitutes a fair rebate. We then discuss the statutory framework

which specifies minimum rebates payable for early settlement of consumer credit

agreements, including home credit. This is followed by a comparison of this

minimum statutory rebate with estimates of the costs associated with early

settlement, derived from cost models. We then consider how missed repayments

should be considered in the context of rebates before drawing some conclusions.

What is a fair rebate?

Article 8 of the European Directive on Consumer Credit (87/102/EEC) requires that

consumers should have an equitable reduction in the total cost of credit at early

settlement.

The concept of fairness implicit in this requirement may be summarized in the

proposition that, at early settlement, customers should not have to pay costs that

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have not actually been incurred by the lender.9 It is acknowledged that it would be

impracticable to attempt to allocate costs with total precision in every possible case.

Regulation of early settlement rebates aims to provide a reasonable approximation

of the economic reality of the way costs are attributed throughout the loan contract.10

14. The calculation of a fair rebate is based on an approximate allocation of costs

through the life of a loan. If all costs associated with a loan are incurred in full at the

start of a loan then it would generally be a fair allocation for the customer not to

receive a rebate at all. Some costs will typically be avoided by the lender at early

settlement. Costs can be regarded as broadly falling within the following three

categories depending on their profile of expenditure during the term of the loan. We

shall for convenience call these fixed costs, variable costs and interest costs as

follows:

Fixed costs. These are costs incurred in full at the start of the loan. An example

would be the administrative costs in setting up the loan. A fair allocation would

result in these costs being borne by the customer.

Variable costs. These are costs incurred at a constant rate throughout the life of

the loan. For example, in home credit, there are weekly costs associated with

weekly collections. A fair allocation would be to share the costs pro-rata

according to time left for the loan to run.

Interest costs. These are costs that depend on the amount of the loan

outstanding and decline at a rate derived by using an actuarial formula. An

example could be the interest the lender pays to its provider of capital that is

attributable to the loan to the customer. This would decline as a proportion of

periodic repayments throughout the life of a loan. Other costs could have a

9Thus, the DTI stated that [the right to early settlement] exists because otherwise consumers who settled early could pay

interest and other charges under an agreement that have not actually been earned by lenders. Source: Tackling loan sharks

and more!, DTI Consultation document CCP 002/02, paragraph 2.1.10Source: DTI Tackling loan sharksand more!, paragraph 2.29.

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similar profile. A fair allocation of such costs can be derived by using the

actuarial formula.11

15.

16.

17.

One issue that is open to debate is how much of its expected profit margin (ie the

amount by which the revenue from a loan is expected to exceed costs) the lender

should retain on a loan that settles early. One approach would be to treat the profit

margin as a funding cost and allocate it in proportion to the costs of financing the

loan. However, other methods of allocating this margin may be equally or more

appropriate. For example, the profit margin could be allocated between periods in

proportion to the total costs incurred in each period or could be treated in the same

way as a variable cost, and rebated pro-rata to the customer.

The 2004 Regulations

The 2004 Regulations set a statutory minimum level of rebates. This statutory

minimum rebate is determined by an actuarial formula, whereby the customer is

entitled to receive as a rebate the interest remaining on the loan at the settlement

date. The settlement date may be deferred by up to four weeks to allow both parties

to organise for processing of the final payment12. For loans of more than one year,

lenders can retain an extra months interest to help lenders cover any early

settlement costs.13

In developing the 2004 Regulations, which are generally more beneficial to the

customer than the previous arrangements, DTI needed to take a sector-wide view.

The 2004 Regulations were therefore designed to apply to a wide range of consumer

credit agreements, including (with some exceptions) mortgages and personal loans

11It is worth noting that the capital employed by a lender over the life of a loan is a combination of the original loan principle and

the cash flows over the term of a loan (primarily the costs incurred and collections received). Where costs other than interestare significant, funding costs will not follow exactly the same profile as the actuarial formula.12

Source: DTI Guidance notes on the 2004 Regulations(2004).13

Source: DTI Guidance notes on the 2004 Regulations (2004). The lender may elect to make this 30 days instead of onemonth.

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up to 25,000. The approach taken in the 2004 Regulations is consistent with the

following three assumptions, which may provide a reasonable approximation of the

cost structure of providing other forms of credit.

18.

Most of the costs of providing consumer credit are interest costs or can be

approximated by applying the actuarial formula using the headline APR on the

loan. There are few variable costs.

It takes about one month to arrange for early settlement. Alternatively,

customers can and do wait until the settlement date before obtaining their further

advance.

The costs associated with early settlement are equivalent to around one months

interest for longer loans.14

None of these assumptions appears appropriate to home credit:

A high proportion of costs are incurred after issue. In particular variable weekly

collection costs are highcommission payments to agents are generally

between 8 and 10 per cent of the Total Amount Payableand some

administrative costs are also variable.

When loans are renewed, early settlement normally happens within a few days

of the request being made, rather than the four weeks envisaged by the 2004

Regulations.15

The administrative costs of early settlement are small. The main additional cost

is the calculation and payment of the rebate. In meetings with the DTI in 2003,

the CCA estimated that, for the smaller and medium-sized trader, the

administrative costs of early settlement would, on average be around 1.82 per

14There are two aspects to this. First, there may be some costs which are only incurred if the loan is settled early. Second, with

high fixed and low variable costs, an actuarial formula may understate the costs that have been incurred at settlement.15

This point was noted by the OFT in its response to the DTI consultation on the Consumer Credit Act (paragraph 2.9). TheOFT suggested that the deferment period for weekly collected credit should be reduced to 13 days.

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settlement.16,17 For large suppliers, administrative costs are considerably lower.

For example Provident has estimated its administrative costs of early settlement

to be around []p for each loan settled early.18 Set-up costs are also relatively

low: Provident estimated average set-up costs to be around [] a loan.19

19.

The high headline APR of home credit loanscompared with the headline APRs

on other credit productswhich arises in part from the cost structure of home

credit, means that an actuarial formula calculated using headline APRs gives

rise to low rebates during the later stages of a loan and that four weeks interest

calculated using this formula is a large sum compared with the balance

outstanding on the loan.20 All of these differences between the cost structure of

home credit loans and the cost structure consistent with the 2004 Regulations

will tend to provide low rebates for early settlement of home credit loans,

compared with underlying costs.

Provident analysis of early settlement rebates

Provident have submitted that the minimum statutory rebates nonetheless offer a

reasonable approximation to the costs avoided by the lender at early settlement and

that rebates are more or less fair in practice. In support of this view, Provident

submitted an analysis of early settlement rebates, which was prepared by LEK.

16The CCA told us that different practices existed within the sector in terms of the way these settlements were physically

handled. However, one normal system was to send the rebate by post. This helped the smaller and medium-sized trader(SME

trader) ensure that the payment got to the customer and so performed an audit function, enabling them to prove they hadcomplied with the legal requirement to pay the rebate. The 1.82 figure supplied to the DTI comprised matters such as thetraders time, typing and printing, cost of the cheque, cost of the envelope and cost of the stamp. The CCA told us that this wasa conservative estimate and it was clear to the CCA that some traders would spend more. The difference between lenderswould turn on factors such as the degree of computerization.17

The CCA said it estimated that SME traders served about 500,000 customers. Making the assumption that each of these tookout two or more agreements over the course of a year, the CCA said that it believed the 2004 Regulations would require,perhaps, an extra 200,000 or so early settlements to be processed each year. The CCA therefore estimated that the aggregateextra administrative cost for the SME traders would therefore be something in the region of 400,000 a year. This estimate didnot cover the position of the larger companies, nor did it include the increased costs to SME traders flowing from the removal ofthe deferment period.18

Source: LEK model. Provident told us that its settlement costs were low because of the efficiency of its back office functions,resulting from significant investment in IT systems. This investment is treated by Provident as an overhead and is not reflectedin the []p figure.19

Source: LEK model.20

See paragraph 19 of the working paper on The Consumer Credit (Early Settlement) Regulations 2004for an example of the

impact of a four-week deferment. See paragraph 62 of the working paper on Renewal Loansfor details of the size of rebatespaid compared with balances outstanding on renewal loans.

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20.

21.

The approach taken in this analysis is to compare the revenue that a home credit

lender would receive if a loan settled in any given weektaking the current level of

rebates as givenwith typical level of costs incurred on the loan up to that point,

including an allowance for a profit margin. This methodology bears some similarity to

the avoidable cost approach outlined in paragraphs 13 to 15, though it starts from

the perspective of the lender rather than the borrower.

The starting point for the LEK analysis is a breakdown of PPCs costs and

revenues,21 consistent with the companys management accounts. This is shown in

Table 1. The two largest cost items for PPC are agent commissions and bad debt.

Issue-related costs account for [] per cent of costs ([] per cent of total revenue)

and the administrative costs of early settlement account for [] per cent of costs

(less for total revenue). The overall profit margin for PPC (before interest and tax) is

[] per cent.

TABLE 1 Breakdown of PPC costs and revenue

Item million % of costs% of

revenue

Total agent commissionsBad debt charge

Other costsIssue relatedWeekly (excl commissions)Bad debt and arrears related(excl bad debt charge)

Early settlement related (exclcommissions)Total costs

PBITTotal Revenue

Source: Provident.

22. A cost profile for Providents 55 week and 31 week products was then developed,

using the average loan size for each product, to allocate costs and profit margin

according to the week on which loans are settled. It is worth noting here, that the

LEK analysis of Providents bad debt costs suggests that its time profile

21Provident submitted that the analysis would be similar if GPC were chosen instead.

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approximates better to the profile of interest rather than to a flat weekly cost or to a

one-off fixed cost.

23.

24.

25.

This cost allocation may then be combined with data on repayments to calculate an

average weekly margin, calculated as a rate of return on investment during the life of

the loan.22 The lender is considered to be indifferent to the timing of settlement if this

weekly margin is unaffected by the date on which the loan is settled. Figure 1 shows

the average weekly margin generated by the LEK model for Providents 55-week

loan product.

FIGURE 1

Weekly return on investment for a 55-week loan

[]

Source: CC estimates, using LEK model.

If the loan settles on the contractual date, then Provident makes an average weekly

return on investment of around [] per cent (considerably higher than home credit

lenders funding costs of around 0.2 per cent a week). Loans that settle before week

[] earn a higher weekly margin than this. Loans that settle after term earn a lower

weekly margin, although they still appear to be profitable as long as they are

eventually settled. LEK then reallocated PPCs total profit margin across all loans

that settle to calculate a constant weekly return on investment (also [] per cent)

irrespective of the week in which settlement took place.

The results of LEKs analysis for a [] loan with Providents 55-week product are

shown below in Figure 2.23 The top line shows the revenue that Provident would

22Investment in this instance comprises capital outstanding and direct costs incurred over the duration of the loan, plus fixed

and bad debt costs allocated to the loan less actual collections received.23All assumptions about this product are the same as in the earlier example.

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earn if a loan was settled in any given week. This is equal to the total charge for

credit on the loan ([]) less the minimum statutory rebate for early settlement

calculated according to the 2004 Regulations. The shaded areas show the

allocations of costs and profit margins between loans settled in different weeks.

FIGURE 2

LEK/Provident comparison of revenue against costs

[]

Source: Provident.

26.

27.

28.

If we accept the underlying analysis, Figure 2 shows that loans that settle at week

[] or earlier are between [] and [] more profitable for Provident than loans

which run to term. Loans that settle in weeks [] to [] are between [] and

[] more profitable than those which run to term. Loans that settle in weeks [] to

[] are between [] and [] less profitable than those which run to term (despite

the fact that no rebate is paid on early settlement).

However, there are two core assumptions in the LEK model which have a substantial

effect on the results.

First, the LEK model allocates its profit margin between weeks on which settlement

takes place to generate a margin calculated on a constant average weekly rate of

return. Given the considerable difference between the average weekly return on

investment and the costs of funding, it is not clear that the entire profit margin should

be, in effect, treated as a funding cost (see paragraph 15). The size of the profit

margin as a proportion of Providents revenue means that the results of this model

are highly sensitive to assumptions made about how this margin is allocated. In

addition, there is an element of circularity in using this approach to assess whether or

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not a system of rebates is fair, in that the total margin allocated in this way is, itself a

function of the rebates regime in question. Using this approach can tend to generate

cost-based rebates that are similar to those allowed under the current regime,

whatever that regime may be.

Second, the LEK model treats commission paid by Provident at early settlement24 as

a cost of early settlement, and hence a cost that should be recovered by the supplier

rather than rebated to the customer at early settlement. This is open to question

because the activity that gives rise to the cost (i.e. the collection) has not in practice

taken place.25 Companies may choose to reimburse their agents for activities that

they have not carried out, but this is not a cost that needs to be recovered from

customers.

29.

30.

31.

32.

Both of these assumptions tend to increase the estimates of the costs incurred for

loans that settle early. If alternative assumptions were made, different conclusions

may be reached about whether the statutory minimum rebate is at a fair value.

In summary, the allocation of costs in the LEK model appears to be reasonable and

this cost analysis is helpful in identifying costs that have been avoided through early

settlement. However, the treatment of profit margin as a cost and the way in which

margin is reallocated according to the week of settlement mean that the LEK model

is only of limited usefulness in assessing whether the level of rebates are fair.

CC analysis of cost-based rebates under different scenarios

We estimated the amount of a cost-based rebate using a range of assumptions about

cost structures. The product used for these calculations was Providents 55-week

24Equal to around [] per cent of the amount collected at settlement. Companies differ in their policies for paying commission

on early settlement.25

We were told that agents face an element of hassle when administering an early settlement and that if agents were not paidcommission on early settlement, other aspects of the commission package would have to rise.

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product, which has a TCC of 65 per 100 advanced. This is the most widely held

home credit loan product in the UK. We considered early settlement rebates payable

on a 400 loan26 at various stages of the loans life.

33.

34.

35.

36.

At early settlement, a cost-based rebate would allow the lender to recover the capital

sum advanced and all variable and interest costs that have been incurred up to that

point. It would also allow the lender to retain the profits earned up to that point. The

customer would receive as a rebate, those variable and interest costs that had not

been incurred, and the profit that had not been earned, when settlement takes place.

The administrative costs of early settlement (in the case of Provident, around []p)

may be subtracted from this rebate.

In calculating a cost-based rebate, we assumed that all costs could be categorized

as fixed costs, variable costs or interest costs.27 We assume to start with that no

repayments are missed during the life of the loan. Missed repayments will be

discussed in paragraphs 42 to 45.

Table 2 summarizes a range of assumptions about the split between fixed, variable

and interest costs for this loan. A central scenario assumes fixed costs of 30 (just

over one-tenth of the TCC) and variable costs are 66 (one-tenth of the total amount

payable and around a quarter of the TCC). These are broadly consistent with the

LEK analysis of Providents fixed and variable costs in Table 1.

This central scenario estimates variable costs to be of the same order of magnitude

as commission payments, and hence treats the entire profit margin as an interest

26We understand this to be typical of the amounts borrowed on a loan of around one years duration. Providents average loan

size for a 55-week product is [].27

In categorizing costs as interest, we are making an assumption about the profile with which costs are incurred during a loan

(ie that it can be approximated by the declining profile given by an actuarial formula). Not all interest costs in this sense will befunding costs.

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cost. As discussed in paragraph 15, this assumption is open to question and the

central scenario therefore errs on the side of allocating costs to interest, rather than

to variable costs. A cost-based rebate calculated in this way will be lower than one

which could be calculated if, for example, the profit margin were treated like a

variable cost or were allocated in proportion to all costs.

37. Nine scenarios are generated by allocating the TCC according to different

combinations of fixed, variable and interest costs. These scenarios may be

considered as reflecting differences between the cost structure of different providers

and loans28 and as illustrating a range of assumptions about the allocation of the

profit margin over the life of the loan. It is assumed that all costs apart from fixed and

variable costs decline over the course of the loan and are treated as interest. The

actuarial formula used in the 2004 regulations may be considered to be a special

case of this more general model, in which all of the TCC is assumed to be interest.

The last column calculates an implicit interest rate that is used to allocate the

interest component of the loan over its life. This is less than the headline APR on

the loan, as only a proportion of the price of the loan is assumed to constitute

interest.

28

For example, the low variable cost scenarios may be thought of as reflecting the view that the customer should only berebated half of the commission payments that would have been paid, if the loan had run to term.

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TABLE 2 Range of cost assumptions for a 400 loan with a TCC of 260

Scenario

Repayment ofcapital

Fixedcosts

Variable costs

Interest costs

HeadlineAPR

%

Rate used forallocating interest

costs%

Low fixed, lowvariable 400 15 33 212 177.0 134.5

Low fixed, med

variable 400 15 66 179 177.0 108.2Low fixed, highvariable 400 15 132 113 177.0 62.0

Med fixed, lowvariable 400 30 33 197 177.0 122.2

Med fixed, medvariable 400 30 66 164 177.0 96.9

Med fixed, highVariable 400 30 132 98 177.0 52.6

High fixed, lowvariable 400 60 33 167 177.0 99.1

High fixed, medvariable 400 60 66 134 177.0 75.8

High fixed, highvariable 400 60 132 68 177.0 34.9

Actuarial

formula 400 0 0 260 177.0 177.0

Source: CC analysis.

38. We then calculated a cost-based rebate for each scenario. This is equal to the sum

of variable and interest costs that had not been incurred at early settlement. Table 3

summarizes the difference between the statutory minimum rebates payable (in which

the settlement date on a 55-week loan for the purposes of calculating the rebate is up

to eight weeks after settlement takes placesee paragraph 16), the rebate

suggested by the actuarial formula on the actual date of settlement and rebates

based on costs avoided by the supplier at early settlement. Evidence from suppliers

and customer surveys suggested that around half of renewals take place with eight

weeks or less remaining.29

29Renewal Loans working paper paragraphs 53 to 60.

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TABLE 3 Difference between statutory minimum and cost-based rebates under range of scenarios

Cost assumptionsWeek of settlement

All interestActuarialformula

High fixed, lowvariable

Smallest difference

Medium fixed, Mediumvariable

Central scenario

Low fixed, highvariable

Largest difference

0 61 1 31 465 57 7 35 51

10 53 12 37 55

15 49 17 39 5720 44 20 40 5825 39 22 39 5730 33 23 37 5435 26 21 33 4840 19 18 27 4045 11 12 18 2850 3 5 8 13


39. In each of the scenarios, the statutory minimum rebate (ie using the actuarial formula

with an eight-week delay to the settlement date) is lower than a cost-based estimate

throughout the entire life of the loan. This difference is greatest for loans which settle

at around the midpoint of the loan and in the high variable cost scenarios. Apart from

the last one to two weeks of a loan, the shortfall between the statutory minimum

rebate and any of the cost-based estimates is of a different order of magnitude from

the administrative costs of early settlement. Other than for loans settled very early

on or near to term, rebates calculated according to the actuarial formula (but without

the eight-week delay to the settlement) fall within our illustrative range of cost-based

scenarios. This is shown in Figure 3.

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FIGURE 3

Comparison of statutory minimum rebates with cost-based scenarios

0

50

100

150

200

250

300

0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 52 54

Week of settlement

Amountofrebate

Low f ixed, high var iable High f ixed, low var iable Actuar ia l formula Statutory minimum


40.

41.

This analysis suggests that while the actuarial formula falls within our range of

possible approximations of underlying costs, the statutory minimum rebate is

consistently below any plausible cost-based estimate.

In Annex A, we developed an analysis intended to reflect more closely the situation

of a typical smaller provider. The higher administrative costs associated with early

settlement in this example imply that cost-based estimates of early settlement

rebates for loans that settle in the last three weeks are close to zero. For loans that

settle between weeks 4 and 25, the statutory rebate is lower than a cost-based

rebate on all scenarios. For loans that settle with eight weeks remaining, the

difference is in the range 4 to 11, compared with a statutory minimum rebate of

2.37.

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Treatment of missed repayments

42.

43.

44.

The analysis so far has assumed that customers make all their repayments on time.

If a customer has missed some repayments before the settlement date, then the

supplier is entitled to calculate any rebate payable either by reference to the amounts

and times that repayments are required under the contract (contractual repayments)

or by reference to actual repayments made.

If actual repayments are used, then the impact of charging the customer compound

interest on missed repayments at the headline APRs on the loan, mean that

customers can face substantial reductions in rebates for missing a small number of

repayments, particularly if these are missed early on during the loan.30 This does not

bear any resemblance to the underlying economic reality for home credit. The

reductions in rebate implied by the formula are considerably greater than the extra

funding costs associated with a missed payment. This is because the headline APR

on home credit loans is several times higher than suppliers cost of funds.

Moreover missed repayments are a common and accepted feature of home credit.

We have been told that a customer who makes two repayments out of three is

generally considered to be a good payer. Provident estimated that at least one

repayment is missed in over 95 per cent of its loans.31 The expectation of a certain

number of missed repayments is factored into the price and there is an implicit

understanding between lenders, agents and customers that occasional missed

payments will not be penalized.32

30Examples of the dramatic impact of missed repayments where rebates are calculated by reference to actual payments are

provided in paragraphs 41 to 47 of the working paper on The Consumer Credit (Early Settlement) Regulations 2004.31

Source: Provident response to market questionnaire Q46.32In part, because repayments may be missed for reasons related to the agent rather than the customer.

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45.

46.

47.

Using contractual repayments as a basis for calculating rebates is more appropriate

to home credit. The analysis conducted above may therefore be considered as

estimating a cost-based rebate for early settlement at a given stage in the contractual

term. Most home credit suppliers are using contractual repayments as a basis for

calculating early settlement rebates.

Conclusion on the level of early settlement rebates

Our analysis suggests that there is little justification in either principle or in practice

for home credit lenders to retain four or eight weeks charges over and above that

provided for in the actuarial formula in the 2004 Regulations. We can see no

justification for home credit lenders to retain a larger amount for loans of longer than

one year, than for loans of less than one year. These findings are robust to a wide

range of assumptions about the cost structure of home credit. The model developed

by LEK for Provident does generate a cost profile which is a closer approximation of

the rebate formula. However, this result appears to be driven by the size of

Providents profit margin in relation both to its revenue and its funding costs and the

assumptions made about the way in which that margin is allocated over the course of

a loan.

By contrast, the unadjusted actuarial formula appears to fall within our illustrative

range of possible underlying costs for the purposes of calculating a cost-based

rebate. However, if refinancing was subject to effective competitive pressure, we

might expect terms of early settlement to be more generous to customers than this

amount. The set-up and bad debt risk costs associated with renewal loans are lower

than for other home credit loans.33 In addition, the actuarial formula produces

rebates that are towards the bottom end of our illustrative range during the latter

stages of a loan when most early settlements take place.

33See Renewal loansworking paper, paragraphs 20 and 21.

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Section 3: The competitive impact of early settlement rebates

48.

49.

50.

51.

We noted in paragraph 9 that competition between home credit suppliers over the

terms of rebates is muted and that the price paid by many customers for early

settlement of home credit loans is determined by the minimum rebates set out in

legislation. The analysis in paragraphs 11 to 47 suggests that this statutory minimum

may be less than a fair value. This indicates a degree of harm to home credit

customers who settle loans early, whether renewing an existing loan or for any other

reason. In this section, we consider whether any such harm to customers may be

considered to be either a cause or a consequence of a lack of competition. The rest

of this section is structured around the following two questions.

Do low rebates prevent, restrict or distort competition?

Would rebates be higher if competition were more intense?

Do low rebates prevent, restrict or distort competition?

A rebate is a payment from an incumbent lender to a customer at early settlement. If

rebates were too low, early settlement would be highly profitable for incumbent

lenders and expensive for customers. Conversely, as rebates increase, early

settlement becomes less profitable for incumbent lenders and cheaper for customers.

Rebates could distort competition if the amount of the rebate significantly alters the

incentives of customers and/or lenders in ways that protected incumbent lenders

from competition or otherwise reduced rivalry between firms. We consider the impact

of rebates on customers and lenders incentives below.

Impact on customer incentives

The fundamental impact of low rebates on customers incentives is to reduce the

attractiveness to customers of settling loans ahead of term.

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52.

53.

54.

One implication is that low rebates can weaken customer incentives to transfer the

balance of an existing loan to another supplier mid-term. This is a common form of

switching in other credit markets (eg mortgages and credit cards).34 However, if

rebates are low, then the cost of early settlement could outweigh any benefits of

switching in this way, even where a new supplier is offering substantially lower prices

(see example at Annex B).

The effect is to reduce the likelihood of customers switching suppliers in this way

and to reduce the ability of other suppliers to attract customers to switch through

lower prices. However, the example at Annex B also suggests that, even with higher

rebates, large price differentials are required for it to be beneficial to customers to

transfer the balance on short-term loans from one provider to another. In addition, it

can be argued that customers have other ways of switching in home creditfor

example at the end of a loan or by multi-sourcing and switching at the margin.35 As

such, the competitive significance of this form of switching may be less for short-term

home credit loans than for longer-term credit products, such as mortgages, in which

transferring the balance of an account is likely to be a very important method of

switching suppliers.

Provided the same rebate is offered to all customers who settle early, the amount of

the rebate should not affect customers perception of the relative attractiveness of

refinancing a loan with different suppliers. Although it is rare for refinancing to take

place with companies other than the incumbent supplier,36 it seems unlikely that this

is because customers choices have been distorted by low rebates. Other, more

34For example, in its report Switched on to switching, NCC found that 31 per cent of customers surveyed in 2005 had switched

mortgage providers. Credit card providers frequently offer reduced interest rates to customers who transfer their balance fromanother provider.35

See paragraph 42 of the CC working paper on Customer Turnover, Multi-sourcing and Switching published alongside

Emerging Thinking.36See paragraphs 44 to 46 of the CC working paper on Customer Turnover, Multi-sourcing and Switching.

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plausible, explanations for this pattern are incumbency advantages and differences in

suppliers incentives to offer refinancing (see paragraphs 56 to 59).

55.

56.

57.

58.

Customers choice between suppliers could be affected, if suppliers offered more

favourable rebates to customers who are renewing a loan than to customers who

settle early for any other reason. Mutual offers a refinancing discount for customers

who renew a loan, but most suppliers offer the same rebates on all early settlement.

We do not consider the practice of offering differential rebates for renewals to be

intrinsically anti-competitiveindeed we might expect it to be a natural response of

suppliers in a competitive environment (see paragraph 64). However, the impact of

differential rebates on competition might be different if it were more widespread.

Impact on supplier incentives

The fundamental impact of low rebates on suppliers incentives is to increase the

benefits to incumbents of customers settling early. Rebates do not have a direct

effect on any other suppliers incentives, though they may have an indirect effect by

affecting their likelihood of winning business.

The amount of the rebate therefore affects incumbent lenders incentives to refinance

loans with existing customers. In particular, if rebates are too low, incumbent lenders

will have an additional incentive to refinance a loan arising from the windfall on early

settlement of the first loan. This incentive is not shared by any other lender, as it is

only the incumbent lender who benefits from early settlement.

This has two potential implications for competition. First, it is a factor increasing the

relative profitability of serving existing customers compared with new customers.

This could reduce rivalry between suppliers. Second, the difference in incentives to

offer refinancing between incumbents and other lenders may increases the likelihood

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that incumbents win refinancing business with customersfor example, because

they are able to pass on part of these incentives to their agents (or, in principle, to

customers).

59.

60.

It appears likely that these two effects are currently dominated by other factors.

Better information about the credit risks of existing customers and, consequently,

lower default risks and the ability to offer larger loans are likely to be more significant

factors affecting the profitability of existing customers compared to new ones. Other

incumbency advantages are likely to be more significant factors in determining that

most refinancing takes place with incumbent lenders.

What might happen in a more competitive environment?

In paragraphs 51 to 59, we considered the impact of rebates on competition between

home credit lenders under current competitive conditions. However, it is possible

that competition between home credit lenders may not be working as well as it might.

For example, in our Emerging Thinking, we found little price competition between

providers compared with what might be expected in a competitive market 37 as well

as incumbency advantages deriving, in part, from a lack of transparent, readily-

available data about the creditworthiness of customers.38 In the rest of this section,

we explore what might be the impact on rebates of more vigorous price competition

and/or a lessening of incumbent advantages. It should be noted that the CCs

assessment of price competition and incumbency advantages is ongoing. No

inference should be drawn about the CCs view of these issues from the following

analysis, the purpose of which is to help understand the role of rebates in the

competitive process, by considering alternative scenarios.

37

Emerging Thinking paragraphs 71 to 74.38Emerging Thinking paragraph 54 and paragraphs 85 to 81.

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More vigorous price competition

61.

62.

63.

If there were more vigorous price competition between home credit suppliers, this

might be expected to have an impact on rebates, if customers and suppliers consider

rebates to form part of the price of home credit. We consider that it would be rational

for them to do so. Low rebates increase the effective APR paid by customers and,

for those customers who regularly settle early and refinance their loans, the rebate is

an important determinant of the actual amount the customer pays for credit. More

broadly, in a market subject to intense price competition, levels of rebate might be

one among many competitive variables used by lenders, even if not the most

obvious. More vigorous price competition could affect the level of rebates in two

ways.

First, customers initial choice of a lender might be affected by the rebates on offer.

Firms could compete for new business on the basis of offering favourable terms at

early settlement alongside other aspects of their product (eg the headline APR and

the length of loan). This would affect rebates paid on all early settlements. However,

it could be argued that this mechanism would be weak, even in a more competitive

market. It may not be realistic to expect new customers to focus on this aspect of

price.

Second, lenders may seek to offer better rebates to retain existing customers.

Offering good value on rebates could become a way in which suppliers demonstrate

good customer service and provide incentives for loyalty. The significance of rebates

as part of the overall cost of borrowing is likely to be clearer to an existing customer

than to a new customer. Existing customers are also likely to have a greater

understanding than new customers of their likelihood of settling future loans early.

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64.

65.

66.

67.

The extent to which competitive forces would affect the level of rebates may differ

according to the reason for early settlements. Where a customer is renewing a

loanor if a customer is settling a loan early but might wish to use the supplier again

in the future39then lenders in a more competitive environment could have

incentives to maintain goodwill by offering a higher rebate. Suppliers are less likely

to seek to offer better rebates to customers who wished to repay a loan early, but

had no intention to do any more business with them.

Lessening of incumbent advantage

If incumbency advantages were weakened, then we might see greater competition at

the point of renewal. Customers wishing to refinance a loan might have a wider

choice of lenders willing to offer the amount the customer wishes to borrow.

In these circumstances, the difference in incentives between the incumbent and other

lenders identified in paragraph 58 may become more relevant to competitive

outcomes. Faced with increased competition at the point of renewal, incumbents

might seek to restore an element of incumbency advantage by offering better rebates

to customers who stay with them. If statutory rebates were too low, incumbents

would be able to profitably offer a better rebate to customers who refinance a loan

with them than the statutory rebate, which may continue to be offered to customers

who wish to settle early and switch to another supplier. There appears to be little

need for incumbent suppliers to do this at present.

Counterarguments

Various arguments have been put to us to suggest that competition between home

credit suppliers is inherently unlikely ever to focus on rebates.

39

For example, a customer who took out a home credit loan due to a short-term shortage of funds and was in position to payback the loan ahead of term might be more inclined to use the same lender in similar circumstances in the future.

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68.

69.

70.

71.

It has been put to us by several parties that the choices customers make are based

much more on immediate prosaic factors (eg how much is this going to cost me a

week; how much will it cost me overall; are there any extra charges if I miss) than

on something as esoteric as an early settlement rebate.

This argument is not without force. Price competition is most likely to focus on the

most visible aspects of pricenotably the headline price of the loan. In this sense,

low rebates are similar to hidden charges in other markets and may not be

competed down to costs, even in a generally competitive market. An alternative

scenario might be that, with more vigorous price competition, rebates would be

unaffected, but that increased competition would manifest itself through lower

headline prices. There would be a cross-subsidy between customers who settle

early and those who do not, but the process of rivalry would bid overall prices down

to competitive levels.

It was also put to us that credit advertising law requires APR to be given more

prominence than rebate and that this could reduce the likelihood that price

competition for initial loans would focus on the rebate. This appears to place a

disproportionate emphasis on the impact of these regulations.

We were also told that for any trader to systematically compete on rebate they would

(other things being equal) need to charge higher cash cost and APR than their

competitors. To be more competitive on rebate they would have to be less

competitive on price. We have not seen any evidence to suggest that suppliers who

currently offer more favourable rebates have higher charges than those that offer the

statutory minimum.

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72.

73.

74.

75.

Finally, it was put to us that a lack of observed competition on rebates suggests that

rebates are already at the right level. Home credit lenders have told us that they are

generally happy with the approach taken to rebates in the 2004 Regulations.

However, we do not consider that it would be correct to infer that the observed lack of

variation between suppliers, of itself, demonstrates that rebates are set at a level that

is fair to both consumers and suppliers.

Conclusion on competitive impact of rebates

Rebates may affect competition between home credit providers in three ways:

low rebates reduce customers incentives to switch providers through

transferring the balance from one supplier to another (see paragraph 52);

differential loyalty rebates provide incentives for customers to refinance with

their existing supplier and act as a barrier to switching (see paragraph 55); and

low rebates create an additional incentive for incumbent suppliers to refinance

customers loans compared with other lenders. This could reduce rivalry

between suppliers and be used reinforce incumbency advantages (see

paragraphs 57 and 58).

Looking at the first of these effects, we note that there are other ways in which

customers may switch between home credit suppliers and that, even with higher

rebates, large price differentials are required for it to be beneficial to customers to

transfer the balance on short-term loans from one provider to another.

It is difficult to see that the second and third of these effects are currently having a

strong adverse effect on competition. Only Mutual currently offers higher rebates on

renewals than for other early settlements. At present, other incumbency advantages

appear more significant than any additional incentive for incumbent suppliers to offer

refinancing.

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76.

77.

78.

However, low rebates might be a symptom of a lack of competition in home credit or

might have an adverse effect on competition, if other impediments to competition

were removed. We therefore also considered what might happen to rebates in a

hypothetically more competitive environment.

One scenario is that more vigorous price competition between lenders could focus on

headline prices, leaving rebates unaffected. It seems unlikely that suppliers would

actively seek to compete on rebates for all customers, even if the market were more

competitive. For this to be a rational strategy, customers would need to be well-

informed about rebates at the point of taking out their initial loan. At this stage, the

rebate may appear of little relevance to the cost of credit and customers may focus

on other parts of the customer offering. In this sense, low rebates are similar to other

hidden charges. This is, in essence, the market failure rationale for setting a

statutory minimum level of early settlement rebates, even in markets which are

generally competitive.

However, with more vigorous price competition and a weakening of incumbency

advantages, we might expect more suppliers to offer refinancing on better terms to

existing loyal customers. A greater focus on the cost of borrowing (including the

rebate) from existing customers, plus a more credible threat to switch elsewhere,

could put more pressure on suppliers to seek to retain them by offering better rebates

on refinancing. If rebates were too low to start with, they would be able to do this

profitably. If rebates paid under other circumstances were unaffected, this could

increase barriers to switching. Although the market would be more competitive in

this scenario, low statutory rebates might, at this point, act as an impediment to

further competition.

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ANNEX A

Alternative scenario for smaller provider

1.

2.

3.

The example developed in paragraphs 32 to 40 is based on Providents 55-week

product. This is the most widely held home credit loan product in the UK. However,

it is not typical of smaller providers, who tend to offer loans for repayment over a

shorter term. The CCA also told us that smaller providers faced higher costs

associated with early settlement. In meetings with the DTI in 2003, the CCA

estimated that, for the smaller trader, the administrative costs of early settlement

would, on average be around 1.82 per settlement.

We developed an analysis intended to reflect more closely the situation of a typical

provider. The product we considered was a 28-week loan, with a TCC of 40 on

100. A typical loan size for a product of this duration would be 200, on which the

customer was making an average weekly repayment of 10. As with the example in

the main body of the text, we considered a range of cost scenarios. In the central

scenario, we assume the fixed costs associated with this loan to be 14. Weekly

variable costs in the central scenario are 28 (equivalent to 10 per cent of the Total

Amount Payable or 1 a week). As with the example in the main body of the text, the

remaining 38 is assumed to be incurred with a similar time profile as interest. The

implicit interest rate used for allocating these costs between periods is 90.0 per cent,

compared with a product APR of 258.6 per cent. In all scenarios we used the CCAs

average cost of early settlement of 1.82.

Table 4 shows the range of scenarios considered.

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TABLE 4 Range of cost assumptions for a 200 loan with a TCC of 80

Scenario

Repayment ofcapital

Fixedcosts

Variable costs

Interest costs

HeadlineAPR

%

APR forallocating

interest costs%

Low fixed, lowvariable 200 7 14 59 258.6 163.1

Low fixed, med

variable 200 7 28 45 258.6 112.2Low fixed, highvariable 200 7 42 31 258.6 69.7

Med fixed, lowvariable 200 14 14 52 258.6 136.5

Med fixed, medvariable 200 14 28 38 258.6 90.0

Med fixed, highvariable 200 14 42 24 258.6 51.3

High fixed, lowvariable 200 21 14 45 258.6 112.2

High fixed, medvariable 200 21 28 31 258.6 69.7

High fixed, highvariable 200 21 42 17 258.6 34.5

Actuarial

formula 200 0 0 80 258.6 258.6


4.

5.

Using these assumptions, we calculated cost-based early settlement rebates for

each week of settlement using the formula in Figure 4.

FIGURE 4

Formula for calculating cost-based early settlement rebates

Rebate = Weekly costs avoided by customer settling early

plusinterest costs avoided by customer settling early

minusadministrative cost of early settlement (= 1.82)

Source: CC.

Table 5 calculates the difference between the statutory minimum rebates payable

calculated using the actuarial formula subject to a four-week defermentand rebates

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based on the costs avoided by the supplier at early settlement. The statutory

minimum rebate payable is included as the final column.

TABLE 5 Difference between statutory minimum and cost-based rebates under range of scenarios

Difference from statutory minimum

Cost assumptionsWeek

All interestActuarialformula

High fixed / lowvariable

Minimum

Med fixed, medvariable

Central scenario

Low fixed highvariable

Maximum

Rebate payableStatutory minimum

0 19 4 3 10 60.875 16 1 7 14 40.02

10 13 4 10 16 22.9815 10 5 10 15 10.2420 6 4 7 11 2.3725 1 0 2 3 0.00


6. In the high fixed cost scenarios, the statutory minimum is below the cost-based

rebate for loans that settle in the first two to three weeks. The higher administrative

costs associated with early settlement in this example also imply that cost-based

estimates of early settlement rebates for loans that settle in the last three weeks are

close to zero. For loans that settle between weeks 4 and 25, the statutory rebate is

lower than a cost-based rebate on all scenarios. For loans that settle at week 20, the

difference is in the range 4 to 11, compared with a statutory minimum rebate of

2.37.

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ANNEX B

Impact of rebates on incentives to transfer outstanding balances

1.

2.

Consider a customer who has taken out a 400 loan on a Providents 55-week

product, which has a TCC of 65 per 100 advanced.

Now suppose that, after making 27 repayments, the customer is approached by

another supplier, offering a 28-week loan at a total charge for credit of 40 per 100

advanced. The customer does not want to borrow any more at that stage, but is

interested in switching away from her current lender. Table 6 shows the details of

the first loan and the situation after 27 weeks.

TABLE 6 Details of first loan and situation after 27 weeks

Terms of first loanOriginal loan size () 400TCC per 100 () 65TCC () 260Total amount payable () 660No of weeks 55Weekly payment () 12

Situation after 27 weeks

No of weekly payments made 27Balance outstanding on first loan () 336TCC per 100 for new provider () 40

Source: CC analysis based on Provident loan example.

3.

4.

In order to illustrate the implications of rebates for the incentives to switch in this way,

we consider four scenarios for the rebate. At one end of the spectrum, the customer

receives no rebate. At the opposite end, the customer receives a rebate calculated

at a flat rate (ie the customer is rebated 28/52 of the total charge for credit). In

between are the rebate calculated using the actuarial formula with and without the

retention of eight weeks interest.

Table 7 shows the impact of different rebate regimes on incentives to switch. With

the rebate calculated as a flat rate, the customer is 51 better off for switching. With

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the actuarial formula, the customer is 22 worse off. The differential is larger still, if

the incumbent supplier chooses to retain eight weeks interest.

TABLE 7 Impact of rebates on incentives to transfer balances

Rebate regime Flat rate Actuarial

Actuarialless eight

weeks No rebate

Cost of paying off loan with incumbent 336 336 336 336Rebate 132 80 43 0Amount borrowed from new provider 204 256 293 336Total amount payable with new provider 285 358 410 470Customer saving / cost of switching 51 22 74 134


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Early Settlement Rebates-further Analysis

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