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The Coronavirus pandemic has spawned a raft of responses to address potential debt problems faced by businesses and individuals (see here). For example, the most recent FCA initiative includes temporary payment freezes on mortgages and credit cards for up to three months with the further proviso that these measures should not adversely affect a consumer’s credit rating (see here).
These provisions have been layered onto existing FCA protections for individuals facing difficulties with repayment. These include the general principle to treat customers fairly (here), provisions on forbearance in debt collection(here), and rules on addressing persistent credit card debt (here). Critics have suggested that firms have not embedded these policies consistently into their practice (see here). This is one reason for the proposed statutory “breathing space” (see generally here and here) for individuals with problem debt, which has been slowly working its way through the policy process.
I do not want in this blog to engage in a detailed analysis of these provisions. I want rather to note the significance of these specific developments in relation to thinking about and the teaching of contract law, and in particular the approach of the law to changed circumstances affecting contract performance. This is ultimately of much practical importance.
English law students learn from standard textbooks in first year contract law that the courts are very reluctant to adjust the terms of contracts because of a change of circumstances. “Mere” hardship or inconvenience will not permit adjustment. Students learn that a contract will only be frustrated i.e. brought to an end, where without the default of either party, performance has come to be radically different from that which was undertaken (see e.g. Davis Contractors Ltd v. Fareham Urban District Council  AC 696). This proposition is supposedly given more authority by being expressed in Latin… non haec in foedera veni (roughly translated as it was not this that I promised to do).
This approach reflects classical contract law where the assumption is that parties fix all the risks at the time of entering into the contract. Strict rules on adjustment create incentives on parties to plan at the outset, for example, by inserting a force majeure clause into the contract. A standard force majeure clause is that of the International Chamber of Commerce (ICC) which includes “the occurrence of an event or circumstance (“Force Majeure Event”) that prevents or impedes a party from performing one or more of its contractual obligations under the contract, if and to the extent that the party affected by the impediment (“the Affected Party”) proves: a) that such impediment is beyond its reasonable control; and b) that it could not reasonably have been foreseen at the time of the conclusion of the contract; and c) that the effects of the impediment could not reasonably have been avoided or overcome by the Affected Party.” A party successfully invoking this Clause is relieved from its duty to perform its obligations under the Contract and from any liability in damages or from any other contractual remedy for breach of contract, from the time at which the impediment causes inability to perform, provided that the notice thereof is given without delay (see here). If the impediment is temporary then the party obtains relief only during the temporary period.
Force majeure clauses may be common in many commercial projects and contracts. However lenders do not voluntarily provide such clauses in consumer loan contracts, not surprisingly, given the recognition that consumer credit contracts often represent standard form contracts of unequal bargaining power. The UK Supreme Court recognised this in 2014 in Plevin v. Paragon Personal Finance (see here) where Lord Sumption commented that ‘the great majority of relationships between commercial lenders and private borrowers are probably characterised by large differences of financial knowledge and expertise. It is an inherently unequal relationship’.
It follows from these propositions that events such as loss of employment are not treated as a defence to repaying one’s debts.
However, the statutory development of the law such as the FCA rules above, envisage the potential adjustment of obligations in the event of a change of circumstances.
The introduction of a statutory breathing space confirms this conclusion. It draws inspiration from earlier provisions such as section 107 of the Tribunals, Courts and Enforcement Orders Act 2007 which introduced an Enforcement Restriction Order. This would have restricted enforcement where an individual was unable to pay one or more of his debts, was suffering from a sudden and unforeseen deterioration in his financial circumstances and there was a realistic prospect that the debtor’s financial circumstances would improve within the period of six months beginning when the order is made. Unfortunately the government did not bring this provision into force but it provided an inspiration for the lobbying by debt charities for the introduction of a statutory breathing space. The 2007 provisions could themselves be traced back to the report of the Cork Committee in 1982 (often regarded with great reverence by English insolvency lawyers) which had recommended the introduction of an enforcement restriction order for such period and on such terms as the court may deem expedient (see para 310).
In addition, section 129 of the Consumer Credit Act 1974 permits a court to make a time order for repayment, if it appears to the court ‘ just to do so’, having regard to the means of the debtor as well as permitting the remedying of any breach by a debtor. Undoubtedly the courts look at the circumstances of the loan, the reasons for the default and the payment record of the debtor in making such an order. Such a discretion continues a historical approach of some lower courts which exercised discretion to protect lower income debtors from overreaching creditors.
Moreover, bankruptcy and insolvency law are in substance mandatory ground rules of contracts permitting an individual to discharge their obligations if they are an honest and unfortunate debtor. Tables 1 and 2 below outline the importance of change of circumstances such as loss of income, increased expenses and relationship breakdown, as reasons for debtors filing bankruptcy and Debt Relief Orders.
Taken together, all these factors support a general legal principle of social force majeure, as a ground rule of consumer contract law, with the consequence of a temporary or more permanent adjustment of the contract. Thomas Wilhelmsson outlined the idea of social force majeure in the early 90s (see here) as being when an individual is affected by unfortunate change of circumstances outside of her control which cause difficulties in repayment and the consumer is not at fault in causing this situation. To the extent that this may cause any increase in costs, creditors are in a better position to bear and spread these costs. In reality a temporary breathing space may be a method of more effective recovery in the long run rather than an aggressive enforcement policy.
Recognition of such a principle links contract law to one of the pillars of the welfare state, namely protection against unexpected drops in living standards caused by for example unemployment or illness. This principle could inject discussion of unemployment and social divisions into the world of contract law doctrine and texts. Rather than being viewed as an exception to the dominant idea of pacta sunt servanda (agreements must be observed) , social force majeure represents a counterprinciple in private contract law and not a topic relegated to an exception or to be discussed only in specialised consumer or welfare law courses.
Table 1: Debtor application bankruptcy by reason between Quarter 2 2014 and Q1 2018
|Reason for bankruptcy||Number||%|
|Living beyond means||8,280||16.9%|
|Reduction of bankrupt’s income||5720||11.7|
|Loss of bankrupt’s employment||4970||10.2|
|Loss/reduction of household income||4650||9.5|
|Loss of market||3120||6.4|
|Other reason given||2550||5.2|
Table 2: Causes of Debt Relief Order: 2015
|Increase in expense||2885||11.9|
|Living Beyond Means||3760||15.5|
|Loss of employment||2795||11.5|
|Reduction in household income||8080||33.3|
N cases =24175, multiple causes cited in some cases. Source: Insolvency Service
Much attention has focused on the recent EU Directive on Restructuring, aimed primarily at facilitating corporate restructuring. Less attention has been paid to the Directive’s provisions in relation to individual insolvents. The Directive here only addresses individuals as entrepreneurs, defined as ‘a natural person exercising a trade, business, craft or profession’. The relevant provisions limit the period of discharge for ‘honest entrepreneurs’ to no longer than three years, whether or not the insolvency procedure requires a repayment plan. Discharge will be automatic without the necessity for an application to court. Professional disqualifications based on insolvency may not exceed the discharge period. When personal and business debts are intertwined, they are to be dealt with in a consolidated procedure.
The provisions on entrepreneurs are driven by the Commission’s belief in the link between a ‘soft-landing’ in bankruptcy and the promotion of entrepreneurialism and innovative risk-taking, a link which also drove the liberalisation of the English bankruptcy discharge to one year in 2002. I commented on this in an earlier post on the draft EU proposals (here) when I raised questions about the connection between a liberal fresh start and entrepreneurialism based on studies using self-employment as a proxy for entrepreneurialism (see here at 173-179).
The Commission’s recent Directive offers little for consumer debtors. At a recent Finance Watch conference which I attended, an official of the EU Commission hinted at the possibility of action on debt advice at the European level. Increasing awareness exists at the international level of the importance of making insolvency proceedings available for consumers and providing a swift fresh start. However, the EU Commission seems not to be following up on this issue at the European level, or realising the important role of personal insolvency as part of the ground rules of a consumer credit market.
Undoubtedly the issue of consumer insolvency may be more politically contentious with conservative jurisdictions such as Germany and Sweden likely to be opposed to a more generous fresh start for consumers. The exit of the UK, with its relatively swift fresh start, from the EU, may paradoxically reduce the likelihood of further action on this topic by the EU in the near future.
Branko Milanovich in Global Inequality documents the winners and losers from the globalisation of economies since 1988. Middle and lower income groups in the rich world have stagnating incomes while countries such as China and India have witnessed an increasing middle class. Both groups have increasingly a shared characteristic: high household debt. The IMF has issued a warning about high world debt (here) and has developed a global debt database. In countries of the North, the declining middle class use debt to hold on to their way of life in a period of stagnating wages, in emerging economies credit is part of the move to a consumer society. The growth in inequality within rich countries also means that low income individuals make greater use of credit to get by, while low income consumers gain access to credit in emerging economies as part of a drive to financial inclusion. Inevitably there are casualties who are overindebted. Farmers in rural India struggle to repay micro-credit; those facing reduced circumstances in the UK experience a spiral of debt through using credit cards to maintain a lifestyle. This global phenomenon of debt has spawned international proposals to regulate credit and protect the casualties of the credit system. The global financial crisis of 2008 spurred the international financial institutions into action as they discovered consumer finance protection as one tool for fostering financial stability and promoting continued market expansion for credit. The 2017 World Bank’s guide to consumer finance protection now runs to over 200 pages.
A global proliferation of individual bankruptcy laws has occurred to provide a safety net for the casualties of the credit system. China, until recently one of the few jurisdictions not to have a consumer bankruptcy law which permits discharge of debts, is now considering reform in the context of rising household debt from 10 percent of GDP in 2006 to 45 percent in 2016 (see here). An increasing global phenomenon is that of the ‘low-income no-asset debtor’ or ‘no-income no-asset debtor’ who may be unable to pay for bankruptcy in those jurisdictions which require individuals to pay for access. In the early 2000s New Zealand floated the idea of a simple “No asset procedure”. English policymakers picked up the idea and the Debt Relief Order was enacted in 2007, a low-cost, means tested, administrative procedure accessible only with the assistance of approved debt advice agencies. Variations on this model exist in Ireland and Scotland.
The IMF persuaded Cyprus to introduce a No-Asset procedure in 2015 as part of its structural adjustment programme and Kenya and India now have No- Asset procedures. The details of these laws differ but the rapid globalisation of the idea of the need for debt relief for low income individuals is striking.
Women dominate the use of the DRO in England and Wales: they may often be sole parents who have been hardest hit by austerity. The DRO is now the most common form of debt discharge in England, outstripping bankruptcy. Similar findings exist in relation to New Zealand’s no asset procedure. In the US reforms to bankruptcy law in 2005 substantially increased the costs of achieving a fresh start through bankruptcy and several writers propose a more simplified procedure for individuals with few assets and little income.
The DRO provides an individual solution for the low income and overindebted, but we know little about its long term effects in providing a fresh start or merely a breathing space in a continuing struggle with debts. A radical question is whether this individualised form of relief draws attention away from structural problems of insufficient income and support and the ever present compulsion of credit to meet everyday needs. The introduction of a DRO procedure in India is of particular interest since it contrasts with the across-the-board use of debt jubilees in that country. The Indian government, and the government of Uttar Pradesh have both on different occasions simply wiped out the debts of rural farmers (here). Croatia wrote off the debts of its poorest citizens in 2015 to provide them with a fresh start (here). The Debt Jubilee campaign in the UK, championed by the actor Michael Sheen, proposes a targeted debt jubilee for individuals trapped in persistent debt, and the Financial Conduct Authority has raised the possibility of credit card companies writing off persistent long term debt.
Johnna Montgomerie in a recent monograph “Should we Abolish Household Debts?” provides a lively argument for a modern form of debt jubilee. Montgomerie outlines a blueprint for debt cancellation, arguing that it would be an effective method of ending wider economic stagnation. The proposals include a ‘household debt cancellation fund’ equal to half the amount given to the financial sector ten years ago. This would fund long term refinancing for consumer and mortgage loans commenced in 2009. It would also pool together old and onerous debt, including the cancellation of non-performing loans and those already written off by lenders. The jubilee would therefore target specific types of debt rather than debtors.
The premise of the proposal is that of a more balanced credit system. At present banks can create credit from nothing, a phenomenon recognised by the Bank of England. The state guarantees this system and steps in to rescue it through methods such as quantitative easing. Debtors meanwhile must continue to repay. Debt cancellation would balance the system.
Economists will undoubtedly worry about moral hazard and the impact on credit availability but we need to start an international conversation about when it is legitimate not to repay debts (see e.g. here).
One aspect of the memorandum of understanding between the EU and Greece in mid-August 2015 concerns reform of Greek household insolvency law with Greece being required to modify its existing law and administration.
Greece introduced a personal insolvency law in 2010. This included a mandatory pre-judicial settlement procedure and a repayment period of 4 years before a discharge. It also permitted under certain circumstances an individual to remain in her primary residence provided she repaid 80% of the value of the home over 20 years. The law was hardly a debtor’s charter and was based on the defective German personal insolvency law (see e.g. criticisms by Backert et al here) .
It was predictable therefore that the Greek law would face initial problems in implementation. The pre-judicial settlement phase rarely resulted in an agreement. Consumer groups attributed this to the intransigence of the banks but it is also possible that limited specialist advice existed for consumers and no guidelines existed for negotiations. Courts were ill equipped to address bankruptcy issues, free legal advice was not available and the courts became overloaded. Individuals might have to wait years–even in extreme cases until 2024!– for a hearing. These failures on a smaller scale were experienced by France and Germany when they initially introduced individual insolvency laws without thinking through the proper infrastructure for administering large numbers of cases of individuals with few assets.
Greece also introduced in substance a moratorium on foreclosures of primary residences under a certain value.
In face of increasing levels of non-performing loans (not surprising in the light of the austerity measures) the IMF concluded in 2012 that the Greek law was a failure. They claimed that the blanket protection of the moratorium resulted in ‘strategic default’ and moral hazard. Greece duly agreed to change its law, substituting targeted relief for ‘vulnerable debtors’ so as to minimize moral hazard and modernize the Act in line with ‘best practices in the EU’. When the Syriza government was elected it proposed to reintroduce the moratorium while at the same time pursuing strategic defaulters.
The agreement of August 2015 imposes a battery of reform obligations on Greece with a demanding timetable. The obligations include: establishing a stricter screening process to deter ‘strategic defaulters’, tightening the eligibility criteria for protection of the primary residence, introducing measures to address the backlog of cases, short form procedures for debtors with no income or assets, developing specialised court chambers for individual and corporate insolvency and training additional judges, establishing a regulated insolvency profession in line with ‘good cross-country experience’, reactivating the government council of private debt, amending the out of court procedure to encourage debtors to participate while ensuring fairness among creditors. Debt to public agencies will now be dischargeable and the discharge period for entrepreneurs reduced to three years in line with the EU recommendation of 2014. This process of reform will draw on ‘independent expertise’, external consultants and ‘cross country experience’. Greece commits to review the process of reform by mid 2016.
The policies are a mixture of potentially progressive ideas and less well thought out reforms. The introduction of a swift no-income-no-assets procedure and the inclusion of public creditors in the discharge are welcome. Stricter screening criteria are likely to be problematic in implementation and deter those in genuine need. It is not a simple matter to distinguish ‘strategic’ from ‘good faith debtors’. Such measures taken in a crisis may not be dismantled after the crisis, having a long-term detrimental impact on access to insolvency.
This imposition of reforms by the EU raises concerns (for a trenchant critique of the provisions see Yanis Varoufakis here) . Technocratic knowledge substitutes for democratic decision-making. One might feel less unhappy if the technical expertise was based on sound empirical studies and well-tested theories of insolvency administration. However, data were never presented on the level of ‘strategic defaulting’ taking place or the extent of ‘moral hazard’ in Greece. Increases in non-performing loans do not necessarily equate with large increases in strategic default. The abstract economic categories of strategic behaviour and moral hazard may not be helpful for understanding the situation of a country in crisis. I do not doubt that some strategic default existed but the Troika and IMF never provided data on its extent. Given the absence of a ‘scientific’ basis for the EU requirements what is the source of legitimacy for the insolvency norms being imposed? Unlike business insolvency where the UNCITRAL guidelines are used to measure a country’s insolvency law, no international standards exist for individual insolvency. The IMF recognised this fact in 2013. Yet by 2015 the EU is appealing to ‘best practices’ and ‘cross-country experience’ (without identifying countries or why they represent best practice) in justifying its imposition on Greece of particular insolvency norms. In truth, given the absence of international norms, the IMF in their work on personal insolvency reform in Europe have been ‘making it up’ as they go, with changing scripts depending on the ability of the country to resist IMF pressure. It is unlikely that Greece will be able to meet the demanding time line for introducing insolvency reforms, such as the creation of an effective infrastructure of courts. Creating a well-functioning bankruptcy infrastructure is not a short-term task. It is as if Greece has been set up to fail.
Several countries (Canada, US, Scotland) now include debt counselling as part of the individual bankruptcy process but evidence is limited as to its beneficial impact.
Many official inquiries have supported the integration of counselling in the debt enforcement system. In the 1960s and 70s counselling was justified by the perception of a debtor as needing assistance in managing her financial affairs and possibly having wider problems in coping with life. The English Payne Committee (1970) proposed a social service office for debtors as part of a state enforcement office based on ‘abundant evidence that many debtors incur and fail to pay their debts because they are inadequate personalities or irresponsible in managing their affairs… They need to be assisted to financial health and stability.” (para 1210) Social workers would ‘perform for financially incompetent or inadequate or irresponsible debtors, the functions which are discharged for more successful members of the community by bank managers, accountants or solicitors’ (1216). The influential Brookings Commission study (1971) in the US proposed that financial counselling should be available to all debtors after finding that 31 percent of debtors attributed their problems to poor debt management, and the US Bankruptcy Commission(1973) proposed that access to bankruptcy should be dependent on a debtor receiving counseling by the new administrative agency which would administer the bankruptcy process. The Bankruptcy Reform Act 1978 contained no formal requirement for counselling. The US National Bankruptcy Commission in the late 1990s endorsed the introduction of counseling on a voluntary basis.
Canada pioneered in 1992 the legislative introduction of two counseling sessions during bankruptcy for individual bankrupts (see here). The objective was to prevent repeat bankruptcies and to further rehabilitative goals of behavior modification. The Insolvency regulator (Office of Superintendent of Bankruptcy), debt counselling agencies and the Canadian Bankers Association supported its introduction. In Canada the trustee (or their delegate) must now: (1) make a pre bankruptcy assessment outlining options including that of a consumer proposal (repayment of a portion of debt usually over three years), (2) provide an initial counseling session shortly after bankruptcy is declared entitled consumer and credit education and (3) a second session shortly before discharge which normally takes place nine months after the declaration of bankruptcy. Counselling is financed by a fee which comes out of the bankruptcy estate– $85 for each stage of counselling-usually made from income payments by bankrupt. Ninety percent of the sessions last under one hour. Counselling is a condition for receiving a discharge. The current Directive (OSB 1R3) defines it as ‘educating debtors on good financial management practices, including the prudent use of consumer credit and budgeting principles, developing successful strategies for achieving financial goals and overcoming financial setbacks and where appropriate making referrals to deal with non-budgetary causes of insolvency (ie gambling, addiction, marital and family problems)’.
Has the Canadian system of counselling achieved its objectives? It is difficult to measure this rigorously because one ideally needs a control group who go through the process without counseling. In early reviews bankrupts generally were favourable in their assessments of counseling. But does counselling change behavior or result in fewer repeat bankruptcies? The only rigorous study of the Canadian system using a control group, conducted by Saul Schwartz and published in the American Bankruptcy Law journal in 2003, concluded that counseling did not lead to ‘any appreciable improvement in future creditworthiness’ and ‘has little effect on repeat bankruptcies in the first five years after an initial bankruptcy filing’. In Canada the overall repeat filing rate has increased from 10 percent in 2002 to 15 percent in 2011 and 16 percent in 2012. Notwithstanding these data a recent evaluation in 2013 by the Canadian Department of Industry argues that counselling has a positive impact because ‘debtors found the sessions useful’. The report admits that ‘determining the effectiveness of mandatory counseling is challenging because it is difficult to disentangle the results of two counseling sessions from the broader changes that occur in a bankruptcy or insolvency’. The study suggests some short-term changes in understanding and behavior by debtors and notes that repeat bankrupts were slightly less likely to cite overuse of credit as a reason for bankruptcy. But the study is hardly a ringing endorsement for mandatory counselling for all bankrupts.
In the US the 2005 Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) introduced mandatory counselling at the pre-bankruptcy stage as an eligibility condition for filing for bankruptcy and also required bankrupts to undertake a financial education course during bankruptcy as a condition of receiving a discharge. Pre-bankruptcy counselling is premised on the assumption that debtors turned too quickly to bankruptcy as a solution for their problems. The Act is vague on the contents of the financial education course but the Federal US trustee has promulgated rules which indicate that the course must include budget development, money management, wise use of credit (including distinguishing wants from needs), consumer protection, and coping with unexpected financial crisis. The financial education course must last a minimum of two hours but may be completed in person, over the phone, or through the Internet.
Michael Sousa in a recent article surveys existing pre- and post- BAPCPA studies of voluntary counselling in bankruptcy. He also presents the results of a qualitative study of the effects of the BAPCPA counselling requirements. Most debtors did not find the courses helpful. Pre-bankruptcy counseling was just ‘jumping through hoops’. It did not have the consequences hoped for by Congress–where debtors rethought their decision and entered a debt management plan. Rather it either confirmed the correctness of an individual’s decision to file for bankruptcy or helped to allay any fears about declaring bankruptcy. Most debtors thought that a two-hour financial education course was not enough to provide long-term effects and in any event was often inappropriate since many individuals filed for bankruptcy because of external economic changes unrelated to financial capability. Sousa concluded that the existing BAPCPA counselling requirements are ‘by and large misguided and are in desperate need of overhaul and reform’.
Scotland recently introduced counselling in the 2014 Bankruptcy and Debt Advice (Scotland) Act which Act will, according to the relevant Minister, Fergus Ewing, deliver ‘the most significant change to the bankruptcy process in Scotland for a generation and take us closer to making the financial health service a reality’ (more on this claim in a subsequent blog). Individuals must consult a money advisor before obtaining access to any statutory debt relief. The policy objective is that of ensuring that individuals are aware of all debt relief options, although I suspect that it is partly motivated by the objective of ensuring that individuals do not enter too easily into writing down debt rather than the statutory Debt Arrangement Scheme which will generally require full repayment (again more about this on a further blog). Financial education during bankruptcy is not mandatory for all debtors. Only repeat bankrupts within the previous 5 years, or debtors subject to a bankruptcy restriction order made against them must undertake a course. In other cases a trustee may refer a debtor to a financial education course where ‘the trustee considers that the pattern of behavior is such that the debtor would benefit from a financial education course or the debtor agrees to undertake a financial education course.’ The Scottish legislation recognises that counselling is not necessary for all debtors. This suggests that legislators do learn something from comparative experience, since they seemed to be aware of the criticisms of the US provisions.
England and Wales rejected counselling in the 2002 reforms primarily because most groups consulted opposed its introduction. Debtors may therefore experience a variety of advice before and during insolvency, depending on whether they seek advice in the public sector through Citizens Advice Bureaux, non-profit debt counselling such as Step Change, or a private intermediary.
The UK is sometimes contrasted with continental Europe where it is assumed that a more ‘social’ approach exists to counselling debtors. But this is not the case. Counselling is not an integral part of the French process. Although debt counsellors play a central role in Germany, the large demand for their services means that they function more as processors rather than being able to provide substantial financial counselling. In Sweden, a recent official report was very critical of the standards of debt counselling which are operated by municipalities.
Debt counselling in bankruptcy is a programme which in the abstract can attract a broad support. It is a policy around which a coalition of creditor, consumer and debt counselling interests can agree, and for regulators it gives a sense of purpose to the bankruptcy system–so the Scots view it as part of a ‘financial health system’. It is likely therefore to continue to be attractive but experience suggests an unwillingness by governments to invest significant resources in the project.
The credit counselling requirements are often based on the assumption that bankruptcy is a consequence of imprudent or unwise use of credit or the need for individuals to adapt their credit behaviour to more desirable norms. But this is clearly not the case for many debtors who are subject to adverse changes of circumstances, unforeseen health costs or small business failures.
The Bank of France issued recently its Barometer of Overindebtedness for the third trimester of 2014. Filings with the Commissions reached over 230000, a rise from 217000 in 2009. In an earlier post I outlined the findings of the Bank’s Enquête Typologique of debtors in 2012. The Bank issued in November 2014 a further report for 2013. This indicates similar demographic characteristics of debtors–overrepresentation of renters, single individuals, and women in the rétablissement personnel procedure, those between 25-54, the unemployed and blue and white-collar employees. Debtors are atypical of the French population. In 2004 31 percent of debtors had no repayment capacity, in 2013 54 percent had no repayment capacity and 71 percent less than €250. Applications to the commission represent 4.35 persons per 1000 of the national population (15 years or older).
The report breaks down over-indebtedness by region, comparing the filing rates with the regional levels of unemployment, RSA (social welfare), separation and divorce rates, and disposable income of the population. Filings corresponded generally with these factors; the old industrial regions exhibited higher levels of filing. However there were some anomalies with for example southern regions such as Midi-Pyrenées (3.74) having significantly lower levels than Haute-Normandie (6.24) notwithstanding similar indicators on unemployment, social welfare, divorce and disposable income. The report speculates that these differences might be explained by other factors such as social norms.
The issue of subnational variations in insolvency filings within Europe has not been studied systematically. In England and Wales recent data from the Insolvency Service also indicate significant differences between regions with the North East and South West having higher than national levels of bankruptcies and DROs, and London a significantly lower level. Paul Bishop has analysed these data over the period 2000-2007 using a variety of techniques. He finds a persistently high level of bankruptcies in the South West which may be associated with low incomes and the large presence of ex-military personnel. He also found a low-level of filings in London which may be associated with higher incomes and the “Capital city effect”. US studies of persistent regional variations have often focused on state variations in laws and local legal culture but also recognise other demographic characteristics. The European studies suggest that greater attention might be paid to regional variations in bankruptcy filings. Since these filings may often be the ‘canary in the mine’ signifying economic or social problems, regional studies may be more helpful in identifying problems and targeting potential policy solutions.
The above headline is taken from the English tabloid Daily Mail which claims that the new FCA responsible lending rules under the Mortgage Market Review have resulted in long and detailed questioning of potential borrowers on their household outgoings. The Financial Times on May 17th reports a lending logjam as a consequence of the stricter and more exhaustive lending criteria.
The affordability rules (for those interested in the detail see here ) are the target of attack. These require lenders to verify household income and ensure that the mortgage is affordable taking into account borrowers’ ‘committed expenditures’ and ‘basic household expenditure’. The lender may not rely on capital appreciation as a basis for lending and must take into account market expectations of future interest rate increases over a minimum period of five years. Self-certified mortgages are prohibited and interest only mortgages are only permitted if there is a clearly understood and believable alternative source of capital repayment.
These rules were developed through a process of consultation including an impact analysis which estimated the extent of market exclusion in both subdued and boom markets. The overall exclusionary impact was predicted to be most significant for credit-impaired consumers rising from 10.5 percent in a subdued market to 69.7 percent in a boom. This was the sector which had exhibited the poorest underwriting standards ‘in some cases bordering on the predatory’. The impact on first time buyers was much smaller rising from 0.9 percent to 10.5 percent in a boom period.
The media may simply be pointing to teething problems in implementation. However other issues may be raised. First, the potential difficulties of maintaining political support (at least in the UK) for rules which exclude individuals from the market. The justification for the rules are clear–to avoid future problems with repossessions, debt difficulties and default as well as ensuring the capital stability of financial institutions. Given the importance attributed to home ownership in England– and the many business and financial interests associated with the housing industry as an ‘engine of growth’–political pressure may build both to reduce the impact of the rules and at the same time challenge the authority of the regulator. The ideology of access and choice has been the norm since the deregulation of the mortgage market in the 1980s. As the memory of the Great Recession becomes dimmer, particularly among first-time buyers, we may witness continuing attempts to reduce the effects of these changes.
A second issue concerns the most effective method of implementing the concept of responsible mortgage lending. The UK model tracks the G20 Financial Stability Boards principles on sound residential mortgage lending but does not adopt sharp loan-to-value limits or debt-service ratios which exist in countries such as Canada and Japan. The FSA (now FCA) rejected loan-to-value limits, notwithstanding the evidence of a relationship between high LTVs and arrears, because of the potential impact on first-time buyers. Strict debt-service ratios were rejected because of the perceived weakness of correlation between high debt-service ratios and arrears and the over-inclusive nature of this approach (i.e significant numbers of ‘good’ borrowers might be excluded; see here at 55-59). The advantages of strict bright line rules over the affordability tests are in theory their simplicity and reduced compliance costs. The disadvantage is that they are inevitably over-inclusive. Whichever system is adopted will present ‘gaming’ opportunities. The web already reports on methods to avoid the requirements.
The UK developments anticipate the implementation of the EU Mortgage Market Directive (see recent post here) and the approach of the Directive reflects the influence of the FCA in its approach to assessing creditworthiness. Responsible lending is now a worldwide phenomenon. The World Bank now has a responsible finance site including a study which indicates the world-wide growth of responsible lending provisions since the Great Recession with an increase from 20 to 40 countries imposing explicit limits such as loan-to-income ratios. There is a need for systematic comparative analysis of the different approaches and their effects in emerging as well as mature credit markets.
Twenty five years ago many EU member states did not have a law which permitted individual non-traders to obtain a discharge of their debts. However by 2014 almost all EU member states have some form of discharge for this group.
In March 2014 DG Justice issued a recommendation (a form of soft law) on a new approach to business failure and insolvency. In addition to proposals on restructuring, a minimum standard of an automatic discharge after no more than three years for ‘honest entrepreneurs’ is a central recommendation. Although the recommendation is not aimed at consumers it does invite (see Recital 15) member states to apply relevant provisions (such as the discharge) to consumers. This recommendation is part of the drive by the EU to promote entrepreneurialism (see eg here and here and here) through the provision of a non-stigmatising second chance. Entrepreneurialism also drove the liberalisation of the English discharge in 2002 to one year and recent German reforms which reduce the discharge period from 6 to three years (but only under restrictive conditions: see here). The EU recommendation does not define ‘entrepreneur’ but it is presumably equated with self-employment.
Meanwhile a variety of expert reports (see here, here, here and most recently here) addressing consumer over-indebtedness over the past decade have proposed a fairly consistent set of reform proposals for individual debt-adjustment in the EU: 3-5 year repayment plan as a condition of discharge with a simple and swift discharge for those with no likelihood of repayment; open access but controls on bad faith; automatic stays on enforcement action. An IMF paper by individuals involved in European insolvency reform as part of bailout packages suggests similar principles. These ideas are hardly revolutionary or even radical: the 1883 English Administration Order was based on not dissimilar principles . If these principles were adopted it would make the UK an outlier with its one year discharge period and the absence of a repayment plan as a condition of discharge.
These EU developments in consumer and business insolvency have run on parallel but distinct tracks. There is in fact significant overlap. Self-employment (which accounts for about 15 percent of total employment in the EU) may simply describe an individual who was employed and is in a precarious position with low income and few social protections. Self-employment may–or may not– be innovative and rewarding (see here). Studies which draw a connection between liberal bankruptcy regimes and entrepreneurialism use self-employment as the proxy but do not draw conclusions as to the quality of the self-employment (see here). One US study suggests little connection between generous insolvency laws and innovative entrepreneurship. The distinction between consumption and production debt may be blurred when an individual uses credit to invest in education, or uses a home to guarantee a business debt. The question is whether the EU should propose a unified approach to individual insolvency with relatively easy access for both consumers and entrepreneurs.
Although increasing convergence does exist within the EU on personal (consumer and individual business) insolvency significant differences remain relating to such issues as entry requirements (e.g. strict in Sweden, liberal in England) and the institutional process. The influential German model with a mandatory period of ‘good conduct’ through a repayment plan may become viewed as a norm with a burden of proof on those promoting a more liberal regime. Yet the German system appears socially wasteful since the majority of insolvents have no repayment capacity (see here) and must simply wait out a period of purgatory before being permitted a return to the market. Other European systems have developed swifter processes for those with no repayment capacity.
France differs from the UK in its approach to credit bureaux. The Bank of France administers ‘negative’ credit reporting systems which contain information on whether individuals have made applications to the Over-Indebtedness commissions or are in substantial arrears on repayment. They do not include ‘positive’ information on loans taken out and payment record, a characteristic of UK credit reference systems. Private credit bureaux do not operate in the French consumer credit market and in 2007 the Conseil d’État upheld a refusal by the French privacy regulator (CNIL) to permit Experian to establish a central database.
The French system was introduced in 1989 as part of the loi Neiertz to address 0ver-indebtedness. However, the continued rise in over-indebtedness in France since then has resulted in pressure to introduce positive credit reporting on the assumption that this will enhance credit decision-making and prevent subsequent over-indebtedness.
The introduction of positive credit reporting in France is controversial. First, a strong conception of privacy–understood as the ability to shield one’s financial affairs from market and commercial intrusion–is argued to be influential in France. This is best developed by James Whitman in his study of Western cultures of privacy. Undoubtedly this is a factor but political interest groups have also been influential in the debate. Although one might expect financial institutions to be in favour of having more information available on potential debtors, French banks through their lobbying group have opposed the creation of a positive reporting system. Why? The answer is probably a fear of greater foreign competition and new entrants to the consumer credit market. The ability of a financial institution to access a neutral third-party information source on debtors would reduce the advantage of existing incumbents who already have built up sophisticated scoring systems on their clients. Consumer groups are also divided in their support. Some groups are opposed, although those involved with over-indebted individuals (such as Crésus) support the introduction of a positive system. The opposition here is partly a concern that because the primary cause of over-indebtedness relates to events which occur after the credit has been granted then more information will not necessarily reduce the risk to an extent that the economic and social costs of introducing a system outweigh the benefits.
It seemed as if a positive credit reporting system operated by the Bank of France would be introduced when an expert body appointed as a consequence of the 2010 Loi Lagarde implementing the EU 2008 Credit Directive, recommended this option. It was included within the recent loi Hamon which introduced a variety of consumer protections. However, the relevant sections were referred to the Constitutional Council (Conseil Constitutionel) which on March 13 2014 struck down the sections as a disproportionate intrusion on the constitutional right of privacy which was not outweighed by benefits related to credit decision-making.
This French decision is interesting internationally in terms of the role of credit bureaux and the balance of positive and negative information. International agencies such as the World Bank promote strongly the introduction of credit bureaux with wide information sharing. They argue that it promotes better screening and risk assessment, reduces bad debts, increases competition by reducing the advantages of local incumbents, makes it easier for consumers to switch, and widens availability of credit. But although these institutions may be useful in kick-starting a credit system, there are concerns that in mature credit economies comprehensive credit information on individuals becomes part of a lender strategy to maximise profits rather than minimise risk, with the expansion of the market to include higher risks and targeting of individuals who are highly profitable because they will yield high late payment and other fees. This is the so-called ‘sweat box’ model of credit card lending.
These concerns combined with privacy issues and accuracy of information have prevented the EU from developing an EU wide credit reference system or set of norms. The EU established an expert group on credit histories in 2009. It could not agree on whether positive reporting should be a norm concluding that the ‘economic literature offers contradictory (and often not definitive) views and that the European experience shows that both approaches can work effectively’. Thus although the EU may require lenders to consult credit databases in mortgage lending and to have cross-border access to databases where necessary, no agreement on the form of the credit database exists.
Two further points. The existence of extensive credit reporting in the US and the UK did little to prevent the sub-prime lending crisis, or in the UK the large run-up in credit card debt prior to the Great Recession. The credit reference industry and multinational credit firms have an interest in expanding the role of credit bureaux, so that they become central sources of information for purposes such as checking tenants or employees. The example of France where they are unable to operate in the consumer credit market represents a challenge to their growth and to influential thinking about credit bureaux, suggesting that the overall economic and social value of these systems needs further analysis and debate.
[Photo credit: http://www.LendingMemo.com]
This post discusses the EU Mortgage Credit Directive (2014) . This Directive imposes greater ex ante controls on the granting of mortgage credit. Creditors must make a ‘thorough creditworthiness assessment’ of a prospective borrower (art.18) which may include cross-border access to credit databases. Credit grantors must provide adequate explanations of proposed agreements so that a consumer is enabled to assess whether the agreements meet his needs and financial situation. A standardised pre-contractual European information sheet must also be provided ‘in good time’ before entering into the agreement. The Directive also regulates standards for property valuation, arrears and foreclosure procedures, and foreign currency loans. Member states must promote financial education measures for consumers in relation to responsible borrowing and debt management and the Commission must deliver a report by early 2019 on ‘the wider challenges of private over-indebtedness directly linked to credit activity’ (art 45). ‘Irresponsible behaviour by market participants'(Recital3) as well as the conventional objective of reducing the barriers to the creation of an efficient internal credit market (Recital 2) are the rationales for the Directive with its objectives being to achieve ‘a more transparent, efficient and competitive internal market, through consistent, flexible and fair credit agreements relating to immovable property, while promoting sustainable lending and borrowing and financial inclusion, and hence providing a high level of consumer protection’.
The Directive represents a step change from the earlier 2008 Consumer Credit Directive which applies to unsecured consumer credit. The Mortgage Credit Directive has a stricter and more specific creditworthiness assessment process than the Consumer Credit Directive with an obligation on a creditor not to grant credit if a consumer does not meet the test. Greater attention is paid to ensuring that creditors have properly trained staff and supervision of these standards by regulators.
The Mortgage Credit Directive reflects post-crisis politics. The introduction of the Mortgage Credit Directive took place against the background of international post-crisis measures of consumer protection in financial services and the adoption by the G20 of high level principles on financial consumer protection in 2011, whose content was partly influenced by international consumer groups. These principles are ‘voluntary’ but the document requests that all G 20 members ‘and other interested economies should assess their national frameworks for financial consumer protection in the light of these principles’. The initial Commission draft of the Mortgage Credit Directive was amended significantly by the European Parliament Economic and Monetary Affairs Committee (rapporteur Antolin Sanchez Presedo) to include greater specificity in responsible lending obligations and provisions on arrears and foreclosures. A high level of consumer protection, preventing another mortgage crisis and addressing the problems of indebted homeowners drove the amendments. References are now made in the Directive to the G-20 principles (e.g. Recital 3).
The legislative outcome of the Mortgage Credit Directive contrasts with the Consumer Credit Directive. The original draft of the Consumer Credit Directive was introduced in 2002 as a comprehensive directive on consumer credit including a ‘suitability of credit’ obligation of responsible lending based on Belgian law. Financial interests operating through the European Parliament, and their national governments succeeded in gutting many of the provisions of the original Directive. The Directive’s proposals became associated with a paternalistic image of consumer protection during a period when the ‘democratisation of credit’ was in the ascendancy. Ironically the modest final Draft of the Directive came into force a few months before Lehman brothers crashed and along with it the confidence in the idea of credit as ‘the lubricant of economic life’. These two Directives create different regimes for responsible lending in unsecured and secured credit. Such a distinction is not justified particularly since problems with unsecured credit may be most significant for individuals with lower incomes.