Money Advice Scotland Annual Conference Exhibition 2016

Money Advice Scotland Annual Conference & Exhibition 2016 Crieff Hydro, 2 nd & 3 rd June 2016

Understanding the effects of the recent financial crisis on UK households and looking to the future Elaine Kempson Emeritus Professor, University of Bristol May 2016

Wide variations across Europe in the effects of the financial crisis on households • Across Europe, proportion of households experiencing arrears increased from 10% in 2007 to a peak of 13% in 2014 • But very wide variations across countries in extent and nature of arrears – A very modest increase, from a fairly low level • N Europe: Sweden, Germany, Netherlands, Norway, UK – Entered downturn with very high levels which rose fairly modestly • South East Europe: Bulgaria (31% to 35%), Romania – Rapid escalation from a high level before downturn • Greece (26% to 46%), Cyprus, Hungary – Rapid escalation from a fairly low level before downturn • Ireland (8% to 24%), Iceland – Long-term trend of falling arrears reversed and steep increase • Estonia (5% to 14%) and other Baltic countries

Interaction between three main factors seems to explain the effects of the financial crisis on households • Macro-economic and regulatory environment when the economic downturn hit – Restructured economies in Eastern Europe; budget deficits (eg in Greece); financialised economies and house price bubbles (eg Ireland, Iceland, UK) – Regulation of banking sector • The state of household finances as the economic downturn hit – High levels of poverty (Eastern Europe) – Living beyond their means, heavy borrowing (Greece, Ireland, Iceland) – Mitigated by savings and support from family and friends (Spain) • Actions taken by governments, regulators, lenders and others – Inside Euro-zone households bore the brunt of the actions, other governments had more room for manoeuvre – Big variations in speed of action by consumer protection regulators and lenders

Bulgaria and Romania • Entered downturn with very high levels of arrears which rose fairly modestly and have levelled out since 2013 • Restructuring of the economy had already led to high levels of arrears – Privatisation of essential services such as utilities and rapid price rises – Widespread poverty & incomes not keeping pace with price increases • Financial crisis caused slowdown in economy, putting a further strain on household incomes • Mainly arrears on household bills eg utilities (Bulgaria 33%, Romania 28%) • Proportion of loans in default rose rapidly (eg Romania 3% to 22%) – But the increase in proportion of households with arrears on loans was modest (4% to 7%) because levels of borrowing were relatively low

Greece and Cyprus • Rapid escalation of arrears from a high level before downturn, levelled off in 2014 • Economies run at a large budget deficit • Households living beyond their means • Effects of austerity measures made a bad situation worse eg high unemployment, falls in real wages and pensions • Rapid increase in household arrears across all commitments eg Greece – Utility bills 16% to 37% – Rent and mortgage 7% to 15% – Loans 12% to 17% (proportion of loans in default rose from 26% to 39%)

Understanding why arrears levels in the UK were lower than expected: Comparing the UK with Ireland Norway

The situations before the financial crisis in the UK Ireland Norway were remarkably All three countries: • Had experienced a period of sustained growth prior to the financial crisis in late 2007 • Had experienced a housing boom leading to high levels of mortgage borrowing and rising levels of unsecured borrowing • They had a similar level of household arrears in 2007 • Ireland 8%, UK and Norway 9% • And a similar proportion of non-performing loans (1%) • Both the UK and Irish economies were badly hit by the crisis • Norway’s was not • So would expect household arrears to rise far more in UK and Ireland than in Norway

But this was not what happened… • Levels of arrears trebled in Ireland (8% to 24% in 2012) – But in the UK they rose very little and peaked in 2010 (9% to 10%) – And were similar to Norway • The proportion of non-performing loans rocketed in Ireland from 1% to almost 26% in 2013 – The increase in the UK was more modest: from 1% to a peak of 4% in 2010 – And again was more like Norway: where levels rose from 1% to 2% in 2010 • What are the possible explanations for this paradox?

What are the possible explanations for this paradox? • Have looked at the interaction between the three main factors that seemed to explain the effects of the financial crisis on households across Europe as a whole: – The macro-economic and regulatory environment when the economic downturn occurred – The state of household finances as the economic downturn hit – Actions taken by governments, regulators, lenders and others

Macro-economic and regulatory environment • Economies in all three countries were reliant on consumer spending for GDP growth • All had experienced strong and long-term growth in house prices and mortgage lending • UK and Irish economies heavily reliant on financial sector, with light prudential regulation. Banks taken into public ownership after the crisis – Irish economy also heavily reliant on the construction sector – Norwegian economy dominated by oil and gas. Banks accounted for only 2% of economy and tougher prudential regulation • Only Ireland was in the Eurozone, which restricted the autonomy of the government when crisis occurred • Explains low rise in arrears in Norway and rapid rise in Ireland – But not the paradoxical low rise in the UK

State of household finances just before the financial crisis • In all three countries households: – Had experienced rising prosperity and low unemployment up to 2007 – Were borrowing ever larger sums of money, in both cash terms and as a proportion of income, as lenders loosened lending criteria – And were saving less • But lower-income households in UK and Ireland had not benefited from rises in real incomes in recent years – In contrast to Norway where all income groups benefitted

State of household finances after the crisis hit • Norwegian households experienced continued rise in real incomes and only a small increase in unemployment (to 3. 5%). House prices and borrowing continued to increase • Both Irish and UK households experienced falls in real incomes (of a similar order of magnitude). This hit the poorest households hardest • New lending was curtailed in Ireland UK and amounts owed by households fell • Ireland experienced very large rise in unemployment (to 14. 7%) – The rise in UK was more modest rise (to 8. 1%). • Severe and sustained house price correction in Ireland leaving many with negative equity – Fall in UK was smaller and shorter-lived • Explains low rise in arrears in Norway and rapid rise in Ireland – But only partly explains the paradoxical outcomes in the UK

Responses to the crisis in Ireland the UK: macroeconomic factors • UK monetary policy set by the Bank of England, Ireland is part of the Eurosystem • UK was able to: – allow currency to devalue – reduce interest rates more quickly – determine the extent and nature of the austerity measures imposed • Ireland lacked these freedoms – could not let its currency devalue – had to wait for the ECB to reduce interest rates across the Eurozone – when it experienced a profound sovereign financial crisis it had to seek financial assistance from the EU and IMF ₋ the austerity measures imposed and their consequences for households were more severe than in the UK

Responses to the crisis in Ireland the UK: arrears management • UK government, regulators and lenders were more adept at managing arrears than their Irish counterparts – Significant shifts by lenders to more proactive arrears management and debt recovery had already taken place – Underpinned by prompt action by the regulator where needed – Government action to stem the rise in arrears included: ₋ Improved Support for Mortgage Interest scheme ₋ Accelerated introduction of a Pre-Action Protocol for possession claims ₋ Mortgage Rescue schemes • In Ireland – Lenders had no or inadequate processes and expertise to deal with arrears – Changes had to be devised and imposed by the regulator – Government action was restricted by EU/IMF bailout

Responses to the crisis in Ireland the UK: other factors • UK had far better legal procedures relating to debt and insolvency – Irish law in need of reform that took place 7 years after the crisis occurred • Greater flexibility of UK labour market kept unemployment levels down • Compensation for mis-sold payment protection insurance policies injected over £ 25 bn into the economy – Irish regulator acted to prevent the mis-selling crossing the Irish Sea! • It is the UK responses to the crisis that largely explain why arrears levels among UK households did not rise as much as the state of the economy and the state of household finances would have predicted

In summary • Norwegian households were spared the effects of the financial crisis and arrears levels rose very little mainly because the economy was not adversely affected by it • In Ireland, arrears levels rose rapidly because: – The economy was badly hit and the Government had limited options to deal with this – Household finances were very vulnerable – And mitigating actions were largely absent • UK households should have experienced much higher levels of arrears given the vulnerability of both the economy and household finances – But mitigating actions were taken by the government, the regulator and lenders – And fortuitous factors (such as PPI) helped as well

Looking to the future: risks faced by UK households • Many households remain under financial strain and struggle with high levels of borrowing – Despite an up-turn in the economy many have not seen a rise in their incomes – and especially those on low-to-middle incomes – Many households avoided arrears through strategies that may not be sustainable in the long term • Forbearance by lenders remains an important issue – Not all lenders are fully engaged • Interest rates will eventually rise – The effects on household finances will depend on the sequencing and the economic environment at the time • We are, again, experiencing an up-turn in consumer spending and borrowing

‘While my fellow economists and I may differ on the solutions to this problem, all of us agree on one thing. If we can’t break this dependence on debt, it is only a matter of time before we face another disaster. ’ Adair Turner, former chair of the Financial Services Authority

Understanding the effects of the recent financial crisis on UK households and looking to the future Elaine Kempson Emeritus Professor, University of Bristol e. kempson@bristol. c. uk