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William Thomson

William is Director of International Economics, Experian

  

 

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Higher interest rates: How will you prepare?

Interest rates have been at a historical low for a long period and there is only one way that rates can go, and that is up. Given the current economic recovery, the questions are when will rates rise, by how much and at what speed?

Interest rates will rise

The storm clouds over the UK economy have passed, and expectations of a sustained economic recovery are now in place. Even the International Monetary Fund (IMF) has raised its growth forecast for the UK economy this year, moving the UK firmly into the growth fast lane of developed economies, and out of its position among the group of growth laggards. This is good news indeed, but with the economy improving the need for supportive monetary policy from the Bank of England in terms of quantitative easing (QE) and a 0.5% base rate diminishes rapidly. The Bank of England has indicated that interest rates will not rise before the International Labour Organisation (ILO) measure of unemployment has fallen below 7.0%. It currently stands at 7.1%, but is likely to fall below 7.0% next month.

Technically, this opens the door to a rise in the base rate at that point, although current market expectations are for a move in early 2015. The breach of the 7.0% threshold later this year comes two and a half years before the Bank of England originally anticipated. Of course, there are a number of economic and financial risks out there that mean that interest rates could go up faster and by more than can be reasonably expected over the next 12-18 months.

The cost of borrowing

While changes in lending rates typically reflect movements in the Bank of England base rate, it can also reflect the cost of funding in the market place, which encompasses both longer term interest rates as well as money market and overnight rates. A number of other factors determine these rates, such as the supply and demand for government bonds (long term rates) and financial sector confidence (e.g. overnight rates) as we saw when the credit crisis post-Lehman played out.

What is the impact on affordability?

One of the key features of the economic recovery is that households have yet to feel the benefits of the economic upturn as growth in wages and incomes remain very weak. In real terms incomes are still lower now than they were pre-Lehman, and of course some customer segments and some local economies have been affected more adversely than others. Prospects for wages are poor as productivity growth remains weak, although inflation has fallen to its lowest level since November 2009 which will dampen the drag on price purchasing power.

However, if interest rates rise before there is evidence of a sustained recovery in incomes, then affordability issues will become more severe for more indebted borrowers, as higher interest rates will raise debt servicing payments and the effect will be compounded the faster that interest rates increase. Expectations are for real disposable incomes to rise only modestly over the coming 12-18 months. Of course there are those who will benefit from rising rates, most notably net savers who were those that suffered during the immediate aftermath of Lehman when interest rates collapsed.

What does it mean to your portfolio?

The impact of higher interest rates on the borrower’s ability to pay requires a full customer view of the borrower. The ability to pay will depend upon the debt servicing obligations across all the credit products against which the borrower has obligations. Therefore, future affordability calculations need to account for future income streams of the borrower as well as their future debt servicing obligations once other essential items have been deducted. Does the interest rate increase leave sufficient household disposable income, in light of individual customer circumstances and forecast changes in economic conditions?

Understanding the impact of higher interest rates, should already be built into the current portfolio performance plan, and the more aggressive trajectories for interest rates can be viewed as relevant stress tests of the portfolio at least for good housekeeping, but can be used as additional scenarios for regulatory submissions. The key questions in any such interest rate analysis would include:

  • Who would be impacted? Which customers? Which accounts? Do they have other repayment obligations to the same or other lenders?
  • Which accounts would be most at risk? What would be the risk concentrations? By geography and by customer type?
  • What would be the impact on future arrears and losses? How would this affect my capital requirements?
  • What actions do I need to take to mitigate the risks for these customers?

The scenario narrative is the key to any simulation of higher interest rates

There are many different triggers for interest rates to rise in the coming years, and each of these will have different economic consequences for both borrowers and lenders. In terms of affordability, the underlying drivers of the interest rate rise will affect different borrowers in different ways. Consequently, any generic simulation of higher interest rates does not pick up the likely household budget impacts of different borrowers. The development of the interest rate scenario narrative becomes a key component in the simulation process itself, and will play an even greater role in discussions with the Bank of England over the methods and assumptions used in such exercises.

More than ever it is time to evaluate the potential impact

So what on the face of it is excellent news over the economic recovery comes with a huge sting in its tail, as this will ramp up affordability pressures on borrowers since interest payments rise across the retail product suite. Have you planned for alternative interest rates scenarios? Do you know who will be affected the most? How much is at risk? Will your products still be fit for purpose when rates do rise?

 

About the author

William Thomson

Director of International Economics, Experian

William has worked for many years to help some of the world’s leading private sector organisations understand how economic change will impact their business portfolios.
During his career at Experian he has been helping customers apply economic forecasts and analysis to portfolio loss forecasting and stress testing.

 

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