Fitch: NBFIs Most Exposed to Weakening UK Household Finances

Conditions are likely to get tougher for the UK's non-bank lenders, given their exposure to the deteriorating financial health of the country's household sector, Fitch Ratings says. Household focused non-bank financial institutions (NBFIs) are typically more sensitive to this sector than banks, given their narrower focus. Most bank lending to the household sector is in the form of mortgages to owner-occupiers, mainly prime borrowers.

The UK household debt/income ratio has risen significantly in recent years and is likely to keep rising, given the sector's swing into a net financial deficit over the last year. The rise has been largely driven by growing consumer credit, notably car loans, and NBFIs have an increasing share of the exposure. NBFIs' share of overall UK consumer credit (which excludes mortgages) rose from a post-crisis low of about 25% during 2010 to more than 35% during 2017.

NBFIs have benefited from tailwinds including record low interest rates and unemployment levels, as well as the formal banking sector exiting certain higher-risk segments. Low interest rates mean that the rise in debt/income has yet to increase the debt service burden. But the household sector's worsening financial health reduces consumer resilience to income or interest rate shocks, which could lead to pressure on lenders' asset quality.

A major interest rate shock appears unlikely (we forecast the UK base rate to rise gradually, to 1.25% by end-2019), but a more immediate shock could come from tightening credit supply. Brexit uncertainty increases the risk of a shock to economic growth and employment.

The extent of deterioration in conditions for lenders would depend on the pace at which unemployment, in particular, and interest rates might rise. The potential impact across UK NBFIs would not be uniform, as the sector comprises specialist lenders with different mixes of near-prime or sub-prime customers and various types of lending product, which could be affected in different ways.

The rated NBFI universe operating in this sector is small and tends to be sub-investment-grade, given its niche focus and the non-prime nature of the target market. Recent rating actions have been driven by the impact of changes in business models rather than deteriorating asset quality, but this could change if unemployment rises sharply.

Finance companies owned by motor manufacturers face increased risk of residual value-related losses, as a consequence of sharp increases in personal contract purchases and, to a lesser extent, falling demand for diesel cars.

Lending-oriented NBFIs have also been increasingly exposed to regulatory developments around pricing transparency, affordability and customer protection. There is evidence that the Financial Conduct Authority's focus on persistent debt has led some NBFIs to reduce their exposure to higher-risk (but also more profitable) customers or to lower their pricing, both of which would reduce their profitability.