Context

The Financial Conduct Authority (FCA) has a particular focus on ensuring that processes to help consumers cope with unexpected life changes are provided and used appropriately within the financial services sector.

The period of high inflation and rising interest rates between mid-2021 and 2024 (the ‘Cost of Living Crisis’) put a strain on many consumers’ financial circumstances. This made them more sensitive to unexpected changes in income (‘income shocks’) and potentially to poor financial outcomes such as increased borrowing and arrears.

Prior to the Cost of Living Crisis, the COVID-19 pandemic was an economic shock with unique characteristics, in which income shocks were experienced by many consumers as a result of reductions in houses, furlough, and loss of bonuses and tips. This afforded the current study an opportunity to explore the impacts of different types of income shocks on subsequent outcomes and to do this based on individuals’ subjective expectations of their incomes.

The study

The study was undertaken by the FCA to identify circumstances which may lead to increases in debt, arrears and defaults following an income shock. It used a subjective-expectations methodology to examine the impact of income shocks during Covid-19 on three consumer outcomes:

• consumption (as a proxy for welfare gain or loss)
• credit use
• arrears on credit products (as an indicator of financial distress).

The study involved analysis of primary data from a UK panel survey, which was run across five quarterly waves between February 2020 and May 2021 (coinciding with the first months of the COVID-19 pandemic) and designed to provide a representative sample of the UK adult population by age, gender and region.

The survey sample started at 7,300 individuals at wave 1 and, with an average re-interview rate of 55%, was topped up each wave returning a total of 16,790 individuals across all five waves. For 7,424 individuals, their survey data was matched successfully to credit file data, containing information about credit products and repayments (including missed payments) and the matched data were analysed using (multivariate) regression analysis.

Key findings

Statistical significance was reported throughout at the 90% level of confidence (p<.10).

• Expectations of impacts of income shocks: individuals’ expectations of the impact of income shocks on consumption, credit demand and arrears varied substantially depending on whether an income change was perceived subjectively as: a shock; permanent or transitory; and positive or negative.
• Negative income shocks: permanent shocks led to consumers cutting back consumption (eg a 10% negative shock reduced consumption by 6.3%), but not to changes in credit use.
  • Discretionary spending was impacted more than non-discretionary spending by a permanent shock (eg a 10% negative shock led, respectively, to 12% and 4.7% spending reductions).
  • Transitory shocks led to more credit use (eg a 10% negative shock increased the likelihood of borrowing by 3.9 percentage points), but no significant reduction in consumption.
  • There was no significant impact on the likelihood of credit arrears of either permanent or transitory negative shocks.
• Positive income shocks: transitory shocks led to more credit use (eg 10% positive shock increased the likelihood of borrowing by 3.7 percentage points).
• Consumers were pessimistic but resilient: Consumers consistently overestimated their risks of unemployment, and underestimated income and hours worked.
  • They were more likely to expect to be in arrears following a permanent negative shock (eg a 10% income shock increased the perceived risk of being in arrears by 2.25 percentage points).
  • A pessimistic outlook may have led to more cautious behaviour and help explain consumers’ typical resilience to the impacts of negative shocks.
  • During a negative transitory shock consumers maintained their consumption, and hence their welfare, by using savings (eg a 1% transitory shock led to a 0.92 percentage point reduction in the savings rate).

Points to consider

Methodological strengths or limitations:

• This report describes a rigorous and considered data collection and analytical approach.
• Some of the sample numbers available for specific analyses were much smaller than the headline sample numbers, and a moderate re-interview rate may have resulted in bias in the final sample.
• The unit of analysis was at the individual level, and household influences (eg other income earners) were not controlled for.
• ·The credit use outcome measure did not include informal methods of borrowing, although this was analysed separately as an additional outcome measure (borrowing from family/friends) alongside others.
• The authors note that the findings related to an unusual and potentially unique context (the COVID-19 pandemic and its associated policy responses).
• The authors note that expenditure shocks were not considered in their analysis but were nonetheless likely to be contributing factors.

Applicability:

• The empirical insights, and the policy implications considered in the report, should be of interest to a wide range of stakeholders, including policymakers, employers, practitioners who support people facing financial difficulties, and researchers.

Relevance:

• The research offers important insights into the way that individuals responded to unexpected changes in income during the economic shock of the COVID-19 pandemic.

Generalisability/transferability:

• The findings may generalise to contexts in which there are other large and generalised economic shocks.