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Agenda Advancing Economics in Business Individual Voluntary Agenda Advancing economics in business Individual voluntary arrangements: cashing in on consumer debt? The popularity of individual voluntary arrangements in the UK has grown substantially in the past year, with over 44,000 taken out in 2006, a 118% increase on 2005 figures.1 With IVAs being increasingly used by consumers in debt as an alternative to bankruptcy—despite recent warnings about misleading advertising by some financial management businesses promoting IVAs—what are some of the drivers of this trend? Individual voluntary arrangements (IVAs) are intended to financial situation of the debtor and makes a proposal to offer consumers protection, giving debtors in financial the creditors of the debtor, specifying the total amount of difficulty the option of having a proportion of their debt debt the debtor can repay and the repayment period. written off and paying back the remainder of what they The proposal is discussed in a formal meeting with the owe over an agreed period, typically five years. Although creditors and the debtor. If 75% of creditors (in terms of consumer credit regulation and responsible lending amount of debt) agree, the agreement becomes binding practices are aimed at avoiding situations of on all parties. If the creditors do not agree to the over-indebtedness, in practice, there are always likely to proposal, they can either renegotiate or recommend be some borrowers who are not able to meet their other solutions to the debtor. financial obligations—for example, they may get into financial difficulty as a result of unanticipated events Debtors in financial difficulty have other options available such as unemployment or divorce. IVAs, together with to them. They can enter into an arrangement with each of other arrangements such as bankruptcy, offer these their credit providers separately (a debt management consumers a way out of over-indebtedness. plan), apply for bankruptcy through a formal court procedure, or, in some circumstances, refinance their In the UK an IVA is an agreement between a debtor and debts. From the debtor’s perspective, one key advantage their creditors. This is facilitated by a debt management of an IVA compared with bankruptcy is that it allows the business (IVA provider), which acts as an insolvency debtor to retain some of their assets and avoids a public practitioner (IP) (see Figure 1). The IP assesses the announcement of the bankruptcy order. For creditors, an IVA may be more attractive than a bankruptcy if, for Figure 1 Outline of the IVA process example, the debtor has future revenue streams that can Creditor 1 Creditor 2 Creditor 3 be used to pay off the debt. The time period of repayment for IVAs is usually five years, whereas the duration of the Additional fees bankruptcy procedure is only up to one year. IP nominated by creditor The increase in IVAs could result in a cost to credit IVA lenders receive providers since they usually involve a write-off of some of the agreed proportion the debt. Furthermore, IVAs that fail (ie, debtors are of debt less IVA fees ultimately unable to pay back what was agreed and may Fees subsequently be bankrupted) can lead to an inefficient use IP/IVA provider - set-up fee - annual management fee of credit providers’ resources in terms of time spent on evaluating an IVA and fees paid to IVA providers. In the Debtor pays a sum over a number of years as agreed long term, an increase in costs as a result of the growth in IVAs is likely to be passed on by credit providers to Debtor consumers in the form of higher interest rates—it may also result in a restriction in the supply of credit to higher-risk Note: Some creditors may hire an IP to assess the proposal for an IVA (this is the case for creditor 3 in Figure 1). consumers. Source: Oxera. Oxera Agenda 1 March 2007 Individual voluntary arrangements: cashing in on consumer debt? What is driving the increase in IVAs? written off as a result of insolvencies has grown faster still. This suggests that there are likely to be other factors Personal insolvencies (consisting of bankruptcies and driving the recent increase in insolvencies. IVAs) have increased relatively rapidly in the past few years in the UK.2 In 2006 the number of insolvencies It is significant that the use of IVAs has grown faster than rose by around 58% compared with 2005 figures, and in the issuance of bankruptcy orders, especially since 2004 the fourth quarter of 2006, IVAs were 82% up on the (see Figure 3). The profile of IVA applicants has also number for the same period of 2005.3 This has led to a changed. A typical IVA applicant is now more likely to be growth in both the number of bankruptcy orders and the young, female, renting rather than owning a property, number of IVAs. What might be the causes of this? and employed rather than self-employed.5 To some extent, the growth in insolvencies may reflect Another possible driver behind the increase in IVAs may general market trends such as changes in the economic be the aggressive marketing by IVA providers. The UK climate—interest rates have risen every year since Office of Fair Trading (OFT) recently warned a large 2003—and the general increase in lending in recent number of financial management businesses promoting years. However, insolvencies were on the rise before the IVAs that their advertisements and websites potentially increase in interest rates. Moreover, if macro conditions mislead consumers.6 This followed a compliance sweep were to blame, one might also expect corporate undertaken by the OFT of a large number of insolvencies to increase somewhat, yet they rose by only advertisements in national newspapers and websites 2% from 2005 to 2006.4 As Figure 2 shows, although promoting and marketing IVAs. Examples of misleading unsecured lending to consumers has increased since statements include claiming that ‘up to 90 percent of 2000, and particularly since 2004, the amount of debt your debt may be written off’, when, in reality, the maximum would be in the region of 60–70%;7 failing to state that entering into an IVA also Figure 2 Increase in unsecured consumer lending and affects an individual’s credit rating for six years; write-offs 600% and failing to state that set-up and administrative fees will be incurred and deducted before the Amount outstanding 500% creditors receive any payment. Write-offs Write-offs have picked up since 2000 400% A link with the structure of the market for IVAs? 300% Unsecured lending has An alternative way of understanding the drivers been growing constantly 200% behind the usage of IVAs is to look at the structure and performance of the market together 100% with the conduct of market participants. The structural features of the market may to some 0% extent determine the conduct of market 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 participants, which may in turn determine the Source: Bank of England. performance of the market in terms of prices and variety of product offering (see Figure 4 below). Figure 3 Increase in IVAs versus bankruptcies Like many markets in the financial services 300% sector, the market for IVAs is characterised by Bankruptcy orders certain market failures. Market failure is a 250% IVAs In 2004 IVAs represented situation in which markets do not efficiently 9% of all insolvencies organise production or allocate goods and 200% services to consumers. For example, there may be asymmetric information between the IVA 150% Bankruptcies have been increasing since 2000 provider and debtor—debtors may find it difficult 100% to understand the advantages and disadvantages The number of IVAs has increased sharply since 2004 of an IVA and the differences between the IVA 50% providers in terms of quality of advice and level of charges. This is exacerbated by an incentive 0% misalignment between the IVA providers and their 2000 2001 2002 2003 2004 2005 customers (ie, creditors and debtors). While the Source: DTI Insolvency Service. debtor wants to minimise repayments and the Oxera Agenda 2 March 2007 Individual voluntary arrangements: cashing in on consumer debt? Thus IVA providers are selected by the debtors, but their Figure 4 Structure, conduct and performance of the fees are paid for by the creditors. This may affect the IVA market degree of competition between providers. Although Structure - asymmetric information between IVA creditors can request modifications to the proposal provider and debtor (including the fees paid to the IVA providers), the level of - misalignment of incentives between IVA provider, debtor and creditor fees may be considered relatively low compared with the - IVA provider selected by debtor but de facto paid for by creditor amount of the loan that the debtor proposes to pay back, Policy responses possibly resulting in limited competitive pressure on the - OFT warning against misleading marketing IVA provider's fees. IVA providers may use the fees - industry code of conduct Conduct charged to creditors to fund their marketing activities, - extensive marketing activities by IVA which could explain the currently extensive marketing of providers External factors - most proposals for IVAs are accepted (affecting conduct and IVAs in newspapers, and on radio and television. by creditors performance) - changes in economic Feedback Concluding remarks - credit providers climate become better at - changes in awareness evaluating proposals of options of bankruptcy It is possible that the recent increase in IVAs is for IVAs and IVAs temporary and that the market will adjust itself. In - changes in consumer Performance attitudes towards December 2006, the British Bankers’ Association and - number of IVAs per year bankruptcy and IVAs - failure of IVAs representatives of the IVA industry agreed to work - costs of IVAs to creditors together to create industry standards to regulate how Source: Oxera.
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