Buy now, pay later – regulate how?

Posted February 8, 2021
by Diego Zuluaga

The Woolard Review and the likely implications for BNPL firms

A new payment option has become increasingly popular at e-commerce checkouts, as more and more shopping has moved online because of pandemic-related lockdowns. Known as ‘buy now, pay later’ (BNPL) and offered by relatively new brands such as Klarna, Clearpay and Laybuy, this option allows buyers to delay payment at no additional cost - typically for 30 days after purchase or spread across three monthly instalments. BNPL, which barely existed in the UK five years ago, already accounted for 3% of total online purchases in 2019, and online searches for it doubled during the first lockdown in 2020.

BNPL has remained largely unregulated because its most popular offerings (short-term interest-free loans) meet an exemption in the Consumer Credit Act (CCA) originally meant for invoice discounting. That is about to change following a review, led by Christopher Woolard at the Financial Conduct Authority, recommending that the sector be brought under the FCA’s purview. The government has already heeded this call, announcing imminent legislation to give the requisite powers to the FCA. 

While many BNPL firms welcome regulation, the full implications remain uncertain, and there are steps the industry can take to educate policymakers and the public about BNPL and mitigate potential adverse effects on consumers. This article discusses the Woolard Review’s findings, the likely form that regulation may take, and some ideas for industry-led action to address concerns about misuse of BNPL and ensure the product is seen as a healthy innovation.

How consumers use BNPL

The Woolard Review offers some data about BNPL users: three-quarters of them are under 36 years old; a similar fraction are female; and nine out of ten purchases are for clothes and footwear. While the Review does not analyse the products BNPL competes with, the firms have in the past presented it as a more transparent alternative to credit cards. Indeed, many younger consumers who shunned credit cards after the 2008 financial crisis seem to use BNPL in a similar way: to smooth their cash flow across the month or a longer period without paying interest. By helping these consumers to avoid going overdrawn before they get paid, BNPL could make their lives better. The Review recognises this, stating that BNPL can be ‘a cost-free way to access credit easily’.

The Review also offers some evidence of potential misuse. It points out that some consumers mistake BNPL for a payment technology instead of a credit product, while others seem to think it is subject to the same rules and protections as regulated credit. The Review mentions that 10% of a sample of BNPL users exceeded their overdrafts in the same month that they made a BNPL payment. Whether that is more or less than normal depends on the proportion of all consumers who exceeded their overdrafts, which the Review does not specify. Regulatory changes in mid-2020 to make overdrafts less costly may have affected behaviour during the period under study. The Review sees the finding that a substantial minority of BNPL users exceeded their overdrafts as evidence that BNPL firms did not do enough to ensure they can afford their product.

Unlike most regulated credit, it is not consumers but retailers who pay for BNPL, in the form of a 4-6% charge on merchandise value. The Review cites a firm’s pitch to retailers, apparently claiming that BNPL can ‘increase their sales by up to 30%’. There could be several different drivers of this sales growth, such as higher demand from giving greater payment flexibility to those who can repay and from consumers who, without the option of BNPL, would spend their money elsewhere. The Review’s concern is that a focus on sales might lead both retailers and BNPL firms to neglect affordability, potentially harming consumers’ financial health.

Implications of BNPL regulation

What will FCA regulation mean in practice? As a starting point, it will require firms to be authorised and comply with the FCA’s Principles for Business and the Senior Managers Regime. Because many BNPL firms already offer some regulated products, this ‘fixed cost’ of regulation may be less steep than for firms that are completely outside the perimeter.

The government’s legislative changes will expand FCA oversight to the most popular BNPL products that provide the bulk of their revenue. For those products, regulation will likely start with mandating a creditworthiness assessment involving not just credit risk but affordability as well. While the FCA views both measures as part of the same assessment, affordability in practice means a higher threshold for approval, as lenders must take reasonable steps to ensure borrowers can repay in a sustainable manner, that is, without facing financial difficulties or adverse consequences.

Consumers will be able to file complaints against BNPL firms with the Financial Ombudsman Service, a remedy that can prove costly to financial firms, since they must pay a case fee of £650 for every complaint they face after the first 25 in a calendar year, regardless of the outcome. Not only is that quite a low threshold for firms lending small amounts to hundreds of thousands of individual borrowers, but it creates an incentive to file complaints even when they lack merit, since the claimant bears no cost. Claims management firms in particular may find it attractive to pursue dubious complaints, given they face little downside from doing so. To BNPL firms, on the other hand, a wave of claims could pose an existential risk.

Tradeoffs and the wider credit ecosystem 

Policymakers will need to consider the risk that regulation will drive some providers out of the market, since BNPL firms serve a demographic whose access to other credit products may be less than that of the UK population as a whole. This is not to say that concerns about potential financial distress are unwarranted. With BNPL repayment performance unrecorded by credit reference agencies (CRAs) and seemingly little information-sharing between BNPL firms, some users could fall into a debt spiral without anyone noticing until much later. As the sector takes up a bigger share of e-commerce and even in-store purchases, the aggregate risk from this lack of information can only grow. It is interesting that some providers have emerged who offer a single credit line with interest-free split payments, instead of item-by-item BNPL. Helping consumers to manage their overall commitments seems to be part of their proposition.

Some of the Woolard Review’s recommendations may require broader changes to the consumer credit infrastructure. BNPL firms point out that CRAs lack the internal processes to accommodate high-frequency, low-amount BNPL data, which could complicate reporting consumers’ information in a timely and accurate fashion. This gap could affect the informational quality of the credit checks most BNPL providers already conduct. To ensure lenders can evaluate BNPL performance in real time, the FCA should seek to remove barriers to credit information provision, including by Open Banking challengers. As the FCA is concurrently looking at the market for credit information, action on this front could help it achieve various objectives at once.

Next steps

While not all of the challenges identified can be solved through more regulation of BNPL, the industry has done well to anticipate the Review by announcing that it welcomes regulation. Both they and policymakers confront the challenge of keeping BNPL safe for consumers without crippling access to an inexpensive cash-flow management tool. As with other forms of consumer credit, there is a danger that well-meaning regulation could drive borrowers to costlier options - in this case, credit card or overdraft debt. BNPL firms should also consider measures they could take as an industry to address potential harms, from standards around credit reporting and debt collection to information-sharing about financial distress. Australia, where a broad coalition of BNPL firms is finalising a code of practice to do just that, offers a relevant case study.

The industry should think strategically about the division of labour between the private sector and the regulator to ensure good consumer outcomes. BNPL firms appear well-placed to deliver the competitive benefits of innovation, such as a lower cost of credit and better expense management by consumers. The FCA, for its part, might prove most helpful addressing gaps in the credit reporting infrastructure and monitoring industry-wide data to identify any concerning trends.  

By achieving the right balance, BNPL firms could turn regulation from a source of uncertainty into an opportunity for growth. With a total transaction value equivalent to more than 1% of UK consumer credit in 2020, BNPL may be relatively new but it has already become quite popular. FCA regulation could help the industry to gain a permanent foothold in the market by strengthening perceptions that its product is healthy and subject to high standards. In the areas where the industry can act on its own, it should consider the wisdom of doing so now to avoid paying a heavy price later. The Woolard Review only marks the beginning of this process.