The warning comes from Consumer Focus in a new report which examines high-cost credit and financial inclusion in other countries - focusing on France, Germany and Australia - and looks at what lessons can be learned for UK policy makers.
In particular the watchdog identifies that mainstream banks must follow the lead of their overseas counterparts and do more to promote social lending to help fill affordable credit gaps in the UK.
The Government recently announced it will research whether a cap on high-cost credit could help prevent individuals building unmanageable debts, or whether such restrictions could have unintended negative consequences. Simply capping high-cost credit alone would not provide a solution to the whole problem and could potentially fuel illegal lending, according to Consumer Focus.
Whether or not interest rate caps are introduced, Consumer Focus believes that social lending in the UK must be improved if people living on low incomes are to access affordable credit.
Marie Burton, financial services expert at Consumer Focus, said: “High cost credit can be crippling and can lead some people into a debt trap it is difficult to escape from. A cocktail of falling incomes and increasing living costs could lead to more people using high cost credit to fill the gaps and falling into trouble.
“At the moment we have the worst of both worlds - high cost credit and very little in the way of affordable alternatives. Capping interest rates is one option, but unless other affordable options are put in place this risks driving people to illegal loan sharks.
“Social lending through credit unions and community initiatives is a key part of making affordable credit available, but the big banks should also follow the example of banks overseas and work with charities and public bodies to provide low cost borrowing to people on low incomes.”
The UK has the second highest level of consumer borrowing in Europe - almost twice the level of France and Germany. It also has one of the most developed sub-prime credit markets in the EU. Lower income groups take out billions of pounds each year in high cost credit from non-mainstream lenders, such as home credit, pawn-broking or payday lending.
The issue of whether or not to cap interest rates, as a solution to stop debt-spiralling for individuals, has been widely debated in recent years. Both France and Germany have rules which provide a cap on interest rates. In each country the sub-prime sector is small, suggesting lenders may struggle to design viable financial products because of these restrictions. This seems to result in some people on low incomes having difficulty accessing credit if they need it.
Social lending is available to low income consumers in both countries - for example, the French Government guarantees loans through co-operative and postal banks and Germany has socially orientated co-operative banks competing with mainstream banks to provide simple accounts and products to low income groups.
Like the UK, Australia has a fairly liberal approach to credit regulation and one of the largest credit markets in the world. Australian policy makers are also debating whether to introduce interest rate caps, with opinions divided, as in the UK.
In contrast to the UK, in Australia banks are an important part of social lending. Aided by Federal Government, charities work in partnership with government and major banks which fund their own micro-finance and loan programmes. Usually these loans are only available for purposes deemed productive such as large household items, education or training, rather than paying bills or rent.
Consumer Focus believes the UK could be learning lessons from overseas on replacing high-cost credit:
The UK has lower levels of financial inclusion than France and Germany. The situation is improving, but the barriers for consumers who are vulnerable or live on low incomes must be addressed, to ensure everyone has access to bank accounts, savings products and affordable credit.
British High Street banks could make affordable credit more available to people on low and minimum incomes, one example of how this could be done is working with leading charities as has been the case in Australia. Australia's innovative approach could offer particularly important lessons for UK policy makers.
Consumer Focus is urging the government and the financial services industry to help develop and promote social lending through credit unions and community-based initiatives.
The question of whether to introduce interest rate restrictions or caps is a thorny one. Consumer Focus believes more research is necessary around credit regulation in the UK to assess how it would impact on low income consumers.
