Motor finance – driving reform?

At some point in December 2018, the Financial Conduct Authority (FCA) is expected to announce the findings of its review into motor finance. Prompted by a material rise in consumer credit, with the sale of personal contract purchases (‘PCPs’) constituting a significant portion of the rise, it is designed to assess whether current sales processes ensure that customers are being treated fairly and whether lending firms are properly managing risk.

With the scope of the review having been updated earlier this year – the FCA has already concluded that financing firms are adequately managing the residual risk from financing contracts – it remains focused on three questions:

1. Is the customer provided with sufficiently clear information such that the risks can be understood and an informed decision reached?
2. Are the contracts affordable for the customer?
3. Do commission arrangements create conflicts of interest between dealers and lenders which could harm the customer?

When published we expect that the findings, in conjunction with new guidelines and rules in relation to assessing creditworthiness in consumer credit¹, will create a challenging environment for the motor finance industry. Early adopters of change through the use of innovative technological solutions may benefit from more consumer-focused outcomes and gain a competitive advantage.

Economic background

The findings will come at what is already a difficult period for the motor industry: new car sales in September 2018 were 20% down on the prior period², diesel sales are being affected by new emission standards and Brexit is just four months away, with some manufacturers already planning for plant closures whether a deal is reached or not.

In its role as protector of the consumer such macroeconomic factors should not directly influence the FCA, however it must also recognise the impact its findings could have on a market sector which relies heavily on the provision of regulated finance products to help promote sales, both in the primary and secondary markets. With most people considering a car a necessity, a robust marketplace is needed, offering transparent deals to customers which take into consideration their own financial conditions, needs and preferences.

Why the spotlight on PCPs?

Debt attributable to car finance continues to be the fastest growing component of consumer credit, with PCPs accounting for 80% of new cars sold on finance in 2017. In addition to the market for used cars sold on finance, over £22bn of new PCP contracts were agreed last year.³

PCPs are like any other financial product – when presented and sold appropriately they may suit specific customer needs. The FCA indicated that it would conduct a ‘mystery shopper’ exercise to better understand how these products are marketed, offered and sold – the “customer journey” – in particular with regard to other financing products available in the market. The concern is that the intricacies of the product may not be clearly laid out during discussions with customers.

Transparency of information

How much information and how much time does a customer need to arrive at an informed financing decision? While there is no one answer to this question, sales processes need to be free from bias and not rushed so that the customer is able to make the best decision based on their individual circumstances.

The FCA does not normally prescribe a set of rigid guidelines on what information should be provided during a sale; rather, it tends to prefer a principles-based approach which requires firms to assess the needs and understanding of the individual. Although subjective, this approach allows:

• a one-size-fits-all rulebook to promote the offering of regulated products so long as the customer is appropriately informed and
• administrative costs to be kept to ‘normal’ levels so that credit does not become too costly for the consumer.

Financing packages need to be presented on equal terms; unfair comparisons which are designed to favour a particular product or a particular lender could easily influence a large proportion of borrowers, in much the same way as offering only one product will suggest to some parties that there are no other options available. While this may not change the way in which vehicles are currently financed, it will help ensure that customers enter into financing contracts better informed of the make-up of the monthly running costs and of their position once the contract has run its course.

Affordability

In July 2018 the FCA issued its policy statement on creditworthiness in consumer credit. There are two aspects for consideration – credit risk to the seller and affordability for the buyer. The statement acknowledges that there are no easy metrics for assessing affordability at the inception of a loan.⁴ Indeed, even with a complete customer credit history there is no guarantee that future payments can be met, but the argument expected from the FCA is that dealers and lenders must do more in this market to satisfy themselves at the point of sale that the repayment risk from the customer’s viewpoint is mitigated. In the Open Banking era getting complete information from a customer should be easier, although encouraging customers to release data remains a difficult issue.

Another point the FCA may raise is that affordability checks must not just be carried out⁵, but that there must be proof that they were carried out. Such checks would likely lead to additional control requirements at the point of sale, followed by an industry debate as to whether the additional costs should be borne by the dealer or the lender. With some manufacturers now looking to sell cars direct to customers online, and cutting out the dealer altogether, how will the industry cope with this potential pinch point?

Commissions

Commissions payable by lenders to dealers are the least clear part of the car financing cycle. Indeed, they may not be referred to at all, as they do not necessarily have a direct impact on the customer. However, given the role that commission arrangements have had in PPI redress payments it is likely that the FCA will look for far greater transparency here.

The main concern is that certain incentive agreements can be structured in the dealer’s favour, heightening the risk of customer detriment and potentially leading to customers unknowingly paying higher interest rates. This contravenes the notion of treating customers fairly. Any proposed changes in this area may adversely affect the sales of new cars under PCP agreements, where the lender’s commission is used by the dealer to subsidise the car.

As with transparency of information, providing greater clarity over how commissions are paid to (and used by) dealers may not change current practices, but it would enable the customer to have greater insight when making purchasing and financing decisions.

Possible review outcome and suggested next steps

In July this year the regulator published a discussion paper to canvas stakeholders’ views on whether a new duty of care is owed to consumers. In opening this discussion, the FCA has shown again that securing appropriate protection for the consumer is a key cornerstone of its approach to financial regulation. Our discussions with the regulator indicate that there is a concern over the overall debt burden faced by the consumer, and that this needs to be taken into consideration with each additional finance product sold.

The FCA has recognised that delinquency rates on PCPs are low, and so its ongoing review is more likely to look at ways of improving current practices rather than redressing the past. Even if nothing were to change, under ’new normal’ interest rates the provision of PCPs (or other forms of motor financing) may not lead to a significant rise in delinquency or default rates.

We expect a demonstrable tightening of the sales process to be proposed in the FCA’s review of motor finance – in terms of clearer marketing literature, more accurate comparative pricing, better record keeping and greater disclosure of incentive payments.

In preparation for the publication of the FCA report, businesses that have yet to consider their own practices should:

• review current marketing literature and ensure that all financing products are presented on a like-for-like basis, and that the risks of entering into a financing contract are clearly disclosed
• assess whether such risks are also made clear to the customer at the point of sale (and preferably well in advance of a transaction)
• consider whether current affordability checks are fit-for-purpose and provide suitable protection for potentially vulnerable customers
• investigate whether commission structures are being used to the detriment of the customer.

Rather than consider the FCA’s review as an added burden, we believe that businesses should see it as a potential opportunity to reform current practices and gain a competitive edge.

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¹ The FCA published a Policy Statement in July 2018 entitled ‘Assessing creditworthiness in consumer credit’: https://www.fca.org.uk/publications/policy-statements/ps18-19-assessing-creditworthiness-consumer-credit

² https://www.smmt.co.uk/2018/10/uk-new-car-market-falls-in-exceptional-september-as-supply-issues-bite/

³ https://www.motortrader.com/motor-trader-news/automotive-news/196279-12-02-2018

⁴ In the Finance Ombudsman Service’s Annual Review 2017-18 it is noted that “some lenders aren’t being thorough enough with the affordability checks they’re carrying out right at the start”: https://www.financial-ombudsman.org.uk/publications/annual-review-2018/full-review.pdf

⁵ Affordability should also consider the validity of the lending decision made. Consider the actions of the Australian Securities and Investments Commission in 2016: https://asic.gov.au/about-asic/news-centre/find-a-media-release/2016-releases/16-417mr-asic-action-sees-bmw-finance-pay-77-million-in-australias-largest-consumer-credit-remediation-program/