A wide-ranging review of historic motor finance commission arrangements has rocked the UK’s banking sector at a time when the biggest players are reporting record profits.
Following a spike in complaints, the Financial Conduct Authority (FCA) announced last month that it would launch a review into so-called discretionary commission arrangements (DCAs) between 2007 and 2021.
The FCA has pledged to ensure consumers receive an “appropriate settlement” if it finds evidence of widespread misconduct.
What were DCAs?
A DCA was an agreement between a lender and car dealers or brokers allowing the latter to set interest rates on car repayment plans within a range given by the lender.
Brokers’ commission payments were then linked to the difference between the lender’s base rate and their own rate, giving an incentive to charge at the higher end.
DCAs were industry standard until the regulator banned them in January 2021. The FCA found in 2019 that the practice cost customers £300m more per year than the flat-fee models lenders use now.
The FCA’s probe came after two “test cases” which saw the Financial Ombudsman order Lloyds and Barclays to pay compensation for “unfairly” paying brokers commission without customers’ knowledge, finding that DCAs created a conflict of interest between broker and customer.
Aerial view, new and secondhand cars are seen for sale on a dealership forecourt on September 21, 2023 in Ellesmere Port, England. (Photo by Christopher Furlong/Getty Images)
In the case of Lloyds-owned Black Horse, more than half of the customer’s interest went towards extra commission for the broker. The ombudsman found the broker exploited the customer’s vulnerability, having been refused by four other lenders.
The annual percentage rates charged in these cases were 10.5 per cent and 8.9 per cent respectively.
Compensation in both was set as the difference between the minimum rate set by the bank and the rate contracted by the broker, plus eight per cent interest since each payment.
The Finance and Leasing Association, which represents the motor finance industry, has said dealers often used DCAs to lower interest rates to secure deals in a competitive market.
Which banks could be on the hook?
Analysts have put forward a range of figures on compensation costs for the motor finance industry, with the highest reaching £16bn.
Black Horse, which is the country’s largest auto lender, makes Lloyds the most exposed bank to DCAs in absolute terms.
Analysts at Numis have noted that Black Horse originated around £30bn of consumer motor finance between 2014 and 2020 alone.
Lloyds today announced a £450m provision for the potential impact of the review, which it said included “estimates for costs and potential redress”.
RBC analysts’ latest downside estimates say Lloyds could face a hit of up to £3.5bn, with their base case at £2.5bn.
“We find it interesting that the accountants of other banks have concluded that there is too much uncertainty to raise a provision, whereas Lloyds accountants have taken a different view,” RBC analyst Benjamin Toms told City A.M.
“Given that the key variables governing the size of the impact sit largely with the regulator, all the provision today really tells us is that other banks may have to start provisioning as well. It does not really give us any indication of the ultimate size of any redress.”
He added that it was “not a coincidence” that the size of Lloyds’ provision was roughly in line with its write-back resulting from the sale of The Telegraph, keeping its balance sheet “clean”.
Santander UK, meanwhile, could take a hit of up to £1.5bn. The bank has not yet made any provisions related to the review.
It said in its full-year results report that despite receiving “a small number” of county court claims, there remained “significant inherent uncertainties regarding the existence, scope and timing of any possible outflow which make it impracticable to disclose the extent of any potential financial impact”.
Barclays performed auto lending between 2010 and late 2019, although its operations were relatively small. RBC analysts said its bill could be up to £500m.
The bank has not made any provisions, saying on Tuesday that the outcome of the review was “unknown, including any potential financial impact”.
Close Brothers, one of the UK’s oldest merchant banking groups, is poised to take the biggest relative hit at up to £350m – almost half of its current market capitalisation.
Auto lending made up around a fifth of Close Brothers’ loan book at £1.95bn as of last July. Its website claims that every year it helps more than 100,000 Britons pay monthly for their vehicle.
The probe forced it to scrap its dividend for 2024 and puts its 2025 dividend under review last week, causing shares to collapse.
Natwest has not provided commission-based motor finance for decades and said last week that it had no exposure to the probe.
Deja vu?
At a time when the regulator is focusing more than ever on banks’ duty to consumers, some have compared the potential redress to the infamous PPI scandal – which caused banks to hand back more than £38bn between 2011 and 2019.
One of these people is Martin Lewis, the founder of MoneySavingExpert. He said earlier this month that he had received more than a quarter of a million emails just one day after his website launched a free motor finance reclaim tool.
However, auto finance is not a major part of most banks’ loan books, with UBS analysts noting that motor lending makes up just two to three per cent of large bank lending.
When asked about comparisons to PPI, Lloyds chief financial officer William Chalmers said in a call with reporters on Thursday that the potential impact was “not like prior remediations”. His firm paid £2.5bn to deal with its final PPI claims in 2019.
Analysts have pointed out that banks did not benefit from discretionary commissions in the way they did from misselling insurance and have less market share. JP Morgan analysts said non-bank lenders backed around 60 per cent of UK dealership car finance loans as of 2017.
“Analyst estimates for total potential industry cost are much smaller than PPI, yet lingering uncertainty will likely continue to be a sentiment drag,” said Tomasz Noetzel, an analyst at Bloomberg Intelligence.
The FCA is due to provide an update on its review in September, which could give more clarity on potential redress.