Estimating exposure in motor finance

The potential for remediation related to commission payments in motor finance continues to evolve. The FCA announced in March that it would consult on a sector wide redress scheme, which would require firms to identify all affected customers and offer appropriate remediation to them. Further, the keenly awaited Supreme Court ruling on the correct interpretation of the law in this area could fundamentally drive the scope and scale of redress required.

Santander has provisioned £295 million for commissions paid by consumers on motor finance, based on a range of scenarios that could result from legal and regulatory proceedings. Lloyds has put aside £1.2 billion for potential exposure of its Black Horse arm. Estimates from rating agency Moody’s, put total sector exposure from £8bn to £21bn, possibly rising to £30bn depending on whether and what aspects of the Court of Appeal ruling the Supreme Court validates or overturns.

All the above figures were produced before the FCA’s March announcement. This article considers how potential exposure might be arrived at under different circumstances, including what factors are behind the wide ranges referred to in press to date.

Potential scale of exposure under different scenarios

Without commenting on their likelihood, we consider three scenarios that could lead to substantially different levels of exposure under a sector wide redress scheme implied by FCA’s March announcement:

Scenario A: Remediation based on interest charges that customers may have been subject to because of broker incentives from Discretionary Commission Arrangements (DCA). This is the basis that the FCA used to estimate consumer harm in its 2019 Consultation Document and how the FOS has approached remediation so far.

Scenario B: Remediation based on the return of commission payments made by lenders to dealers/brokers under DCAs.

Scenario C: Remediation based on the return of commission payments made by lenders to dealers/brokers under any not-properly-disclosed commission arrangements (which was part of the focus of the Court of Appeal judgement).

Potential exposure will also depend on specific rules and calculations the FCA would need to consult on and set out for the redress scheme, including how far back the scheme goes. For illustration only, we assume this ranges from 2014 to 2017in each scenario. We have made various other simplifying assumptions as well.

Our calculations use data from the FCA’s 2019 Consultation Document based on over 16,000 loans and representative of 61% of the estimated £41bn UK motor finance market in 2019.

The FCA’s 2019 Consultation details the modelling used to estimate the increase in interest incurred for DCA loans, compared to those that were not arranged under DCA. The modelling includes controls for loan characteristics, customer credit score, and other factors that could influence the rates charged.

The FCA estimates that the harm suffered by consumers in their 61% sample was £308m, implying that the total harm attributable to DCAs would be £505m, from loans originated in 2017.

If loans originated during the FCA’s 2007 – 2021 window would be eligible for remediation under this scenario, the aggregate exposure by the sector could be up to £13.6bn. If in this scenario the remediation period starts from 2014 instead, the sector wide exposure could be up to £5.8bn, including interest.

We can also back out a per-DCA-originated-loan excess interest cost from the FCA’s 2019 Consultation Document, at £253 per loan. This gives a first approximation for a per-loan exposure for lenders under Scenario A. For example, if a lender originated 400,000 loans involving DCA during the relevant period, the first approximation of exposure under Scenario A would be £101m, before interest.

Based on the figures in the FCA’s 2019 Consultation Document, loans arranged under DCAs involved payment of approximately £1.5bn in broker commissions in 2017 alone. If the period subject to remediation runs from 2014 – 2021 or from 2007 to 2021 and not accounting for changes in market size or commission levels, the exposure to remediation based on the return of DCA commissions paid across the sector could vary between £16.8bn and £39.3bn, including interest.

We can also calculate that the average level of commissions under DCA was £709 per customer per the FCA’s 2017 sample. So, if a lender originated 400,000 loans involving DCA during the relevant period, the first approximation of exposure under this scenario would be £284m, before interest.

This scenario would bring non-DCA commissions within the scope of remediation. This is pending the current legal and/or the FCA proceedings to determine what constitutes ‘disclosure’.

If 60% of lending fails to meet the standard, for the periods 2014- 2021 and 2007 – 2021 that would mean total exposure of £20.3bn and £40.9bn respectively, including interest.

A first approximation of individual lender exposure under this scenario would be to multiply the average commission in the FCA data, £615, with the number of loans where disclosure of commission arrangements does not meet the to-be-established standard. Under this scenario it is also plausible that the period in question could extend to 2024. If a lender originated 800,000 loans (increased from previous scenarios to account for a longer period), exposure to remediation would be £492m, before interest.

How to quantify exposure for specific lenders

As shown above, estimates of potential exposure can vary widely due to key factors that are yet unknown. A sector wide redress scheme, as implied by FCA in March, would remove one of the key uncertainties – the proportion of eligible consumers coming forward for remediation. The figures presented here derive from indicative calculations that extrapolate data from the consultation. To arrive at a more accurate picture for a lender or broker we would need to factor the profile of loans, customer numbers and broker arrangements.

In principle, lenders could undertake detailed bottom-up exercises to observe or recalculate the commissions paid, or counterfactual interest charges that would have been paid at customer level. However, that may not be practical or proportionate.

It is more likely, and more practical, that the level of exposure is estimated using an econometric model that utilises a robust, random representative sample of more recent data. Such models would be applicable to addressing whole books as well as responding to individual claims.

 

How we can help

For motor finance lenders, exposure to consumer remediation impacts provisioning, regulatory capital and capital planning. Our Economic Consulting team are experts in quantifying exposures of this type. To provide reliable estimates, we apply robust mathematical and econometric modelling to our clients’ circumstances. We also assist with preparing for and responding to FCA’s eventual consultation on the redress scheme design.

To explore how we can help you plan for different outcomes, please contact Jyrki Kolsi.

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