Estimating exposure in motor finance

The Supreme Court judgment on motor finance, and subsequent FCA statement of intentions, are finally here, and have helped to narrow the field on potential redress considerations. Much uncertainty remains, however.

Fairness of the relationship and deal with the customer will be at the heart of the considerations. It is also clear that FCA intends the redress scheme to reach back to 2007, cover DCAs that "were not properly disclosed" and calculation of redress "will be informed by the degree of harm suffered by the consumer". Also, interest on the amount of redress will be based on commercial rate, likely base rate plus 1%, which will substantially reduce the interest element compared to previous estimates.

All eyes are now on the FCA's consultation, in October. That will have to resolve the remaining areas of uncertainty, the key ones including:

  • Will the FCA propose an opt-out or opt-in scheme.
  • What is the proposed basis of redress – i.e. how is the consumer harm determined. The FCA has explicitly said it may not be as high as return of full commission, i.e. contrary to Supreme Court decision in the Johnson case.
  • How will the FCA expect lenders to apply, in practice and in detail, the five factors that could indicate an unfair relationship, to identify loans in scope of redress.
 

The FCA has given itself longer than the previously indicated six weeks to work out the consultation proposals. For now, it has indicated that plausible aggregated cost estimates would be towards the middle of its £9 - £18 billion range, and that most individuals "will probably receive less than £950 per agreement".

This article considers how different basis of redress would fit into the range indicated by the FCA, making convenient simplifying assumptions about the other key uncertainties.
 

Potential scale of exposure under different scenarios

Without commenting on their likelihood, we consider three basis of redress that could lead to substantially different levels of exposure. Throughout, we assume a sector wide, opt-out, redress scheme and that roughly 50% of loan agreements would be in scope of the scheme. We have made various other simplifying assumptions as well.

Scenario A: Remediation based on "excess interest charges" that customers may have been subject to because of an unfair relationship. This is the basis that the FCA used to estimate consumer harm in its 2019 Consultation Document.

Scenario B: Remediation based on "excess interest charges" and difference in commission paid to dealers/brokers between DCA and non-DCA deals.

Scenario C: Remediation based on the return of full commission payments made by lenders to dealers/brokers, consistent with Supreme Court in the Johnson case. Our calculations use data from the FCA’s 2019 Consultation Document, still the most recent source of published data by the FCA on motor finance, based on over 16,000 loans and representative of 61% of the estimated £41bn UK motor finance market in 2017.

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. Those figures together with other data points from the FCA imply per-DCA-originated-loan excess interest cost of £245 per loan. Using that as a basis and scaling it, roughly, to the motor finance market between 2007 – 2021, gives an aggregate industry wide redress estimate at c. £6.3 billion including interest. If we assume a 20% uplift for operational costs, the total cost would be c. £7.6 billion.

Scenario A would be somewhat below FCA’s range, but given the various simplifying assumptions in these indicative calculations, could still indicate that the bottom of the FCA’s range is consistent with its previous approach to consumer harm in motor finance.

Based on the figures in the FCA’s 2019 Consultation Document, we can calculate that the average commission on a DCA loan was £709 per loan in the FCA’s sample from 2017. The average commission on a non-DCA loan works out to be £520 in the same sample, giving an average difference of £189 between DCA and non-DCA commissions to dealers/brokers. (Clearly, this does not control for any other factors that could lead to the difference, such as loan amounts involved for example.)

Combining the £189 with the £245 consumer harm per loan from Scenario A, gives total remediation of £434 per agreement. Scaling that as in Scenario A, would lead to an aggregate industry wide redress estimate of £11.2 billion, and potential total cost to the industry at £13.4 billion.

Scenario B would seem to produce figures in the middle of the FCA’s indicated range (the mid-point being £13.5 billion).

This scenario would be based simply on return of the commissions paid on loans in scope of redress. The average commission across the whole of FCA’s 2017 sample (DCA and non-DCA) was £615 per arrangement, where as the DCA specific average was £709 per arrangement. Using these as the basis of a range, and scaling up as above, gives a range for aggregate industry wide remediation of £15.9 - £18.3 billion. With a simple uplift for operational costs as above, the total cost range would be £19.0 to £22.0 billion.

While higher than FCA’s indicated top range, those figures could still be indicative that the top end of range is based on FCA’s analysis of remediation based on return of total commissions of agreements potentially in scope. For example, DCA loans with zero percent interest could be excluded from scope, bringing down the above range accordingly.

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. The FCA seems likely to consult on an option that is based on quantifying actual harm suffered by consumers, as well as the somewhat simpler, in principle, approach of returning commission paid chosen by the Supreme Court in the Johnson case.

The figures presented here derive from indicative calculations that extrapolate data from FCA’s 2019 Consultation Document. 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 estimates the consumer harm in the round, including how the harm varies due to customer or loan characteristics. 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 economists 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 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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