In its 2017/18 business plan, the Financial Conduct Authority (FCA) made a commitment to review the motor finance market, largely due to it being the third largest lending sector in the UK worth £64bn. Its aim was to understand the use of motor finance products, assess sales practices and the potential for consumer harm in this sector.
The FCA published an update on its review of this sector in March 2018, in which it acknowledged that Personal Contract Purchase Agreements (PCPs), which accounted for approximately 66% of the value of new and used car finance lending in 2017, provide flexibility to consumers and lower monthly costs due to the design of the product. It also concluded that the largest lenders were adequately managing the prudential risks from a potential severe fall in used car values.
The next stage of its review focused on the issues of greatest potential harm to consumers, including:
- whether lenders are adequately managing the risks around commission arrangements, and whether commission structures have led to higher finance costs for consumers because of the incentives they create for brokers;
- whether consumers are being given the right kind of information, at the right times, to enable them to make informed decisions, and whether firms are complying with relevant regulatory requirements; and
- whether firms are properly assessing whether consumers can afford to repay the credit, particularly when lending to higher-risk consumers.
The FCA analysed contracts between some of the largest lenders (accounting for approximately 45% of the motor finance market) and their top dealers covering the period 2013 to 2016. They identified four main types of commission structure:
- increasing Difference in Charges (DiC) - also known as 'Interest Rate Upward Adjustment' where brokers are paid a fee which is linked to the interest rate payable by consumers. The contract between the lender and the broker sets a minimum interest rate, and the fee is a proportion of the difference in interest charges between the actual interest rate and the minimum interest rate;
- reducing DiC - also known as 'Interest Rate Downward Adjustment' which is similar to the Increasing DiC, except that the contract between the lender and the broker sets a maximum interest rate;
- scaled commission - also known as a 'variable product fee' where the broker is paid a fee which varies (within parameters) according to certain product features such as the type of credit agreement or the interest rate; and
- flat fee commission - where brokers are paid a fixed fee for each credit agreement they process or arrange.
The FCA found that Increasing and Decreasing DiC arrangements could provide strong incentives for brokers to arrange finance at higher interest rates as the amount of commission the broker receives increases with the interest rate that consumers are charged. In the FCA's sample of contracts reviewed, the brokers often had discretion to set the interest rate payable by consumers, within parameters set by the lender.
Further, the FCA found that there was a strong association between broker commission and interest costs for the DiC models, regardless of other factors such as consumers' credit scores, the size of loans and the length of agreements. According to the FCA, consumers with lower credit risk (having higher credit scores) should typically receive lower interest rates. However, in its sample of contracts reviewed, it found that there was typically little relationship between the interest rate charged to consumers in DiC models, whereas the relationship was more apparent for scaled and flat fee models.
Across the firms in its sample, which comprised approximately 60% of the market, the FCA estimated that 560,000 consumers who were affected by such commission models could pay in total £300m more annually in interest costs.
It is not clear to the FCA why brokers should have such wide discretion to set or adjust interest rates. It is concerned that lenders are not doing enough to monitor and reduce the risk of harm which their commission structures may pose.
Information and Disclosure
The FCA undertook a mystery shopping exercise which involved visits to 122 motor retailers and other brokers, comprising 37 franchised retailers, 60 independent retailers, 14 car supermarkets and 11 online brokers.
On the whole, the FCA found that most brokers appeared to make sufficient efforts to establish consumers' change cycles, ownership/usage preferences and budget. However, the FCA had concerns regarding pre-contract disclosure and explanations, and was not satisfied that firms are complying with regulatory requirements.
In particular, the FCA found that some brokers for new car sales tended to focus on PCP, only using Hire Purchase (HP) as a comparator, even in circumstances where the consumer expressed a clear desire to own the vehicle outright at the end of the agreement. The lower monthly costs associated with PCP were generally promoted as a key benefit; however, the key downsides of the finance option were not explained to consumers in a similar, balanced way.
Moreover, there were concerns that disclosures or explanations given during the initial visits were often incomplete, and sometimes potentially misleading. Pre-contract disclosure requirements are principally located within the Consumer Credit Act 1974 and the obligations usually fall on the lender, as the creditor, although the lender may choose to delegate these to the broker or other intermediary. The lender, must, however, be satisfied that the intermediary has disclosed the required information to the consumer as per regulatory requirements. Failure to do so, may render a credit agreement unenforceable without a Court order and the FCA may also decide to take enforcement action.
Regarding key features, the FCA found that some key features, such as the final balloon payment for PCP, were usually clear and transparent. However, only 31% of brokers explained that, for PCP and HP, consumers do not own the goods until all sums have been paid and conditions satisfied. Moreover, only 28% of brokers explained the total amount payable, the consequences of failing to make payments and the effect of withdrawing from the agreement.
Finally, the FCA found that only a small proportion of brokers disclosed that a commission may be received for arranging finance. It is a regulatory requirement for brokers to disclose their status and remuneration to consumers, especially where there are commission arrangements which may affect the broker's impartiality in promoting a particular product.
The FCA was not satisfied, during its review, that all lenders were complying with FCA rules on assessing creditworthiness, including affordability. Some seemed to focus unduly on credit risk to the lender, rather than affordability for the borrower.
In its report, the FCA has warned firms to review and, where necessary, amend their policies and practices in light of the FCA's findings.
- lenders should assess their commission models and determine whether they are doing enough to limit the risks arising from those arrangements - the FCA has made clear that the onus is on lenders to ensure that any differences in commission rates are justified, based on the work involved for the broker;
- lenders should review their systems and controls in light of the FCA's findings in respect of commission arrangements. Where harm, or potential harm is identified, this should be addressed;
- firms should ensure that financial promotions and communications, including oral communications at point of sale, are clear, fair and not misleading. In particular, they must be balanced, and must not emphasise any potential benefits of a product without also giving a fair and prominent indication of any relevant risks. They must also not disguise, omit, diminish or obscure important information, statements or warnings. They must be sufficient for, and presented in a way that is likely to be understood by, the average consumer;
- lenders should ensure that pre-contractual disclosure, whether provided direct or through a broker, is given to consumers in good time to enable them to make a reasonable assessment of whether they can afford the credit and to understand the key associated risks. Lenders should assess their oversight arrangements over brokers where they have delegated this responsibility; and
- firms should ensure they are familiar with the FCA's rules and guidance on 'assessing creditworthiness' which were introduced in July 2018. Firms should review their policies and procedures in light of those new rules and make changes were necessary.
The FCA has particular concerns over existing commission structures and has started policy work with a view to consulting, subject to a cost benefit analysis, on changes to strengthen existing FCA rules and to explore other policy interventions such as banning DiC and similar commission models, or limiting broker discretion altogether.