Car finance has largely been shielded from the fines, headlines and scrutiny that have peppered the banking sector in recent years.
However, attention is now turning to a market that represents a significant share of consumer debt in many developed economies.
The UKs Financial Conduct Authority (FCA) has announced an investigation into the industry and regulators in other countries have expressed concerns. Further pressure may come from rising borrowing costs as interest rates rise, intensifying financial problems.
As a group, car makers seem less prepared for that scrutiny than financial services peers. This is a significant issue for investors. Schroders' Sustainability Team has engaged with the leading car makers to understand better their strengths and weaknesses.
Why is there so much concern? Auto financing has grown rapidly in many Western economies. Bank of England figures estimate that growth averaged 20 per cent a year since 2012, increasing by more than £30 billion in that period.
Mirroring its growing importance to buyers, car finance has become critical to auto companies business models. Research published by Exane BNP Paribas in 2017 estimated that 90 per cent of new cars in the US and UK, and 80 per cent in the EU, were financed or leased.
Since the financial crisis, regulators have increased their scrutiny of banks lending practices and treatment of customers, and we believe the auto industry is likely to face similar pressures in the future. This is particularly the case in the UK where motor finance comprises 30 per cent of total consumer credit, according to the Bank of Englands most recent data.
Rising regulatory scrutiny
There is concern that rising interest rates in the US and UK will raise defaults and expose irresponsible lending, and declines in the prices of used cars could trigger write-downs against expected residual values of these cars.
Already in the US, 6.3 million Americans are at least 90 days late on their car finance payments, an increase of about 400,000 from a year earlier, according to New York Federal Reserve data published in November.
Our focus has been on auto companies responsible lending practices and resilience to increasing regulatory risk. The payment protection insurance (PPI) mis-selling scandal demonstrates the financial cost of misleading consumers: the FCA estimates that £29.2 billion has been paid in refunds and compensation since January 2011.
There are signs that those potential risks are becoming more tangible.
In the UK, the FCA has conducted a motor finance review due to concern over possible “lack of transparency, potential conflicts of interest and irresponsible lending in the motor finance industry”. Its investigation is due to wrap up in September.
Meanwhile, the Australian Competition and Consumer Commission has investigated Volkswagen, Kia and Fiat Chrysler over complaints and consumer rights. Elsewhere, the US Consumer Financial Protection Bureau has fined car manufacturers or third-party providers for discriminating against minority borrowers, inflating consumers incomes and a general lack of responsible lending provisions.
As a result, we believe it is important to understand the steps auto companies have taken to ensure robust lending practices. We engaged with 16 global auto companies during the second half of 2017 to gain a better understanding of their responsible lending practices, relationships with other stakeholders and their adaptability to the emerging regulatory risk.
Each was scored across a range of measures from internal controls to customer complaints management.
Car makers have more work to do
The industry as a whole has a long way to go. None of the major car makers have faced the same scrutiny or regulatory pressures as financial service peers. As a result, disclosures are weaker and practices appear less robust. With attention growing, however, we expect companies practices to become an increasingly important competitive driver.
Companies relationships with third-party finance providers exacerbate concerns. While most car companies operate their own captive finance operations, those that are classed as “non-investment grade companies”, such as Peugeot and Fiat Chrysler, often use third-parties which are responsible for all aspects of delivering financing to customers.
Some firms have come under the spotlight recently in the US: Santander Consumer USA and Ally Financial (which collectively provide 40 per cent of Fiat Chryslers US leasing sales) have both been fined for irresponsible lending practices.
Oversight of third-party lenders is particularly important in the US where more vulnerable subprime borrowers make up over 25 per cent of the market compared to 3 per cent in the UK. Four of the companies we engaged with have exposure to third-party providers: Hyundai, Fiat Chrysler, Jaguar Land Rover and Kia. Of these, only Jaguar Land Rover could publicly provide any detail on the partner selection process.
We also found a repeated contradiction on the risks regarding brand and loyalty. On the one hand, companies were keen to stress the benefits of leasing to support vehicle sales and promote brand loyalty. Volkswagon told us that customers who lease are 37 per cent more likely to return to the brand than those who buy outright.
On the other hand, companies using third-party financing firms viewed the service as a transactional, arms-length relationship with limited focus on the customer experience in those leasing contracts. Because the partner takes on the risk of a fall in second hand values, these agreements were often seen as risk-free. This is not the case.
We believe that negative consumer experiences with a third-party provider will have harmful consequences for the brand, and that this risk is underestimated by the car companies we engaged with. Weak policies or standards, inadequate training or failure to respond to customer complaint data all leave car makers exposed to higher regulatory, compliance and training costs. On the flip side, there is an opportunity. Companies able to maintain robust standards while also leveraging the competitive branding benefits that financing offers are well placed to gain at the expense of competitors.
We found VW scored relatively well across our measures. Daimler, BMW and Renault also demonstrate good standards.
The industry is facing intense scrutiny following the emissions scandal; especially VW. It may be the companies that were in the eye of that storm have learned a lesson and may be best placed if and when the industry faces another crisis.
The rise of the personal contract plan
The primary driver of the industrys growth has been the “personal contract plan” (PCP). In a PCP, there is no deposit – the driver makes monthly payments until the end of a fixed term. The car is then either returned, upgraded or bought at a reduced price. PCP deals are generally less applicable for old vehicles, since their values become far less predictable over time.
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