The FCA recently published an update on its work in the motor finance market. Having identified in July 2017 four key questions to review, the update covers the regulator’s progress so far in respect of each question. Jo Davis, partner, and Timothy Anson, paralegal at Locke Lord summarise the key points.
Prudential risk from inadequate asset pricing
The Finacial Conduct Authority’s (FCA) interest in this area is as to whether firms are adequately pricing asset valuations and managing the risk that these could fall.
In particular the FCA is interested in whether firms have sufficient capital to cope with a significant fall in used car values.
The FCA undertook a review of the largest FCA solo-regulated lenders of motor finance – i.e. not also PRA-regulated – firms that account for 52% of the total market. The regulator found that asset valuations and risk management processes at these firms appear to be robust and that stress tests showed the financial impact of a fall in residual values would not materially affect their overall financial soundness.
While positive, the FCA does remind firms to regularly assess the prudential risk of structural changes in the market that could affect firms’ assumptions upon which strategic plans rest.
Adequate affordability assessments
The FCA’s interest in this area at this stage is around whether recent growth in motor finance is leading to more consumers being unable to afford repayments.
The findings published in the update are that most of this growth has been through lending to lower-risk consumers, which in turn has resulted in arrears and default rates remaining low.
Interestingly, the FCA did find that there were no meaningful patterns in the timing of defaults.
On this point the FCA was looking at the question of whether defaults in other consumer credit products typically preceded or followed defaults in motor finance products.
In practice, the FCA wanted to know if consumers prioritise repayments on their car over other obligations. Its findings, however, appear to indicate that consumers do not prioritise their motor finance arrangements in this way.
The FCA confirms in the latest update that the next phase of its work in this area will focus on whether current affordability procedures are working in the interests of consumers
Conflicts and commission arrangements
Alongside its recent review of staff incentives, remuneration and performance management in consumer credit firms, the FCA is keen to understand whether any conflicts of interest arise from commission arrangements between lenders and dealers and, if so, how these are appropriately managed to avoid harm to consumers.
The FCA identified four main types of commission structure, as well as additional mechanisms such as volume bonuses and consumer fees.
The four structures identified were:
Interest Rate Upward Adjustments, also known as Increasing Difference in Charges (Increasing DIC);
Interest Rate Downward Adjustments, also known as Reducing Difference in Charges (Reducing DIC);
Scaled Commission, also known as variable product fee, and
Flat Fee Commission.
The FCA’s current findings are that some of these arrangements can provide incentives for brokers to arrange finance at higher interest rates for their customers.
Consequently, in the next phase of its analysis, the FCA is planning to test the effectiveness of lenders’ systems and controls to assess whether the risks presented by such commission structures are adequately controlled by lenders. The FCA will also test whether commission structures have led to higher finance costs for consumers, because of the incentives they create for brokers.
Sufficient and transparent information
The FCA wanted to know if the information provided to potential customers by firms is sufficiently clear and transparent so that the customer can understand the risks involved and make informed decisions.
The findings in the update are that contracts are generally transparent and website terminology and language appear to be clear and consistent. However, the FCA does go on to say that within the review it has seen cases where information is not sufficiently prominent.
The FCA’s next step on this issue is to complete a mystery-shopping exercise, through which the regulator hopes to assess consumers’ access to clear, timely and transparent information at the point of taking out motor finance.
The FCA expects the review to last until September this year.
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