Motor finance won’t put brakes on UK banking sector

An otherwise fairly uneventful year for the UK banking sector has occasionally been dented by headlines concerning the Financial Conduct Authority’s (FCA) investigation into motor finance commission arrangements.

To be clear, while compensating customers could have a material impact on certain smaller institutions, we don’t see this as a systemic problem for UK banks, and the Bank of England devoting a single paragraph to the issue in last week’s 120-page Financial Stability Report would appear to support this view.

However, given we expect to see uneven outcomes across individual banks, and with memories of the Payment Protection Insurance (PPI) scandal living long in the memory, we expect ongoing press coverage in the coming months and it is therefore worth putting the scale of the problem in perspective.

Scrutiny of motor finance is not new

As far back as 2017 the FCA had expressed concern about a “lack of transparency, potential conflicts of interest and irresponsible lending” in the motor finance industry. The City watchdog’s chief concern was around so-called discretionary commission arrangements (DCAs), whereby lenders would pay commission to car dealers or motor finance brokers based on the interest rate charged on the loan.

The FCA concluded that these commissions were costing consumers more than flat fee arrangements, were not disclosed to clients clearly enough, and created a potential conflict of interest with dealers and brokers receiving higher commissions for charging customers more. As a result, the regulator introduced a ban on DCAs from January 2021, and motor finance lenders adjusted their practices accordingly.

Court rulings increase potential losses

During the Covid-19 period and its aftermath the issue took a back seat from a regulatory standpoint, but customer complaints relating to commission arrangements before the 2021 ban gathered pace in the UK’s Financial Ombudsman Service and the civil courts. While motor finance lenders had rejected most of these claims on the basis they did not act unfairly, the Financial Ombudsman ruled favourably on two cases and some were also upheld in the civil courts, opening the door to a significant increase in complaints.

In response, in January the FCA launched a further review of historical motor finance commission arrangements. The regulator was seeking to identify whether widespread misconduct took place, and if so, how best to compensate customers. The outcome of this review was due in Q3, but has now been postponed to May 2025.

In the meantime, the judicial processes have been ongoing. Significantly, in October the Court of Appeal ruled in favour of customers, and while it may still be tested in the Supreme Court, the decision has been seen as likely to increase the overall amount of compensation UK motor finance lenders may have to pay out.

No systemic issue for UK banks

It is worth noting that approximately 60% of motor finance in the UK is originated by non-bank institutions (or FCA regulated firms). Lending within the banking sector (so 40% of the total stock) is also rather fragmented; some major banks have zero motor finance business, while for some smaller lenders it accounts for as much as 40% of their loan book. The largest lenders in the UK do not have significant exposures to motor finance, and they also have broader business models which offer some additional protection through diversification.

Despite the number of moving parts, what we can conclude at this stage is that the impact could be material for certain financial institutions. Broker estimates are pointing to total losses for the sector of around £20bn (though again the major banks only represent about £6bn of this). As a percentage of Common Equity Tier 1 capital (CET1), the average redress estimate for motor finance provisions and losses is no greater than 12% for the major banks, but it could be 25% or above for some smaller lenders with a minimal amount of bonds outstanding. These are preliminary estimates, as they cannot consider any unforeseen court rulings or mitigating actions such as early settlements.

However, the UK banking sector overall is very well capitalised, and profitability is the highest it’s been in years. This means potential losses in the region of £6bn across the major banks in our view wouldn’t be an issue for the sector as a whole. As noted, the more severe implications will be contained to smaller lenders with large exposures to motor finance. For context, the PPI scandal cost the sector over £50bn at a time when UK banks had less capital and lower profitability as a result of ultra-low interest rates.

In our view, it is not necessarily the outcome of the October ruling that is damaging to the sector as much as the uncertainty around it. For one, for those smaller lenders with the most exposure the lack of clarity will be a considerable hurdle to any capital raising activities. More broadly, the uncertainty around the ultimate scale of the liability has led to increasing loss estimates for the sector and questions around any impact on shareholder dividends, which may unduly depress equity valuations for those banks more heavily involved in motor finance.

For bank bondholders, the situation is certainly worth monitoring closely. We are mindful of the potential for secondary effects as the scale of losses at certain smaller lenders becomes clearer, but we don’t think that poses a systemic risk for the UK banking sector, or indeed to the credit profiles of the major banks.