A decade on from the financial crisis, concern about the growth of consumer credit is growing again, this time fuelled by the spectacular growth of motor finance. In the US, motor finance lending to sub-prime segments of the market have sounded alarm bells; in the UK, a shift from traditional hire purchase arrangements to Personal Contract Plans (PCPs) has also attracted regulators’ attention. The Financial Conduct Authority (FCA) will shortly begin a formal investigation to examine what these changes mean for competition.
Existing research suggests that customers shop around far less for motor finance than for other financial products, which suggests dealerships may hold a “point of sale advantage”. If the FCA finds that significant numbers of customers could get better deals away from the forecourt, expect behavioral or structural remedies to follow.
Total outstanding consumer credit balances increased by around 10% in the 12-months to September 2017, continuing the high growth rates seen in previous years. There are no signs of a slowdown: most lenders expect to continue to grow their consumer credit portfolios.
Credit cards and personal loans accounted for more than half of consumer credit growth in the past year. But motor finance has seen the fastest expansion. Car finance now totals around a third of all outstanding consumer credit – a category which includes overdrafts, peer-to-peer lending, store credit, lending from credit unions and small money lenders such as pawnbrokers and payday lenders.
Source: Bank of England, ONS, Frontier calculations
The post-2010 regulatory system has certainly been more alert to changes in consumer credit than its predecessor. Notably, the Bank of England has increased the focus on consumer credit as part of its stress tests. And the FCA has launched multiple investigations, now including one specifically on motor finance.
Motor finance consists of loans offered to customers at the point of vehicle purchase. This type of lending is not new. Traditionally, car finance would take the form of a hire purchase agreement, where the customer would pay a share of the purchase price as a deposit and take out a loan to cover the remaining balance. The balance would be paid off with interest in regular monthly instalments, amortising fully over the lifetime of the contract.
The recent rapid growth in car finance has been associated with a shift to a different form: Personal Contract Plans (PCPs). Under a PCP, the expected vehicle value at the end of the contract period is assessed at the outset. A deposit is paid, and monthly repayments set such that the outstanding balance at the end of the contract should be equal to the minimum predicted value of the vehicle, which can then be cleared with a final “balloon” payment.
As Figure 2 indicates, PCPs have proven extremely popular. PCPs now represent over 80% of new car finance, and have grown at over 20% per year since 2012.
Source: Finance & Leasing Association, Society of Motor Manufacturers and Traders, Frontier calculations
Explaining the growth of PCPs is a fundamental question for regulators in working out the degree to which they should be worried about motor finance. There are many possible general explanations – the general recovery in markets, technical innovation fuelling demand for new cars, the availability of cheap finance, and perhaps easier access to this form of credit compared to other sources.
However, while some of these general factors may have played a part, they do not explain the rise of PCPs within overall car finance. Another lens is needed for that. Over the past decade, advances in behavioural economics, and in regulators’ confidence in applying the techniques, have provided a new set of diagnostic tools and applicable remedies.
There are several factors at work, familiar to behavioural economists, which can help to explain the popularity of PCP agreements relative to traditional car finance.
As with previous inquiries, the FCA will want to understand how customers make decisions (behavioural analysis), and where profits are generated (profitability analysis). Examining the interplay between customer behaviour and provider profitability will provide insight into competitive dynamics.
For example, as shown in Figure 3, recent work from the FCA shows that significantly fewer motor finance customers shop around when making a purchase than they do for other financial products. This suggests dealerships may hold a “point of sale” advantage, which in turn raises questions as to how any advantage is used. Has this been used to limit the ability of customers to search, and consequently limit the ability of other finance providers to exert a competitive influence? Regulators may well reach the view that this is the most important behavioural issue to investigate and address in the motor finance market.
Source: FCA Financial Lives Survey 2017, Table 9.12.
As the inquiry gets going, the next stage will be the inevitable raft of questions and information requests that mark the start of more formal investigations. The requests can be expected to cover a range of issues, of the kind listed below.
These are all issues where cutting through to the underlying economics is far from straightforward. As the Chief Executive of the FCA Andrew Bailey said recently, there is nothing wrong with PCPs “per se”. But there are enough issues that warrant investigation if we are to understand whether customers are getting the right information to enable them to make the right decisions. If the FCA finds that significant numbers of customers – or the most vulnerable customers – could get better deals away from the forecourt, behavioural or structural remedies may follow.
What should be remembered by those in the market is that a financial instrument that is fine in theory may still prove to have been mis-sold in practice (as in the Payment Protection Insurance saga). They would be wise to take this investigation seriously – and review their own behaviour at the same time.