Rabbit in the headlights


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.

Buying now, paying later

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.

Figure 1.           Strong recent growth in consumer credit

Source:   Bank of England, ONS, Frontier calculations

Changing gear

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.

Figure 2.           PCPs have become increasingly popular over time

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.

Behavioural drivers

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.

  • Framing. PCP contracts “frame” the cost in a very different way from traditional motor finance, or indeed other forms of finance. Price is presented as a monthly charge (typically in the low £’00s), rather than the vehicle cost (typically over £10,000). Further, the contract shifts initial payments downwards, with a greater emphasis on the final balloon payment, which many dealers are keen to point out can be avoided (by moving to another PCP). Customers often focus more on the present than the future, and make decisions accordingly.
  • Attention. A vehicle is an exciting purchase, meaning customer attention is usually placed on the vehicle, rather than the type and structure of the finance used. To the extent that customers do focus on the finances, their attention is most likely to be on monthly repayment amounts. It can be particularly hard to assess the relative costs of a PCP compared with other forms of motor finance, given differences in repayment profiles and the importance of guaranteed future values.
  • Optimism bias. Many customers underestimate the level of risk that applies to them. In the context of PCPs, this may mean customers take on monthly repayments that they are unable to afford in practice, and are over-confident about their ability to make the final balloon payments. This effect is exacerbated if affordability checks are less stringent for motor finance.
  • Social proof. It is increasingly common to rent (via a PCP), rather than own a vehicle. A general shift towards asset rental rather than ownership can be observed across a large range of markets (e.g., for mobile phones), with customers willing to trade off ownership (and potentially overall cost) for access to regular upgrades and the latest models. The prevalence of mainstream media car advertising on the basis of PCPs, as well as the general growth in PCP use, is likely to reinforce the social trend towards PCP contracts.
  • Loss aversion. This is likely to be a contributory factor. The PCP contract effectively requires customers to “overpay” for the rental by the end of the contract period, building a store of “equity” at that point. Dealers market this “creation of equity” as a customer benefit, used to spend as a deposit for a new vehicle. This marketing does not fully reflect the underlying economics.

The elephant in the showroom

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.

Figure 3.           Rate of shopping around when taking out product

Source:   FCA Financial Lives Survey 2017, Table 9.12.

What next?

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.

  • Profit analysis. This will be required to understand where, how, and from whom, motor finance profit is generated (relative to the sale of the vehicle itself). This will need to be linked to behavioural analysis to understand the relevant customer decisions, and the associated sales incentives provided to dealership staff.
  • Vulnerable customers. If some customer segments contribute disproportionately to profits, this may be viewed unfavourably, especially if those customers show signs of financial distress or vulnerability. If profit pools were to be found in sub-prime segments, that would attract particular attention.
  • Gains from shopping around. The scale of any potential customer harm will be driven by the extent to which customers could get better deals elsewhere. Given the size of the transactions involved and the nature of PCP contracts, the potential customer detriment may be large.
  • Entry barriers. The FCA will be interested in the process through which firms compete and undercut one another, and how successful this is in practice. A point of interest is likely to be whether motor sales are tied exclusively to particular credit providers.
  • Point of sale advantage. If the FCA does conclude there is a point of sale advantage, any future design of remedies may be focussed on how to break this advantage. There may be scope for early trials to investigate this (and influence remedy design), rather than leaving this issue until late in the process, when time can be limited.

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.

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Retail and consumer
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Phil Sneade
Antti Lemberg