A probe into motor finance deals after a spike in consumer complaints has put struggling UK banks under further pressure as they prepare to make provisions for redresses that analysts estimate could reach as much as £16bn.

“If we find there has been widespread misconduct and that consumers have lost out, we will identify how best to make sure people who are owed compensation receive an appropriate settlement,” the Financial Conduct Authority said when it launched its investigation in January.

Shares in Lloyds Banking Group, which owns the UK’s largest motor finance provider Black Horse, have fallen about 10 per cent since the announcement, while City bank Close Brothers’ stock has nearly halved, prompting it to suspend dividends. 

The review, amplified by consumer protection advocate Martin Lewis, has echoes of the payment protection insurance mis-selling scandal that was initially played down by banks but ultimately cost them more than £50bn.

Discretionary commission arrangements

Until the FCA banned the practice in 2021, banks providing car finance allowed car dealers to set their own interest rate on repayment plans, a practice known as discretionary commission arrangements. This meant salespeople could undercut the banks’ preferred rate to secure a deal — but also overshoot it in order to earn a bigger commission.

Two complaints prompted the FCA’s probe. One, upheld against Black Horse, related to case whereby a consumer paid a 10.5 annual percentage rate and another upheld against Clydesdale, then owned by Barclays, was linked to a deal through which the consumer paid an 8.9 per cent APR. In both rulings the ombudsman noted that the lending banks would have accepted much lower rates and said there was a conflict between the interest of consumers and brokers.

However, experts say the two examples are not indicative of the whole landscape. A Numis analysis of Lloyds motor loans data found that before the 2021 DCA ban, the majority of its car finance customers paid APRs of 5-7 per cent.

Motor finance trade body the Finance and Leasing Association said dealers had more often than not used the practice to bring interest rates down in order to offer competitive plans. However, dealers’ commissions were widely calculated as a percentage of the total interest a consumer was charged, meaning they had an incentive to secure sales at higher rates.

Since the 2021 ban, the industry has adopted a fixed fee model whereby lenders set a common rate that dealers cannot tweak unilaterally. The typical rate paid by consumers now varies from 6 per cent to 12 per cent but can be higher depending on their risk profile.

According to a 2019 FCA review, DCAs cost consumers £300mn more a year than flat-fee models, with consumers paying an extra £1,100 in interest charges over a typical four-year repayment plan on a £10,000 loan. The study also found that the difference between the average and highest commission was higher under DCA arrangements — at about £2,000 compared with £700 under a flat-fee model.

The cost facing banks

Experts say it is still too early to gauge the extent of the scandal.

Much uncertainty remains about the FCA’s approach, including whether it sets out a redress scheme, what it deems an appropriate gap between the rate set by banks and those paid by consumers, how it splits the cost burden between lenders and car dealers as well as whether it decides all affected customers should be refunded or only those who file claims. The regulator is due to offer more clarity in an update in September.

Calculating the extent to which consumers have lost out will be a complex task: analysts say it is impossible to determine the typical rates on car finance deals covered by the probe given there was no minimum APR when they deals were signed, while commission structures and rates varied hugely across dealerships, regional locations and type of cars sold.

However, the watchdog’s clarification that its probe will cover any deals that took place between 2007 and 2021 has already led analysts to increase their initial forecasts for redress cost. Estimates from the likes of Jefferies, JPMorgan, HSBC, RBC and Shore Capital range from £6bn to £16bn for the banking industry.

Meanwhile, bank executives say the FCA’s heightened focus on consumer protection enshrined last July through the Consumer Duty regulation suggests the regulator may take a harsh stance.

But while the costs to the UK banking industry could be significant, they look unlikely to reach those of the PPI scandal. Car finance accounts for about 5 per cent of household lending, while banks backed about 40 per cent of all UK dealership car finance loans as of 2017, according to JPMorgan analysts, with the rest accounted for by non-bank lenders including the financing arms of global car manufacturers.

“We do not expect the scale of any compensation costs in this probe to be comparable to that of the mis-selling of payment protection insurance,” said Fitch ratings analyst Huseyin Sevinc. “Motor finance loans generally represented a relatively small share of UK bank lending.”

Banks most exposed to the scandal

Lloyds has the most exposure to DCAs in absolute terms. Experts say the cost is likely to be material for the high-street bank, whose share price has fallen 14 per cent since the start of the year. By contrast NatWest — the country’s second-largest high-street bank — has virtually no exposure.

Barclays, Close Brothers and Santander UK are also expected to face compensation costs. Analysts at RBC Capital Markets estimate the redress bill could total £2bn for Lloyds, £850mn for Santander, £250mn for Barclays and £110mn for Close Brothers.

However, Close Brothers faces an outsized hit, with JPMorgan estimating it will suffer a 270 basis point erosion of its common equity tier 1, a measure of financial resilience, compared with just 110 basis points for Lloyds.

Motor finance loans represented 22 per cent of the FTSE 250 lender’s gross loan book at the end of 2021, according toFitch, compared with just 3.1 per cent for Lloyds. The bank last Thursday suspended its dividend pending the conclusion of the regulator’s review, saying it would make a decision on whether to reinstate the dividend in 2025 “once the FCA has concluded its process and any financial consequences for the group have been assessed”.

Although companies have not yet started to make provisions for redresses, one JPMorgan analyst said he expected the looming cost to lead Lloyds to buy back just £1.5bn worth of its own shares when it publishes annual earnings on Thursday, below previous market expectations of £2bn.

Potential hit to carmakers

Car finance is a lucrative enterprise for manufacturers and can be more profitable than the business of making vehicles. Carmakers and other non-bank lenders offer the majority of car financing services, according to JPMorgan analysts.

Many manufacturers offer loans directly to their customers through a “captive finance” arm that offers motorists the attractive leasing deals that have come to dominate car-buying.

Groups such as Ford and Volkswagen collect healthy profits from their captive finance divisions.

Of Ford’s $1.1bn profit in the final quarter of last year, roughly a quarter came from the Ford Credit arm. In 2021, the finance unit generated half of Ford’s entire annual profits.

Volkswagen’s financial services arm in 2022 reported €5.5bn of earnings, with a profit margin of 14 per cent — higher than the carmaking parts of the company.

More than 90 per cent of new vehicle purchases in the UK use a “personal contract purchase” or similar leasing arrangement where customers pay monthly to cover the expected depreciation of a car’s value over a timeframe, normally about three years.

However, carmakers are huge global companies with revenues often in the hundreds of billions of pounds. UK fines, even if they run into hundreds of millions of pounds for an individual carmaker, will be paltry within the overall business. For context, VW paid out more than $30bn over the dieselgate emissions cheating scandal.