(Bloomberg) -- A court ruling that challenges the legality of car loan commission payments is ringing alarm bells in the UK banking industry.
The Oct. 25 decision by Court of Appeal judges in London highlighted an arrangement that’s been common for years — lenders paying car dealers to sell their loans to motorists, often without their knowledge. A handful of further court cases and an in-depth regulatory review will shape how lenders have to respond.
If it doesn’t go their way, the industry may be forced to pay billions of pounds in compensation to consumers. It has the potential to rival the scale of payouts linked to missold payment protection insurance — the UK’s most expensive consumer scandal to date.
What’s the problem?
A lot of British car dealers don’t just sell cars. They also arrange the loans that customers take out to buy them. Historically, dealers offered what they claimed were competitive loans without properly testing the market on the buyer’s behalf. The dealer won twice — making a profit on the sale of the car, and a commission from the lender for introducing the business to them.
Dealers can take direct payments from lenders, which could be a fixed percentage of the amount borrowed. Prior to a regulatory change in 2021, they were also able to take a cut of the interest payments, a practice known as discretionary commission that risked further inflating costs for the buyer.
The judges ruled it illegal for banks to pay commission to a car dealer without obtaining the customer’s informed consent.
Their ruling focused on loan contracts signed around a decade ago. So millions of people who took out car loans since then in which the dealer received some form of undisclosed commission could be in line for compensation.
What happens next?
The ruling in the case against lenders Close Brothers Plc and FirstRand Ltd. sent their shares tumbling. Both intend to appeal the decision and then it’s likely to be down to Supreme Court judges to set a framework for how the industry operates in future. Another case involving Barclays Plc over its loan practices is awaiting a ruling.
Meanwhile, the Financial Conduct Authority is conducting a far-reaching investigation into the discretionary commission arrangements that were banned in 2021. The FCA warned Britain’s lenders they needed to prepare for additional costs as part of a possible compensation program.
What’s the impact on the car market?
Banks have been changing the way they do business in response to the court cases and the FCA probe, and it’s still easy for motorists to get a loan to buy a car.
“Many banks have updated their underwriting to be compliant with the Court of Appeal ruling and are currently lending,” said Farooq Khan, a senior analyst of financial institutions at Moody’s Ratings. “We therefore expect banks to continue to offer motor finance, even during the uncertain period until the potential redress is resolved and also when related costs are absorbed.”
Could anyone who bought a car on finance make a claim?
Not as it stands. The only people who can make a claim are those who weren’t given or weren’t told the full details of any commission payment tied to their car finance.
How much is at stake for banks?
Analysts suggest that lenders could be on the hook for anything between £10 billion and £38 billion. Santander UK said it has already set aside £295 million to handle any fallout from the court cases. Lloyds Banking Group Plc, the UK’s biggest provider of car finance, has set aside £450 million to pay for possible compensation and other costs. Close Brothers, where one-fifth of the loan book is dedicated to motor finance, has said it won’t pay any dividends for the 2024 financial year as it looks to strengthen its balance sheet while the review continues.
“When resolved, it likely leads to improved transparency on motor finance deals and may ultimately drive interest rates down for consumers and in turn lower profitability for the banks and captive auto finance companies,” said Michael Dean, Senior European Automotive Analyst at Bloomberg Intelligence.
Is this really as bad as the PPI scandal?
The PPI scandal saw millions of people paying for insurance they did not need when taking out all kinds of loans. Most recent data from the FCA calculated that the total cost to the banking industry was £35.7 billion, though estimates since then have reached as high as £53 billion.
“The two issues center on apparent disclosure and transparency failings,” said David Hamilton, Partner at Howard Kennedy. But it’s complicated further by the court rulings, he said. The PPI scandal was largely a regulator-led program.
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