PCP car finance deals could become a new mis-selling scandal

Out-Law Analysis | 19 Feb 2018 | 2:56 pm | 6 min. read

ANALYSIS: Banks and insurers could be exposed to the same type of risks that have emerged from the payment protection insurance (PPI) scandal because of the way 'personal contract purchases' (PCPs) are sold to car buyers.

UK regulators are looking closely at the sale and use of PCPs. A report due out before the end of next month from the Financial Conduct Authority (FCA) is likely to offer greater clarity on its views on the fairness of the arrangements to consumers.

 While regulatory developments are still in their early stages, there is real potential for PCP contracts to develop into a major regulatory issue affecting the lenders that support the financing arrangements provided for PCPs and the FCA-regulated businesses which do the front line selling.

PCPs and the growth in their popularity

Like traditional car financing, PCP arrangements allow consumers to purchase a car by paying a series of monthly payments.

The central feature of PCPs is that the future value of the car is guaranteed at the start of the contract – this being the guaranteed future value (GFV). PCP deals are therefore based on the dealer's estimation of the depreciation of the vehicle.

At the end of a PCP, the customer generally has three options. They can:

  • give back the car to the car finance business;
  • enter into a new agreement based on any equity built up over the course of their existing agreement, or by using the value of the car under the existing agreement to start again with a new finance deal on a different car;
  • pay a lump sum to keep the car.

Under the arrangements, therefore, the customer does not pay off the full value of the car and they will not own the vehicle at the end of the agreement, unless they choose to pay the lump sum. As such, the initial deposit and monthly deposit are often lower than alternative finance options.

Much like hire purchase agreements, consumers are usually required to keep their car in good condition and within an agreed mileage limit. Any damage or excess mileage over the course of the PCP must be paid for by the consumer. Finance is generally provided by either the dealer's proprietary car finance business or third party lenders.

According to the National Association of Commercial Finance Brokers (NACFB), approximately one million cars were sold via PCPs last year, making PCPs the predominant type of car financing model in the market.

Risks facing consumers who enter into PCPs

There are increased risks that consumers will get caught out at the end of the agreement because an inadequate assessment of affordability has taken place or due to a lack of clarity in understanding the contract which they have entered into.

The NACFB carried out market research with consumers on the topic of PCPs. The results of its study suggest that consumers are led to believe they can make a 'profit' on the car with PCP if the car is more than the GFV at the end of the contract; and/or that consumers are not told that they may be paying more interest as compared to a hire purchase finance agreement, even if the annual percentage rate (APR) is identical.

Potential consumer harm could arise if car dealers do not properly explain how the payable interest works on PCP deals and/or do not present hire purchase as an alternative even when asked by customers.

Increasing regulatory scrutiny of the sale and use of PCPs

In the UK, the FCA is currently considering the potential harm which may have been caused to consumers who have entered into PCP financing arrangements. The regulator is expected to set out its findings next month.

The FCA's interest in the issue can be traced back to its 2017/18 business plan, in which it raised concern about transparency, potential conflicts of interest and irresponsible lending in the motor finance industry.

At the time, it committed to conducting a review to "identify who uses these products and assess the sales processes, whether the products cause harm and the due diligence that firms undertake before providing motor finance" and to use the results of its study to determine "whether and how to intervene in the market".

In July last year, the FCA followed up with further details of its work on motor finance. It specifically referenced PCPs and said that it is "essential that consumers understand the risks and particular features of motor finance there are taking on".

The FCA stated that it would look into whether:

  • firms are taking the right steps to ensure that car finance firms are lending responsibly and assessing whether consumers can afford a particular product;
  • there may be conflicts of interest arising from commission arrangements between lenders and dealers;
  • customers are able to make informed decisions based on the information they are being provided with;
  • firms are managing the risk that asset valuations could fall and the pricing of that risk.

The FCA also said that it would take forward a range of work, including supervisory work with authorised lenders, a detailed analysis of anonymised credit reference agency records, and monitoring of sales and practice to decide if "interventions may be necessary". An update on this work is expected from the FCA before the end of the first quarter of 2018.  

The prudential and systemic concerns in respect of PCP and car finance more generally

Alongside the FCA's scrutiny of the car finance market, the Prudential Regulation Authority (PRA) has also been looking at the prudential and systemic risks arising out of the modes of financing.

Those risks were flagged in the Bank of England's Financial Stability Report of June 2017 in which it estimated "major UK banks' total exposures to UK car finance to be around £20 billion".

Given that borrowers are ten times more likely to default on consumer credit than mortgages, there is concern that car finance will affect the stability of the entire financial market.

In its 2017 statement on consumer credit, the PRA made particular reference to the risk exposures around PCPs.

The PRA noted that GFVs need to be set in a prudent manner so lenders can take action to address potential losses if car prices fall materially. If this were to happen, this could lead to a surplus of used cars in the market, which could further weaken prices and cause material losses to lenders through their GFV risk, the regulator said.

The PRA is therefore concerned that lenders should be looking at whether their motor finance books could withstand a significant downturn in used car prices.

On 17 January the PRA issued a follow-up (5-pagre / 218KB PDF) to its July statement on consumer credit, saying that: “PRA-regulated firms providing motor finance have adopted a reasonably prudent approach to GFV setting, ranging from 85-95% of expected future value”.

On 30 January Bank of England governor Mark Carney was asked for his views on banks’ exposure to the car finance market by the House of Lords’ Economic Affairs Committee.  The governor was seemingly more concerned about the rising level of UK household debt and consumer credit, which currently stands at around £1.4 trillion, than he was about car finance.

Carney suggested that the “overall level of PCP debt includes something that [the borrower on a PCP contract] is not responsible for, which is the balloon payment at the end for the car… there is more risk for the lender about the residual value of the auto when the contract ends.” He said that he was comfortable about UK banks’ exposure from a financial stability perspective.

Car finance – a long term concern that may become a major regulatory issue

The fact that concerns are being raised about car financing deals is not new. In 2009, the Financial Ombudsman Service (FOS) reported "a steady increase in the number of complaints" raised by consumers with it regarding car finance. At that time, the majority of the complaints concerned hire purchase agreements, it said.

We believe it is only a matter of time before more complaints relating to PCP arrangements begin to appear.

While the regulatory developments are still in their early stages, there is real potential for PCP contracts to develop into a major regulatory issue affecting the lenders that support the financing arrangements provided for and the insurers that underwrite the risk in those contracts.

Firms should consider carrying out a review of historic sales practices and implementing new practices where issues are identified. Some products sold should be assessed and may need to be redesigned.

Once conclusions are drawn by the regulators as to the risks around PCPs and, in particular regarding the harm to consumers, firms should look to engage with regulators and any FOS schemes that emerge and further prepare themselves for the possibility that they will need to establish redress schemes for disadvantaged consumers.

Colin Read is an expert in expert in insurance law and regulation at Pinsent Masons, the law firm behind Out-Law.com.