Last week, FCA chief executive Andrew Bailey, sent a small peace offering to the consumer motor finance market. He stated, in a speech delivered at the City of London Banquet, that the shift to Personal Contract Purchase (PCP) based lending might not be “per se bad”.
As if praise like that that was not enough for car finance providers concerned about an ongoing FCA review of the market, he went still further. He said that PCP “seems to me to recognise the nature of a car as an asset, that is, consumers are comfortable renting rather than owning the car.”
Of course, Bailey couldn’t give PCP a completely clean bill of health half-way through his own body’s review. So he added: “That said, there are issues that we seek to understand on the terms of such lending and how well they are understood by consumers, so we are not complacent on such terms.”
If these messages in the speech appear slightly contradictory, that’s possibly a reflection of PCP itself. In many ways, PCP is a model for excellence in design of consumer credit. Yet, at the same time, it is complicated and that can lead to misunderstandings and a risk of poor consumer choices.
PCP is two products in one: one simple, and the other a piece of quite sophisticated financial engineering. First, it’s a rental / hire arrangement for a period that is much shorter than the expected life of the car. Second, it’s a put option, whereby the consumer has the choice, but not the obligation, to buy the car at a set price at the end of the contract.
The average user of car finance is unlikely to have studied finance at university, so may not know what a put option is. Fortunately, it’s now abundantly clear on the websites of the car manufacturers exactly how they work. The explanations have improved markedly in the last year or two. Furthermore, as PCP has been in the market for over 20 years, many consumers will be experienced users.
The hire / put option combination delivers some important benefits that the FCA, together with other regulators including the Prudential Regulation Authority and its parent the Bank of England, seem now to be recognising:
- Customers’ financial commitments are lower than they would be if they for alternative credit solutions, such as personal loans.
- Customers wishing to keep their car at the end of the hire period may do so, allowing them to avoid entering into a new financial commitment.
- All the risk of second-hand car values falling is taken by lenders, not consumers (noting, in passing, that the biggest risks are taken by car manufacturers, not banks).
- All the potential benefit of second-hand car values rising is enjoyed by consumers, not lenders.
If this is sounding too good to be true for the consumer, we need to be clear that a put option comes at a price, at least in theory. As we have seen, the option shifts residual value risk to the lender. In simple economic theory, so putting aside the real-world complications of the UK’s new car market, the lender would be expected to charge a fee for taking that risk. In the theoretical world of the economist, consumers would then see the cost of the option and be equipped to make informed choices. Only those valuing the benefits would purchase the option.
The problem that Andrew Bailey appears to be alluding to in his speech is that in the car finance market, the cost of the option component of the PCP product is comparatively opaque. Consumers are not shown the cost of the option. A smart consumer might be able to compare two agreements, one hire-only, and the other hire with put option, and from that work out the cost of the option. But often even that is not possible, as the hire-only option may not be available at all, it may not be promoted as clearly as PCP, or it may be difficult to compare if PCP is offered on a subsidised (e.g. “interest-free” basis) but hire is not.
Our recently published research into the car dealer point of sale (POS) finance market looks in some depth at the rise of PCP and possible future trends. There has been a shift towards PCP from other forms of credit previously used to finance cars, in part because manufacturers have focused their marketing budgets on offering subsidised interest rates for PCP loans.
Our market projections are based on our assessment that the FCA will not intervene to stop PCP being provided. It is fundamentally a useful product. We do expect, however, the FCA to conclude there is a need for improved transparency about the cost of the put option. They are likely to consider that this would help to ensure that only consumers that value the option will buy it. Andrew Bailey’s speech seems to provide a strong hint that this is now the most likely substantive outcome of the FCA’s review.
Frank Proud, Apex Insight, Director
Apex Insight has produced a white paper report UK Car Dealer Point of Sale Finance of which a preview can be viewed here.