It should come as no surprise to the motor industry that the Financial Conduct Authority (FCA) is considering consumer credit rule enhancements that will likely require considerable changes to how car dealerships do business. Proposed changes are likely to sweep down from internal governance and oversight to commission arrangements and interactions with customers. The very process of selling a car will probably look quite different in 2020 than it does today.
Why the Change?
The FCA set out in both the 2017/18 and 2018/19 Business Plans how it will focus on the motor finance industry with a focus on responsible lending and credit checks, conflicts of interest to the detriment of customers and the clarity of information on risks and informed decision-making.
In March 2018, the FCA published a report setting out initial findings that highlighted a rise in customers taking out finance in the form of a personal contract purchase (PCP), unclear or not easily understood information provided to customers and potential conflicts of interest in commission arrangements that could provide incentives for dealers to arrange finance at higher interest rates.
In March 2019, the FCA published its final findings and, one year on, they have found considerable cause for concern of customer detriment and poor business practices in the areas of commission arrangements, sufficient, timely and transparent information and affordability assessments.
The FCA is considering a ban on commission models which link broker commission to the customer interest rate and allow brokers wide discretion to set the interest rate e.g. Difference in Charges (DiC) models. The FCA has stated that "it is not clear... why brokers should have such wide discretion to set or adjust interest rates, to earn more commission" and it is "concerned that lenders are not doing enough to monitor and reduce the risk of harm". Whilst the FCA is not against commissions, there is real concern regarding the incentives within commission structures that may reward behaviors that are detrimental to customers.
When it comes to commission disclosures, the FCA is not satisfied that lenders appear to be relying on the regulated status of brokers to ensure they comply with CONC rather than taking reasonable steps as required of the lender by CONC 1.2.2R.
The regulator is currently considering a requirement for the full disclosure of commission and potentially requiring an explanation of how commissions are calculated to be disclosed to customers. The FCA ultimately wants to see commission earning levels that reflect the work undertaken to facilitate the loan and more correlation between the rate charged and the risk of the loan. Potential changes in this area may include a rate for risk model that will change how APRs are calculated in the industry with caps set on dealer discretionary adjustment of rates.
The FCA is not satisfied that firms are complying with regulatory requirements in relation to precontractual disclosure and explanations. From mystery shopping exercises, the FCA found that disclosures and explanations were not always complete, clear or easy to understand. Customers may not have been able to make informed decisions and suffered customer detriment as a result. Lenders and brokers should expect stricter monitoring and control requirements, with potential on-site inspections put in place to ensure adequate disclosures and compliance with CONC generally.
The FCA has also warned lenders that they must review policies and procedures in light of the new rules and guidance on assessing creditworthiness published last July (which came into force on November 1, 2018). The FCA has found evidence to suggest that some lenders are focusing unduly on credit risk to the lender rather than affordability for the borrower with gaps and anomalies in information provided.
On the Horizon
Jonathan Davidson, Executive Director of Supervision – Retail and Authorizations at the FCA, gave a speech at the Credit Summit, London on March 21, 2019 where he stated categorically that the FCA's focus on affordability, healthy business models and healthy culture "hasn't and won't change".
In its work in the debt management sector, the FCA found that affordability and culture were key with "firms that were doing best", going beyond a compliance culture and purposefully focused on customer outcomes. Mr. Davidson went on to say that "in a purposeful and safe culture, compliance is much easier. If everyone is focusing on delivering the right outcomes and have the right capabilities, then you have less need for some of the ponderous and complicated compliance functions and tick box processes that we see burgeoning".
The Senior Managers and Certification Regime (SMCR), expected to provide minimum standards for culture across financial services, is likely to have a profound effect on the motor industry, particularly with regards to governance structures, accountability and documented systems and controls. SMCR is featured heavily in the 2019/20 Business Plan and the FCA "want[s] firms to have the leadership capability to create and maintain healthy cultures".
The FCA has seen customer detriment in the industry and will therefore look to make rule changes quickly. The FCA has already started policy work with a view to consulting on changes to CONC to strengthen existing provisions—the regulatory change timescale may result in final rule implementations by spring 2020.
The FCA is currently focused on consumer credit arrangements in the motor industry, however, it has kept general insurance, particularly GAP insurance and other motor ancillary products, under review. The 2019/20 Business Plan singles out motor insurance as part of the next stage in the protecting consumers initiative. Since the introduction of the Insurance Distribution Directive (IDD) on October 1, 2018, motor firms acting as insurance intermediaries are already expected to have tightened their controls to ensure transparency of commissions, conflicts, cross-selling and product features.
Staff must now complete a minimum of 15 hours continuous professional development (CPD) annually and have background checks for fraud and financial crime. The FCA expects insurance intermediaries, including those in the motor industry, to have developed appropriate processes and documentation to meet the requirements of the IDD and be able to demonstrate that customers' needs are at the core of their processes.
In the Annual Perimeter Report published on June 19, 2019, the FCA gave the example of a veterinary practice arranging pet insurance. The FCA will authorize the firm, approve its senior managers and set minimum standards and rules for its insurance distribution activities. Whilst the FCA will not pre-emptively monitor the vet's unregulated activities, if there were any fraudulent activity the FCA "may decide that the firm is not fit and proper to conduct the regulated insurance distribution services" and "would consider removing their authorization and prohibiting senior management." For some motor retailers, the cost of losing authorization for regulated activities may be more than the business model can sustain and perhaps the more cost-effective option is to invest in risk management framework covering all activities, not just those that are regulated.
It is also worth noting that the Perimeter Report highlighted warranties for repair services which, upon closer inspection, could be construed as contracts of insurance. The FCA stated, "we intervene, including through enforcement action, where we identify such contracts. We are also considering whether we need to take any further steps".
Speaking out about insurance products that are sold without due regard for the value the customer receives including poor manufacturing, sales and distribution approaches, Jonathan Davidson, executive director of Supervision – Retail and Authorizations, at the FCA said:
"The widespread extent of these issues demonstrates a culture which pays insufficient regard to customer outcomes in some parts of the general insurance sector. We are going to carry out further supervisory work to make sure that firms meet their obligations and will not hesitate to use the full range of our regulatory powers."
Is the Motor Industry Ready?
Many firms in the motor industry do not have fully resourced compliance, risk and internal audit functions. Those that do rarely have the capacity to keep pace with the regulatory change agenda on top of business as usual activities. The FCA has already begun investigations in the industry with actions being taken against leading car dealerships and over 30 cancellations issued to smaller dealerships due to their failure to satisfy the suitability threshold condition, and breach of Principle 11 (to be open and honest with the regulator). The FCA has expressed concerns regarding poor governance of regulatory obligations, insufficient management information, inadequacy of controls, monitoring and escalation of issues.
The FCA considers the occurrence of regulatory breaches, customer detriment and behavioral issues in more than one site to be systemic and firms should not delay in undertaking root cause analysis and swift action to reduce risk of recurrence. Recognizing and appropriately taking remedial actions can be a challenge for many firms where key functions are too junior, under-resourced or there is poor management information available to senior management.
The FCA has informed the Financial Leasing Authority (FLA) that firms can expect to receive "Dear CEO" letters in the near future setting out its expectations of the industry and firms will be expected to take action to ensure they are meeting expected standards.
Instilling a positive compliance culture requires material time, dedication, and "buy-in" by all staff across a firm. In his March 2019 speech, Mr. Davidson concluded, "My top tip for today is to keep ahead of the rules, you can invest in expensive tick box compliance or you can get on top of your culture. A healthy purposeful culture will be the best way to deliver value for you, your clients and your business". For an industry that has not historically been subject to intensive regulatory scrutiny, the challenge will be considerable as it attempts to get to grip with the ever-changing regulatory landscape in which it operates.
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