UK car financing review not material for large UK banks

The UK Financial Conduct Authority’s car finance review, initiated following a high number of complaints and compensation claims, may weigh negatively on profits for some banks but it is not a systemic credit issue for the banking sector.

By Alvaro Dominguez Alcalde, Financial Institutions

The UK banking sector is in good health, as confirmed by the 2023 results season. Among the UK’s largest banks, we expect the FCA’s review of potential mis-selling relating to discretionary car finance commissions will have a negligible impact on Barclays, HSBC, NatWest and Nationwide Building Society, as these banks have no or very limited exposure to this segment.

We also see any outcomes being manageable for Santander UK and Lloyds Banking Group under our base-case scenario. Lloyds has an exposure to auto lending of around GBP 15bn (via its Black Horse subsidiary) equivalent to 3.4% of its total loan book. Santander UK Group has an exposure of roughly GBP 4.5bn, 2.2% of its total loan book.

So far, Lloyds is the only bank in our rated UK bank universe to have booked provisions related to the issue, recognising a GBP 450m provision for operational and legal costs as well as potential customer redress in its Q4 2023 results. This is based on various scenarios using a range of assumptions related to commission rates, applicable time periods, response rates and other factors. The provisions represented 6% and 8% of 2023 pre-tax profits and net income respectively.

Santander UK highlighted in its Q4 2023 quarterly management statement that it had received a small number of county court claims and complaints related to historical discretionary commission arrangements (DCAs), which were banned in 2021. Nevertheless, the bank does not currently consider these claims will require provisions.

Barclays noted on its Q4 2023 results call that it had not received many complaints about this issue, having exited the segment in 2019. The bank has made no provisions for the matter.

Given the underlying uncertainty and the lack of detail on commission structures (zero-commission, reasonable commission rates etc.), we do not rule out more severe outcomes, particularly for smaller lenders. We expect banks with meaningful motor finance exposure will accumulate provisions as the review advances. We also note the emerging culture of litigation in the UK following the Payment Protection insurance (PPI) mis-selling scandal, which resulted in significant compensation payments and exposed banks to serious reputational risk.

At the same time, banks are well equipped to deal with any unexpected hits. Lloyds, which has the highest exposure of large UK banks relative to the size of its loan book, made a 2023 net profit of GBP 5.5bn, equivalent to a RoTE of 15.8%. The pro-forma CET1 capital ratio was 13.7%, including the dividend received from the insurance business in February 2024 and the full impact of the announced share buyback. We believe Lloyds’ share buyback programme of up to GBP 2bn underscores the group’s ability to generate excess capital as well as management’s confidence that any further impact can be managed though recurring profitability.

Under a stressed scenario, Lloyds would remain profitable to the tune of GBP 2.7bn, with a forecast high single-digit return on equity in 2024. The stressed scenario assumes a challenging operating environment leading to a mild decrease in lending, worsening asset-quality indicators, a gradual increase in arrears, and a recurring charge of GBP 450m for motor insurance in every quarter of 2024,

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