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When the US economist George Akerlof wrote his Nobel Prize-winning paper on the problem of information asymmetry in business in 1970, his leading example was used car dealers. Akerlof noted that it was impossible for a buyer to grasp whether a car they were being offered was a bargain or a dud. Only the dealer knew.
Time has passed but some things do not change. Substitute “used car finance deal” for “used car” and this summarises the scandal that has emerged in the UK motor finance industry. The liability for compensating customers who were mis-sold loans by car dealers and brokers could reach many billions. This recalls the payment protection insurance fiasco that ended up costing British banks £50bn.
It already weighed heavily on banks including Close Brothers and Lloyds before a Court of Appeal ruling that made matters a great deal worse for all of those involved. The court ruled that dealers have a fiduciary duty to offer the best finance deal to car buyers, and not to shroud excess interest charges in small print that they are “highly unlikely to read”.
The deception at the heart of the affair involved dealers receiving higher commissions for persuading buyers to sign costly finance deals, a tactic that was banned by the Financial Conduct Authority three years ago. The long tail of liability for past deals, and now on dealers that did not provide enough information even about FCA-approved finance, is growing by the month.
It has triggered an avalanche of claims from unhappy buyers, along with legal claims management companies that thrive on misbehaviour. By the time the claims are resolved, many buyers will have been compensated, many lawyers will be richer, and bank shareholders will have paid a very high price.
Whether drivers will be better off is another matter. Many of these deals involved high interest rates being paid by buyers with low credit ratings, but eliminating information asymmetry is not the same as making loans cheaper. It is a fair bet that some lenders will withdraw (or collapse) and the cost to others of making brokers behave better will fall on future customers.
It is an unholy mess from which neither banks nor dealers and brokers emerge well. Nor does the FCA, given that even lenders that have obeyed its rules since 2021 (and did so before that) could still be liable to pay compensation. If you can follow a regulator’s code of conduct but remain exposed to mis-selling claims, running a consumer credit business is hazardous.
That said, many dealers were not obeying these regulations in practice, let alone meeting the higher standard the court has laid out. Remarkably few were complying before 2021, judging by a survey the FCA carried out at the time. It found that only one of 37 franchised dealers that were visited anonymously was informing buyers of receiving commissions for fixing finance deals, as its code of conduct required.
This is not as shocking as it should be. Dealers used to have a greater information edge over buyers when Akerlof wrote his article. Thanks to the internet, new and used vehicle prices are now more transparent and it is harder to profit from car sales alone. More of the return now lies with servicing, warranties, and other add-ons to which dealers turn when the basic deal is done.
I lodged a complaint myself after the court’s ruling, since so many others have. My car finance deal in 2020 was on a low fixed rate, but the salesman did not put on a hat labelled “regulated credit broker” when it came to explaining the paperwork. Did he inform me fully, according to the new legal standard? I cannot remember and I doubt whether he does.
I do recall the effort he put into selling me coverage for potential repairs for damaged wheel-rims: it was hard to refuse, and I sensed that he was highly motivated. Lenders and insurers must now ensure that dealers tell buyers exactly what is their economic incentive to care about such things. It was already foolhardy to leave this to dealers; it could now be ruinous.
But will buyers be better off when the market is reformed? The FCA estimated that consumers could save £165mn annually from its 2021 changes, but it may not work out like that. Some banks are pulling back from the market because of the potential costs and the premium over base interest rates on the average used car finance deal has risen, according to consultants Apex Insight.
Risk will be repriced further if this compensation bill runs into billions and car dealers were a high-risk bunch to start with. The essential flaw in the motor market of buyers being misled, which Akerlof described more than half a century ago, still remains. Fixing it will be very expensive.