Liquidity lowdown: The motor finance industry is back under the spotlight

The motor finance industry hasn’t had an easy ride over the past few years.

Back in 2019, the Financial Conduct Authority (FCA) published a report which concluded that some consumers taking out car finance had overpaid on their deals through inflated interest rate charges. Consumers had complained that lenders had rejected compensation claims for so called ‘discretionary commission arrangements’ (DCAs).  These arrangements allowed car dealerships and brokers to set the interest rate themselves on a purchaser’s finance arrangement. This may have encouraged them to set inflated level of interest to boost their own commissions. DCAs were subsequently banned in 2021.

Fast forward to 2024, and the motor finance industry is back under the spotlight. In January 2024, the FCA conducted a review of all historical car finance commissions dating back to 2007 following years of complaints from consumers. A court ruling previously in favour of Close Brothers was overturned in October 2024 as three customers successfully appealed against a motor finance case because broker commissions were not clearly disclosed to them. Close Brothers will now head to the Supreme court to appeal this decision, but a major cloud now overshadows the motor finance industry as uncertainty about potential fines and financial losses loom. Major lenders, including Close Brothers, have been strengthening their balance sheet since the start of the year, having been forced to set aside large sums of capital for any potential fallout. Close Brothers are currently in a strong financial position, having sold its wealth management business in September 2024 for up to £200m, which helped to boost their capital ratio by about 100 basis points. They also axed dividends this year as a result of ongoing uncertainly surrounding the FCA review, in yet another attempt to boost their capital position.

a major cloud now overshadows the motor finance industry as uncertainty about potential fines and financial losses loom

Car loans account for around 20% of the Close Brothers loan business (c£2bn) – the largest percentage of any loan book across all major lenders. Whilst the magnitude of any potential fines for Close Brothers may not be as large as for other major lenders, it will still be a major blow to the bank with some fearing another PPI (payment protection insurance) mis-selling scandal outcome. Analysts estimates for potential liabilities are wide-ranging. As a worst-case scenario, some analysts believe Close Brothers may need to pay out up to £800m in compensation, but this assumes that everybody taking out car finance deals dating back to 2007 is compensated, which we believe would be an unlikely scenario.

Currently, Close Brothers hold around £523m of common equity tier 1 (CET1) headroom to cover any financial losses before additional tier 1 (AT1) instruments, designed to absorb losses on a going concern basis, are written down. The EU Banking and Resolution Directive (2014/59/EU) (BRRD) mandates that CET1 must be written down before AT1 and Tier 2 instruments and was designed in 2016 to prevent taxpayer money being used to bail out failing banks. Whilst Close Brothers await their day in the Supreme Court, there remains a large degree of uncertainly and speculation on any potential financial fallout, but nonetheless, Close Brothers have in the meantime, suffered a pretty major hit to their reputation.

Within our liquidity strategies, we hold a very small exposure to Close Brothers in only our RL Short Term Fixed Income Enhanced fund. We have assessed our existing exposure and are happy to continue to hold this as it makes up a very small exposure within the fund and it is not AT1, which we believe is the area of the capital structure that is most at risk. We have, however, ceased buying or adding any Close Brothers exposure until we have more clarity on the legal outcome.

This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.