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Car Loan Boom Led by Lloyds Stokes Loss Fears as Sales Dip

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As U.K. car sales drop for the first time in six years, Britain’s banks could be forgiven for getting nervous about their 24 billion pounds ($32 billion) of exposure to motor loans.

The Bank of England has been raising alarm bells over the car finance market’s potential to trigger losses for lenders, with growth that’s outpaced household incomes. Lloyds Banking Group Plc, Britain’s largest mortgage lender, has the most skin in the game with 11.6 billion pounds of car loans, according to JPMorgan Chase & Co. analysts.

Chief Executive Officer Antonio Horta-Osorio has strengthened Lloyds since the financial crisis, and car finance comprises only about 3 percent of its total loans. But the bank has grown in riskier consumer credit. It acquired MBNA’s U.K card business for 1.9 billion pounds in December, while its Black Horse motor finance arm boosted assets by 20 percent last year. Including its joint venture with Jaguar Land Rover and the Lex Autolease business, its exposure to car finance was 15.6 billion pounds last year. Such expansion may bring additional risk in the event of an economic downturn.

“If the demand for new vehicles stalls, then the credit quality of car finance companies deteriorate -- that’s the transmission channel that could lead to a wider shock for the industry," said Philip Rush, chief economist at Heteronomics in London.

New car registrations in the U.K., Europe’s second-largest market, tumbled 9.3 percent in September on the back of uncertainty over Brexit and concerns about the pollution caused by diesel vehicles. Used car sales declined in the second quarter after record volumes in 2016. In the event of such a drop in demand and potential fall in values, the structure of the car finance contracts that have helped fuel the growth pose a risk for lenders.

Hidden Risk

With Personal Contract Purchase agreements, consumers pay a deposit and make monthly payments over an agreed period. At the end of the contract, the driver can opt to buy the car at a price fixed at the start of the deal, or return the vehicle to the dealer. 

Under the contracts for example, a new 24,000-pound BMW 1 Series 3-door Sports Hatch can be financed with a deposit of about 5,000 pounds and regular payments of 209 pounds. With an upfront payment of 30,000 pounds, a customer could drive away with a 200,000-pound Lamborghini Huracan, paying about 1,500 pounds to 1,800 pounds a month. But with PCPs, the lender stands to lose if the car is returned at the end of the contract and its second-hand value is lower than that initially agreed with the customer.

“A potential oversupply of used vehicles may be placing downward pressure on the used car market, exposing lenders to potentially higher-than-anticipated future losses,” said Joana Seara da Costa, a senior financial analyst at the rating firm DBRS in London.

Car finance grew at an average rate of about 20 percent a year between 2012 and 2017 and represented almost a third of the U.K.’s 198 billion-pound consumer credit market at the end of April, according to the BOE. Car manufacturers such as Volkswagen AG, BMW and Renault SA provide about 34 billion pounds of credit, indicating that traditional lenders, with 24 billion pounds of credit, have the smaller slice of the market.

Price Drop

“The banks could be affected indirectly if the non-banks drive down prices and terms in the car finance market,” said Tomasz Walkowicz, vice president analyst, global financial institutions group, at DBRS in London.

If losses on car loans increase by 1 percentage point more than expected, Lloyds’s pretax profit in 2018 could decline by 2 percent, UBS Group AG analysts led by Jason Napier estimated in a report on auto finance on Wednesday. The same measure is more than 6 percent for Close Brothers Group Plc, a London-based lender with more than one quarter of its loan book tied to vehicles, the report shows.

Yet some analysts point out that for most banks, car finance isn’t yet a big part of overall lending. A spokesperson for Lloyds said it conducts “regular stress tests to assess the impact of potential future market reductions in car valuations and are comfortable with our exposures based on these” and the company is a responsible lender.

“Car financing is a relatively small proportion of the loan book,” Walkowicz said. “This combined with conservative risk management are mitigating factors in terms of potential impact.”

Nevertheless, Britain’s Financial Conduct Authority CEO Andrew Bailey has issued a fresh warning on the levels of consumer indebtedness which might cause increasing financial distress. And the BOE is scheduled to report the results of stress tests on banks on Nov. 28 that will include the impact of falling used car prices in 10 percent increments on capital and financial performance, according to a July statement.

“A 10 percent drop is manageable and it’s already factored in those contracts," Heteronomics’s Rush said. “However, if prices fall below that, they will fall a lot of quicker and there could be the same phenomena seen in U.S. during the subprime crisis where people gave their houses key back instead of serving the debts as prices were collapsing.”

— With assistance by Donal Griffin

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