The FCA has announced its proposals to address consumer harm in the motor finance market by banning commission models that incentivise brokers (including motor dealers) to increase a customer's interest rate.
In this insight, Sushil Kuner and Simon Stephen explore the types of commission arrangements which the FCA is proposing to ban in its latest consultation paper (CP19/28) and discuss implications for motor finance providers and brokers. They also summarise key changes to the FCA's commission disclosure rules which will apply to all consumer credit markets.
In our insight 'FCA warns lenders and brokers that change is needed in the motor finance market' in March 2019, we summarised the FCA's findings of its review of the motor finance market, identified the four different types of commission structure recognised by the FCA and outlined the FCA's key concerns which included:
- widespread use of commission models that link a broker's commission to the customer's interest rate under the finance agreement and allow brokers wide discretion to set or adjust that interest rate, ultimately leading to higher finance costs for consumers due to incentives for brokers; and
- high levels of non-compliance with the FCA's commission disclosure requirements resulting in consumers not being given the right type of information, at the right times, to enable them to make informed decisions.
To address the above concerns, the FCA has proposed:
- a ban on the use of discretionary commission models; and
- to clarify rules in the FCA's Consumer Credit Sourcebook ('CONC') to better reflect the FCA's intention that customers receive more relevant information about the existence of commission which would apply to all credit brokers, not just those operating in the motor finance market.
We explore each of these proposals below.
Ban on discretionary commission models
The FCA is proposing a ban on commission models where the amount received by the broker is linked to the interest rate that the customer pays and which the broker has the power to set or adjust. The FCA refers to these as 'discretionary commission models'. The most common examples in the motor finance market are:
- increasing Difference in Charges (DiC) - also known as 'Interest Rate Upward Adjustment' where brokers are paid a fee which is linked to the interest rate payable by consumers. The contract between the lender and the broker sets a minimum interest rate, and the fee is a proportion of the difference in interest charges between the actual interest rate and the minimum interest rate;
- reducing DiC - also known as 'Interest Rate Downward Adjustment' which is similar to the increasing DiC, except that the contract between the lender and the broker sets a maximum interest rate; and
- scaled commission - also known as 'Variable Product Fee' where the broker is paid a fee which varies (within parameters) according to certain product features such as the type of credit agreement or the interest rate.
Through its study, the FCA found there was a relationship between incentives for brokers created by discretionary commission models and inflated interest charges for consumers. Transactions achieved under these models displayed a strong association between increases in commission and increases in interest costs, even after controlling for factors that may influence total interest costs.
In fact, the FCA estimated that across the firms in its sample, which accounted for 60% of the market, the 560,000 customers of the firms affected by such commission models could pay in total £300 million more annually in interest costs as a result of the discretionary commission models compared to flat fee models.
The FCA also found that loans originated within the discretionary segment showed a weaker link between the interest rate and consumers' credit scores, compared to other commission models. The FCA has been clear on its view that a customer's interest rate should be based, for example, on credit risk, rather than on misaligned incentives for the broker.
Intervention to stop lenders and brokers from using such discretionary commission models removes the financial incentives for brokers to increase the customer's interest rate, which the FCA hopes will, in future, be based on legitimate factors such as consumers' credit scores.
The FCA is proposing to define 'discretionary commission arrangements' with reference to the total charge for credit, rather than just the interest rate, in an attempt to prevent firms from circumventing the proposed ban.
The FCA is aiming to finalise its rules at the beginning of Q2 2020 and firms would then have a three month period for implementing the proposed ban on discretionary commission models.
Clarifying the FCA's commission disclosure rules
In 2018, as part of its motor finance review, the FCA conducted a mystery shopping exercise which identified that only a small number of brokers disclosed to the customer that commission may be received for arranging finance.
Rules in CONC at the time expected firms to disclose the existence of any financial arrangements with a lender that may impact on the broker's impartiality in promoting a particular credit product. They also outlined that disclosure ought to be made in good time before a credit agreement is entered into.
The mystery shopping exercise showed that firms were interpreting the FCA's rules on commission disclosure inconsistently. The FCA saw firms:
- uncertain about whether disclosure of commission is triggered when they are promoting a product and during the sales process;
- interpreting the disclosure rules narrowly such that disclosure would not be made if they were promoting but not 'recommending' a product or on the basis that disclosure would be unlikely to affect the customer's decision; and
- state that a commission 'will or may be payable' without elaborating in any way, for example, by stating the amount may vary by lender or product.
To address the FCA's concerns on the adequacy of commission disclosure, the FCA has proposed to amend:
- CONC 3.7.4G by making it clear that firms should disclose the nature of commission in their financial promotions (as well as when making a recommendation). Guidance clarifies that firms should consider whether and how much commission can vary depending on the lender, product or other permissible factors and tailor their disclosures accordingly; and
- CONC 4.5.3R to clarify that the existence and nature of commission arrangements where the commission varies depending on the lender, product or other permissible factors should always be disclosed prominently. The disclosure must also cover how the arrangements could affect the price payable by the customer.
Through the above changes, the FCA hopes that customers will receive more relevant information about commission arrangements which will enable them to make better informed decisions, consider alternative options, find a cheaper deal or negotiate the finance or other price or ancillary elements of the deal or transaction.
Again, the FCA is aiming to finalise these rules in Q2 2020, but the proposed changes to the disclosure rules and guidance would come into force on the day the rules are finalised.
Remuneration policies and risk management
This is also a timely reminder to ensure remuneration policies and practices are reviewed and kept up to date to ensure risks to consumers - and especially in this context conflicts of interest - are appropriately managed.
As part of considering how to implement proposed changes and rules, firms should be reviewing their risk management profile to ensure that the risks of harm to consumers identified by the FCA, created by commission arrangements, are identified and suitable controls are in place.
Firms should also have in place appropriate consequence management where there are breaches of the FCA's rules and guidance or control failures - such as the disclosure failures highlighted by the FCA's mystery shopper results.
For those who are part (or will be part) of the Senior Managers and Certification Regime this takes on even more importance in the context of the overall aim being to create more accountability and cultural change within the finance sector.
The FCA is asking for views on its proposals from firms by 15 January 2020.