With the ban on discretionary commissions coming into force on 28 January 2021, closer inspection of the text from the FCA announcing the ban indicates that rate-for-risk models are worthy of further investigation. Whilst this isn’t a green light from the FCA, auto finance companies should be now looking at this model and considering its adoption.
The term rate-for-risk details the process wherein a lender assigns a customer a rate based on their credit risk and affordability profile.
Some direct to consumer web operators already employ rate for risk but the model that is typically used in UK dealer showrooms tends to be a fixed APR offered to every customer, regardless of their credit rating.
To offer a more in depth look at how a company can adopt a rate-for-risk model, Asset Finance International sat down with Amar Rana (pictured above), chief executive officer of CrediCar and David Betteley, content advisor at the International Asset Finance Network and chairman of CrediCar.
CrediCar’s rate-for-risk use-case
Rana explained: “The process is fairly straightforward; our system gets access to granular data on the customer's credit file to help us understand what the true credit and risk profile is. We have a sophisticated decision engine which allows the lender to input their risk appetite within our internal system and then once we’ve got the credit profile of the customer, we know which banding from which lender to place them in. We then display that particular APR to the customer.
“An important distinction to make is that we’ll work with a lender to establish a set of criteria that a customer has to meet before being eligible for finance with that lender, then our software allocates each customer to the relevant lenders from a dealer’s panel. It’s essentially a lender-for-risk model.”
According to Rana, this type of model can provide an accurate and personalised quote to the customer based on their unique credit risk and affordability profile.
He said: “We're also preventing customers from harm caused by an unnecessary hard credit search footprint being put on their credit file and by providing key information on finance quotes in good enough time to allow them to make an informed decision.”
Open banking may not be suitable
As with the standard financing process, open banking has been hailed as a potentially game-changing advantage for the rate-for-risk model in recent months. However, Rana pointed out several flaws in the implementation of such a solution.
He explained: “In theory, open banking sounds great but when you actually consider the online customer journey, it can actually increase the number of barriers in place that a customer will have to jump over. For example, if we want to obtain the customer’s banking data, we need the customer to log into their bank and give us access to get that data. Very few customers will complete this process to obtain a quote which means a lot of customers are going to drop off at that point.
“We’ve put open banking at the back end of our process so that if the lender wants more information from the customer once the proposal has been submitted, that’s when we redirect them to open banking. This way the customer is further along the journey so they're less likely to back out and hopefully they’ll be prepared to do that extra little bit to secure the finance at the end.”
Betteley pointed out that if CrediCar were to request permission from a customer to access open banking at the start of the customer journey, it would cause a significant amount of the customers to abandon the process, causing the company to lose out on a valuable customer.
He said: “It’s just too much commitment early on in the customer journey. At the moment, CrediCar doesn’t even ask for any bank details as they see that as too much commitment. There’s a sense of irony there, that in order to assess rate-for-risk it’s a huge benefit to have more information such as bank details and you can make a better assessment. However, the irony is that every request for information from a lender to a customer represents a drop-off point.”
How likely is it that the UK will adopt a rate-for-risk model as the standard?
Rana continued: “I think it’s the way forward, because almost every customer is looking for personalisation. Many companies out there put a few sliders on their website where the customer can adjust the deposit, term and mileage and call it personalisation.
“However, it’s not true personalisation because someone with a credit score of 300 will get the same quote as someone with a credit score of 900. This is also the problem with linking the rate to the asset. With our system, it doesn’t even matter where a customer sits in the risk banding, we're going to provide an APR based on their personal circumstances, which is true personalization.”
Betteley added: “There are three distinct barriers to the adoption of rate-for-risk for the industry:
- Systems – A lot of systems will need to be updated. When looking at systems development, particularly for big corporates, it’s going to take a lot of money and time to iron out the details;
- Pricing – How do they price for these different tiers if they’ve not done it before. It’s quite a challenge for lenders to go from the setting the rate in relation to the car, to setting the rate in relation to the customer’s risk profile;
- Risk – Not directly a function of rate-for-risk but linked as another trend in the market that should be taken into account by lenders when assessing system capability is usage risk. Currently, banks and finance companies are experts at assessing credit risk, but when the payment amount is linked to the customer’s use of the asset (e.g. more use equals more revenue for the finance company) this is a completely different risk scenario where there is almost zero data and experience.”
Opportunities and risks
Currently, there’s a cut-off point, whereby if a customer should fall below a certain credit rating, they can no longer get accepted for credit by mainstream lenders. Therefore, one advantage of the rate-for-risk model is that it could give more customers access to mainstream lenders, pulling them out of the territory of unscrupulous lenders.
Betteley added: “I think it’s likely that the spread of customers that the mainstream lenders will take might grow a little bit at the sub-prime end. Traditionally, if a lender set up a rate-for-risk model for a one-off finance agreement with a high-risk customer, it was typically frowned upon by the consumer lending bodies as “taking advantage of a sub-prime customer”. However, if the FCA is hinting at endorsing rate-for-risk as a nationwide standard then there can’t be any complaints if the sub-prime lenders charge more interest for certain customers. This could enable sub-prime lenders to buy more deeply and more accurately.
“At the other end, a lot of customers might find that they’re actually in the prime market where they weren’t before, so they get access to cheaper credit. This could happen if lenders start looking more closely at a customer’s credit rating and widening their range of criteria that customers are assessed by. Open banking would help in this regard because it would serve to boost the amount of information a lender can garner from a customer, potentially boosting their chances of being accepted.”
Another point is that under this model, the lender would be able to offer dealers a different set commission rate for each risk banding.
However, this isn’t without complications because, as Betteley pointed out, one of the risks is that intermediaries may try to “game the system”. If the commission rate is linked to the customer’s credit rating there is the temptation to try to bump a customer up from one tier to another so that they get a higher commission from the lender.
Betteley said: “This is the case in the US, and it would certainly be a risk here in the UK which probably isn’t that well understood by the FCA at the present time. If the FCA goes ahead with this model, then further research into markets where this is a normal business practice would be crucial to see what the issues are and how they have been dealt with by the regulator.”
Speaking of regulation, Rana stated that it in itself may pose a significant risk if technology providers, dealers and lenders do not keep up to date on changes. An example is the recent FCA discretionary commission model ban, and the diagnostic work that the FCA are conducting to understand whether there are business models in the retail lending sectors that allow consumers who cannot afford to pay to obtain finance.
He said: “The FCA is paying close attention to how well firms comply with the ban by carrying out supervisory work across a sample of firms. It also intends to review its intervention in the motor finance market in 2023/24. Using market research reports, it will track the volume and composition of motor finance agreements contracted over time and the volume of vehicle purchases.”
MotoNovo's rate-for-risk car finance solution
One company that have successfully implemented a rate-for-risk model is MotoNovo Finance. It’s flagship product, named MotoRate, allows dealers to offer a headline APR interest rate and the ability to offer pricing based on a customer’s circumstances.
Karl Werner, deputy chief executive at MotoNovo Finance, explained: “One alternative to a rate-for-risk model would be for dealers to move to a flat-rate structure. However, doing so could rob them of a significant low headline APR rate opportunity to compete with personal loan providers.
“All of our evidence demonstrates that with a rate-for-risk model, such as MotoRate, dealers can have a low headline rate and a better income platform for the metal and other services courtesy of the new level of online customer control and transparency.”
Furthermore, MotoNovo Finance stated that the rate-for-risk model has already made a positive impact to dealers who have adopted its solution. According to research commissioned by the company in an effort to assess consumer attitudes to buying and financing a used car, 83% of customers described the dealers – who were using MotoRate – as ‘helpful’ and 90% describe them as ‘friendly’.
This feedback outperformed the view of both dealer groups and independent dealers not using MotoRate by a significant amount. Non-MotoRate dealers’ ‘helpful’ rating was in the 42-49% range, while the ‘friendly’ attribute ranked 36- 48% range.
Mark Standish, chief executive officer of MotoNovo, noted: “We had already seen the positive impact of the MotoRate pricing model on dealers’ finance penetration and heard the anecdotal feedback from dealers. We wanted to gain an independent, objective insight on the impact of the greater transparency in the finance process afforded by the risk-based pricing approach.
“Overall, as hoped, the MotoRate finance process and the fact that dealers can happily explain to customers that they have no input on the interest rate, which purely reflects customers’ credit status is changing the trust dynamic.
Dealers are seen as more transparent and clearer. Not only is this enabling dealers to increase their finance activity; many are reporting that the ‘halo-effect’ of enhanced trust is helping to close more sales and increase the sale of added value products.”
Now in use by more than 2,000 dealers across the UK, MotoRate was designed to enable dealers to sell more vehicles and increase profitability by boosting transparency and personalising the finance rate to the customer’s risk and affordability profile. This is forecast to attract more customers that otherwise could have been disillusioned by the shady reputation of dealers in the past, as illustrated in the research above.
The clock is ticking
Jo Davis, partner at Auxilias, added: “The clock is ticking. The ban on discretionary commission models in motor finance is primed to come into effect at the same time as the changes to the commission disclosure requirements.
“It is critical that lenders and brokers have fully implemented the changes – especially as the FCA is not allowing a transitional period – with the cut off for the old commission model taking place on 27 January leaving the broker unlikely to be able to claim old commission accrued after this date. Many are therefore going live with new commission models at the end of December this year.
“The commission disclosure statements that apply to all regulated credit products can be challenging and firms need to ensure that their disclosure statements comply with the new rules from the deadline.”
Providing a useful reminder of the FCA policy statement and the final rules, UK-based law firm Auxilias are sharing their recent white paper to highlight the key areas. It can be downloaded by filling in your details below.