• Cognizant 20-20 Insights

Managing the Impact of CFPB Regulations

Auto lenders must overhaul their IT systems and operations to prepare for increasing scrutiny around their practices and policies.

Executive Summary facing such stringent scrutiny for the first time – At US$934B, auto-loan debt is the third posing significant challenges for them. largest household debt in the U.S., with no signs of decreasing. This shows an increasing demand In this white paper, we provide a brief background for vehicles among consumers. The concern is that on the auto finance industry and CFPB laws, and most of the growth is in the subprime auto loan list the major reasons why the CFPB has had market. Default rates in auto loans and vehicle to step in. We also touch on existing consumer repossessions have also increased significantly in financial laws that affect the industry. Finally, we recent years. Furthermore, there are indications of will present a high-mid-level analysis of the cur- discrimination and unfair lending practices, and a rent process deficiencies on the lenders’ end, and lack of transparency. These issues have prompted suggest solutions to overcome these obstacles by an intervention by the Consumer Financial Protec- improving the performance of supporting pro- tion Bureau (CFPB), which has taken action in the cesses, people and technologies. form of fines, stricter implementation of consumer protection laws, and steps to prevent unfair prac- The State of Auto Loan Debt tices and ensure transparency. As of Q3 2014,2 total auto loan debt in the U.S. stood at $0.934T3 – coming in third after mort- In May 2014, the CFPB announced plans to target gages ($8.131T) and student loans ($1.126T), and the auto finance industry for enforcement of fair ahead of credit card debt ($0.68T). Banks and lending laws. The regulatory body plans to moni- other lenders issued $105B in new auto loans in tor the top players in the industry by defining a Q3 2014. Banks have the largest share of the auto “Larger Participant”1 rule, similar to its regula- finance market share, followed by captive finance tion for the student loans sector. Direct lenders companies, credit unions, independent finance (banks) have already gone through several cycles companies and Buy Here Pay Here (BHPH) lenders. of regulatory changes, such as the Making Home Auto loan debt grew significantly in Q3 2014 – over Affordable (MHA) program, CFPB rules, etc., 10% when compared with Q3 2013, and over 3% and have managed the impact of regulations on when compared with Q2 2014.4 This growth has not their processes, people and systems. While most been uniform. Subprime auto loan debt has dou- of these institutions will find it easier to comply bled since 2010 (see Figure 1, next page), whereas with the new laws, the top indirect lenders will be prime auto debt has increased by only a third.

cognizant 20-20 insights | april 2015 The Auto Lending Landscape

Size and Scale Key Players

• Consumers, direct lenders, indirect lenders, • $0.934T as of Q3 2014. dealers and regulators. • Top 20 direct and indirect lenders account • $105B in new loans in Q3 2014. for 47.9% of all retail loans. • Allys is the largest lender, with a share of 5.56%, • Banks and captive finance companies have a followed by Wells Fargo at 5.32% and Toyota 63.4% share of the auto finance market. FS at 4.49 %.

Source: Experian.com Figure 1

Captive finance companies such as Honda 16 titles. The Consumer Financial Protection Finance, Toyota Financial Services, Ford Motor Bureau (CFPB) was formed as part of Title X. Auto Credit and BHPH, for example, have contributed dealers that have an unaffiliated financing source to most of the growth in the subprime market; the fall under the Federal Trade Commission’s jurisdic- dollar value of their subprime loans was almost tion and not the CFPB’s. However, CFPB has inves- three times that of banks in Q3 2014. tigative and enforcement rights over indirect auto lenders and other auto dealers. Direct lenders The Industry Structure such as banks are under the CFPB’s jurisdiction. The U.S. auto finance industry encompasses direct lenders, indirect lenders and Buy Here As shown in Figure 2 (next page), the main Pay Here (BHPH) lenders. Direct lenders are drivers behind the CFPB’s intervention in the auto usually banks and credit unions that lend directly lending industry include: to consumers. In indirect lending, consumers approach dealers, who coordinate with various • Discrimination against consumers due to their lenders to obtain auto loans for the consumers. sex, color, religion or origin – which violates Indirect lenders are made up of captive finance the ECOA and Fair Lending Act. This is based companies, banks, credit unions, independent on reports of dealers selling loans at higher finance companies and other investors. BHPH interest rates to consumers from minority lenders generally cater to the subprime market, groups. Dealers can do this by changing the and finance most of their loans through captive markup on interest rates offered by lenders. (affiliated) finance companies. • An increase in 60+ days past due account Regulatory Compliance volume from $4.07B in Q3 2013 to over $5.38B in Q3 2014. Auto lenders reported $355M in The auto finance industry is regulated by broader non-performing auto loans in Q3 2014 – stating consumer financial laws that govern other an increase of 8% YoY. Since March 2012, the consumer financial industries, such as mort- CFPB has been accepting customer complaints gages, student loans and credit cards. All auto across various consumer finance categories, lenders and dealers have to comply with acts including auto loans. The complaint categories such as the Equal Credit Opportunity Act, the Fair specific to auto loans are Billing and Credit Credit Reporting Act, and the Truth in Lending Reporting (44%), New Loan and Modifications Act, among others. The Dodd-Frank Act made the to Loan Terms (23%), Default Management Consumer Financial Protection Bureau (CFPB) (22%) and Loan Marketing and Sales (11%). responsible for enforcing these laws. • Repossession of vehicles was at a record high Why CFPB Intervened in 2013. In response to the financial and housing crisis of 2008, the Dodd-Frank Wall Street Reform Act and The total balance of newly originated subprime Consumer Protection Act of 2010 (Dodd-Frank loans as of Q3 2014 was $81.2B – an eight-year high Act) was enacted. The Dodd-Frank Act includes representing 28% of all new auto loans in 2014.5

cognizant 20-20 insights 2 In 2014, the CFPB announced that the auto compensation policies. In December 2013, CFPB, finance industry would be a fair lending enforce- along with the Department of Justice (DOJ), ment target. Both direct and indirect auto lenders imposed a stiff penalty on a top auto lender for had been passing on the onus of complying with discriminatory lending practices.6 In May 2014, various regulations to the dealers. The CFPB’s CFPB officially confirmed that it would be creat- steps placed the burden back on the lenders to ing new rules for auto lenders. ensure that they are held accountable for the credit processes and practices of the dealers. The Currently, the bureau supervises large banks regulator has already taken actions against some in auto finance, but not non-bank auto finance large auto lenders, and penalized lenders for companies. CFPB is proposing to extend its super- vision authority to these institutions by defining failure to comply with ECOA and FCRA. a “larger participant” rule. This rule is likely to affect 50% of the auto lending market, which Key Timelines could include up to 20 top auto lenders. Similar to The CFPB began its campaign in March 2013 – the mortgage market, the CFPB plans to impose asking indirect auto lenders to comply with reporting requirements on auto lenders to spot ECOA, Regulation B, and the Fair Lending Act, unfair practices. The regulator also intends to and to ensure controls for dealer markups and

The CFPB Intervention Timeline

March 2013: May 2014: CFPB on Indirect CFPB Rule-Making Agenda Auto Lending • The CFPB officially confirmed • Ensure that lenders comply it would proceed with creating • The CFPB to present rules with ECOA and Regulation B. rules for auto lenders. for auto lending that would • Lenders to set in place • The CFPB began developing be built around “large controls related to dealer a proposal to identify “larger participants,” similar to markup and compensation participants” in the market student loan servicing. policies. for auto lending. The CFPB • The “large participant“ had defined larger participants • Lenders must comply with threshold from the CFPB is in consumer debt collection, the Fair Lending Act. expected to include major student loan servicing and players in the market, based credit reporting. on market coverage and number of consumers impacted.

What to Expect

December 2013: May-August 2014: Action against Ally Bank CFPB Action Against Auto Lender • The rule is likely to impact at • The CFPB and the Department of • The CFPB took action against least the top 20 auto lenders, Justice announced an enforce- six auto lenders, including three including banks and non-banks. ment action and consent order banks and three non-banks, for • The CFPB to target auto that required Ally Bank to pay violating fair lending practices. lenders’ compliance-managing $80M in damages to consumers • American Honda Finance Corp. systems or methodologies, as who were harmed by discrimina- and Toyota Motor Credit Corp. well as their complaint-handling tory dealer markups and received notice from the CFPB systems. compensation policies between and the Department of Justice. April 2011–December 2013. • Texas-based First Investor • The discriminatory policy Financial Services Group has affected 235,000 African- been fined $2.75M by the American, Hispanic, Asian CFPB for knowingly providing and Pacific Island consumers. inaccurate information to • Ally was also required to pay an credit-reporting agencies for additional $18M penalty to years. CFPB’s Penalty Fund.

Figure 2

cognizant 20-20 insights 3 provide advisory services and feedback channels all industry participants, several of which were to consumers, similar to home ownership coun- hitherto not covered by the CFPB. seling for mortgages. Companies in the auto finance industry will need The Impact on the Auto Finance to make significant changes to their processes Industry and systems, and train associates to comply with the stricter regime. The change will be harder The CFPB’s actions point to a stronger regula- to manage for indirect auto lenders, such as tory environment for the auto finance industry. captive finance companies and BHPH lenders, Through these regulations, the CFPB is looking than for banks, since these organizations do not to bring greater accountability, improvements have experience in handling similar regulations. in customer service, a reduction in defaults and the elimination of unfair practices. The bureau Based on our experience and analysis, we believe has not indicated that it plans any amendments that the auto finance industry should focus on to existing consumer financial laws, or is aiming five key areas when analyzing their processes, to introduce new laws for auto lenders. Rather, it people and systems, and preparing for CFPB seems to be focused on ensuring compliance by supervision, examination and reporting require- ments expected in the near future (See Figure 3).

Preparing for CFPB Regulations: Five Key Areas

Complaint Markup & Compliance Pricing & Credit Management Compensation Monitoring Disclosures Bureau Policies Reporting System

Figure 3

Impact Analysis Using our knowledge and experience, we conducted a high-mid-level analysis of the typical process challenges, corresponding process improvements and technology changes in the five focus areas cited above:

Challenges, Improvements and Changes

Process Challenges Proposed Process Improvements Proposed Technology Changes

Limited controls and policies Develop policy, controls and Enhance dealer-facing on dealer interest rate markup reporting for dealer interest systems to: on top of lender-provided rate rate markup. • Implement new rules-based could lead to a significant in- Implement alternative compen- compensation policies and crease in interest rates. sation mechanisms that can be controls on markups. Dealer compensation policy. proven to be non-discriminatory. • Provide reporting and alerts Lenders usually provide a Monitor dealers for compliance. for dealer activities on Policies percentage on above markup markups. as compensation. Dealer ratings should be based on monitoring and incentives for • Develop dealer compliance compliance in the form of reports on various regulations, Markup & Compensation & Compensation Markup preferential rates. such as ECOA.

table continued...

cognizant 20-20 insights 4 Process Challenges Proposed Process Improvements Proposed Technology Changes

Limited reporting and analysis Build separate team and process Create new database and of dealer compliance with CFPB for regulatory compliance reports for various compliance regulations. analysis, monitoring and report- reports on fair lending. Limited controls on marketing. ing on various activities, such as Develop e-learning modules Lenders have delegated the mar- adverse actions, loan marketing. to train and track associates’ keting of loan products to dealers Lenders should train associates learning. without ensuring compliance. at the dealership on and practice Build rules-based, flexible Limited oversight to ensure fair lending principles. systems to quickly incorporate compliance. Lenders have been Provide regular fair lending regulatory compliance changes. passing on the onus of comply- training on principles, documents Enhance systems to: ing with fair lending laws to the and process to dealers. • Define and implement dealers. Dealers have not focused Provide evidence of compliance on regulatory compliance as they UW rules based on fair to prove fair lending practices lending laws. are regulated by FTC, not CFPB. have been followed. • Manage, log and record Robust compliance framework. Implement UW policies in an

Compliance Monitoring Compliance UW exceptions. Many lenders, especially captive objective, rules-based manner units, BHPH, etc., lack a robust so UW decisions are process- compliance framework. based rather than people-based Lack of institutionalized UW and are reportable. policies. Subjective underwriting decisions that are not documented/noted lead to unfair lending practices.

Vehicle pricing transparency. Train associates to itemize and Enhance systems to: Currently, dealers do not provide explain each product/service sold • Create new mechanisms for breakup (by each component) of to the consumer. documenting, delivering and total price like vehicle sales price, Train dealers on explaining GAP tracking to ensure the cus- additional equipment price, ad- coverage, terms, costs and refund tomer understands all costs ditional warranty price, taxes and process to consumers. associated with the contract title costs, and trade-in values. Create a process to educate terms, products and services. Guaranteed Asset Protection consumers on GAP benefits, • Calculate GAP refund amount (GAP) Insurance. Dealers cur- premium and refund process. and assist dealers in explain- rently provide limited information ing GAP terms and refund. on GAP pricing, corresponding Lenders should ensure that terms and conditions, and the dealers educate end consumers • Capture GAP waiver forms refund process. on spot delivery risks/conditions signed by customers. and obtain their consent. Spot delivery. In a spot delivery, • Provide counter-offers so the customer signs the lending Develop a process/forms to customers can choose from disclose/explain all the fees/ various options. Pricing & Disclosure contract and takes delivery of the vehicle before financing is payments not included in TIL. approved. This can cause issues if the contract terms or rate change later. Truth in Lending (TIL) disclo- sure. Customers are not edu- cated about the components not covered in the TIL, such as GAP.

• Reporting payments and • Provide reporting, analysis • Enhance customer credit overdue amounts. Some and exception management reporting. Dispute handling lenders have understated on credit reporting by lenders. and tracking system with cus- customer payments reported • Dispute management team tomer notification features. to credit reporting agencies. and process for resolving Equip systems to: • Reporting delinquencies. customer concerns about • Send copies of credit report Some lenders incorrectly re- credit reporting. to customers post-correction. port dates of first delinquency. • Develop process and forms • Build reports to pre-emptive- • Mischaracterization of vehicle to record voluntary surrender ly catch customer reporting surrender. In some cases, even by consumers. exceptions. if the customer voluntarily sur- • Capture and track voluntary

Credit Bureau Reporting Bureau Credit rendered the vehicle, lenders reported it as a repossession, surrender information. which adversely impacted the customer’s credit report.

table continued...

cognizant 20-20 insights 5 Process Challenges Proposed Process Improvements Proposed Technology Changes

Complaint handling. Lack of Build a strong complaints- Develop a multi-channel well-defined process, SLAs, management process with SLAs complaint system to streamline dedicated resources and system and infrastructure. the complaint intake process. to handle customer complaints. The system should be able to Set up a complaints- record, categorize, track and Recordkeeping. Maintain audit management team that will manage customer complaints. trail of all complaints handled. identify, monitor, analyze and System resolve complaints. Use SPOC concept for

Complaint Management Management Complaint complaints management and resolution.

Figure 4

Conclusion to focus on and invest in retooling processes, While auto loan debt in the U.S. has increased improving employee training, and enhancing and rapidly in recent years, most of this growth is in building new systems and reports that can handle the subprime segment. There is also a noticeable compliance requirements. Lenders will not only surge in defaults and repossessions, and evidence need to remain compliant; they will also have to of unfair lending practices. Consumer complaints provide evidence of such with various fair lend- to the CFPB related to auto finance are lower ing laws, and supply data/reports on compliance, compared to complaints related to mortgages, non-compliance and actions taken to ensure student loans and credit cards. However, the compliance – even for their dealers. CFPB’s moni- CFPB believes the auto-lending sector should be toring of auto lenders will test the latter’s resil- better monitored to prevent another subprime ience. The adaptation and upgrade process, which crisis and protect consumers from unfair lending could take several months, will strengthen auto practices. In fact, in 2014 the bureau fined some lenders’ capabilities to meet future regulatory auto lenders and announced that auto finance requirements. was its target for enforcing fair lending in 2014. Based on our research, we believe that com- The CFPB plans to define a “Larger Participant” panies that adopt a proactive, comprehensive rule similar to the one it specified for student approach to CFPB compliance will learn how to loan servicers, and bring most large auto lend- make the most of their internal resources (peo- ers under its domain. If the rule for the student ple, processes and technologies). They will also loan servicing market is any indicator, the new look to external resources, such as the Software directive for auto lenders could at the very least as a Service (SaaS) model, and call on consulting impact the top 20 players. and technology organizations with the expertise to needed to successfully manage the impact of To manage regulatory monitoring, oversight and CFPB regulations on a sustainable basis. reporting, direct and indirect auto lenders need

Footnotes 1 http://www.consumerfinance.gov/newsroom/cfpb-proposes-new-federal-oversight-of-nonbank- auto-finance-companies/

2 http://www.newyorkfed.org/householdcredit/2014-q3/data/pdf/HHDC_2014Q3.pdf

3 www.ycharts.com

4 http://www.experian.com/assets/automotive/white-papers/experian-auto-2014-q3-presentation. pdf?WT.srch=Auto_Q22014FinanceTrends_PD

5 http://www.consumerfinance.gov/newsroom/cfpb-and-doj-order-ally-to-pay-80-million-to-consumers- harmed-by-discriminatory-auto-loan-pricing/

cognizant 20-20 insights 6 http://www.consumerfinance.gov/newsroom/consumer-financial-protection-bureau-to-hold-auto- lenders-accountable-for-illegal-discriminatory-markup/

6 http://www.consumerfinance.gov/newsroom/consumer-financial-protection-bureau-to-hold-auto- lenders-accountable-for-illegal-discriminatory-markup/

References • http://www.consumerfinance.gov/ • http://www.cfpbmonitor.com/ • http://www.treasury.gov/ • http://www.autonews.com/ • http://www.experian.com/ • http://www.ibisworld.com/ • http://www.mortgagenewsdaily.com/

About the Authors Saurabh Parakh is a Consultant with Cognizant Business Consulting. He has over seven years of experience working with leading banks in product management and business process optimization across geographies. He can be reached at [email protected].

Sivaraj Lakshmanan is a Senior Consultant with Cognizant Business Consulting. He has over 10 years of experience working with leading banks in project management, product management, and business process optimization. He can be reached at [email protected].

Ashish Shreni is a Principal Consultant with Cognizant Business Consulting and has worked for over 14 years in the banking and insurance space on projects spanning business and IT strategy, business process optimization and complex project execution. His core focus area is Consumer Finance. He can be reached at [email protected].

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