Indirect Lending: Time for a Change?
Many banks and credit unions rely on indirect vehicle lending as a sizeable component of their earning asset mix. However, pressure from a variety of sources should make institutions reconsider its role in that mix.
In our recent study for Raddon Research Insights, “Self-Drive My Car: Buying and Financing in an Uber World,” we look at ways technology is influencing consumers’ behavior in buying and financing vehicles. The trends are not positive for lenders.
Americans are buying fewer vehicles per capita (68 per 1000 adults compared with 84 per 1000 in 2000) and are keeping their vehicles longer (79 months in 2015 compared with around 52 months in 2006). One reason for these behaviors is that the newer cars and trucks are better made and last longer than vehicles did 30 years ago. In addition, consumers are now making fewer trips.
As a result, the foreseeable trend is a shrinking market for auto sales. Because only 54 percent of consumers have financed their current vehicles, every decline in the sales market is nearly doubled in the finance market.
Among consumers looking to finance their next auto purchase, only 26 percent intend to get financing at the dealership (see Figure 1).
It is important to note that, even though consumers say they intend to finance other than indirectly at the dealer, dealer financing represents 65 percent of all current financing options. Once a consumer is in the little room at the dealership with the F&I professional, financing there is hard to resist. Still, only 48 percent of indirect borrowers intend to finance their next vehicle the same way.
To add insult to injury, indirect lending is becoming increasingly less profitable. Because fewer loans are now available, dealers are able to demand a higher reserve to paper-starved financial institutions. Whereas a decade ago, 1 percent was a typical dealer reserve, anecdotally, we are hearing of dealer reserves as high as 4 percent in some markets. Even amortized over the life of the loan, that expense burden becomes challenging to profitability.
In addition, indirect vehicle loans charge off at a higher degree than direct vehicle loans. Among institutions in the Raddon Performance Analytics program, for every dollar charged off on direct loans, indirect losses were 0.86 percent of balances, compared with 0.54 percent for direct loans, as of June 2018. Although indirect loans earn a higher interest rate than direct loans, the increased margin does not cover the increased risk.
As a result, the average institution earns a return on balance of 0.42 percent on direct auto loans but loses 0.09 percent return on balance on indirect loans. As a point of comparison, credit cards earn 3.5 percent return on balance, while equity lines earn 0.85 percent.
So if demand is falling and returns are shrinking, should institutions abandon indirect lending completely? That depends on the alternatives that exist for a given institution. At this point, keeping extra liquidity in cash would be more profitable than making an indirect loan, and other options like credit cards and commercial lending could be significantly more profitable if an institution has the opportunity to grow those portfolios.
However, exiting the indirect marketplace has its risks as well. Once an institution stops financing at a dealership, that dealership will be disinclined to use that institution in the future. It could even attempt more aggressively to capture direct deals from that institution’s customers. Maintaining an indirect portfolio requires a strong input of new dollars to replace the runoff; without dollars being lent, an institution could see its overall margins take a large hit as the portfolio declines faster than the alternatives can grow.
In short, there is no easy answer as to whether to continue indirect lending. Consider your balance sheet, asset-liability management (ALM) requirements, and cash flow. If an alternative investment or lending program makes sense, consider how an exit strategy can work. If not, consider how you can control dealer costs, losses, or other expenses. The market is shrinking; do not get squashed.
 Bureau of Economic Analysis, 2018
 INS Markit, 2016