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You share Lloyds Banking Group (LSE: LLOY) closed up 7% on Friday. The stock is down a further 2% as of writing on Monday (October 28). That's a 9% drop in two trading days – the biggest drop in FTSE 100 stock.
The decline in the bank's share price was caused by news of the Court of Appeal's decision that could lead to higher compensation costs for the financial sector.
Why is this important?
Lloyds' Black Horse subsidiary is the UK's largest car finance provider, with around a third of the market. It is also one of a number of UK companies currently involved in an investigation by the Financial Conduct Authority (FCA) into historic motor vehicle commission payments.
In short, the FCA's review is whether commission payments made by finance providers to used car dealers were not properly disclosed to car buyers. Friday's news is related to a touching case Close the Brotherhoodone of the UK's largest car finance providers.
The case relates to a single complaint. But the fear among lenders is that the FCA could use the decision to take a tougher line on compensation than previously expected. This can lead to very high compensation costs for all lenders involved.
Lloyds has already set aside £450m to pay compensation. But in a statement this morning, the bank said this decision “set a high bar for exposure” than “it was understood … before the decision”.
As a result, Lloyds says now “assessing the potential impact of decisions”.
What happens now?
Close Brothers said they intend to appeal last week's decision to the UK High Court. It may still be postponed.
Lloyds has around £15bn of car loans, giving it almost a third of the UK market. Although this is a large number, it is only a small part of the group's total loan book of around £450bn – mainly mortgages.
I am sure that Lloyds can handle any compensation payments that may be necessary. But the question for potential investors – myself included – is how the cost of this would affect shareholder returns.
Is this another PPI?
Experienced investors may remember the PPI scandal. The UK's biggest banks were forced to pay more than £50bn in insurance compensation to protect against mis-sold payments. Lloyds was the biggest payer, paying more than £20bn in compensation.
Some City analysts believe the FCA's car finance probe could be the next PPI. Estimates reported in Financial Times from leading buyers put the total potential costs for car finance lenders at between £6bn and £16bn.
Buy Lloyds under 60p?
Nothing is certain yet. The FCA is not expected to provide another update on its progress until May 2025.
Meanwhile, Lloyds' latest update for the third quarter suggests that current trading is strong enough. The forecast dividend yield of 5.6% looks safe to me, as it should be covered twice by 2024 earnings.
The risk, in my view, is that the refinancing of motor vehicles could lead to a multi-year drag on profits and shareholder returns. That's what happened with PPI.
I prefer to avoid this kind of regulatory risk, so I would look elsewhere if I were buying bank stocks today.
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