Auto Finance: Size of the Industry to Quadruple with New Financing Structures

Industry profitability likely to be maintained

CRISIL Research

CRISIL Research believes that the car finance industry is evolving new financing structures that can help reduce the total cost of ownership and consequently drive car demand. Until now, the car finance market in India has been dominated by the hire purchase loan structure of financing. CRISIL Research believes that operating leases and hire purchase loans of 3-4 years tenure with a pre-agreed upon residual value (RV) are the two new financing structures that are evolving rapidly and will change the operational dynamics of this industry.

Both of these new financing structures will have similar impact on the auto as well as the auto finance market. The new financing structures will allow financiers to grow the pie dramatically, while sharing it.

CRISIL Research's analysis indicates that financiers can afford to incur around 50 per cent higher expenses under the new financing structures compared to the traditional hire purchase loan structure. This will help them offset any increase in operating expenses and/or cash losses, while maintaining their profitability.

Further, CRISIL Research believes that the new financing structures will most likely be introduced in the high-end cars and gradually percolate down to the base models.

New financing structures

a)	Operating lease Operating lease refers to a situation where the financier (bank/NBFC/manufacturer-backed NBFC (MNBFC) leases the asset to a customer and recovers only a part of the asset value (depending on the term of the lease), through lease rentals. The asset remains on the books of the financier, and the financier claims depreciation against the asset. At the end of the lease period the client can:
	▪	purchase the asset back, or
	▪	refinance the balance amount at the then prevailing interest rate, or
	▪	surrender the asset back to the financier.
	This type of financing structure is popular in the developed countries.
b)	Hire purchase loans of 3-4 years tenure with a pre-agreed upon RV This is a hybrid financing structure, wherein a hire purchase agreement is entered into with the customer and the terms are as follows:
	▪	The loan tenure is expected to be 3-4 years.
	▪	Instead of repaying the entire principal amount of the loan, the customer is required to repay only a part of the principal. This is achieved by introducing the concept of RV, wherein the customer is required to repay the principal down to the RV agreed upon at the time of taking the loan. Although, as of now players are talking about RV in the range of 30-35 per cent of the value of the car for a 3-4 year tenure loan, we believe that over the next 2-3 years this would increase to 40-45 per cent of the value of the car.
	▪	At the end of the loan tenure, the customer can:
		a.	make a bullet payment equal to the RV of the car and own the car, or
		b.	surrender the car at the pre-agreed upon RV, if it is in proper condition and free himself/herself of the loan obligation, or
		c.	refinance the RV at the then prevailing interest rates.
Currently prevailing financing structures The structure of the currently prevalent hire-purchase loans is as follows:
	▪	The loan tenure is typically in the range of 3-7 years.
	▪	The entire principal amount of the loan has to be repaid by the customer over the tenure of the loan.
	▪	The loan is secured by the car/utility vehicle (UV) but the financier has the right to recover the loan from the borrower as if it were an unsecured loan.
	▪	Today, close to 85 per cent of the value of vehicle is typically financed.

New car demand and new car finance disbursements and outstanding under current financing structure

(Rs billion)	2005-06	2010-11P	2006-2011 CAGR (%)
New car sales volumes ('000 units)	882	2,003	17.82
New car finance disbursements	216	437	15.07
New car finance outstanding portfoio	475	1,087	18.00

 
P: Projection

Assuming that the incremental penetration of the addressable market remains the same, the demand for new cars can increase by an additional 36 per cent over and above the 2 million units in 2010-11 forecasted by CRISIL Research under the traditional hire purchase loan structure of financing and reach 2.72 million units. This effectively means that the annual growth rate in car demand will increase by 750 basis points (bps) to at least 25-26 per cent.

Similarly, under the new financing structures, assuming 'status quo' on the loan to value (L TV) and the finance penetration, the new car finance disbursements are expected to grow by 22.37 per cent, an increase of 650-750 bps, compared to the growth of 15 per cent under the traditional hire purchase loan structure.

New car demand and new car finance disbursements and outstanding under new financing structures

(Rs billion)	2005-06	2010-11P	2006-2011 CAGR (%)
New car sales volumes ('000 units)	882	2,723	25.30
New car finance disbursements	216	594	22.37
New car finance outstanding portfoio	475	2,261	36.62

 
P: Projection

The car finance outstanding portfolio is expected to grow at a phenomenally higher rate of 37 per cent, an increase of nearly 1800-1900 bps, compared to a growth rate of 18 per cent under the traditional hire purchase loan structure. This incremental growth will be driven by the increase in the sales volumes of cars and an increase in the average value of the loan outstanding during the tenure of the loan as explained in Box 1.

Margins of the auto finance industry likely to be maintained

The use of new financing structures will give financiers the flexibility to incur around 50 per cent higher expenses compared to those they could incur under the traditional hire purchase loan structure as the average value of the loan outstanding during the tenure of the loan increases by 50 per cent. This will help the financiers offset any increase in operating expenses and/or cash losses, while maintaining their profitability. Currently, as per our interactions with industry sources, the operating expenses incurred by a financier in car finance are 1.5 per cent of the outstanding portfolio.

Our analysis reveals that under the new financing structures, the operating expenses will rise by around 75-100 bps over those prevailing in the traditional hire purchase loan structure due to the l1eed to revalue the used car, store the car while it awaits resale and loss of interest on the car value during the period it is awaiting resale. We believe that the financiers can pass most of these expenses to the customers as they are being incurred for a benefit that the customers are getting. We, therefore, believe that the effective operating expenses incurred by the financiers under the new financing structures should not increase significantly from those they incur at present.

Box-1

More than 50 per cent increase in the average value of the loan outstanding during the tenure of the loan ▪  In the traditional hire purchase loan structure, a customer gets financing up to around 85 per cent of the car value. He has to repay the entire principal over the tenure of the loan. The average value of the loan outstanding over the tenure of the loan works out to around 42.5 per cent.   ▪  By contrast, in the new financing structures, the customer gets financing up to around 85 per cent of the car value. However, he is required to repay only up to the pre-agreed upon RV over the tenure of the loan. In the event of the RV or the purchase value under the operating lease being 45 per cent of the value of the car, the average value of the loan outstanding over the tenure of the loan/lease works out to as high as 65 per cent of the value of the car.   ▪  This results in an increase in the average value of the outstanding over the life of the loan by as much as 53 per cent under the new financing structures compared to the traditional hire purchase loan structure.

 
However, under these structures, it is feared that risks incurred by financiers can rise. CRISIL Research has identified four types of additional risks that a financier may face in the new financing structures.

▪	Accidental risk - Accidental risks cover accidental physical damage to the car, damage due to fire, flood, earthquake, theft, collisions, etc. Today, almost all cars are under motor vehicle insurance and these risks are covered by the insurance companies. However, even then the financier can run the risk of loss, as the insurance company will typically cover only 90 per cent of the depreciated value of the car. CRISIL Research's analysis indicates that the incidence of these events is to the extent of 2-5 per cent of the car population. Our analysis indicates that the credit loss to the financiers will be to the extent of 2-5 bps on account of this after taking into account the fact that financiers typically provide finance up to only 85 per cent of the value of the car and that some portion of the principal outstanding will be repaid over time.
▪	Maintenance risk - This risk arises from the improper maintenance of vehicles. The financiers can hedge this risk by insisting that the car purchaser take extended warranties from the manufacturers. The extended warranties today anyway cost only a. marginal amount. This will ensure that the customers maintain their cars in proper condition.
▪	Usage/Mileage risk - Usage/Mileage risk is incurred when the customer uses the car more than that estimated by the financier while promising a repurchase value. A large fraction of the cars used by the taxi operators would suffer this risk. By avoiding use of these structures while financing cars purchased by taxi operators, or while financing car models that are usually used as taxis, financiers can avoid this risk. Besides taxi operators, usage varies by individuals. CRISIL Research estimates that only 5 per cent of the car purchasers will most likely be subject to this risk. Further, if RV is arrived at prudently, it will ensure that not more than 5 per cent of the original value of the cars is subject to this risk even for this set of customers. This indicates that the overall usage/mileage risk will be less than 25 bps of the value of the car or less than an expense of 10 bps over the tenure of the loan [25 bps of the value of the car over the tenure of the loan (4 years) applied on average value of the loan outstanding (65 per cent of the value of the car)].
▪	Obsolescence risk - This risk arises out of a particular car model having no demand in the market and this is a highly subjective area of debate. We have not tried to estimate this risk but believe that financiers can avoid this risk by having detailed discussions with the manufacturers about their long-term model plans and not providing new financing structures on the models expected to be phased out. As detailed above, three of above-mentioned risks combined are equivalent to an additional cash loss of less than 15 bps and the fourth can be avoided by proper selection of the models on which these finance structures will be provided. At the same time, operating expenses are not expected to increase beyond current expense levels in rupee terms. As a result, the operating expenses as a percentage of loans outstanding are expected to decline by 50 bps. Therefore, CRISIL Research believes that the profitability of the auto finance industry will at least be maintained under the new financing structures.