New Fed Report Attributes Rise in Nonbank Auto Lending to Credit Availability in Times of Crisis

For better — and maybe for worse — auto lenders who remain open for business in times of crisis take share from those who don’t. That’s the big takeaway from a new report by José Canals-Cerdá and Brian Jonghwan Lee of the Federal Reserve Bank of Philadelphia.

Canals-Cerdá and Jonghwan Lee’s study, “Who Provides Credit in Times of Crisis?” tracked originations among banks, credit unions, and nonbank auto lenders over 20 years. It found that while traditional bank lenders extended credit to the subprime marketplace during the 2008 Great Recession, the story was different during 2020’s COVID-19 pandemic.

During that crucial year, sharp downward shifts in bank auto loan originations across narrow risk score segments remained low while originations rebounded quickly among nonbank lenders (and credit unions) beginning in May.

Banks haven’t recovered as auto lenders since the COVID-19 pandemic, a new study from the Philadelphia Fed asserts.

That led to a “significant substitution,” to use the study’s terms, that accelerated the shift away from bank auto lending and gave finance companies heightened strength.

The study’s insights ought to be of particular interest to all auto lenders with a specialization in the subprime category. First, it calls into question the commonly held belief among traditional finance professionals that finance companies and fintechs are more fragile than banks.

Instead, the data shows that finance companies responded during the pandemic with what the study called “relative lender resiliency,” meaning they were comparatively more open to making loans than banks.

The study also takes a deep dive into the factors at play in banks’ market share loss during COVID-19. While prior research has tended to account for the banks’ retreat as a consequence of new regulations and illiquidity, the authors argue here that the banks themselves were responsible.

“Specific features of corporate structure and client relationships . . . may have contributed to the sluggish recovery in risk appetite on the part of banks relative to finance companies and credit unions,” the study noted.

How these findings play into recent events remains uncertain. However, with other data from the Fed marking auto loan delinquencies at highs not seen since the aftermath of the Great Recession (see table), it’s fair to ponder whether the rise of so-called credit resilience among nonbank entities has had something to do with it.

The study doesn’t take a position, opting to explain the dynamics behind sudden financial events in terms that focus on the numbers.

The data demonstrates that finance companies experienced sharp declines during the Great Recession due to the collapse of the short-term commercial paper that funded some or most of their operations. Although they lost share during the crisis, they rebounded quickly (unlike the banks) and began gobbling up new business as they had before the crisis.

In fact, while nonbank entities originated only about 40% of auto loans in 2009, and banks and credit unions originated the other 60%, those numbers had reversed by 2019.

Then COVID-19 came and delivered another altering blow. The study shows that subprime lenders as a whole experienced the brunt of the lending downturn relative to the near-prime, prime, and super-prime categories. But this “persistent negative effect” in subprime arose from the distinctive response of banks to the crisis.

“Bank-financed originations experienced the most dramatic drop in auto loan originations during both the initial and recovery months of the pandemic,” the study read. “On the other hand, finance companies and credit unions experience[d] an initial contraction . . . followed by a much stronger recovery between May and December that almost offset these drops.”

During the recovery period after the onset of COVID-19, in other words, finance company-originated auto loans grew by leaps and bounds while bank-originated loans did not. Originations in the recovery period contracted most significantly for banks across all risk score groups.

“The differences are stark,” the study noted.

Now let’s get into the “specific features of corporate structure and client relationships” the study asserted have been drivers of banks losing ground in favor of finance companies.

The question was whether a tightening in lending standards or a shift in borrowers’ preference toward nonbank loans caused the reduction in the supply of bank credit during the pandemic. It answered that a tightening in standards almost certainly produced the response the data tracked.

The study analyzed opinion surveys, cross-channel data on county-bank lending dependence (data that tracks the extent to which different counties rely on bank-originated loans), and other sources. The data showed subprime audiences flocking from banks to finance companies during the acute and recovery months of the pandemic.

Counties with the highest pre-COVID dependence on traditional banks fared worse during the crisis. In fact, the higher the reliance on conventional banks, the stronger the shift.

The study argues against regulatory frameworks and funding sources fueling the change in favor of factors such as the exclusive focus of auto lending companies on their prime objective.

Similar to how credit unions gain an advantage over banks through mission-driven lending, finance companies gain a bigger advantage by targeting specific customer segments with a laser focus, even on the lot.

Meanwhile, banks have more diverse lending portfolios — and generally a more complex set of product/service responsibilities in general — with potentially more risk exposure over the long term. It’s a case where the specialized approach seems to be winning out in the subprime auto lending segment.

Where that will lead is an open question, the study’s authors suggest. What’s not in doubt is that while securities-funded finance companies lost out to banks during the Great Recession, they have gradually increased their share of the market ever since — especially since the pandemic.

But the study leaves room for further evolution, attributing the contrast in the nonbank response to the Great Recession and the COVID-19 pandemic to the “inherent uncertainty of outcomes” instead of as evidence of the advantages of a targeted approach.

That means things could change again as the risk-reward dynamic in subprime changes.