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Floorplan finance is commonly used in the automotive industry by dealers to purchase inventory. However, there can be a fair amount of risk for floorplan finance lenders since they don’t have complete control over the vehicles on which the loan is secured. For this reason, audits are regularly scheduled to protect the lender’s collateral and try to ensure that dealerships don’t default on their loans.
With audits as a critical risk management tool for floorplan lenders, it’s crucial that they are conducted properly – and that anomalies and violations are used to improve processes. All too often, however, audits are conducted without a clear understanding of how to best use their findings to mitigate risk, too inconsistently to compare like with like, or too infrequently to inform timely decision-making properly.
Risks Associated with Floor Plan Lending
The primary risk in floorplan lending is credit risk. Dealers often have low collateral margins and face the potential depreciation of their assets, making it difficult to recover from default risks if they occur in loans made against the dealer’s inventory.
However, floorplan lending can be a strategic, profitable and low-risk activity if correctly monitored and controlled. Unnecessary risk arises from poor borrower credit analysis and risk selection, weak underwriting, and poor collateral controls and monitoring. By taking the necessary precautions, lenders can ensure that their floorplan lending activities remain well managed and profitable.
Selling Vehicles out of Trust
A key issue for floor plan funders is discovering vehicles that have been sold out of trust.
This happens when a dealer sells a vehicle but doesn’t pay off the loan promptly, perhaps using the funds to cover other expenses. The funder is then left without any security for the loan.
This type of issue can be discovered during an audit, but it’s often after the fact – by which time, it may be too late to do anything about it.
Why does a dealer sell out of trust?
There could be several reasons:
- The dealer may be temporarily facing cash flow difficulties and using the loan proceeds to cover other expenses in a “Peter to pay Paul” cycle.
- The dealer might not have intentionally sold the vehicle out of trust but just have poor internal admin and controls to stay on top of funding admin.
- The dealer may be intentionally trying to defraud the lender where they are consciously flouting the terms of their loan.
- There may be a miscommunication or omission within the dealership that leads to the improper use of loan proceeds
Whatever the reason, the consequences of selling out of trust can be severe, both for the dealer and those caught up in the chain – other dealers, creditors and customers. For example, the buyer of a vehicle may not be able to get the title to the car they are driving because the dealer did not clear the title at the time of sale.
When a dealer is discovered to have a vehicle sold out of trust, there needs to be immediate and decisive action taken.
However, dealing with all instances of finding a vehicle sold out of trust, in the same way, will likely be unnecessarily ‘blunt’ and impact business opportunities.
There’s a case to be made that not all violations should carry the same consequences. For example, suppose a dealer has a long-standing relationship with the lender and has been an otherwise good customer, they may be just facing a cashflow pinch. In that case, the appropriate action may involve restructuring some debt, but it should certainly be different from a situation with a new dealership or one already deemed high risk based on persistent violations. For the latter, then selling out of trust could be the final straw that causes the funder to pull the plug on the credit line and relationship.
It’s also important to investigate the reasons behind why any vehicle was sold out of trust. In busy, multi-location dealer groups, it can very easily be an honest mistake. We have seen cases where extended ‘grace periods’ after a vehicle sale, from 24hrs to 72hrs, have eliminated ‘SOT’ violations and enabled the funder/dealer relationship to blossom.
The risk assessment should drill into the detail and take into account factors such as:
- The volume of vehicles on the floorplan
- The average input and output of vehicles each week
- The frequency of floorplan changes
- Whether vehicles are added daily but settled in one go
- The total value of vehicles sold out of trust as a percentage of the credit line
- How often audits are conducted
- The percentage of total assets that are ‘sold out of trust’
- Whether there is a history of similar violations
Once these factors have been considered, a more refined risk management strategy can be implemented for each credit line. This may involve more frequent audits, higher levels of monitoring and oversight, or increased reporting requirements. By taking a closer look at the risks involved in selling vehicles out of trust, the funder can better protect their organisation’s exposure.
Taking a Nuanced Approach
Due to difficulties in managing information relating to floorplan lending, many funders do have blunt criteria that are applied to all. However, this approach may not be the best way to manage risk.
A more nuanced and sophisticated approach would consider the different factors involved in each case and violation while using better intelligence on each dealer’s inventory situation.
One of the factors contributing to the complexity of managing risk is that funders only get to measure the risk infrequently as, traditionally, inventory audits have been carried out manually, often by finance provider staff, travelling around dealer sites to gain a snapshot of financed vehicles on site. Then, paperwork is completed and returned to the funder’s headquarters for input into their systems.
This manual process has clear disadvantages:
- The cost (and opportunity cost) of using expensive resources to travel to numerous locations to undertake the audits
- Interruption to dealer BAU as funder staff complete their reviews
- The potential for lengthy gaps between audits carried out periodically
- The degradation of the information collected before it can be input into funder systems
Funders who embrace technology and digitise the risk management process can increase the frequency of audits and the ease with which data can be gathered.
By gaining closer to ‘real time’ insights/data feeds, any violations will be less impactful, and these regular, timely snapshots will help provide a far clearer picture than infrequent and inconsistent audits.
Benefits of Digital Auditing
After many years of manual funder audits being the industry standard, the shift away from this has been welcomed. Eliminating the requirement for funders to send auditors to visit geographically disparate dealer network locations saves time, money, and emissions. Dealers are also spared the disruption to consumer sales and service activities that these visits typically cause.
Along with reducing cost and distraction from daily business, dealer self-audits allow for greater frequency of vehicle stock appraisals and, therefore, provide more accurate and timely data on which to make future funding decisions.
Via a sophisticated digital platform, CheckVentory Audit goes beyond providing an accurate and up-to-date view of dealerships’ portfolios; it actively assists in identifying those dealer groups that provide the most significant opportunities for growth for financing solutions and highlights potential risk issues.
Aligned to a Banking Evolution
Risk functions in banks have to evolve to meet the needs of an ever-changing business landscape. In particular, they must be able to adapt to new regulatory requirements, new technologies, and changing customer expectations.
Banks have long used technology to automate repetitive tasks and improve efficiency. However, they are now beginning to harness its power to provide insights that can help them make better decisions about risk.
“If banks want their risk functions to thrive during this period of fundamental transformation, they need to rebuild them during the next decade. To be successful, they need to start now with a portfolio of initiatives that balance a strong short-term business case with enabling the long-term achievement of the target vision. Such initiatives could include digitising the underwriting processes, use of machine-learning techniques, and interactive risk reporting.”McKinsey report – the future of bank risk management
One of the trends covered in the McKinsey report is the use of ‘technology and analytics as a risk muscle’.
New technology brings increased computing power, better data storage and innovations that can support and enable new risk management techniques. Trends such as Big Data and machine learning can provide greater refinement, accuracy and speed to risk modelling.
As pressures on margins continue, banks will be seeking opportunities for cost savings and reassessing operating costs. Risk functions will not be exempted from this drive and will need to explore ways to improve efficiency.
Digital auditing is a simple way to save time and reduce costs. It can also improve accuracy by providing a real-time view of risk.
Risk management is no longer a static, compliance-based function. It must be proactive, strategic and agile enough to meet the challenges of a rapidly changing business environment. By embracing new technologies, banks can equip themselves to make better decisions and optimise profitability.