Portfolio Risk in Automotive Finance

Over the past decades, automotive finance has become an industry in its own right. Beyond the financial service entities of automotive groups, many banks, bank-owned and independent finance companies operate significant auto loan and lease portfolios. While their automotive operations have experienced a period of dynamic growth and high returns, the situation is currently changing. Maturing markets and a growing number of market participants have made automotive finance an increasingly competitive business.

Maintaining profitable growth in this dynamic environment requires any of the players in the industry to keep a careful balance between risk and expected return. In this situation, the role of risk management as a source of competitive advantage is certain to grow. It is the accurate assessment of portfolio risk that poses the greatest challenge in this respect. The risks inherent in automotive portfolios differ significantly from those in conventional banking. The strong representation of lease exposures and the focus on a single type of collateral link financial risk to the underlying automotive markets. Established portfolio models fail to come up to the requirements this fact imposes on risk management. Their major shortcoming is their inability to account for residual value risk. Consequently, institutions engaged in automotive finance lack concepts to measure and thus price the risk inherent in their portfolios adequately, leaving risk managers and academics with a challenging problem.

The author has taken this challenge. In the present publication he develops an industry-specific portfolio model providing an integrated approach to the assessment of default, recovery and residual value risk while accounting for their interaction at portfolio level. This model builds on empirical research using a sample of over 450,000 contracts from the portfolio of a global player in automotive finance.