Designing Dealer Compensation in the Auto Loan Market: Implications from a Policy Experiment

Abstract

We study dealer compensation in the indirect auto lending market, where most lenders give dealers the discretion to mark up interest rates and the markup constitutes a dealer's compensation. To protect consumers from potential discrimination by this dealer discretion, several banks adopted a policy that removes dealer discretion and compensates dealers by a fixed percentage of the loan amount. We document that this policy decreased (increased) the interest rates for low-credit (high-credit) consumers; however, the market share of these banks also decreased (increased) in low-credit (high-credit) segments — a reversal of the usual demand curve. This reversal highlights a significant influence of auto dealers on consumer choices. Accordingly, we develop an empirical model that features dealer–consumer bargaining. Our estimation results show systematically different levels of bargaining power across consumer groups. We use the model to explore alternative compensation schemes that remove dealer discretion. We find that a lump-sum compensation scheme obtains the most market share. In addition, the optimized lump-sum scheme improves consumer welfare compared to the adopted policy. Our study highlights the importance of accounting for the incentives and bargaining power of middlepersons.

Keywords: auto loan, interest-rate markup, dealer compensation, consumer protection, Nash bargaining