Shares in Lloyds Banking Group (LSE: LLOY) closed down 7% on Friday. The stock’s down a further 2% as I write on Monday (28 October). That’s a fall of 9% in two trading days – quite a big drop for a FTSE 100 stock.

The bank’s share price slump was triggered by news of a Court of Appeal ruling that could potentially lead to higher compensation costs for the motor finance industry.

Why this matters

Lloyds’ Black Horse subsidiary is the UK’s largest car finance provider, with around a third of the market. And it’s one of several UK firms currently involved in an investigation by the Financial Conduct Authority (FCA) into historic motor finance commission payments.

In short, the FCA’s reviewing whether commission payments made by finance providers to used car dealers were not correctly disclosed to car buyers. Friday’s news related to a case involving Close Brothers Group, another big UK motor finance provider.

The case related to a single complaint. But the fear among lenders is that the FCA may use this ruling to take a stricter approach on compensation than previously expected. This could lead to much higher compensation costs for all affected lenders.

Lloyds has already set aside £450m to cover compensation. But in a statement this morning, the bank said the ruling “set a higher bar for disclosure” than “had been understood … prior to the decision”.

As a result, Lloyds says it’s now “assessing the potential impact of the decisions”.

What happens now?

Close Brothers has said it intends to appeal last week’s decision to the UK Supreme Court. It might yet be reversed.

Lloyds has around £15bn of motor finance loans, giving it around a third of the UK market. While this is a big number, it’s only a small part of the group’s overall loan book of around £450bn – mostly home mortgages.

I’m confident Lloyds can handle any possible compensation payouts that might become necessary. But the question for potential investors – including me – is how the cost of this might affect shareholder returns.

Is this another PPI?

Experienced investors may remember the PPI scandal. The big UK banks were forced to pay out more than £50bn in compensation for mis-sold payment protection insurance. Lloyds was the biggest payer, shelling out more than £20bn in compensation.

Some City analysts believe the FCA’s motor finance probe could be the next PPI. Estimates reported in the Financial Times from leading brokers have pegged the potential total cost for motor finance lenders at between £6bn and £16bn.

Buy Lloyds at under 60p?

Nothing’s certain yet. The FCA isn’t expected to provide another update on its progress until May 2025.

For now, Lloyds’ recent third-quarter update suggests current trading’s solid enough. The forecast dividend yield of 5.6% looks safe to me, as it should be covered twice by 2024 earnings.

The risk, in my view, is that the motor finance review could lead to a multi-year drag on profitability and shareholder returns. That’s what happened with PPI.

I prefer to avoid this kind of regulatory risk, so I’d look elsewhere if I was buying a banking stock today.