6 BANK LOANS 6.1 Consumer Loan Theory 6.2 Consumer Loans Banking 5/27/2018 BANK LOANS 6 6.1 Consumer Loan Theory 6.2 Consumer Loans 6.3 Granting and Analyzing Credit 6.4 Cost of Credit 6.5 Bank Loans and Policy Chapter 1

GOALS Explain asset transformation and modern portfolio theory. Banking 5/27/2018 6.1 CONSUMER LOAN THEORY GOALS Explain asset transformation and modern portfolio theory. Describe components of consumer lending. Explain nonloan sources of bank revenue. Chapter 1

TERMS Asset transformation Modern portfolio theory (MPT) Adverse selection Captive borrower Moral hazard Credit rationing

MANAGING A BANK’S PORTFOLIO Loan categories include Consumer loans Mortgage loans Commercial loans

ASSET MANAGEMENT Asset transformation Using deposits to generate revenue by putting deposits to work via loans When banks transform liabilities (deposits) into assets (loans), asset transformation has occurred.

MODERN PORTFOLIO THEORY Modern portfolio theory (MPT) Within any portfolio of investments, diversification should be used to spread out risk Variation by industry Variation by maturity dates

checkpoint What is asset transformation?

CONSUMER LENDING THEORY Loan selection Adverse selection Borrowers who are most willing to accept a high interest rate are the same borrowers who are most likely to default on their loans Captive borrower When borrowers with certain credit characteristics are more likely to prefer one type of lender to another

Moral hazard Credit rationing When a borrower takes greater risks if they think the harm they will incur from those risks will somehow be minimalized Credit rationing When banks refuse to provide a loan, or when they lend less than the customer requested

DOWNSTREAM LOAN PROFIT Securitization When individual loans are pooled together and sold as securities

checkpoint What is adverse selection?

ADDITIONAL SOURCES OF BANK REVENUE Banks generate revenue from Astutely managing loan portfolios Charging a variety of fees

OFF-BALANCE SHEET ACTIVITIES A brief summary that lists the net profit, owner’s equity, assets, and liabilities for a company Public companies have public balance sheets. Seen by investors Off-balance sheet activities are not seen by investors.

Off-balance sheet activities include Overdraft protection Letters of credit Flex line When overdraft protection is linked to a home equity line of credit

OTHER REVENUE SOURCES Account service charges Safe deposit box rental ATM charges Insurance sales fees Trading fees

checkpoint What are three methods of providing overdraft protection?

GOALS Define major terms associated with consumer lending. Banking 5/27/2018 6.2 CONSUMER LOANS GOALS Define major terms associated with consumer lending. Explain the difference between installment loans and open-end loans. Chapter 1

TERMS Installment loan Secured loan Collateral Lien Unsecured loan Open-end loan Grace period

INSTALLMENT LOANS Consumer loans Installment loan Installment loans Open-end loans Installment loan A loan for which the amount of the payments, the rate of interest, and the number of payments (or length of term) are fixed Repaid on a periodic basis

Personal loans Vehicle loans Home equity loans Education loans

SECURED AND UNSECURED LOANS Some item of value backs the loan in case the borrower defaults on the loan Collateral An item of value that secures a loan

Unsecured loan (signature loan) Lien A legal claim to the property to secure the debt Unsecured loan (signature loan) A loan backed only by the reputation and creditworthiness of the borrower

LENDING TERMINOLOGY Principal Interest The amount borrowed The amount you pay to use the principal Fixed rate Variable rate Indexed rate

It is important to know how interest is calculated. Calculated on the declining principal balance as payments are made Or Payments go toward the interest first, then toward the balance

Fees Finance charge Total payments Other charges for the loan The total dollar amount to be paid for the loan Total payments The total amount a consumer must repay

Payment Acceleration clause The amount the borrower repays each specified period Acceleration clause Brings the entire loan due if payments are missed

checkpoint What is the difference between a secured loan and an unsecured loan?

OPEN-END LOANS Open-end loan The amount owed is flexible The longer you use the money, the more you pay The term is flexible

Credit cards are a form of consumer loan. Grace period An amount of time you have to pay the bill in full and avoid any finance charges

LINES OF CREDIT Line-of-credit plans Home equity reserve Overdraft protection plan Consumers can draw upon this credit as needed

checkpoint What is an open-end loan?

6.3 GRANTING AND ANALYZING CREDIT Banking 5/27/2018 6.3 GRANTING AND ANALYZING CREDIT GOALS List steps in the credit-approval process. Identify major criteria in a person’s credit rating. Chapter 1

TERMS Underwriting Subprime rates Consumer reporting agency (CRA) FICO score

GRANTING CREDIT Every borrower represents a potential risk to the lender. Banks use a well-defined policy of risk management to minimize the risk associated with loans.

Credit-related risk management policies include consideration of The bank’s overall financial position Reserve requirements Cash flow Ratio analyses of liabilities and assets

CREDIT-APPROVAL PROCESS Application Documentation Processing Underwriting Reviewing the loan for soundness Making sure the loan is a prudent use of bank funds

The three Cs of underwriting Collateral Capacity Credit reputation Subprime rates Higher than normal rates set to offset the increased risk represented by a less-than-perfect borrower

Closing Funding

checkpoint What is underwriting?

A key factor underwriters review is credit history. ANALYZING CREDIT A key factor underwriters review is credit history. The best way to predict the future is to see how a person has done in the past.

CONSUMER REPORTING AGENCIES Consumer reporting agency (CRA) A company that compiles and keeps records on consumer payment habits and sells these reports to banks and other companies to use for evaluating creditworthiness

Three Major Reporting Agencies

Most credit reports contain the following types of information: Personal data Accounts history Delinquent accounts Public records Inquiries Consumers are entitled to a free credit report each year.

Example of Credit Report

CREDIT-SCORING SYSTEM A credit-scoring system can provide an efficient and unbiased method of evaluating credit. These scores place a numerical value on the performance or status of an applicant in various categories. The points in each category are added for a total score.

FICO FICO score A three-digit number that credit granters can use in making a loan approval decision Payment history (35 percent) Amounts owed (30 percent) Length of credit history (15 percent) New credit (10 percent) Types of credit (10 percent)

Credit Score Makeup

FICO Score Breakdowns

When To Request Your Copy?

Creditkarma.com

FICO Credit Score Alternative Resource http://www.myfico.com/

checkpoint What is a consumer reporting agency?

GOALS Identify key factors in the cost of credit. Banking 5/27/2018 6.4 COST OF CREDIT GOALS Identify key factors in the cost of credit. Explain the impact of negative credit ratings on consumers. Chapter 1

TERMS Revolving credit Sum-of-digits method Previous balance method Adjusted balance method Average daily balance method Predatory lending

Credit cards are an example of revolving credit. WHAT CREDIT COSTS Revolving credit A line of credit that has a maximum limit Can be used on an ongoing basis until the limit is reached When the balance (or a portion of the balance) is paid off, the credit can be used again until the next time the maximum is met. Credit cards are an example of revolving credit.

REVIEWING APR AND FINANCE CHARGE The amount of interest charged on the loan principal expressed as a yearly figure Understanding the total finance charge depends on how interest charges are applied. Lenders can calculate interest in many different ways, as long as they explain clearly what they are.

If interest is paid first Sum-of-digits method Paying ahead saves the consumer no money Sum-of-digits method Takes the total finance charge, divides it by the number of months in the loan term, and assigns a higher ratio of interest to the early payments Rule of 78

PREVIOUS AND ADJUSTED BALANCE METHODS Previous balance method Taking the amount owed at the beginning of the billing cycle and calculating interest on that figure Regardless of payments or charges Adjusted balance method Subtracting payments made during the billing cycle Usually not counting purchases

AVERAGE DAILY BALANCE METHOD The balances for each day of the billing cycle are added and then divided by the number of days in the billing cycle to yield an average figure on which the finance charge is calculated.

MINIMUM PAYMENTS Lower minimum payments increase bank profits, but contribute to greater consumer debt. Although paying the minimum payment keeps the account in good standing, it doesn’t reduce the principal much.

TERM For installment loans, length of term also affects the total finance charge. Lenders must disclose the total payments.

Based on individual circumstances, consumers should choose between Taking a shorter loan Higher monthly payments Lower total payments Taking a longer loan Lower monthly payments Higher total payments

checkpoint Why is it a good idea for consumers to pay more than their minimum balances on open-ended credit accounts?

THE IMPACT OF CREDIT Healthy economic growth depends upon healthy use of credit.

Overextension can result in A ruined credit rating Notations of bad credit in your credit record for a seven year period A more difficult daily life With disposable income going to service debt

Excessive consumer debt is not in banks’ interest. THE ROLE OF BANKS Predatory lending When lenders create problems for consumers by making credit too easily available without regard to the borrower’s ability to pay Excessive consumer debt is not in banks’ interest.

Credit counseling agencies can help consumers Reorganize debt Renegotiate terms Consumers should use counseling agencies with caution. Some agencies want to make a profit

checkpoint Why do consumers become overextended?

GOALS Explain how loans affect a bank’s income. Banking 5/27/2018 6.5 BANK LOANS AND POLICY GOALS Explain how loans affect a bank’s income. Describe the purpose of a bank’s loan policy committee. Chapter 1

TERMS Liquidity risk Credit risk Market risk

LOANS, THE “BOTTOM LINE,” AND LIQUIDITY Loans and income Loans are a major income source. The loan policies a bank sets must protect its income. Default Failure to repay a loan as called for in the loan contract

Loan factors that affect the lending bank’s liquidity include LOANS AND LIQUIDITY Liquidity Having the funds to meet obligations when required Loan factors that affect the lending bank’s liquidity include Loan term Interest rate Loan type Collateral

Liquidity risk The risk that a bank will have to sell its assets at a loss to meet its cash demands

CREDIT AND MARKET RISK Credit risk Market risk The bank’s estimate of the probability that the borrower can and will repay a loan with interest as scheduled Market risk The risk that an investment will decrease in price as market conditions change

LOAN DECISIONS AND TRADE- OFFS Making loan decisions is a difficult process that generally requires weighing one factor against another. Short-term loan Low risk, relatively quick liquidity, low interest rate Relatively low profit Long-term loan More risk and liquidity concerns, higher interest rate Higher profit

checkpoint How do credit risk and market risk differ?

LOAN POLICY COMMITTEE Lending policy Loan policy committee A written statement of the guidelines and standards to follow in making credit decisions Loan policy committee Sets a bank’s lending policy

Five factors are reviewed when administering commercial loans. Cash flow Liquidity Leverage Collateral Management

Community Reinvestment Act (CRA) The federal law requiring banks to meet the credit needs of the entire communities they serve, including those with low and moderate income

checkpoint What is the function of a loan policy committee?