Banking Systems, 2e © Cengage/South-Western Slide 1 BANK LOANS Consumer Loan Theory Consumer Loans Granting and Analyzing Credit Cost of Credit Bank Loans and Policy 7

Banking Systems, 2e © Cengage/South-Western Slide CONSUMER LOAN THEORY Explain asset transformation and modern portfolio theory. Describe components of consumer lending. Explain nonloan sources of bank revenue. GOALS

Banking Systems, 2e © Cengage Learning/South-Western Slide 3 Asset transformation Modern portfolio theory (MPT) Adverse selection Captive borrower Moral hazard Credit rationing TERMS

Banking Systems, 2e © Cengage Learning/South-Western Slide 4 MANAGING A BANK’S PORTFOLIO Loan categories include Consumer loans Mortgage loans Commercial loans

Banking Systems, 2e © Cengage Learning/South-Western Slide 5

Banking Systems, 2e © Cengage Learning/South-Western Slide 6 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.

Banking Systems, 2e © Cengage Learning/South-Western Slide 7 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

Banking Systems, 2e © Cengage Learning/South-Western Slide 8 What is asset transformation?  checkpoint

Banking Systems, 2e © Cengage Learning/South-Western Slide 9 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

Banking Systems, 2e © Cengage Learning/South-Western Slide 10 Moral hazard 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

Banking Systems, 2e © Cengage Learning/South-Western Slide 11 DOWNSTREAM LOAN PROFIT Securitization When individual loans are pooled together and sold as securities

Banking Systems, 2e © Cengage Learning/South-Western Slide 12 What is adverse selection?  checkpoint

Banking Systems, 2e © Cengage Learning/South-Western Slide 13 ADDITIONAL SOURCES OF BANK REVENUE Banks generate revenue from Astutely managing loan portfolios Charging a variety of fees

Banking Systems, 2e © Cengage Learning/South-Western Slide 14 OFF-BALANCE SHEET ACTIVITIES Balance sheet 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.

Banking Systems, 2e © Cengage Learning/South-Western Slide 15 Off-balance sheet activities include Overdraft protection Letters of credit Flex line When overdraft protection is linked to a home equity line of credit

Banking Systems, 2e © Cengage Learning/South-Western Slide 16 OTHER REVENUE SOURCES Account service charges Safe deposit box rental ATM charges Insurance sales fees Trading fees

Banking Systems, 2e © Cengage Learning/South-Western Slide 17

Banking Systems, 2e © Cengage Learning/South-Western Slide 18 What are three methods of providing overdraft protection?  checkpoint

Banking Systems, 2e © Cengage/South-Western Slide CONSUMER LOANS Define major terms associated with consumer lending. Explain the difference between installment loans and open-end loans. GOALS

Banking Systems, 2e © Cengage Learning/South-Western Slide 20 Installment loan Secured loan Collateral Lien Unsecured loan Open-end loan Grace period TERMS

Banking Systems, 2e © Cengage Learning/South-Western Slide 21 INSTALLMENT LOANS Consumer loans 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

Banking Systems, 2e © Cengage Learning/South-Western Slide 22 Personal loans Vehicle loans Home equity loans Education loans

Banking Systems, 2e © Cengage Learning/South-Western Slide 23 SECURED AND UNSECURED LOANS Secured loan Some item of value backs the loan in case the borrower defaults on the loan Collateral An item of value that secures a loan

Banking Systems, 2e © Cengage Learning/South-Western Slide 24 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

Banking Systems, 2e © Cengage Learning/South-Western Slide 25 LENDING TERMINOLOGY Principal The amount borrowed Interest The amount you pay to use the principal Fixed rate Variable rate Indexed rate

Banking Systems, 2e © Cengage Learning/South-Western Slide 26 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

Banking Systems, 2e © Cengage Learning/South-Western Slide 27 Fees Other charges for the loan Finance charge The total dollar amount to be paid for the loan Total payments The total amount a consumer must repay

Banking Systems, 2e © Cengage Learning/South-Western Slide 28 Payment The amount the borrower repays each specified period Acceleration clause Brings the entire loan due if payments are missed

Banking Systems, 2e © Cengage Learning/South-Western Slide 29 What is the difference between a secured loan and an unsecured loan?  checkpoint

Banking Systems, 2e © Cengage Learning/South-Western Slide 30 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

Banking Systems, 2e © Cengage Learning/South-Western Slide 31 CREDIT CARDS 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

Banking Systems, 2e © Cengage Learning/South-Western Slide 32 LINES OF CREDIT Line-of-credit plans Home equity reserve Overdraft protection plan Consumers can draw upon this credit as needed

Banking Systems, 2e © Cengage Learning/South-Western Slide 33 What is an open-end loan?  checkpoint

Banking Systems, 2e © Cengage/South-Western Slide GRANTING AND ANALYZING CREDIT List steps in the credit-approval process. Identify major criteria in a person’s credit rating. GOALS

Banking Systems, 2e © Cengage Learning/South-Western Slide 35 Underwriting Subprime rates Consumer reporting agency (CRA) FICO score TERMS

Banking Systems, 2e © Cengage Learning/South-Western Slide 36 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.

Banking Systems, 2e © Cengage Learning/South-Western Slide 37 RISK MANAGEMENT Credit-related risk management policies include consideration of The bank’s overall financial position Reserve requirements Cash flow Ratio analyses of liabilities and assets

Banking Systems, 2e © Cengage Learning/South-Western Slide 38 CREDIT-APPROVAL PROCESS Application Documentation Processing Underwriting Reviewing the loan for soundness Making sure the loan is a prudent use of bank funds

Banking Systems, 2e © Cengage Learning/South-Western Slide 39 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

Banking Systems, 2e © Cengage Learning/South-Western Slide 40 Closing Funding

Banking Systems, 2e © Cengage Learning/South-Western Slide 41 What is underwriting?  checkpoint

Banking Systems, 2e © Cengage Learning/South-Western Slide 42 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.

Banking Systems, 2e © Cengage Learning/South-Western Slide 43 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

Banking Systems, 2e © Cengage Learning/South-Western Slide 44 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.

Banking Systems, 2e © Cengage Learning/South-Western Slide 45 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.

Banking Systems, 2e © Cengage Learning/South-Western Slide 46 FICOFICO 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)

Banking Systems, 2e © Cengage Learning/South-Western Slide 47 What is a consumer reporting agency?  checkpoint

Banking Systems, 2e © Cengage/South-Western Slide COST OF CREDIT Identify key factors in the cost of credit. Explain the impact of negative credit ratings on consumers. GOALS

Banking Systems, 2e © Cengage Learning/South-Western Slide 49 Revolving credit Sum-of-digits method Previous balance method Adjusted balance method Average daily balance method Predatory lending TERMS

Banking Systems, 2e © Cengage Learning/South-Western Slide 50 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.

Banking Systems, 2e © Cengage Learning/South-Western Slide 51 REVIEWING APR AND FINANCE CHARGE APR 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.

Banking Systems, 2e © Cengage Learning/South-Western Slide 52 SUM-OF-DIGITS METHOD If interest is paid first 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

Banking Systems, 2e © Cengage Learning/South-Western Slide 53

Banking Systems, 2e © Cengage Learning/South-Western Slide 54 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

Banking Systems, 2e © Cengage Learning/South-Western Slide 55 AVERAGE DAILY BALANCE METHOD 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.

Banking Systems, 2e © Cengage Learning/South-Western Slide 56 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.

Banking Systems, 2e © Cengage Learning/South-Western Slide 57 TERMTERM For installment loans, length of term also affects the total finance charge. Lenders must disclose the total payments.

Banking Systems, 2e © Cengage Learning/South-Western Slide 58 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

Banking Systems, 2e © Cengage Learning/South-Western Slide 59

Banking Systems, 2e © Cengage Learning/South-Western Slide 60 Why is it a good idea for consumers to pay more than their minimum balances on open- ended credit accounts?  checkpoint

Banking Systems, 2e © Cengage Learning/South-Western Slide 61 THE IMPACT OF CREDIT Healthy economic growth depends upon healthy use of credit.

Banking Systems, 2e © Cengage Learning/South-Western Slide 62 OVEREXTENSIONOVEREXTENSION 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

Banking Systems, 2e © Cengage Learning/South-Western Slide 63 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.

Banking Systems, 2e © Cengage Learning/South-Western Slide 64 CREDIT COUNSELING Credit counseling agencies can help consumers Reorganize debt Renegotiate terms Consumers should use counseling agencies with caution. Some agencies want to make a profit

Banking Systems, 2e © Cengage Learning/South-Western Slide 65 Why do consumers become overextended?  checkpoint

Banking Systems, 2e © Cengage/South-Western Slide BANK LOANS AND POLICY Explain how loans affect a bank’s income. Describe the purpose of a bank’s loan policy committee. GOALS

Banking Systems, 2e © Cengage Learning/South-Western Slide 67 Liquidity risk Credit risk Market risk TERMS

Banking Systems, 2e © Cengage Learning/South-Western Slide 68 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

Banking Systems, 2e © Cengage Learning/South-Western Slide 69 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

Banking Systems, 2e © Cengage Learning/South-Western Slide 70 Liquidity risk The risk that a bank will have to sell its assets at a loss to meet its cash demands

Banking Systems, 2e © Cengage Learning/South-Western Slide 71 CREDIT AND MARKET RISK Credit 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

Banking Systems, 2e © Cengage Learning/South-Western Slide 72 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

Banking Systems, 2e © Cengage Learning/South-Western Slide 73 How do credit risk and market risk differ?  checkpoint

Banking Systems, 2e © Cengage Learning/South-Western Slide 74 LOAN POLICY COMMITTEE Lending policy A written statement of the guidelines and standards to follow in making credit decisions Loan policy committee Sets a bank’s lending policy

Banking Systems, 2e © Cengage Learning/South-Western Slide 75 Five factors are reviewed when administering commercial loans. Cash flow Liquidity Leverage Collateral Management

Banking Systems, 2e © Cengage Learning/South-Western Slide 76 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

Banking Systems, 2e © Cengage Learning/South-Western Slide 77 What is the function of a loan policy committee?  checkpoint