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Banking Systems, 2e © Cengage/South-Western Slide 1 1 BANK LOANS 7.1 7.1 Consumer Loan Theory 7.2 7.2 Consumer Loans 7.3 7.3 Granting and Analyzing Credit 7.4 7.4 Cost of Credit 7.5 7.5 Bank Loans and Policy 7 7

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Page 1: Banking Systems, 2e © Cengage/South-Western Slide 1 BANK LOANS 7.1 7.1 Consumer Loan Theory 7.2 7.2 Consumer Loans 7.3 7.3 Granting and Analyzing Credit

Banking Systems, 2e© Cengage/South-Western Slide 11

BANK LOANS

7.17.1 Consumer Loan Theory 7.27.2 Consumer Loans 7.37.3 Granting and Analyzing Credit 7.47.4 Cost of Credit7.57.5 Bank Loans and Policy

77

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Banking Systems, 2e© Cengage/South-Western Slide 22

7.1

CONSUMER LOAN THEORY

Explain asset transformation and modern portfolio theory. Describe components of consumer lending. Explain nonloan sources of bank revenue.

GOALSGOALS

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Banking Systems, 2e© Cengage Learning/South-Western Slide 33

Asset transformationModern portfolio theory (MPT)Adverse selectionCaptive borrowerMoral hazardCredit rationing

TERMSTERMS

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

MANAGING A BANK’S PORTFOLIOMANAGING A BANK’S PORTFOLIOMANAGING A BANK’S PORTFOLIOMANAGING A BANK’S PORTFOLIO

Loan categories includeConsumer loansMortgage loansCommercial loans

Page 5: Banking Systems, 2e © Cengage/South-Western Slide 1 BANK LOANS 7.1 7.1 Consumer Loan Theory 7.2 7.2 Consumer Loans 7.3 7.3 Granting and Analyzing Credit

Banking Systems, 2e© Cengage Learning/South-Western Slide 55

Page 6: Banking Systems, 2e © Cengage/South-Western Slide 1 BANK LOANS 7.1 7.1 Consumer Loan Theory 7.2 7.2 Consumer Loans 7.3 7.3 Granting and Analyzing Credit

Banking Systems, 2e© Cengage Learning/South-Western Slide 66

ASSET MANAGEMENTASSET MANAGEMENTASSET MANAGEMENTASSET MANAGEMENT

Asset transformationUsing deposits to generate revenue by putting

deposits to work via loansWhen banks transform liabilities (deposits)

into assets (loans), asset transformation has occurred.

Page 7: Banking Systems, 2e © Cengage/South-Western Slide 1 BANK LOANS 7.1 7.1 Consumer Loan Theory 7.2 7.2 Consumer Loans 7.3 7.3 Granting and Analyzing Credit

Banking Systems, 2e© Cengage Learning/South-Western Slide 77

MODERN PORTFOLIO THEORYMODERN PORTFOLIO THEORYMODERN PORTFOLIO THEORYMODERN PORTFOLIO THEORY

Modern portfolio theory (MPT)Within any portfolio of investments, diversification

should be used to spread out riskVariation by industryVariation by maturity dates

Page 8: Banking Systems, 2e © Cengage/South-Western Slide 1 BANK LOANS 7.1 7.1 Consumer Loan Theory 7.2 7.2 Consumer Loans 7.3 7.3 Granting and Analyzing Credit

Banking Systems, 2e© Cengage Learning/South-Western Slide 88

What is asset transformation?

checkpoint

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Banking Systems, 2e© Cengage Learning/South-Western Slide 99

CONSUMER LENDING THEORYCONSUMER LENDING THEORYCONSUMER LENDING THEORYCONSUMER LENDING THEORY

Loan selectionAdverse 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 borrowerWhen borrowers with certain credit characteristics are

more likely to prefer one type of lender to another

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Banking Systems, 2e© Cengage Learning/South-Western Slide 1010

Moral hazardWhen a borrower takes greater risks if they think

the harm they will incur from those risks will somehow be minimalized

Credit rationingWhen banks refuse to provide a loan, or when

they lend less than the customer requested

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Banking Systems, 2e© Cengage Learning/South-Western Slide 1111

DOWNSTREAM LOAN PROFITDOWNSTREAM LOAN PROFITDOWNSTREAM LOAN PROFITDOWNSTREAM LOAN PROFIT

SecuritizationWhen individual loans are pooled together and

sold as securities

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Banking Systems, 2e© Cengage Learning/South-Western Slide 1212

What is adverse selection?

checkpoint

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Banking Systems, 2e© Cengage Learning/South-Western Slide 1313

ADDITIONAL SOURCES OF BANK ADDITIONAL SOURCES OF BANK REVENUEREVENUEADDITIONAL SOURCES OF BANK ADDITIONAL SOURCES OF BANK REVENUEREVENUE

Banks generate revenue fromAstutely managing loan portfoliosCharging a variety of fees

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Banking Systems, 2e© Cengage Learning/South-Western Slide 1414

OFF-BALANCE SHEET ACTIVITIESOFF-BALANCE SHEET ACTIVITIESOFF-BALANCE SHEET ACTIVITIESOFF-BALANCE SHEET ACTIVITIES

Balance sheetA brief summary that lists the net profit, owner’s

equity, assets, and liabilities for a companyPublic companies have public balance

sheets.Seen by investors

Off-balance sheet activities are not seen by investors.

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Banking Systems, 2e© Cengage Learning/South-Western Slide 1515

Off-balance sheet activities includeOverdraft protectionLetters of credit

Flex lineWhen overdraft protection is linked to a home

equity line of credit

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Banking Systems, 2e© Cengage Learning/South-Western Slide 1616

OTHER REVENUE SOURCESOTHER REVENUE SOURCESOTHER REVENUE SOURCESOTHER REVENUE SOURCES

Account service chargesSafe deposit box rentalATM chargesInsurance sales feesTrading fees

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Banking Systems, 2e© Cengage Learning/South-Western Slide 1717

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Banking Systems, 2e© Cengage Learning/South-Western Slide 1818

What are three methods of providing overdraft protection?

checkpoint

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Banking Systems, 2e© Cengage/South-Western Slide 1919

7.2

CONSUMER LOANS

Define major terms associated with consumer lending.Explain the difference between installment loans and open-end loans.

GOALSGOALS

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Banking Systems, 2e© Cengage Learning/South-Western Slide 2020

Installment loanSecured loanCollateralLienUnsecured loanOpen-end loanGrace period

TERMSTERMS

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Banking Systems, 2e© Cengage Learning/South-Western Slide 2121

INSTALLMENT LOANSINSTALLMENT LOANSINSTALLMENT LOANSINSTALLMENT LOANS

Consumer loansInstallment loansOpen-end loans

Installment loanA 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

Page 22: Banking Systems, 2e © Cengage/South-Western Slide 1 BANK LOANS 7.1 7.1 Consumer Loan Theory 7.2 7.2 Consumer Loans 7.3 7.3 Granting and Analyzing Credit

Banking Systems, 2e© Cengage Learning/South-Western Slide 2222

Personal loansVehicle loansHome equity loansEducation loans

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Banking Systems, 2e© Cengage Learning/South-Western Slide 2323

SECURED AND UNSECURED LOANSSECURED AND UNSECURED LOANSSECURED AND UNSECURED LOANSSECURED AND UNSECURED LOANS

Secured loanSome item of value backs the loan in case the

borrower defaults on the loanCollateral

An item of value that secures a loan

Page 24: Banking Systems, 2e © Cengage/South-Western Slide 1 BANK LOANS 7.1 7.1 Consumer Loan Theory 7.2 7.2 Consumer Loans 7.3 7.3 Granting and Analyzing Credit

Banking Systems, 2e© Cengage Learning/South-Western Slide 2424

LienA 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

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Banking Systems, 2e© Cengage Learning/South-Western Slide 2525

LENDING TERMINOLOGYLENDING TERMINOLOGYLENDING TERMINOLOGYLENDING TERMINOLOGY

PrincipalThe amount borrowed

InterestThe amount you pay to use the principal

Fixed rateVariable rateIndexed rate

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Banking Systems, 2e© Cengage Learning/South-Western Slide 2626

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

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Banking Systems, 2e© Cengage Learning/South-Western Slide 2727

FeesOther charges for the loan

Finance chargeThe total dollar amount to be paid for the loan

Total paymentsThe total amount a consumer must repay

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Banking Systems, 2e© Cengage Learning/South-Western Slide 2828

PaymentThe amount the borrower repays each specified

periodAcceleration clause

Brings the entire loan due if payments are missed

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Banking Systems, 2e© Cengage Learning/South-Western Slide 2929

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

checkpoint

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Banking Systems, 2e© Cengage Learning/South-Western Slide 3030

OPEN-END LOANSOPEN-END LOANSOPEN-END LOANSOPEN-END LOANS

Open-end loanThe amount owed is flexible

The longer you use the money, the more you payThe term is flexible

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Banking Systems, 2e© Cengage Learning/South-Western Slide 3131

CREDIT CARDSCREDIT CARDSCREDIT CARDSCREDIT 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

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Banking Systems, 2e© Cengage Learning/South-Western Slide 3232

LINES OF CREDITLINES OF CREDITLINES OF CREDITLINES OF CREDIT

Line-of-credit plansHome equity reserveOverdraft protection planConsumers can draw upon this credit as needed

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Banking Systems, 2e© Cengage Learning/South-Western Slide 3333

What is an open-end loan?

checkpoint

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Banking Systems, 2e© Cengage/South-Western Slide 3434

7.3

GRANTING AND ANALYZING CREDIT

List steps in the credit-approval process.Identify major criteria in a person’s credit rating.

GOALSGOALS

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Banking Systems, 2e© Cengage Learning/South-Western Slide 3535

UnderwritingSubprime ratesConsumer reporting agency (CRA)FICO score

TERMSTERMS

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Banking Systems, 2e© Cengage Learning/South-Western Slide 3636

GRANTING CREDITGRANTING CREDITGRANTING CREDITGRANTING 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.

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Banking Systems, 2e© Cengage Learning/South-Western Slide 3737

RISK MANAGEMENTRISK MANAGEMENTRISK MANAGEMENTRISK MANAGEMENT

Credit-related risk management policies include consideration ofThe bank’s overall financial positionReserve requirements Cash flowRatio analyses of liabilities and assets

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Banking Systems, 2e© Cengage Learning/South-Western Slide 3838

CREDIT-APPROVAL PROCESSCREDIT-APPROVAL PROCESSCREDIT-APPROVAL PROCESSCREDIT-APPROVAL PROCESS

ApplicationDocumentationProcessingUnderwriting

Reviewing the loan for soundnessMaking sure the loan is a prudent use of bank

funds

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Banking Systems, 2e© Cengage Learning/South-Western Slide 3939

The three Cs of underwritingCollateralCapacityCredit reputation

Subprime ratesHigher than normal rates set to offset the

increased risk represented by a less-than-perfect borrower

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Banking Systems, 2e© Cengage Learning/South-Western Slide 4040

ClosingFunding

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Banking Systems, 2e© Cengage Learning/South-Western Slide 4141

What is underwriting?

checkpoint

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Banking Systems, 2e© Cengage Learning/South-Western Slide 4242

ANALYZING CREDITANALYZING CREDITANALYZING CREDITANALYZING 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.

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Banking Systems, 2e© Cengage Learning/South-Western Slide 4343

CONSUMER REPORTING AGENCIESCONSUMER REPORTING AGENCIESCONSUMER REPORTING AGENCIESCONSUMER 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

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Banking Systems, 2e© Cengage Learning/South-Western Slide 4444

Most credit reports contain the following types of information:Personal dataAccounts historyDelinquent accountsPublic recordsInquiries

Consumers are entitled to a free credit report each year.

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Banking Systems, 2e© Cengage Learning/South-Western Slide 4545

CREDIT-SCORING SYSTEMCREDIT-SCORING SYSTEMCREDIT-SCORING SYSTEMCREDIT-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.

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Banking Systems, 2e© Cengage Learning/South-Western Slide 4646

FICOFICOFICOFICO

FICO scoreA three-digit number that credit granters can use

in making a loan approval decisionPayment history (35 percent)Amounts owed (30 percent)Length of credit history (15 percent)New credit (10 percent)Types of credit (10 percent)

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Banking Systems, 2e© Cengage Learning/South-Western Slide 4747

What is a consumer reporting agency?

checkpoint

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Banking Systems, 2e© Cengage/South-Western Slide 4848

7.4

COST OF CREDIT

Identify key factors in the cost of credit.Explain the impact of negative credit ratings on consumers.

GOALSGOALS

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Banking Systems, 2e© Cengage Learning/South-Western Slide 4949

Revolving creditSum-of-digits methodPrevious balance methodAdjusted balance methodAverage daily balance methodPredatory lending

TERMSTERMS

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Banking Systems, 2e© Cengage Learning/South-Western Slide 5050

WHAT CREDIT COSTSWHAT CREDIT COSTSWHAT CREDIT COSTSWHAT CREDIT COSTS

Revolving creditA line of credit that has a maximum limitCan be used on an ongoing basis until the limit is

reachedWhen 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.

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Banking Systems, 2e© Cengage Learning/South-Western Slide 5151

REVIEWING APR AND FINANCE REVIEWING APR AND FINANCE CHARGECHARGEREVIEWING APR AND FINANCE REVIEWING APR AND FINANCE CHARGECHARGE

APRThe amount of interest charged on the loan

principal expressed as a yearly figureUnderstanding 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.

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Banking Systems, 2e© Cengage Learning/South-Western Slide 5252

SUM-OF-DIGITS METHODSUM-OF-DIGITS METHODSUM-OF-DIGITS METHODSUM-OF-DIGITS METHOD

If interest is paid firstPaying ahead saves the consumer no money

Sum-of-digits methodTakes 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

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Banking Systems, 2e© Cengage Learning/South-Western Slide 5353

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Banking Systems, 2e© Cengage Learning/South-Western Slide 5454

PREVIOUS AND ADJUSTED PREVIOUS AND ADJUSTED BALANCE METHODSBALANCE METHODSPREVIOUS AND ADJUSTED PREVIOUS AND ADJUSTED BALANCE METHODSBALANCE METHODS

Previous balance methodTaking the amount owed at the beginning of the

billing cycle and calculating interest on that figure Regardless of payments or charges

Adjusted balance methodSubtracting payments made during the billing

cycle Usually not counting purchases

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Banking Systems, 2e© Cengage Learning/South-Western Slide 5555

AVERAGE DAILY BALANCE AVERAGE DAILY BALANCE METHODMETHODAVERAGE DAILY BALANCE AVERAGE DAILY BALANCE METHODMETHOD

Average daily balance methodThe 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.

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Banking Systems, 2e© Cengage Learning/South-Western Slide 5656

MINIMUM PAYMENTSMINIMUM PAYMENTSMINIMUM PAYMENTSMINIMUM 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.

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Banking Systems, 2e© Cengage Learning/South-Western Slide 5757

TERMTERMTERMTERM

For installment loans, length of term also affects the total finance charge.

Lenders must disclose the total payments.

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Banking Systems, 2e© Cengage Learning/South-Western Slide 5858

Based on individual circumstances, consumers should choose betweenTaking a shorter loan

Higher monthly paymentsLower total payments

Taking a longer loanLower monthly paymentsHigher total payments

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Banking Systems, 2e© Cengage Learning/South-Western Slide 5959

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Banking Systems, 2e© Cengage Learning/South-Western Slide 6060

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

checkpoint

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Banking Systems, 2e© Cengage Learning/South-Western Slide 6161

THE IMPACT OF CREDITTHE IMPACT OF CREDITTHE IMPACT OF CREDITTHE IMPACT OF CREDIT

Healthy economic growth depends upon healthy use of credit.

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Banking Systems, 2e© Cengage Learning/South-Western Slide 6262

OVEREXTENSIONOVEREXTENSIONOVEREXTENSIONOVEREXTENSION

Overextension can result inA ruined credit ratingNotations of bad credit in your credit record for a

seven year periodA more difficult daily life

With disposable income going to service debt

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Banking Systems, 2e© Cengage Learning/South-Western Slide 6363

THE ROLE OF BANKSTHE ROLE OF BANKSTHE ROLE OF BANKSTHE ROLE OF BANKS

Predatory lendingWhen 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.

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Banking Systems, 2e© Cengage Learning/South-Western Slide 6464

CREDIT COUNSELINGCREDIT COUNSELINGCREDIT COUNSELINGCREDIT COUNSELING

Credit counseling agencies can help consumersReorganize debtRenegotiate terms

Consumers should use counseling agencies with caution.Some agencies want to make a profit

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Banking Systems, 2e© Cengage Learning/South-Western Slide 6565

Why do consumers become overextended?

checkpoint

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7.5

BANK LOANS AND POLICY

Explain how loans affect a bank’s income. Describe the purpose of a bank’s loan policy committee.

GOALSGOALS

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Liquidity riskCredit riskMarket risk

TERMSTERMS

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LOANS, THE “BOTTOM LINE,” AND LOANS, THE “BOTTOM LINE,” AND LIQUIDITYLIQUIDITYLOANS, THE “BOTTOM LINE,” AND LOANS, THE “BOTTOM LINE,” AND LIQUIDITYLIQUIDITY

Loans and incomeLoans 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

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LOANS AND LIQUIDITYLOANS AND LIQUIDITYLOANS AND LIQUIDITYLOANS AND LIQUIDITY

LiquidityHaving the funds to meet obligations when

requiredLoan factors that affect the lending bank’s

liquidity includeLoan termInterest rateLoan typeCollateral

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Liquidity riskThe risk that a bank will have to sell its assets at

a loss to meet its cash demands

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CREDIT AND MARKET RISKCREDIT AND MARKET RISKCREDIT AND MARKET RISKCREDIT AND MARKET RISK

Credit riskThe bank’s estimate of the probability that the

borrower can and will repay a loan with interest as scheduled

Market riskThe risk that an investment will decrease in price

as market conditions change

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LOAN DECISIONS AND TRADE-LOAN DECISIONS AND TRADE-OFFSOFFSLOAN DECISIONS AND TRADE-LOAN DECISIONS AND TRADE-OFFSOFFS

Making loan decisions is a difficult process that generally requires weighing one factor against another.

Short-term loanLow risk, relatively quick liquidity, low interest rateRelatively low profit

Long-term loanMore risk and liquidity concerns, higher interest rateHigher profit

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How do credit risk and market risk differ?

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LOAN POLICY COMMITTEELOAN POLICY COMMITTEELOAN POLICY COMMITTEELOAN POLICY COMMITTEE

Lending policyA written statement of the guidelines and

standards to follow in making credit decisionsLoan policy committee

Sets a bank’s lending policy

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Five factors are reviewed when administering commercial loans.Cash flowLiquidityLeverageCollateralManagement

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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

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What is the function of a loan policy committee?

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