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

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7.1

CONSUMER LOAN THEORY

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

GOALSGOALS

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

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

TERMSTERMS


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

Loan categories includeConsumer loansMortgage loansCommercial loans



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.


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


What is asset transformation?

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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


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


DOWNSTREAM LOAN PROFITDOWNSTREAM LOAN PROFITDOWNSTREAM LOAN PROFITDOWNSTREAM LOAN PROFIT

SecuritizationWhen individual loans are pooled together and

sold as securities


What is adverse selection?

checkpoint


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


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.


Off-balance sheet activities includeOverdraft protectionLetters of credit

Flex lineWhen overdraft protection is linked to a home

equity line of credit


OTHER REVENUE SOURCESOTHER REVENUE SOURCESOTHER REVENUE SOURCESOTHER REVENUE SOURCES

Account service chargesSafe deposit box rentalATM chargesInsurance sales feesTrading fees



What are three methods of providing overdraft protection?

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7.2

CONSUMER LOANS

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

GOALSGOALS


Installment loanSecured loanCollateralLienUnsecured loanOpen-end loanGrace period

TERMSTERMS


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


Personal loansVehicle loansHome equity loansEducation loans


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


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


LENDING TERMINOLOGYLENDING TERMINOLOGYLENDING TERMINOLOGYLENDING TERMINOLOGY

PrincipalThe amount borrowed

InterestThe amount you pay to use the principal

Fixed rateVariable rateIndexed 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


FeesOther charges for the loan

Finance chargeThe total dollar amount to be paid for the loan

Total paymentsThe total amount a consumer must repay


PaymentThe amount the borrower repays each specified

periodAcceleration clause

Brings the entire loan due if payments are missed


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

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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


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


LINES OF CREDITLINES OF CREDITLINES OF CREDITLINES OF CREDIT

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


What is an open-end loan?

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7.3

GRANTING AND ANALYZING CREDIT

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

GOALSGOALS


UnderwritingSubprime ratesConsumer reporting agency (CRA)FICO score

TERMSTERMS


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.


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


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


The three Cs of underwritingCollateralCapacityCredit reputation

Subprime ratesHigher than normal rates set to offset the

increased risk represented by a less-than-perfect borrower


ClosingFunding


What is underwriting?

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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.


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


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

Consumers are entitled to a free credit report each year.


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.


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)


What is a consumer reporting agency?

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7.4

COST OF CREDIT

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

GOALSGOALS


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

TERMSTERMS


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.


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.


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



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


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.


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.


TERMTERMTERMTERM

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 betweenTaking a shorter loan

Higher monthly paymentsLower total payments

Taking a longer loanLower monthly paymentsHigher total payments



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

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

Healthy economic growth depends upon healthy use of credit.


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


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.


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


Why do consumers become overextended?

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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


Liquidity riskCredit riskMarket risk

TERMSTERMS


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


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


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

a loss to meet its cash demands


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


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


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


Five factors are reviewed when administering commercial loans.Cash flowLiquidityLeverageCollateralManagement


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


What is the function of a loan policy committee?

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Documents

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