7
7.1
7.2
7.3
7.4
7.5
Slide 1
BANK LOANS
Consumer Loan Theory
Consumer Loans
Granting and Analyzing Credit
Cost of Credit
Bank Loans and Policy
Banking Systems, 2e
© Cengage/South-Western
7.1
CONSUMER LOAN
THEORY
GOALS
Explain asset transformation and modern
portfolio theory.
Describe components of consumer
lending.
Explain nonloan sources of bank
revenue.
Slide 2
Banking Systems, 2e
© Cengage/South-Western
TERMS
Asset transformation
Modern portfolio theory (MPT)
Adverse selection
Captive borrower
Moral hazard
Credit rationing
Slide 3
Banking Systems, 2e
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MANAGING A BANK’S PORTFOLIO
Loan categories include
Consumer loans
Mortgage loans
Commercial loans
Slide 4
Banking Systems, 2e
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Slide 5
Banking Systems, 2e
© Cengage Learning/South-Western
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.
Slide 6
Banking Systems, 2e
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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
Slide 7
Banking Systems, 2e
© Cengage Learning/South-Western
 checkpoint
What is asset transformation?
Slide 8
Banking Systems, 2e
© Cengage Learning/South-Western
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
Slide 9
Banking Systems, 2e
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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
Slide 10
Banking Systems, 2e
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DOWNSTREAM LOAN PROFIT
Securitization
When individual loans are pooled together and
sold as securities
Slide 11
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 checkpoint
What is adverse selection?
Slide 12
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ADDITIONAL SOURCES OF BANK
REVENUE
Banks generate revenue from
Astutely managing loan portfolios
Charging a variety of fees
Slide 13
Banking Systems, 2e
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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.
Slide 14
Banking Systems, 2e
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Off-balance sheet activities include
Overdraft protection
Letters of credit
Flex line
When overdraft protection is linked to a home
equity line of credit
Slide 15
Banking Systems, 2e
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OTHER REVENUE SOURCES
Account service charges
Safe deposit box rental
ATM charges
Insurance sales fees
Trading fees
Slide 16
Banking Systems, 2e
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Slide 17
Banking Systems, 2e
© Cengage Learning/South-Western
 checkpoint
What are three methods of providing
overdraft protection?
Slide 18
Banking Systems, 2e
© Cengage Learning/South-Western
7.2
CONSUMER LOANS
GOALS
Define major terms associated with
consumer lending.
Explain the difference between
installment loans and open-end loans.
Slide 19
Banking Systems, 2e
© Cengage/South-Western
TERMS
Installment loan
Secured loan
Collateral
Lien
Unsecured loan
Open-end loan
Grace period
Slide 20
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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
Slide 21
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Personal loans
Vehicle loans
Home equity loans
Education loans
Slide 22
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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
Slide 23
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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
Slide 24
Banking Systems, 2e
© Cengage Learning/South-Western
LENDING TERMINOLOGY
Principal
The amount borrowed
Interest
The amount you pay to use the principal
Fixed rate
Variable rate
Indexed rate
Slide 25
Banking Systems, 2e
© Cengage Learning/South-Western
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
Slide 26
Banking Systems, 2e
© Cengage Learning/South-Western
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
Slide 27
Banking Systems, 2e
© Cengage Learning/South-Western
Payment
The amount the borrower repays each specified
period
Acceleration clause
Brings the entire loan due if payments are missed
Slide 28
Banking Systems, 2e
© Cengage Learning/South-Western
 checkpoint
What is the difference between a secured
loan and an unsecured loan?
Slide 29
Banking Systems, 2e
© Cengage Learning/South-Western
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
Slide 30
Banking Systems, 2e
© Cengage Learning/South-Western
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
Slide 31
Banking Systems, 2e
© Cengage Learning/South-Western
LINES OF CREDIT
Line-of-credit plans
Home equity reserve
Overdraft protection plan
Consumers can draw upon this credit as needed
Slide 32
Banking Systems, 2e
© Cengage Learning/South-Western
 checkpoint
What is an open-end loan?
Slide 33
Banking Systems, 2e
© Cengage Learning/South-Western
7.3
GRANTING AND
ANALYZING CREDIT
GOALS
List steps in the credit-approval process.
Identify major criteria in a person’s credit
rating.
Slide 34
Banking Systems, 2e
© Cengage/South-Western
TERMS
Underwriting
Subprime rates
Consumer reporting agency (CRA)
FICO score
Slide 35
Banking Systems, 2e
© Cengage Learning/South-Western
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.
Slide 36
Banking Systems, 2e
© Cengage Learning/South-Western
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
Slide 37
Banking Systems, 2e
© Cengage Learning/South-Western
CREDIT-APPROVAL PROCESS
Application
Documentation
Processing
Underwriting
Reviewing the loan for soundness
Making sure the loan is a prudent use of bank
funds
Slide 38
Banking Systems, 2e
© Cengage Learning/South-Western
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
Slide 39
Banking Systems, 2e
© Cengage Learning/South-Western
Closing
Funding
Slide 40
Banking Systems, 2e
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 checkpoint
What is underwriting?
Slide 41
Banking Systems, 2e
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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.
Slide 42
Banking Systems, 2e
© Cengage Learning/South-Western
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
Slide 43
Banking Systems, 2e
© Cengage Learning/South-Western
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.
Slide 44
Banking Systems, 2e
© Cengage Learning/South-Western
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.
Slide 45
Banking Systems, 2e
© Cengage Learning/South-Western
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)
Slide 46
Banking Systems, 2e
© Cengage Learning/South-Western
 checkpoint
What is a consumer reporting agency?
Slide 47
Banking Systems, 2e
© Cengage Learning/South-Western
7.4
COST OF CREDIT
GOALS
Identify key factors in the cost of credit.
Explain the impact of negative credit
ratings on consumers.
Slide 48
Banking Systems, 2e
© Cengage/South-Western
TERMS
Revolving credit
Sum-of-digits method
Previous balance method
Adjusted balance method
Average daily balance method
Predatory lending
Slide 49
Banking Systems, 2e
© Cengage Learning/South-Western
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.
Slide 50
Banking Systems, 2e
© Cengage Learning/South-Western
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.
Slide 51
Banking Systems, 2e
© Cengage Learning/South-Western
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
Slide 52
Banking Systems, 2e
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Slide 53
Banking Systems, 2e
© Cengage Learning/South-Western
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
Slide 54
Banking Systems, 2e
© Cengage Learning/South-Western
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.
Slide 55
Banking Systems, 2e
© Cengage Learning/South-Western
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.
Slide 56
Banking Systems, 2e
© Cengage Learning/South-Western
TERM
For installment loans, length of term also
affects the total finance charge.
Lenders must disclose the total payments.
Slide 57
Banking Systems, 2e
© Cengage Learning/South-Western
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
Slide 58
Banking Systems, 2e
© Cengage Learning/South-Western
Slide 59
Banking Systems, 2e
© Cengage Learning/South-Western
 checkpoint
Why is it a good idea for consumers to pay
more than their minimum balances on openended credit accounts?
Slide 60
Banking Systems, 2e
© Cengage Learning/South-Western
THE IMPACT OF CREDIT
Healthy economic growth depends upon
healthy use of credit.
Slide 61
Banking Systems, 2e
© Cengage Learning/South-Western
OVEREXTENSION
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
Slide 62
Banking Systems, 2e
© Cengage Learning/South-Western
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.
Slide 63
Banking Systems, 2e
© Cengage Learning/South-Western
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
Slide 64
Banking Systems, 2e
© Cengage Learning/South-Western
 checkpoint
Why do consumers become overextended?
Slide 65
Banking Systems, 2e
© Cengage Learning/South-Western
7.5
BANK LOANS AND
POLICY
GOALS
Explain how loans affect a bank’s income.
Describe the purpose of a bank’s loan
policy committee.
Slide 66
Banking Systems, 2e
© Cengage/South-Western
TERMS
Liquidity risk
Credit risk
Market risk
Slide 67
Banking Systems, 2e
© Cengage Learning/South-Western
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
Slide 68
Banking Systems, 2e
© Cengage Learning/South-Western
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
Slide 69
Banking Systems, 2e
© Cengage Learning/South-Western
Liquidity risk
The risk that a bank will have to sell its assets at
a loss to meet its cash demands
Slide 70
Banking Systems, 2e
© Cengage Learning/South-Western
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
Slide 71
Banking Systems, 2e
© Cengage Learning/South-Western
LOAN DECISIONS AND TRADEOFFS
 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
Slide 72
Banking Systems, 2e
© Cengage Learning/South-Western
 checkpoint
How do credit risk and market risk differ?
Slide 73
Banking Systems, 2e
© Cengage Learning/South-Western
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
Slide 74
Banking Systems, 2e
© Cengage Learning/South-Western
Five factors are reviewed when administering
commercial loans.
Cash flow
Liquidity
Leverage
Collateral
Management
Slide 75
Banking Systems, 2e
© Cengage Learning/South-Western
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
Slide 76
Banking Systems, 2e
© Cengage Learning/South-Western
 checkpoint
What is the function of a loan policy
committee?
Slide 77
Banking Systems, 2e
© Cengage Learning/South-Western