7 7.1 7.2 7.3 7.4 7.5 Bank Loans Consumer Loan Theory Consumer Loans Granting and Analyzing Credit Cost of Credit Bank Loans and Policy The U.S. Banking System, 3e © 2017 Cengage Learning®. All rights reserved. 7.1 Consumer Loan Theory Learning Objectives 7.1.1 Explain asset transformation and modern portfolio theory. 7.1.2 Describe components of consumer lending. 7.1.3 Explain nonloan sources of bank revenue. Slide 2 The U.S. Banking System, 3e © 2017 Cengage Learning®. All rights reserved. Key Terms asset transformation modern portfolio theory (MPT) adverse selection captive borrower moral hazard credit rationing Slide 3 The U.S. Banking System, 3e © 2017 Cengage Learning®. All rights reserved. Managing a Bank’s Portfolio Loan Balances in the United States Asset Management Asset transformation is the use of deposits to generate revenue by putting them to work via loans. Modern portfolio theory (MPT) states that within any portfolio of investments, diversification should be used to spread out risk. Slide 4 The U.S. Banking System, 3e © 2017 Cengage Learning®. All rights reserved. Loan Portfolio Composition Slide 5 The U.S. Banking System, 3e © 2017 Cengage Learning®. All rights reserved. checkpoint What is asset transformation? The process of using deposits to generate revenue by putting deposits to work in the marketplace in the form of loans Slide 6 The U.S. Banking System, 3e © 2017 Cengage Learning®. All rights reserved. Consumer Lending Theory Loan Selection Adverse selection is the concept that the 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 is a consumer with a weak credit history and limited options for securing a loan. Slide 7 The U.S. Banking System, 3e © 2017 Cengage Learning®. All rights reserved. Consumer Lending Theory (continued) Loan Selection (continued) Moral hazard occurs when borrowers take greater risks if they think the harm they will incur from those risks will somehow be minimalized. Credit rationing occurs when banks refuse to provide a loan, or when they lend less than the customer requested. Downstream Loan Profit Slide 8 The U.S. Banking System, 3e © 2017 Cengage Learning®. All rights reserved. checkpoint What is adverse selection? The concept that the borrowers who are most willing to accept a high interest rate are the same borrowers who are most likely to default on their loans Slide 9 The U.S. Banking System, 3e © 2017 Cengage Learning®. All rights reserved. Additional Sources of Bank Revenue Off-Balance Sheet Activities Other Revenue Sources Slide 10 The U.S. Banking System, 3e © 2017 Cengage Learning®. All rights reserved. checkpoint What are three methods of providing overdraft protection? A checking account can be linked to either a savings account, a credit card, or a home equity line of credit (flex line). Slide 11 The U.S. Banking System, 3e © 2017 Cengage Learning®. All rights reserved. 7.2 Consumer Loans Learning Objectives 7.2.1 Define major terms associated with consumer lending. 7.2.2 Explain the difference between installment loans and open-end loans. Slide 12 The U.S. Banking System, 3e © 2017 Cengage Learning®. All rights reserved. Key Terms installment loan secured loan collateral lien unsecured loan open-end loan grace period Slide 13 The U.S. Banking System, 3e © 2017 Cengage Learning®. All rights reserved. Installment Loans Installment loan is a loan for which the amount of the payments, the rate of interest, and the number of payments (or length of term) are fixed and repaid on a periodic basis. Personal Loans Vehicle Loans Home Equity Loans Education Loans Slide 14 The U.S. Banking System, 3e © 2017 Cengage Learning®. All rights reserved. Installment Loans (continued) Secured and Unsecured Loans Secured loan is a loan in which some item of value backs the loan in case the borrower defaults on it. Collateral is an item that secures a loan. Lien is the legal claim to the property to secure a debt. Unsecured loan is a loan backed only by the reputation and creditworthiness of the borrower. Slide 15 The U.S. Banking System, 3e © 2017 Cengage Learning®. All rights reserved. Installment Loans (continued) Lending Terminology Principal Interest Fees Finance charge Total payments Payment Slide 16 The U.S. Banking System, 3e © 2017 Cengage Learning®. All rights reserved. checkpoint What is the difference between a secured loan and an unsecured loan? A secured loan uses some item of value as collateral for the loan, while an unsecured loan is based solely upon the borrower’s creditworthiness. Slide 17 The U.S. Banking System, 3e © 2017 Cengage Learning®. All rights reserved. Open-End Loans Open-end loan is a loan that is flexible, as is the term; the longer the loan is used, the more will be paid. Credit Cards Grace period is the amount of time a consumer has to pay a credit card bill in full and avoid any finance charges. Lines of Credit Slide 18 The U.S. Banking System, 3e © 2017 Cengage Learning®. All rights reserved. checkpoint What is an open-end loan? An open-end loan is a loan with no fixed principal and no fixed term. Slide 19 The U.S. Banking System, 3e © 2017 Cengage Learning®. All rights reserved. 7.3 Granting and Analyzing Credit Learning Objectives 7.3.1 List steps in the credit-approval process. 7.3.2 Identify major criteria in a person’s credit rating. Slide 20 The U.S. Banking System, 3e © 2017 Cengage Learning®. All rights reserved. Key Terms underwriting subprime rates consumer reporting agency (CRA) FICO score Slide 21 The U.S. Banking System, 3e © 2017 Cengage Learning®. All rights reserved. Granting Credit Risk Management Credit-Approval Process Underwriting is the process of reviewing a loan for soundness. Subprime rates are rates that are higher than normal to offset the increased risk represented by a less-than-perfect borrower. Slide 22 The U.S. Banking System, 3e © 2017 Cengage Learning®. All rights reserved. checkpoint What is underwriting? Underwriting is the process of evaluating loan applications for soundness and making a recommendation for approving or denying the loan. Slide 23 The U.S. Banking System, 3e © 2017 Cengage Learning®. All rights reserved. Analyzing Credit Consumer reporting agency (CRA) is 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. Credit-Scoring Systems Slide 24 The U.S. Banking System, 3e © 2017 Cengage Learning®. All rights reserved. Analyzing Credit (continued) FICO score is a three-digit number that credit granters can use in making a loan approval decision. Slide 25 The U.S. Banking System, 3e © 2017 Cengage Learning®. All rights reserved. checkpoint What is a consumer reporting agency? A consumer reporting agency, or credit bureau, is a company that compiles and sells data on consumer debt and payment records. Slide 26 The U.S. Banking System, 3e © 2017 Cengage Learning®. All rights reserved. 7.4 Cost of Credit Learning Objectives 7.4.1 Identify key factors in the cost of credit. 7.4.2 Explain the impact of negative credit ratings on consumers. Slide 27 The U.S. Banking System, 3e © 2017 Cengage Learning®. All rights reserved. Key Terms revolving credit sum-of-digits method previous-balance method adjusted-balance method average-daily-balance method predatory lending Slide 28 The U.S. Banking System, 3e © 2017 Cengage Learning®. All rights reserved. What Credit Costs Revolving credit is a line of credit with a maximum limit that can be used on an ongoing basis until the limit is reached. Reviewing APR and Finance Charge Sum-of-digits method is the method of calculating finance charges that 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. Slide 29 The U.S. Banking System, 3e © 2017 Cengage Learning®. All rights reserved. What Credit Costs (continued) Reviewing APR and Finance Charge (continued) Previous-balance method calculates interest on the amount owed at the beginning of the billing cycle, regardless of payments or charges. Adjusted-balance method subtracts payments made during the billing cycle but usually doesn’t count purchases. Slide 30 The U.S. Banking System, 3e © 2017 Cengage Learning®. All rights reserved. What Credit Costs (continued) Reviewing APR and Finance Charge (continued) Average-daily-balance method adds balances for each day of the billing cycle and then divides by number of days in the billing cycle to yield an average figure on which the finance charge is calculated. Minimum Payments Term Slide 31 The U.S. Banking System, 3e © 2017 Cengage Learning®. All rights reserved. checkpoint Why is it a good idea for consumers to pay more than their minimum balances on open-ended credit accounts? Payment of minimum balance does little toward reducing the principal balance, maximizing the cost of credit. Slide 32 The U.S. Banking System, 3e © 2017 Cengage Learning®. All rights reserved. The Impact of Credit Overextension Responsible Lending Predatory lending occurs when lenders create problems for consumers by making credit too easily available without regard to the borrower’s ability to pay. Credit Counseling Slide 33 The U.S. Banking System, 3e © 2017 Cengage Learning®. All rights reserved. checkpoint Why do some consumers become overextended? Consumers may become overextended because they do not fully understand the costs of credit. Other answers may vary. Slide 34 The U.S. Banking System, 3e © 2017 Cengage Learning®. All rights reserved. 7.5 Bank Loans and Policy Learning Objectives 7.5.1 Explain how loans affect a bank’s income. 7.5.2 Describe the purpose of a bank’s loan policy committee. Slide 35 The U.S. Banking System, 3e © 2017 Cengage Learning®. All rights reserved. Key Terms liquidity risk credit risk market risk Slide 36 The U.S. Banking System, 3e © 2017 Cengage Learning®. All rights reserved. Loans, the “Bottom Line,” and Liquidity Loans and Income Loans and Liquidity Liquidity risk refers to a risk that a bank will have to sell its assets at a loss to meet its cash demands. Credit and Market Risk Credit risk is a bank’s estimate of the probability that the borrower can and will repay a loan with interest as scheduled. Slide 37 The U.S. Banking System, 3e © 2017 Cengage Learning®. All rights reserved. Loans, the “Bottom Line,” and Liquidity (continued) Credit and Market Risk (continued) Market risk is a risk that an investment will decrease in price as market conditions change. Loan Decisions and Trade-Offs Slide 38 The U.S. Banking System, 3e © 2017 Cengage Learning®. All rights reserved. checkpoint How do credit risk and market risk differ? Credit risk refers to the possibility that a borrower will not repay a loan. Market risk refers to whether an asset will sell for full value. Slide 39 The U.S. Banking System, 3e © 2017 Cengage Learning®. All rights reserved. Loan Policy Committee All banks must have a lending policy, which is a written statement of the guidelines and standards to follow in making credit decisions. A bank’s board of directors sets its lending policy. The lending policies must be fairly administered and standardized for all applicants in a category Bank policy must meet the provisions of the Community Reinvestment Act (CRA). Slide 40 The U.S. Banking System, 3e © 2017 Cengage Learning®. All rights reserved. checkpoint What is the function of a loan policy committee? It sets the policies the bank will use in determining whether to accept or reject loan applications. Slide 41 The U.S. Banking System, 3e © 2017 Cengage Learning®. All rights reserved.