.. torical performance of a potential borrower. Projections of the borrower financial condition reveal how much financing is required and how much cash can be generated from operations to service new debt, and can be used to determine when a loan may be repaid. The proforma analysis is a form of sensitivity analysis. Three alternatives scenarios to analyze the relationship between the balance sheet and the income statement: -Best case scenario: improvement in planned performance. Worst case scenario: represents the greatest potential negative impact on sales and earnings. Most-likely scenario: indicates the most reasonable sequence of economic events and performance. The three alternative forecasts of loan needs and cash flow establish a range of likely results that indicates the riskiness of credit.
As a conclusion no matter what are the alternatives or the credit analysis adopted, do you think that we will get to have a 100% correct analysis with no risk? Evaluating Consumer Loans Chapter 22 The purpose of this chapter is to analyze the characteristics and profitability of different types of consumer loans and introduces general credit evaluation techniques to assess risk. Commercial loans were available in large volume, net yields were high and the loans were highly visible investments. Consumer loans involved small dollar amounts, a large staff to handle account and a lower prestige associated with lending to individuals. This perception changed with the decline in profitability of commercial loans. Today, many banks target individuals as the primary source of growth in attracting new business.
Even with the high relative default rates, consumer loans in the aggregate currently produce greater profits than do commercial loans. This reflects the attraction of consumer deposits as well as consumer loans. Interest rate deregulation forced banks to pay market rates on virtually all their liabilities. Corporate cash managers, who are especially price sensitive, routinely move their balances in search of higher yields. Individuals balances are more stable. While individuals are price sensitive, a bank can generally retain deposits by varying rates offered on different maturity time deposits to meet the customers needs. From a lenders perspective, the analysis of consumer loans differs from that of commercial loans.
First, the quality of financial data is lower. Personal financing statements are typically unaudited, so it is easy for borrowers to hide other loans. It is similarly easy to inflate asset values. Second, the primary source of repayment is current income, primarily from wages, salaries, dividends, and interest. This may be highly volatile, depending on the nature of individuals work experience history.
The net effect is that character is more difficult to assess, but extremely important. Types of consumer loans: ? Installment loans: Installment loans require the periodic payment of principal and interest. In most cases, a customer borrows to purchase durable goods or cover extraordinary expenses and agrees to repay the loan in monthly installments. While the average loan is quite small, some may be much larger, depending on the use of the proceeds. Installment loans may be either direct or indirect loans. A direct loan is negotiated between the bank and the ultimate user of the funds. The loan officer analyzes the information and approves or rejects the request.
An indirect loan is funded by a bank through a separate retailer that sells merchandise to a customer. The retailer takes the credit application, negotiates terms with the individual, and presents the agreement to the bank. If the bank approves the loan, it buys the loan from the retailer under prearranged terms. Installment loans can be extremely profitable. Depending on the size of the bank, it cost from $140 to $208 to make each installment loan. Acquisition costs include salaries, occupancy, computer, and marketing expenses associated with soliciting, approving, and processing loan applications. Even though these costs are high, banks were able to earn excellent spreads on the average loan. ? Credit cards and other revolving credit: Credit cards are utilized to purchase goods and services on credit in contrast to debit cards, which are used to withdraw cash from ATM (Automated Teller Machine).
Revolving credit: an arrangement by which the borrower and repay as needed during a specific time period, subject to maximum borrowing level. Credit cards and overlines tied to checking accounts are the two most popular forms of revolving credit arrangements. Banks offer a variety of credit cards. While some banks issue cards with there own logo and supported by their own marketing effort, most operate as franchises of Master Card or Visa. All cards display the Master Card and Visa logos along with the issuing bank name. The primary advantage of membership is that an individual bank card is accepted nationally and internationally at most retail stores without the bank negotiating a separate agreement with every retailer.
Some alternatives to the credit cards exist: -Debit cards: they are widely available but not attractive to customers. As the name suggests when an individual uses this card his or her balance at a bank is immediately debited funds are transferred from the card user account to the account of the retailer. But there is a disadvantage in using it, the loss of float, which explains why debit cards are not popular. -Smart cards: is an extension of the debit card and contains a computer memory chip that stores and manipulates information. These cards can handle all purchasing that consumer prefers.
-Prepaid cards: are a hybrid debit card in which consumers repay for services to be rendered and receive a card again which purchases are charged. The advantage of this card is that the processing costs are low and there is little risk. Credit cards are attractive because they provide higher risk-adjusted returns than do other types of loans. Card issuers earn income from three sources: -charging card holders annual fees, charging interest on outstanding loan balances, and discounting the charges that merchants accept on purchases. Consequently as banks have increased their competitive focus they have begun to lower loan rates and annual fees such that many customers can avoid fees entirely and pay interest at rates slightly above NY quoted prime.
Credit card lending involves issuing plastic cards to qualifying customers. The cards have pre-authorized credit limits that restrict the maximum of debt outstanding at any time. Many cards can be used in electronic banking devices, such as automatic teller machines, to make deposits or withdrawals from existing transaction accounts at a bank. Credit cards are becoming extremely attractive. Many banks view credit cards as a vehicle to generate a nationwide customer base.
They offer extraordinary incentives to induce consumers to accept cards in the hope that they can cross-sell mortgages, insurance products, and eventually securities. Credit cards are profitable because many customers are price insensitive. However, credit card losses are among the highest of all loan types. The returns to credit card lending depend on the specific roles that a bank plays. A bank is called a card bank if it administers its own credit card plan or serves as the primary regional agent of major credit card operations.
A non-card bank operates under the auspices of a regional card bank and does not issue its own card. Non-card banks do not generate significant revenues from credit cards. The credit card transaction process: Once a customer uses a card, the retail outlet submits the sales receipt to its local merchant bank for credit. A retailer may physically deposit the slip electronically transfer the information via a card-reading terminal at the time of sale. The merchant bank discounts the sales receipt by 2 to 5 percent as its fee.
Thus a retailer will receive only 97$ credit for each 100$ sales receipt if the discount is 3 percent. If the merchant bank did not issue the card, it sends the receipt to the card-issuing bank then bills the customer for the purchase. Most card revenues come from issuing the card that a customer uses. The bank earns interest at rates ranging from 6 to 22 percent and normally charges each individual an annual fee for use of the card. Interest rates are sticky. Thus, when money market rates decline and lower a banks cost of funds, the net return on credit card revenues. The remaining 20 percent is merchant discount.
? Overdraft protection and open credit lines: Revolving credit also takes the form of overdraft protection against checking accounts. The customer must pay interest on the loan from the date of the drafts receipt and can repay the loan either by making direct deposits or by periodic payments. These loans are functional equivalent of loan commitments to commercial customers. The maximum credit available typically exceeds that for overdraft lines, and the interest rate floats with the banks base rate. ? Home equity loans and credit cards: Home equity loans meet the tax deductibility requirements because they are secured by equity in an individuals home. Many of these loans are structured as open credit lines where a consumer can borrow up to 75 percent of the market value of the property less the principle outstanding on the first mortgage. Individuals borrow simply by writing checks, pay interest only on the amount borrowed and can repay the principal at a rate of the outstanding balance.
In most cases, the loans carry adjustable rates tied to the banks base rate. These credit arrangements combine the risk of a second mortgage with the temptation of credit card, a dangerous combination. Home equity loans place a second lien on a borrowers home. If the individual defaults, the creditor can foreclose so that the borrower loses his or her home. ? Non-installment loans: A limited number of consumer loans require a single principal and interest payment.
The individual borrowing needs are temporary. Credit is extended in anticipation of repayment from a well-defined future cash inflow. The quality of the loan depends on the certainty of the timing and the amount anticipated net cash inflow from the sale. Consumer loans: Consumer loans are extended for a variety of reasons for example, the purchase of an automobile, mobile homes, home improvements, furniture and appliances, and home equity loans. Before approving any loan, a lending officer request information regarding the borrowers employment status, periodic income, the value of assets owned, outstanding debt, personal references and specific terms that generates the loan request.
The lending officer collects information regarding the borrowers five Cs then he interprets the information in light of the bank lending guidelines and accepts or rejects the loan. In addition, banks employ judgmental procedures and quantitative credit scoring procedures when evaluating consumers loans. Recent risk and return characteristics of consumer loans: Historically, banks viewed themselves as being either wholesale or retail institutions, focusing on commercial and individual customers respectively. Recent developments, however, have blurred the distinction, as traditional wholesale banks have aggressively entered the consumer market. The attraction is twofold.
First, competition for commercial customers narrowed commercial loan yields so that return fell relative to potential risks. So consumer loans provide some of the highest met yields for banks. Second, developing loan and deposit relationships with individuals presumably represents a strategic response to deregulation.