Lecture Objectives

Major types of Retail Lending

Consumer Lending Business Loan Facilities

Interest Rate Types
Credit Analysis in Lending
Obtaining Information
Cash Flow and Financial Statement Analysis
Credit Analysis - Judgemental Scoring System vs Credit Scoring Systems
Balancing Loan Losses and Opportunities

Introduction Introduction continued

All banks lend to the consumer or "Person in the Street" Approval process is by volume
Retail customer deposits biggest source of funding Client churn impacts profitability
Consumer lending is lending for consumption rather than production Each product stands alone for returns
interest and fees
Makes possible the consumption of goods and services
In advance of the consumers ability to pay for the item Customer data limited
Consumer's income is key in credit analysis Management of account by exception
Small business is exception in this area
Small $s, Large volume and Homogenous
Major types of retail lending Credit card lending
Credit and debit cards Card holders can borrow against pre-authorised line of credit up to
maximum amount
Housing Finance home mortgage
High rate of growth
Personal Loan & Consumer Credit
avoid burden of carrying cash
Hire Purchase & Consumer Mortgage avoid complications about acceptability of written cheques
additional time to make repayments on loan e.g. interest free periods
useful for consumer cash flow management
acceptability when travelling and overseas
Easy access helped by electronic banking devices
point of sale EFTPOS, online purchases, ATMs, pay pal

Credit card lending continued Home Loans

Merchants expanded sales appeal -worldwide network of banks Long term lending
Driven by economic conditions and sentiment
Bank retains control
approval applicants and credit limits New construction and additions to existing homes
issuing banks collect merchant fees
incur costs operating the card system Terms, types and security
Important feature Profitability
world wide computer credit record Credit Analysis
easy to report lost or stolen
On-selling / marketing
helps determine individuals credit rating score
Bridging Finance
Home Loans continued Home Loans continued
Home loans Interest rates are very important in the economy
often referred to as a mortgage drives lending demand
secured lending for the bank mortgage over property high interest rate era of late 1980's vs current era of record low interest rates
forms part of CPI calculation for cost of living
Growth in home loans can be attributed to many factors gauge of economic health and conditions
major one desire to own your own home
Real estate lending - very political
Many reasons why banks are in this market lack of affordability
Major segment of big 4 lending
negative gearing and tax incentives
Large source of bank income and profitability
level of home ownership vs renting
Cross sell - Borrowers do most of their additional banking with bank which has their home loan
e.g. credit cards, bank accounts, car/personal loans approval for new housing developments and land release
Changes in capital adequacy - added incentive Many innovative loan products developed by banks
Once loaned - very little administrative cost to the bank Principal and interest
Interest only
Most repayments through periodical payment
Loan to valuation ratio very important - LVR

Home Equity Loans Home Equity Loans continued

Large lines of credit, unsecured or secured Growth in home equity loans
range from $20,000 to $millions changes in capital adequacy
secured - equity in borrower's home
cost competitiveness
Loans frequently used for home improvement
increasing value
Home used as collateral (security)
potential for appreciation
Compared with other credit
home equity - loan rate a cheaper
good for bank as they have your home as collateral (security) to ensure loan
repayment
 Personal Loans & Consumer Credit Hire Purchase & Consumer Mortgage
After home loan Hire Purchase (HP)
Ownership retained by supplier/lender
personal loans are a big part of bank lending (15%) Repayment of P & I over set term
principal progressively reduced over life of loan Transfer of ownership at last instalment
each payment - principal and interest (P&I) In HP loan agreement showed
lender owned the asset
1-5 year term "borrower" hired it
Secured and Unsecured last instalment ownership transferred to "borrower".
prior to last instalment payment ownership stayed with lender
Single and Joint names this was important in event of default (i.e. failure to make payment).

Regulated Credit Contracts All changed with Consumer Mortgage

Consumer Mortgage replacing HP
Rarely available for small amounts

Hire Purchase & Consumer Mortgage continued Business Loan Facilities

Consumer Mortgage replacing HP Business Credit Cards / Corporate Cards
Credit cards supplied for purchases related to business activities
Mortgage over property / asset (e.g. car, boat)
Borrower pays deposit then borrows balance Overdrafts
Overdraft allows the borrower to continue withdrawing money even if the account has no
Selling organisation provides loan funds funds in it or not enough to cover the withdrawal.
Transfer of ownership at loan commencement
Commercial Bills
Loan repaid over term of agreement Option for short or long-term financing.
Advantage Normal terms are from one to six months but may be longer.
Greater borrower protection as part of uniform consumer credit laws Borrowers commitment is to repay the face value of each bill at maturity, but if borrower
ownership of property now with borrower rolls the bill, they pay the difference between the face value and the discount amount of
financiers have a mortgage over item the new bill based on prevailing interest rates.
Business Loan Facilities continued Business Loan Facilities continued
Term Loans Leasing
A loan from a bank for a specific amount that has a specified repayment schedule and a A finance lease is a type of lease in which a finance company is typically the legal owner
fixed or floating interest rate. of the asset for the duration of the lease
Lessee has operating control over the asset, but also has a substantial share of the
Term loans usually last between one and ten years, but may be as long as 30 or more economic risks and returns from the change in the valuation of the underlying asset.
years.
A finance lease has similar financial characteristics to hire purchase agreements as the
Mortgage finance usual outcome is that the lessee will become the owner of the asset at the end of the
lease, but has different accounting treatments and tax implications to hire purchase.
A mortgage is a loan in which property or real estate is used as collateral (security).
Factoring
Bridging finance A type of debtor finance in which a business sells its accounts receivable (i.e., invoices)
A bridging loan is when a loan is required to finance the purchase a second property with to a third party (called a factor) at a discount.
the intention of selling the existing one. A business will sometimes factor its receivable assets to meet its present and immediate
A bridging loan is typically an interest only payment with a limited loan term. cash needs.

Business Loans Business Loans continued

Customer submits electronically or application in person Loan purpose and amount
Borrowing entity
Lending policy dictates customer approval/decline process Term and repayment structure
Basis - the traditional approach
Collateral/Security available
Policy built into Credit Scoring or Personal Intervention
Financial statements (Business and Personal)
Lender / Bank systems monitor loan repayments Cash Flows and Income Tax Returns
Need to investigate and verify information
Small business loans are largest group by number of businesses
established Identify and mitigate risks
Business Management is a consideration for loan approval (especially Make decision and price for risk
for small businesses) Provide Letter of Offer
Interest Rates for Loans Retail lending - a major source of business
Fixed Marketing letters, online, TV, radio
Interest rate fixed for a specific term
Referrals - Real Estate, Solicitors, Accountants, Brokers, Car Dealers
Variable Current and Past Customers
Interest rate will fluctuate
Bank Branch Network
Revolving Credit
Credit that is automatically renewed as debts are paid off Direct Sales Force
Re-draws Personal Contact
A redraw facility allows you to access additional repayments that you have made Indirect Lending
on your loan over and above the required minimum repayments

Origin of consumer loans - direct & indirect Lending / Credit Process

Direct consumers approach bank for loan Determine loan purpose and amount
due to advertising or location Obtain information
Consumer credit application
requires a large branch network
Personal financial statement
Telephone lending varying degrees success Income tax returns /Business financial statements
Investigate and verify information
Indirect Lending Analysis - Financial statements Cash flow
Evaluate collateral, if required
Seller of goods acts as agent for bank
Usually goods with high cost (car loans) Negotiate with applicant and agree loan terms
collects information sends to bank for approval Price and structure the credit
bank does not need a large branch network Arrange signing of loan agreement
Credit analysis in lending Consumer lending
Credit analysis used to ensure that repayments can be made on loans Credit analysis - credit scoring system
Vital for banks to exercise effective control over credit granting process
Junior bank staff can do processing
Much the same process with home loan number of loans that can be processed is quite large
Some argue because security is given over property less analysis required
Ensure customer will want to repay loan
Most banks supplement credit analysis with statistical credit scoring Banks must do adequate credit checks to calculate ability to repay
The Financing

Golden Rules of Consumer Credit Retail Lending Profitability

Down payment/deposit -sufficiently large to establish buyers equity in Tracking client profitability is important
merchandise and feeling of ownership Determines resourcing that should be devoted to this sector
Instalments paid should be sufficient to increase the equity established Models
at a faster rate than merchandise depreciates Models determine if customer satisfies risk/ return
If not, purchaser may develop a feeling of renting - rather than owning Single contract looks at loan over its life
most trouble with low deposits, long maturities Steady State looks at portfolio of loans
Fairly homogenous product offering
e.g. home mortgages, credit cards, personal loans
Highly competitive market
So need to generate volume
Obtaining Information Obtaining Information continued
Most information supplied by applicant Secondary source - credit agencies
Information standardised application forms hold data on consumers' credit histories
applications for credit, legal actions, and promptness of payment
Generally requires data on employment, income, living arrangements,
information is supplied by creditors
marital status, assets owned, and outstanding debts
Current personal financial statement Investigation and Verification
require income tax returns and business financial statements on self employed must be verified
applicants Personal financial statements-self prepared
tested for accuracy and realism

Obtaining Information continued Cash Flow and Financial Statement Analysis

Direct verification Primary criteria for determining financial standing and debt service
Contacting present creditors, employers, and other organisations with official capacity of borrower
knowledge of the borrower's income
Collateral- secondary source of repayment
Appraisals on real and personal property Used to reduce risk
Site inspections Not a basis for making loan
Estimate of collateral values Assets: how much liquidity and resale value
Valuation process Lender may require liquid assets to equal or exceed amount of loan
Ensure legal ownership of collateral
Registry searches
Title deed searches
 Cash Flow Analysis Cash Flow Analysis continued
Primary concern Repayment for consumer lending is usually income from wages
identify a specific source of repayment evaluation of employment stability and claims on income, debt payment obligations

Determine borrower's tangible net worth Compares regular sources of income to fixed monthly obligations
calculated and intangible assets ruled out fixed obligations do not include normal daily living expenses

Identify total income from stable, dependable sources Leave reasonable level for living expenses
responsible lending obligations
Understanding of borrower's financial status
Regulators are requiring lenders to leave consumers with a living expense
Structuring loan to fit borrower's repayment ability buffer over and above subsistence more conservative lending policies
Loan cannot exceed specific monthly debt to income ratio

Credit evaluation judgmental credit analysis Credit evaluation - judgmental credit analysis
Relies on loan officer's experience and insight Applicant's income almost always primary source of repayment
borrower's ability & willingness to repay must be adequate
similar to business loan evaluate secondary sources

Character evaluated from credit history Estimate probable future value of collateral
degree of dependability demonstrated through - length, consistency of employment security
liquidity
Apparent sincerity
Applicant's age must be considered
Length of occupancy at home residence and type of residency determinant of future earnings power
owning property vs renting ASIC rules age limit for borrowers
Loan officer must be objective Retirement and life expectancy vs loan maturity
personal biases interfere so predetermined lending policies help mitigate some bias
Credit Scoring System Credit Scoring System continued
Tool that statistically evaluates applications Requires a high volume of applications
Based on historical data and experience of bank
Predictability of each piece of information rated Based on large homogenous sample of past applications
Database constantly enhanced based on history and additional inputs
Total score provided
Profitability by portfolio or any other characteristic (e.g. Purpose,
Choosing cut off score is a critical step Occupation)
Approvals and Declines process within band Track repayments and issue follow ups
Shades of Grey Track defaults quickly
Reference and other additional checks may be necessary Test applications declined or constantly appearing in Grey Area for possible
approval
Risk vs Reward identified by credit scoring system

Credit Scoring System and Shades of Grey Credit Scoring Example

Making loan sales is important Question Answer Points
What is your age 25-29 12
Target is profitability not approvals or declines Years-current address 3-5 4
Own or rent Own 30
Rejected loan requests can still be considered for approval Years in job 3-5 5
additional checks may be required What bank A/cs Card & Savings 24
or lending obligations imposed on borrower e.g. additional financial information, Bank loans Yes 3
or sale of other assets Phone Yes 9

Score may be satisfactory although rejects due to in-built system Credit Cards 1 12

criteria Store cards 0 0

Finance Co loans 0 0
Self Employed
Income Level 25K 13
Some fields may not be completed Total Points 113
Credit Scoring Considerations Credit Scoring Considerations continued
Expensive to derive and to re-validate Statistically derived credit scoring systems have two technical flaws
Derivation based on multi-variate statistical multiple regression or First,
multiple discriminate analysis borrower data used are historical and might be obsolete for current
creditworthiness
Characteristics can be combined to distinguish "bad" from "good"
Second,
"Z score" tries to separates good & bad data may consist of only those loan applications that have been accepted
Cannot eliminate bad loans - groups overlap omit rejected applications

Balancing loan losses and opportunities Judgmental versus Credit Scoring Systems
Two basic types of errors in evaluating loan applications Both systems use applicants characteristics
should be balanced to minimise overall losses credit scoring assigns weights to each characteristic according to its statistical
importance in relation to other characteristics
First type
granting a loan to a borrower who ultimately does not pay satisfactorily
Judgmental systems subject to variation of individual performing the task
can consider certain intangible factors that cannot be quantified
loss of interest income, loss of funds
Credit scoring - removes all issues of policy interpretation
Second type provides more rigid structure and reduces biases
tight lending standards
risk of disqualifying good borrowers
Credit scoring considers characteristics historically associated with
creditworthiness
opportunity cost to lender credit scoring systems less effective with major changes occurring
Bank's loan application evaluation system should achieve an acceptable based on customer data from a potentially unrepresentative period in the past
trade-off Judgemental better able to account for present and future changes quickly
Judgmental versus Credit Scoring Systems
continued Question
Credit scoring considers multitude of characteristics simultaneously Which of the following would be a consumer bridging loan?
a)any loan to a consumer that requires a single repayment of principal and
Judgmental cannot interest
limitations of human mental processes and requires an experienced analyst
b)a loan used to finance the construction of a bridge
In practice, banks use a combination of judgemental and credit scoring c)a loan used to pay for the construction of residential premises
systems d)a loan to fund/part fund the purchase of a new home, to be repaid when the
existing home is sold
Credit scoring readily isolates clearly non-creditworthy and
creditworthy The answer is? d
Gray zone -subjected to further information and judgemental

Question
What is credit scoring?
a)a method of rationing consumer loans that are outstanding according to a
statistically-determined model
b)a method of discriminating against borrowers due to race that has been banned
by government legislation
c)a mechanical consumer loan evaluation procedure that assigns points to
selected characteristics of the borrower and compares the total points to a
statistically-determined criteria
d)a method of determining the rate that should be charged on consumer loans
based on a statistically-determined model
The answer is? C