chapter 18

Financial Markets and Institutions Chapter 18

1

Chapter 18 : Consumer Finance Operations


2

Chapter Objectives

• Identify the main sources and uses of finance company funds

• Describe how finance companies are exposed to various forms of risk

• Explain how finance companies interact with other financial institutions


3

Types of Finance Companies

• Consumer finance companies make direct loans to consumers

• Sales finance companies concentrate on purchasing credit contracts from retailers and dealers

• Commercial finance companies provide loans to firms that can not obtain financing from commercial banks


4

Types of Finance Companies

FinanceCompanies

Consumer

Sales Commercial


5

Sources of Finance Company Financing

BankLoans

Commercial Paper

Deposits and Capital Market Financing

Capital


6

Sources of Finance Company Funds

• Finance companies use loans from banks as a source of funds and consistently renew the loans over time

• Commercial paper – A short-term source but finance companies

roll over their issues to create a permanent source of funds

– Secured commercial paper allows smaller and medium-sized firms access to the market

– Well-known firms use direct placement


7

Sources of Finance Company Funds

• Some states allow finance companies to accept customer deposits

• Bonds are used as a long-term source of funds and the use of this source depends on– Expectations about future interest rates– The balance sheet structure

• Capital comes from retained earnings or issuing stock


8

Finance Company Lending Areas

BusinessLoans$335.1Billion33%

ConsumerLoans$254.9Billion25%

Real EstateLoans$98.5Billion10%

Other$313.7 Billion

31%


9

Uses of Finance Company Funds

• Finance companies make many kinds of consumer loans in the form of personal loans– Auto loans offered by a finance company

owned by the manufacturer– Home improvement, mobile home and other

kinds of personal loans– Credit cards which can be used at a variety of

retail stores


10


– Credit card loans in which a retailer sells a credit contract to a finance company

• Customers make payments to the finance company

• Gives the finance company access to new customers


11


• Business loans and leasing are used to finance the cash cycle of companies– Cash cycle is the amount of time it takes

between when inventory is purchased, the product is sold and customers pay

– This financing is often backed by accounts receivable or inventory

• Leveraged buy out loans

• Factor accounts receivable


12


• Leasing – Finance company purchases equipment– Leases it to businesses

• Real estate loans– Mortgages on commercial real estate– Second mortgages on residential real estate

• Relative importance of uses of funds


13

Regulation of Finance Companies

• Federal regulations apply if finance companies are acting as bank holding companies or are subsidiaries of bank holding companies

• State regulations apply otherwise

• Have ceilings which put a maximum on the loan’s size

• Subject to interest rate ceilings and a maximum term for the loan


14

Balance sheet of finance company


15

Risks Faced by Finance Companies

• Liquidity risk– Finance companies do not hold assets that

can be easily sold in the secondary market– To raise funds they must borrow– Balance sheet structure does not call for

much liquidity because they would not have unexpected deposit withdrawals


16


• Interest rate risk is less than for depository institutions because the maturity of assets and liabilities is relatively short

• Assets are typically not as rate sensitive as liabilities

• Can use adjustable rates and shorter maturities on their loans to manage the risks


17


• Credit risk– Represents an important source of risk– Loan delinquency rates are typically higher

than for other kinds of institutions– Charge a higher interest rate to compensate

for the risk– High return, high risk nature of loans makes

performance sensitive to prevailing economic conditions


18

Valuation of a Finance Company

• Value of a finance companies depends on its expected cash flows and required rate of return

V = f [ E(CF), k]

V = Change in value of the institution

k = Change in required rate or return

Where:

E(CF) = Change in expected cash flows

+


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• Factors that affect cash flows

E(CF) = Expected cash flow

Rf = Risk free interest rate

INDUS = Prevailing industry conditions for the institution

Where:

E(CF)= f ( ECON, Rf , INDUS, MANAB)

ECON = Economic growth

MANAB = The ability of the institution’s management

+ +


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• Economic growth– Positive affect because it enhances

household demand for consumer goods– Economic growth reduces defaults

• Change in the risk-free rates– Cash flows inversely related to interest rate

movement– Short term sources of funds means their rates

change as do those of other interest rates


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• Change in industry conditions which include regulatory constraints, technology and competition

• Change in management abilities


22

Interaction with Other Financial Institutions

• Interact in various ways with other financial institutions

• Concentration in commercial lending means they are closely related to commercial banks, savings institutions and credit unions

• Compete with savings institutions and increase market share when their competitors have problems


23

Participation in Financial Markets

• Participate in a wide range of financial markets– Money markets– Bond markets– Mortgage markets– Stock markets– Futures markets– Options markets– Swap markets


24

Multinational Finance Companies

• Large multinational companies with subsidiaries in many countries

• Reasons why finance companies go global– Enter new markets– Reduce exposure to the U.S. economy

chapter 18

Documents

finance company customers

finance company access

institutions chapter

direct loans

chapter objectives

kinds of consumer loans

stockfinancial markets

longterm source of funds