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Chapter 22 Finance Company Operations Outline Types of Finance Companies Consumer Finance Companies Business Finance Companies Captive Finance Companies Sources and Uses of Finance Company Funds Sources of Funds Uses of Finance Company Funds Interaction with Other Financial Institutions Participation in Financial Markets Valuation of a Finance Company Factors That Affect Cash Flows Factors That Affect the Required Rate of Return Exposure of Finance Companies to Risk Liquidity Risk Interest Rate Risk Credit Risk Multinational Finance Companies Key Concepts 1. Describe the types of finance companies. 2. Describe the finance company’s sources and uses of funds. 3. Discuss the participation of finance companies in financial markets. POINT/COUNTER-POINT: Will Finance Companies be Replaced by Banks? POINT: Yes. Commercial banks specialize in loans, and can provide the services that are provided by finance companies. The two types of financial institutions will ultimately merge into one. COUNTER-POINT: No. Finance companies tend to target a different market for loans than commercial banks. Thus, commercial banks will not replace finance companies because they do not serve that market. WHO IS CORRECT? Use InfoTrac or some other source search engine to learn more about this issue and then formulate your own opinion. ANSWER: Finance companies tend to provide credit to borrowers that exhibit higher risk. They can charge the borrowers a higher interest rate and therefore have the potential to earn a higher return on the loans (if the borrowers repay the loans). Commercial banks are exposed to default risk, but not to the same degree. Their loan portfolios are monitored by regulators. Thus, they are unlikely to replace finance companies. Questions 1. Exposure to Interest Rate Risk. Is the cost of funds obtained by finance companies very sensitive to market interest rate movements? Explain. ANSWER: The interest expenses on short-term funds obtained by issuing commercial paper and other short-term debt are sensitive to interest rate movements. The interest rate expenses on funds obtained from issuing bonds are not sensitive to interest rate movements. 2. Issuance of Commercial Paper. How are small and medium-sized finance companies able to issue commercial paper? Why do some well-known finance companies directly place their commercial paper? ANSWER: They can issue secured commercial paper, so that the debt is backed by assets. Even though they may have moderate risk, their commercial paper should be in demand if it’s backed. Finance companies can avoid commercial paper dealer fees by issuing commercial paper directly; it must develop an in-house system to do this. 3. Finance Company Affiliations. Explain why some finance companies are associated with automobile manufacturers. Why do some of these finance companies offer below-market rates on loans? ANSWER: Some finance companies specialize in providing financing for customers of automobile manufacturers. They may offer below-market rates if they can receive some type of rebate from the manufacturers. The below-market rates can increase the sales for the manufacturers. 4. Uses of Funds. Describe the major uses of funds by finance companies. ANSWER: The major uses of funds are consumer loans (including credit card loans), business loans, leasing, mortgages on commercial real estate, and second mortgages on residential property. Finance companies play a significant role in the financial system by providing various financial services to individuals and businesses. The major uses of funds by finance companies include: 1. Consumer Lending : One of the primary functions of finance companies is to extend credit to consumers for various purposes, such as purchasing automobiles, furniture, appliances, or financing education. Finance companies offer installment loans, personal loans, and revolving credit facilities to meet the diverse borrowing needs of consumers. 2. Small Business Financing : Finance companies provide financing solutions to small businesses that may have difficulty accessing credit from traditional banks. These companies offer small business loans, equipment financing, working capital loans, and lines of credit to support business expansion, inventory purchases, equipment upgrades, and other operational needs. 3. Retail Financing : Finance companies partner with retailers to offer financing options to customers at the point of sale. Through retail financing programs, customers can purchase goods and services on credit, with the finance company providing the necessary funds to the retailer. This arrangement helps retailers increase sales and enables consumers to make purchases through installment payments. 4. Real Estate Financing : Some finance companies specialize in real estate lending, providing mortgage loans, construction loans, and financing for real estate development projects. These companies may offer residential mortgages, commercial mortgages, bridge loans, and other real estate financing products to borrowers in need of property-related financing. 5. Debt Consolidation : Finance companies offer debt consolidation loans to individuals seeking to simplify their finances and reduce their overall debt burden. These loans allow borrowers to combine multiple debts into a single loan with a lower interest rate, making it easier to manage their debt and save on interest expenses. 6. Specialized Financing : Finance companies may provide specialized financing solutions tailored to specific industries or market segments. For example, they may offer healthcare financing, equipment leasing, factoring services, or structured finance solutions to meet the unique needs of their clients. Overall, finance companies play a crucial role in providing access to credit and financial services to consumers, small businesses, and other borrowers who may not qualify for traditional bank financing. By offering a diverse range of lending products and services, finance companies contribute to economic growth, job creation, and financial inclusion. 5. Credit Card Services. Explain how finance companies benefit from offering consumers a credit card. ANSWER: Finance companies finance the purchase by the consumer, charging an interest rate that compensates them for the loan provided. The offering of a credit card essentially creates several periodic loans to consumers. 6. Leasing Services. Explain how finance companies provide financing through leasing. ANSWER: Finance companies purchase machinery or equipment for the purpose of leasing it to businesses that prefer to avoid the additional debt on their balance sheet. Thus, the finance companies are essentially financing the utilization of assets by a company. 7. Regulation of Finance Companies. Describe the kinds of regulations that are imposed on finance companies. ANSWER: Finance companies that act as or are owned by bank holding companies are federally regulated. Otherwise, they are regulated by the state. They are subject to ceiling loan rates and maturities, imposed by the state regulators. They are subject to state regulations on intrastate business. Finance companies are subject to various regulations aimed at ensuring consumer protection, maintaining financial stability, and promoting fair and transparent financial markets. The kinds of regulations imposed on finance companies include: 1. Licensing and Registration : Finance companies are typically required to obtain licenses or register with regulatory authorities to operate legally. This process involves meeting certain eligibility criteria, such as capital requirements, compliance standards, and background checks on key personnel. 2. Capital Adequacy Requirements : Finance companies are often required to maintain a minimum level of capital to ensure their financial soundness and ability to absorb losses. Capital adequacy requirements are designed to protect depositors, creditors, and stakeholders from the risk of insolvency. 3. Consumer Protection Laws : Finance companies are subject to consumer protection laws and regulations that govern their interactions with customers. These regulations may include disclosure requirements, fair lending practices, prohibition of discriminatory practices, and restrictions on abusive or unfair debt collection practices. 4. Interest Rate Regulation : Some jurisdictions impose limits on the interest rates that finance companies can charge on loans and other credit products. Interest rate regulations are intended to prevent predatory lending practices and protect consumers from excessive interest charges. 5. Risk Management and Compliance : Finance companies are required to implement robust risk management policies and procedures to identify, assess, and mitigate risks related to credit, market, liquidity, and operational activities. Compliance programs are also necessary to ensure adherence to applicable laws, regulations, and industry standards. 6. Reporting and Disclosure Requirements : Finance companies are obligated to provide regular financial reports and disclosures to regulatory authorities, investors, and the public. These reports typically include financial statements, regulatory filings, and other disclosures regarding business operations, risk exposures, and compliance activities. 7. Anti-Money Laundering (AML) and Counter-Terrorist Financing (CTF) Regulations : Finance companies are required to implement AML and CTF measures to prevent their services from being used for illicit purposes, such as money laundering, terrorist financing, and other financial crimes. These measures include customer due diligence, suspicious transaction monitoring, and reporting obligations to relevant authorities. 8. Supervision and Examination : Regulatory authorities conduct supervision and examination of finance companies to ensure compliance with applicable laws and regulations, assess financial condition and risk management practices, and address any deficiencies or concerns identified during the examination process. Overall, regulations imposed on finance companies are aimed at promoting financial stability, protecting consumers, and maintaining the integrity and efficiency of financial markets. Compliance with these regulations is essential for finance companies to operate lawfully and sustainably while earning the trust and confidence of customers and stakeholders. 8. Liquidity Position. Explain how the liquidity position of finance companies differs from that of depository institutions such as commercial banks. ANSWER: Reliance on deposits by depository institutions can cause liquidity problems, because the timing of deposit withdrawals is often uncertain. Finance companies obtain funds by issuing bonds and commercial paper, and therefore can anticipate from the security maturities when they will need additional funds. In addition, they have quick access to funds because they are familiar with issuing securities. 9. Exposure to Interest Rate Risk. Explain how the interest rate risk of finance companies differs from that of savings institutions. ANSWER: Since finance company assets and liabilities share somewhat similar interest rate-sensitivity, they are not overly exposed to interest rate movements. Conversely, many savings institutions still concentrate on long-term fixed-rate mortgages, which expose them to interest rate movements because their liabilities are rate sensitive. 10. Exposure to Credit Risk. Explain how the default risk of finance companies differs from that of other lending financial institutions. ANSWER: Finance companies focus on consumer loans and on commercial loans that have moderate risk. Their concentrated loan portfolio exposes them to a relatively high degree of default risk. The default risk of finance companies differs from that of other lending financial institutions due to several factors related to their business models, customer base, and risk management practices: 1. Business Model : Finance companies often specialize in providing credit to borrowers who may not qualify for traditional bank loans, such as individuals with lower credit scores or small businesses with limited operating history. As a result, finance companies may have a higher concentration of subprime borrowers in their loan portfolios, which can increase their exposure to credit risk compared to other lending institutions. 2. Customer Base : Finance companies typically serve a diverse customer base, including individuals, small businesses, and specialty industries. These customers may have varying credit profiles, financial stability, and risk characteristics, leading to a more heterogeneous loan portfolio for finance companies. In contrast, other lending institutions, such as commercial banks, may have a more homogeneous customer base and loan portfolio composition. 3. Underwriting Standards : Finance companies may have more flexible underwriting standards compared to traditional banks, allowing them to extend credit to borrowers with limited credit histories or unconventional financial situations. While this flexibility may provide access to credit for underserved populations, it can also increase the likelihood of default if borrowers are unable to repay their obligations as agreed. 4. Risk Management Practices : Finance companies may employ different risk management practices compared to other lending institutions, depending on their size, scope, and business model. While larger finance companies may have sophisticated risk management frameworks and credit scoring models, smaller or less-established finance companies may have limited resources and capabilities for assessing and managing credit risk effectively. 5. Funding Structure : Finance companies often rely on a combination of sources for funding their lending activities, including deposits, wholesale funding, securitization, and capital markets. The composition of their funding sources can influence their risk exposure and resilience to market disruptions or funding constraints. For example, finance companies heavily reliant on short-term wholesale funding may be more vulnerable to liquidity risk during periods of market stress. Overall, the default risk of finance companies is influenced by their business models, customer base, underwriting standards, risk management practices, and funding structure. While finance companies play an important role in providing access to credit for underserved segments of the population, their exposure to credit risk may differ from that of other lending financial institutions due to the unique characteristics of their operations and loan portfolios. Interpreting Financial News Interpret the following statements made by Wall Street analysts and portfolio managers. a. “During a credit crunch, finance companies tend to generate a large amount of business.” When commercial banks cut back on the amount of loans that they provide, some potential borrowers are unable to obtain bank financing and attempt to obtain loans from finance companies. b. “Some finance companies took a huge hit as a result of the last recession because they opened their wallets too wide before the recession occurred.” Some finance companies were too liberal in providing loans; a high percentage of the borrowers were unable to make payments on their loans, and the finance companies experienced large loan losses. c. “During periods of strong economic growth, finance companies generate unusually high returns without any hint of excessive risk; but their returns are at the mercy of the economy.” When the economy is strong, the default rate on loans by finance companies is low. Given the relatively high rate charged on finance company loans, the return is high during a strong economy. But if the economy suddenly weakens, there may be an abrupt increase in the loans provided by finance companies. Managing in Financial Markets As a manager of a finance company, you are attempting to increase the spread between the rate earned on your assets and the rate paid on your liabilities. a. Assume that you expect interest rates decline over time. Should you issue bonds or commercial paper in order to obtain funds? Issue commercial paper, because you can obtain funds at a lower rate once interest rates decline by using a short-term security. b. If you expect interest rates decline, will you benefit more from providing medium-term, fixed-rate loans to consumers or floating-rate loans to businesses? The medium-term loans may be more desirable, because the rate will stay fixed even if interest rates decline. c. Why would you still maintain some balance between medium-term, fixed-rate loans and floating-rate loans to businesses, even if you anticipate that one type of loan will be more profitable under a cycle of declining interest rates? There may not be sufficient demand for consumer loans to simply focus on consumer loans. Also, you need to maintain good relations with businesses since there will be periods in which you want to provide more business loans. Finally, you must recognize that even though you would benefit more from medium-term consumer loans under a cycle of declining interest rates, your expectations could be wrong. Flow of Funds Exercise How Finance Companies Facilitate the Flow of Funds Carson Company has sometimes relied on debt financing from Fente Finance Company. Fente has been willing to lend money even when most commercial banks were not. Fente obtains funding from issuing commercial paper and focuses mostly on channeling the funds to borrowers. Explain how finance companies are unique by comparing Fente’s net interest income, noninterest income, noninterest expenses, and loan losses to those of commercial banks. Fente’s net interest income is higher than that of banks because it provides riskier loans and can charge a higher interest rate on its loans. Fente’s noninterest income is lower than those of banks. Fente’s noninterest expenses are lower than that of commercial banks because it does not need as many employees and infrastructure to run its business. Fente’s loan losses are higher than that of commercial banks. Explain why Fente performs better than commercial banks in some periods. Fente performs better than banks in some periods when the economy is strong, because its loan losses are low in those periods. However, when the economy is weak, loan losses are high and more than offset its higher net interest margin. Describe the flow of funds channeled through finance companies to firms such as Carson Company. What is the original source of the money that is channeled to firms or households that borrow from finance companies? The original source of money is buyers of commercial paper that is issued by finance companies. Mutual funds and commercial banks are common buyers of commercial paper, but they obtain their funds from other sources. Banks obtain their funds from households and mutual funds obtain their funds from individual shareholders. Solution Manual for Financial Markets and Institutions Jeff Madura 9781133947875, 9781305257191, 9780538482172

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