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  1. 1. Part IV: Non Depository Institutions Topic 13 – Finance Companies
  2. 2. What is a Finance Company? <ul><li>The Federal Reserve definition : a firm whose primary assets are loans to individuals and businesses. </li></ul><ul><li>Other names </li></ul><ul><ul><li>Non-banking financial institutions </li></ul></ul><ul><ul><li>Non-depository credit intermediaries </li></ul></ul><ul><ul><li>Lending companies </li></ul></ul><ul><li>A finance company is similar to a bank in that loans are underwritten to finance the activities of certain lenders </li></ul><ul><li>The balance sheet of a finance company looks similar to a bank, but with one MAJOR exception. </li></ul>
  3. 3. Finance Company Balance Sheet <ul><li>A finance company does not have any depositor liabilities!! </li></ul><ul><li>While finance companies offer mortgages, commercial loans and consumer loans just as a bank do, the finance these activities with non-depositor liabilities, mainly: </li></ul><ul><ul><li>Commercial paper </li></ul></ul><ul><ul><li>Other debt </li></ul></ul><ul><ul><li>Common Stock </li></ul></ul>
  4. 4. Types of Finance Companies <ul><li>Sales Finance Institutions : </li></ul><ul><ul><li>Example firms </li></ul></ul><ul><ul><ul><li>GMAC – General Motors Acceptance Corp </li></ul></ul></ul><ul><ul><ul><li>FMC – Ford Motor Credit </li></ul></ul></ul><ul><ul><ul><li>Sears Roebuck Acceptance Corp </li></ul></ul></ul><ul><ul><li>Specialize in making loans to customers (captive finance companies), providing on the spot financing </li></ul></ul><ul><ul><li>Can process loans quicker and more conveniently than depository institutions </li></ul></ul><ul><ul><li>Adverse selection process might be compromised </li></ul></ul><ul><ul><ul><li>A bank may refuse a car buyer due to bad credit </li></ul></ul></ul><ul><ul><ul><li>GMAC may be willing to take on a borrower with bad credit due to pressure from GM, if sales incentives are high </li></ul></ul></ul><ul><ul><ul><li>Lower rates (e.g. 0% financing) may be required to attract customers to GM cars, hence GMAC may be subsidizing GM. </li></ul></ul></ul><ul><ul><li>Finance company loans are not regulated in the same way that bank loans are, so more risk can be absorbed in the lending decision. </li></ul></ul>
  5. 5. Types of Finance Companies <ul><li>Personal credit institutions : Make installment and other loans to customers </li></ul><ul><ul><li>Example Firms </li></ul></ul><ul><ul><ul><li>Household Finance Corp </li></ul></ul></ul><ul><ul><ul><li>American General finance </li></ul></ul></ul><ul><ul><ul><li>American Express </li></ul></ul></ul><ul><ul><li>Some specialize in low income (sub prime) lending with bad/no credit history, providing higher margins (through higher charged interest rates) if adverse selection is adequately addressed. </li></ul></ul><ul><ul><li>Subject to state-imposed usury ceilings. </li></ul></ul><ul><ul><li>Credit Card companies (Capital One) fall into this category of finance companies </li></ul></ul>
  6. 6. Types of Finance Companies <ul><li>Business credit institutions : Provide financing to corporations </li></ul><ul><ul><li>Example firms: </li></ul></ul><ul><ul><ul><li>CIT Group </li></ul></ul></ul><ul><ul><ul><li>Heller Financial </li></ul></ul></ul><ul><ul><ul><li>GE capital </li></ul></ul></ul><ul><ul><li>Equipment leasing (e.g. aircrafts to airlines) </li></ul></ul><ul><ul><li>Factoring </li></ul></ul><ul><ul><ul><li>Finance companies buy the receivables from corporations at a discount </li></ul></ul></ul><ul><ul><ul><li>Take responsibility for collection with no assurances from the corporation </li></ul></ul></ul><ul><ul><ul><li>Allows the corporation to free up assets (loans), converting them to cash so that they may pursue investments related to their core competency </li></ul></ul></ul><ul><ul><ul><li>The Moral Hazard problem may surface is finance companies have no recourse with the corporation (ie corporation lowers quality of A/R). </li></ul></ul></ul>
  7. 7. Finance Company Asset Funding & Receivables Annual changes in level of funding – source: Board of Governors of the Federal Reserve System” ;Flow of funds Accounts of the United States.”
  8. 8. Finance Company Receivables <ul><li>Similar to a bank, loans are assets and are referred to as accounts receivables </li></ul><ul><li>The three major categories of Financing activity are: </li></ul><ul><li>Consumer loans and leases </li></ul><ul><ul><li>Autos </li></ul></ul><ul><ul><li>Student loans </li></ul></ul><ul><ul><li>Credit lines </li></ul></ul><ul><li>Commercial loans and leases </li></ul><ul><ul><li>Property, plant & equipment </li></ul></ul><ul><ul><li>Motor vehicles </li></ul></ul><ul><ul><li>Other </li></ul></ul><ul><li>Real estate loans </li></ul><ul><ul><li>One-to-four family homes </li></ul></ul><ul><ul><li>Securitized 1-4 family homes </li></ul></ul>source: Board of Governors of the Federal Reserve System” ;Flow of funds Accounts of the United States.”
  9. 9. Finance Company Receivables source: Board of Governors of the Federal Reserve System” ;Flow of funds Accounts of the United States.”
  10. 10. Finance Company Oversight <ul><li>Since finance companies do not accept demand deposits, they are not subject to the same Federal Regulation of Depository Institutions </li></ul><ul><ul><li>Finance companies are not Chartered by the State or OCC </li></ul></ul><ul><ul><li>Finance companies are not examined by the OCC, State </li></ul></ul><ul><ul><li>There is no need for FDIC insurance </li></ul></ul><ul><li>The cost to no federal regulation: there is not regulatory safety net to protect investors </li></ul><ul><ul><li>Finance companies generally have lower leverage ratios than banks to signal solvency </li></ul></ul><ul><ul><li>Shareholders (equity owners) invest in finance companies </li></ul></ul><ul><ul><li>But shareholders of depository institutions do not receive federal assurance for their ownership either </li></ul></ul>
  11. 11. Industry and Competition <ul><li>Finance companies compete head-to-head with banks in certain markets </li></ul><ul><ul><li>Relaxed regulation affords certain competitive advantages </li></ul></ul><ul><ul><li>Finance companies do not have to meet capital adequacy requirements </li></ul></ul><ul><ul><li>Finance companies have managed receivables greater than $1Trillion, about the same size as the Thrift industry, twice as large as credit union industry </li></ul></ul>Source: reprinted from financialservicesfacts.org Some finance companies are actually subsidiaries of commercial banking units (e.g. Citigourp credit card division)
  12. 12. Industry and Competition <ul><li>Concentration of finance company assets: </li></ul><ul><li>The top 20 largest finance companies = 65% of total assets </li></ul><ul><li>The 8 largest finance companies =51% of total assets </li></ul><ul><li>The 4 largest finance companies account for 41% of total assets </li></ul>Source: reprinted from financialservicesfacts.org
  13. 13. Industry Consolidation The total number of finance companies dropped from 1,200 in 1996 to 1,000 last year
  14. 14. Fringe Banking <ul><li>Service offered by non banking financial institutions could be considered “loan sharking”, but have grown in recent years. </li></ul>
  15. 15. Money Transactions by Non Bank Financial Institutions <ul><li>Coopers and Lybrand 1997 Study for the Financial Crimes Enforcement Network (FinCEN) on Non-bank financial institutions, based on size of market. The following diagrams break down the $200 Billion dollar sector measured by dollar transactions. </li></ul>Type of Transaction Revenue Generated ($200 Billion)
  16. 16. Money Transactions by Non Bank Financial Institutions <ul><li>Revenue from money transmissions reflect an average fee of 10%, so while they constitute only 5% of all money transactions, they account for 30% of all money transaction revenue by non-bank financial institutions. Check Cashing fees are roughly 2%. </li></ul><ul><li>Over 158,000 business locations in the U.S. Offer these services, including: </li></ul><ul><ul><li>Grocery stores </li></ul></ul><ul><ul><li>Liquor stores </li></ul></ul><ul><ul><li>Check cashing outlets </li></ul></ul><ul><ul><li>U.S. Postal service locations (25% of transactions) </li></ul></ul><ul><ul><li>Travel agencies </li></ul></ul><ul><ul><li>Bus Stations </li></ul></ul><ul><ul><li>Collection agencies </li></ul></ul>
  17. 17. Money Transactions by Non Bank Financial Institutions <ul><li>97% of the market is concentrated in two companies, and much of the market is focused on money remittances, foreigners sending money back to their home country. Mexico is the largest country by aggregate size of remittances. </li></ul>U.S. Money Transmission Market Share U.S. Market Share of Travelers checks
  18. 18. Money Transactions by Non Bank Financial Institutions U.S. Money Order Market Share U.S. Market Share of Travelers checks cashed