7.1 - Consumer Loan Theory

Flex Line

• Overdraft protection can also be linked to a home equity line of credit, which is also referred to as a flex line.
• Charges for flex lines vary but may include no application fee or charges in the first year.
• Additional years may require a fee to maintain the flex line.

Other Revenue Sources

• There are other fees a bank may charge, such as account service charges, safe deposit box rental, ATM charges, insurance sales fees, and trading fees.

Managing a Bank's Portfolio

• Loans make up a large percentage of bank revenues.
• The three general categories of loans are consumer loans, mortgage loans, and commercial loans.

Asset Management

Credit Rationing

• Banks are financial intermediaries. They attract money in the form of deposits.
• Money leaves through loans.
• Bank income is generated through interest and fees.
• Asset transformation refers to using deposits to generate revenue by putting deposits to work via loans.

• Banks can decide on an appropriate customer base.
• Not everyone who applies for a loan receives a loan.
• Sometimes banks will loan someone a portion of the requested amount.
• When banks refuse to provide a loan, or when they lend less than the customer requested, they are engaging in credit rationing.
• By carefully allocating how their deposit funds will be used, banks are maintaining the stability of their portfolios.

Consumer Lending Theory

Off-Balance Sheet Activities

• Consumer loans comprise a specific portion of a bank's loan portfolio.
• Consumers respresent a specific market segment for bank loans.
• Consumer loan theory has evolved as part of the methodology for developing profitable consumer loan portfolios.

Asset Management Cont.

• There are a number of services banks offer that generate revenue but that are not included on their balance sheets.
• A balance sheet is a brief summary that lists the net profit, owner's equity, assets, and liabilities for a company.
• They are seen not only by company management, but also by investors.
• Off-balance sheet activities are not seen by investors and include overdraft protection and assorted letters of credit.

Loan Selection

• Deposits are bank liabilities because they could be withdrawn by a customer at any point in time.
• Loans are bank assets because they represent money that the bank will receive back, in the form of principal and interest payments.
• For a bank to be profitable, it must intelligently engage in asset transformation.

• Revenue from loans is the primary income source for banks.
• Banks are very selective in deciding the type of customer with whom they will do business.

Downstream Loan Profit

Loan Selection Cont.

Modern Portfolio Theory

• Banks do not always keep loans.
• They often sell loans on the secondary market.
• Securitization of loans occurs when individual loans are pooled together.
• These combined loans can then be sold as securities.
• Securitization can occur for any type of consumer loan including vehicle loans, education loans, and miscellaneous loans.

• Adverse selection is the concept that the borrowers who are most willing to accept a high interest rate are the same borrowers who are most likely to default on their loans.
• For example, a bank that sets one price for all of its checking account customers which runs the risk of being adversely selected against by its low-balance, and/or least profitable customers
• Moral Hazard occurs when a borrower takes greater risks if they think the harm they will incur from those risks will somehow be minimalized.

• In 1952, Harry Markowitz developed the concept of modern portfolio theory (MPT).
• Theory states that within any portfolio of investments, diversification should be used to spread out risk.
• Maintaining a diversified portfolio shields investors from downturns in a particular industry.

Additional Sources of Bank Revenue

• In addition to generating revenue from managing loan portfolios, banks generate revenue from charging a variety of fees, for example deposit accounts.

7.1 - Consumer Loan Theory