Professional Banking Fundamentals PDF

Professional Banking FUNDAMENTALS CHAPTER 6 – UNIT 1 Credit and Consumer Lending Principles of Lending – Part 1 1 FINSIA and the Chartered Banker Institute work together to provide an appropriate qualification framework for Australian financial services....

Professional Banking FUNDAMENTALS CHAPTER 6 – UNIT 1 Credit and Consumer Lending Principles of Lending – Part 1 1 FINSIA and the Chartered Banker Institute work together to provide an appropriate qualification framework for Australian financial services. This document in combination with other learning assets supports the Professional Banking Fundamentals qualification. This qualification is based on existing Chartered Banker Institute syllabuses and learning content and has been amended to reflect the operating environment, legislation, regulation, opportunities and challenges in banking in Australia. Edition 3.2 published February 2023. For further information about FINSIA: https://www.finsia.com Copyright © The Chartered Banker Institute and FINSIA. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written permission of the Chartered Banker Institute and FINSIA. The contents of this book are intended as a guide and not professional advice. Although every effort has been made to ensure the contents of this book are correct at the time of publishing, neither the Chartered Banker Institute nor FINSIA warrant that the information in this book is accurate or complete and accept no liability for any loss or damage suffered by any person acting, or refraining from acting, as a result of the material in this book. 2 CHAPTER 6 Credit and Consumer Lending Unit 1: The Principles of Lending – Part 1 Welcome to this unit: Principles of Lending – Part 1. In this unit we will examine how banks use: The four ‘C’s of credit and other personal information to evaluate a loan applicant. Interest and fees charged on loans to generate income. Learning objectives Contents Unit 1 Principles of Lending – Part 1 By the end of this unit you will be able to Unit 2 Principles of Lending – Part 2 Explain how these key principles Unit 3 Security of lending can be used to make Unit 4 Lending Rates and Products professional and ethical lending Unit 5 National Credit Code Unit 6 Application Assessment decisions. 3  CHAPTER 6 CREDIT AND CONSUMER LENDING PRINCIPLES OF LENDING – PART 1 The basic functions of banks are to accept deposits and lend money. In normal economic circumstances, income from lending is the primary source of revenue to a bank and enables the bank to pay interest to providers of capital, meet its costs in full, discharge its taxation obligations and make a profit. Lending also identifies opportunities for banks to ideally generate revenues from additional sources. For example, through the process of assisting customers with a mortgage, further needs can be identified, and additional products and services offered to meet those needs. This creates an opportunity to achieve greater customer loyalty and revenue streams through banking, insurance and wealth management products. THE BASIC PRINCIPLES OF LENDING The range of bank lending products has increased considerably over the years, as have the legislative requirements that relate to them. However, it could be argued that the basic principles of lending have remained unchanged and can be applied to any lending situation. In the first instance, banks will want to consider the following: DID YOU The person who is applying for the loan. KNOW? The amount, purpose and term of the loan. The basic The person’s ability to repay the loan. principles of lending consider For example, whether dealing with a first-home buyer borrowing $350,000 to purchase who is applying a unit, or a high net worth individual borrowing $2 million to purchase a luxury home, the for the loan and principles that you will apply to assess the loan application should be the same. their repayment ability, the loan THE 4CS OF CREDIT amount and the Whenever we are approached with a lending proposal, the first aspect we consider is loan purpose. the person. In particular, we are focused on the different aspects of character, capacity, collateral and capital. These are often referred to as the 4Cs of credit. Character Capacity Collateral Capital 4  CHAPTER 6 CREDIT AND CONSUMER LENDING CHARACTER The integrity of the borrower is paramount, which is why interviews and discussions with them are so important. Integrity – Many questions are asked by the lender throughout the course of discussions and honest and reliable answers are expected from the customer. If the customer promises certain action, the lender must be assured that this action will be carried out. Proof of identity – If dealing with a customer who is not known to your bank, you must follow the established procedures for recording and verifying the customer’s identity in order to comply with current anti-money laundering and counter-terrorism financing (AML/ CTF) know your client (KYC) procedures. Under 2021 reforms to the KYC procedures, AML/CTF reporting entities (such as banks and lenders) can rely on customer identification being carried out by third parties, provided a number of conditions are met. These conditions include the need for a written agreement with the third party who must be subject to AML/CTF supervision, there must be regular assessments of the arrangement, and the lender must reasonably believe the customer due diligence requirements of the AML/CTF rules are being met. If these conditions are met the lender may be protected from liability – meaning that the legislative “safe harbour” may apply. Note that each bank will also have rules regarding validating the identity of existing customers who are opening new accounts or obtaining loans. Characteristics – In addition to the formal procedures required, it is also prudent to look for the following characteristics to be demonstrated by a customer who has asked to borrow money: Honesty. Trustworthiness. Reliability, stability and dependability. Integrity. You may be able to demonstrate this by reviewing the client’s credit history or credit score. CAPACITY Capacity refers to the borrower’s ability to repay the loan. However, the will to take action is CREDIT not necessarily the same as an ability to see the action through, so you must also be assured HISTORY of the customer’s intent, capacity and capability to meet their financial commitments. Equally, you should not let the borrower’s enthusiasm mask any potential weaknesses in This is a record capability. of a borrower’s repayment of When assessing capacity for a personal lending application, it is important to consider the debts. following factors: The age of the customer(s) and whether this impacts the term of the borrowing. You need to ensure the income streams used to repay the loan will remain sufficient for the term of the loan. In some cases, borrowing will continue, for example, beyond the customer’s retirement age, which may be acceptable, provided capacity remains. The customer’s employability/business and, experience to sustainably generate an income. Repayment capacity can be more complex with self-employed borrowers because of the way they validate their available income to service the debt. This process may be further complicated by the operating method of the business structure, whether it is a company, sole proprietor, firm or trust. Generally, banks have defined credit policies and processes to determine the income capacity of self-employed applicants. Their reputation and credit history. Has this customer borrowed money before? Do they have a satisfactory repayment history? Were all agreed commitments managed well by them? 5  CHAPTER 6 CREDIT AND CONSUMER LENDING A GUARANTOR Is a third party to a loan, helping the customer to obtain a loan by offering additional security support. Guarantors are COLLATERAL generally limited Collateral refers to the asset/s being provided to secure the loan. Collateral is typically to spouses or required for larger loans as a way to reduce the lender’s risk, which often enables lower immediate family rates of interest to be charged. Any asset the lender accepts, which is allowed by law, members, such as can serve as collateral. parents. Some common forms of collateral include: Real estate, which may be the property being purchased, or another property held by the borrower. In the case of mortgage lending, this will typically be the family home or an investment property. Lenders review the value and condition of the property or properties based on the information provided in the valuation (which must be current). Comparable properties for valuation purposes need to be as similar as possible, without excessive adjustments for variations. Cash accounts, although retirement accounts such as superannuation typically do not qualify. Vehicles and equipment. Investments, typically ASX listed shares and managed funds. Personal/third-party guarantees where an individual, such as a parent or other co-borrower provides a guarantee to repay the loan if the applicant cannot make the payments. The person providing the guarantee is known as a guarantor. Security will be discussed further in a separate unit. CAPITAL The amount of capital, often referred to as the deposit or equity provided by the customer, can indicate their commitment to the purpose of the loan. Personal loan In the case of a personal loan, for example, if the customer is intending to use the funds to purchase an asset such as a car, then how big of a contribution are they making towards the overall cost? With car finance, for example, it is common to find that the customer’s contribution comes from the trade-in of their previous car, therefore, rather than making a physical cash deposit to the total cost, they are still contributing financially by deducting the value of their trade-in from the total cost of the new car. Home loan In the case of a mortgage, what percentage of the total cost of the house are they looking for the bank to provide and what percentage of the total cost are they contributing? Generally, the more of their own resources the customer has committed towards financing the underlying asset, the greater their commitment to ensuring the loan is fully repaid. Therefore, the initial risk to the financial institution will be lower. 6  CHAPTER 6 CREDIT AND CONSUMER LENDING OTHER PERSONAL INFORMATION In addition to the 4Cs, there is other information that should be analysed to help reach a lending decision. Reference is also made to the responsible lending obligations (covered in more detail within these units), ensuring we make reasonable inquiries about the customer’s financial situation, their needs and objectives, and take reasonable steps to verify their financial situation. It is critical that we make reasonable enquiries. DID YOU KNOW? Relationship status - the customer’s relationship status can affect their ability to repay the borrowing. For example, a couple has the potential for both to be earning income Collecting this and so increase the amount of available funds to repay the loan. information helps Dependants – dependant refers to a person who relies on another, especially a family if the subsequent member, for financial support. The number and age of any dependant could affect credit assessment repayment capacity. A couple may have a joint income, but if they have a family, their indicates security monthly outgoings will generally be far greater than compared to a couple with no is required in order dependants. Dependants are not just children: verify if they have elderly parents or to approve the others who are dependent on them. loan. Some types Employment - the customer’s employment has a great bearing on their repayment of security are capacity as this directly affects their income. In collecting employment information, of more value to you should find out how much of their total remuneration is salary and how much is bonuses. Normally, only regular salary is considered when assessing repayment the lender than capacity. Employment details may also give you an insight into their future earning others. Knowing potential. For example, is the customer employed with an established employer the number and in a sector of the economy that is growing, or are they working for an unknown type of assets organisation in an economic sector that you know is in decline? the customer Previous connections with the bank - a customer may have an established relationship holds means that with their bank including repeated loan transactions and other products/accounts. a well informed Lending to existing credit customers reduces the risk of default compared to new decision can be customers. Through the relationship with an existing customer, the bank has gained made about the valuable knowledge of the customer’s financial circumstances and behaviour and therefore is better placed to assess the new loan application. Even where there have type(s) of security been no previous loans, a customer’s savings and transactional activity can indicate the required. capacity to repay the loan. CUSTOMER’S ASSETS AND LIABILITIES In the final component of the ‘person’ section it’s time to examine the information you need to record about the customer’s assets and liabilities. The purpose of this financial information is to help build a comprehensive picture of the customer and therefore must include the assets the customer owns and their financial obligations. Examples may include: Assets Liabilities Principal residence Home loan Car Car loan Cash Personal loan Home contents Credit card Shares Payday loan Investment property Superannuation 7  CHAPTER 6 CREDIT AND CONSUMER LENDING ACTIVITY 1 Write your response below, then check the answer given at the end of the unit. What are the typical types of assets and liabilities that a customer may have? NET POSITION The value of one’s investment position, calculated as the position’s market value less the initial cost of entering that position. Having collected detail on the customer’s assets and liabilities, it is then a straightforward task to total their assets and then total their liabilities. The resulting difference is usually referred to as the customer’s net position. We now have an overall picture of the customer’s assets and liabilities and their net position. However, as the purpose of the credit assessment is to make an informed decision on the customer’s request for a loan, we need to look in more detail at their overall financial position, including income and expenditure. ASSETS – LIABILITIES = NET WORTH 8  CHAPTER 6 CREDIT AND CONSUMER LENDING ACTIVITY 2 Write your response below, then check the answer given at the end of the unit. Refer to your list of customer assets and liabilities. What other information would you like to have about these items to inform your lending decision? DID YOU KNOW? Your bank will have defined policies on the types of security that are acceptable, and whether any contingency allowances need to be applied in adopting valuations. You should always exercise care with any reliance you place on any of the assets listed. For example, it is easy to place a value on a bank account because it is easy to value and realise. The same cannot be said for an original painting, because it can be difficult to place an exact value on it, and the value may fluctuate widely, based on demand. If the customer wishes to sell the painting, it may take an extended period of time to find a suitable buyer with both the desire and the means to buy it. 9  CHAPTER 6 CREDIT AND CONSUMER LENDING RETURNS AND PROFITABILITY A bank is no different to any other business – in order to make a profit it needs to generate income from a number of sources. Core sources of bank lending income include: Application fees relating to lending facilities. Fees charged for the loan. Interest charged on the loan. DID YOU KNOW? FEES Normally an Throughout the life of the customer’s loan there can be a number of bank-related fees and application charges payable. fee will be lower for the renewal Application fees of an existing loan facility than Application fees can range from $300 to $1000 and are payable to the lender to the meet for setting up the costs of the following: a completely Staff time spent preparing for and conducting customer interviews and assessing the new one. application. Processing the loan application (including setting up the account and the direct debit for the repayments and arranging drawdown). Preparing the loan documentation, e.g., the offer letter and other documentation. Reviewing the borrowing facility at any review dates. Typically, this fee may either be added to the borrowing or paid separately by the customer. The amount of the application fee can be negotiated between the lender and the customer at the time the borrowing is agreed. Upfront fees While there will be some discussion about the amount of the application fee, there are some constraints which the lender will need to include within the fee structure including valuation fees and transaction costs. Ongoing fees Some or all of these fees can be reduced or removed with the acquisition of a tailored package, which many banks and financial institutions offer, subject to terms and conditions, and paying the annual fee. These fees may include: Loan service fees. Deferred establishment fees. Top up/loan increase fees. Switching fees. 10  CHAPTER 6 CREDIT AND CONSUMER LENDING INTEREST While some customers may express surprise from time to time regarding the need to pay an application fee and possibly a monthly service fee, they will all expect to pay interest on the borrowing. How do banks decide on what level of interest rate to apply? Firstly, for some banking products the interest rate will be fixed at the start and will remain fixed for the duration of the loan. We have already discussed interest rates and the basis on which banks decide the rate to charge, including competition, operating expenses, cash rates set by the Reserve Bank, domestic and international economic conditions. However, a factor impacting on every application is risk. Banks decide on interest rates for lending by comparing risk to return. Basically, this means that the more risk is involved for the bank, the higher the interest rate that will be charged. The idea behind this is that the higher the likelihood that the bank may lose its money, then the more interest it will charge the customer to compensate for this. DID YOU KNOW? Banks decide on rates of interest for lending by comparing risk to return. Basically, this means that the more risk is involved for the lender, the higher the rate of interest that will be charged. For example, the purpose of the lending or the customer’s previous borrowing record may present risk. As we have seen, one way in which the risk to the lender can be mitigated is by the customer providing security. Therefore, all other things being equal, if a customer offers suitable and adequate security, the rate of interest charged by the lender may be lower. It is important that, when offering a rate of interest to the customer, thought is given to the level of risk for the loan, and the rate of interest should be charged accordingly. This will help to ensure a consistent approach with all customers. Banks must always be able to justify why they are charging a particular rate of interest, rather than it appearing to be an arbitrary decision. If this consistency is not applied and the customer subsequently becomes aware that a bank is charging different interest rates for very similar types of borrowing, there may be an adverse effect on the reputation of the bank. It is normal practice for banks to set guidelines for staff regarding the rates of interest that they should be charging. This concludes Unit 1, please proceed to Unit 2 Principles of Lending – Part 2 11  CHAPTER 6 CREDIT AND CONSUMER LENDING Answers ACTIVITY 1 What are the typical types of assets and liabilities that a customer may have? Assets – some or all of: Property. Shares or managed investment funds. Superannuation funds or life endowment policies. Motor vehicles. Bank accounts. Other, such as antiques, paintings, classic cars, or boats. The most current value for each of these assets should be recorded. Liabilities: An outstanding mortgage or mortgages on their property. Personal loans or credit card debts. Guarantees. The values of these should be as current as possible. ACTIVITY 2 Refer to your list of customer assets and liabilities. What other information would you like to have about these items to inform your lending decision? Assets – the following additional information would be useful: Property – location and type of property; date and details of the most recent valuation. Shares or managed investment funds – specific details of the companies or investment funds, volumes and current unit price or valuation and amount of investment returns. Life policies – name of company, current value and sum insured. Bank accounts – name(s) of bank(s), type of account, withdrawal period, balances. Superannuation – current valuation, asset allocation and details of any insurance attached to it. Other, such as antiques, paintings, classic cars, or boats – description of each asset, most recent valuation, basis and date of valuation. Liabilities – the following additional information would be useful: Mortgage loan – amount outstanding, property to which the mortgage refers, type of mortgage (Principal & Interest or Interest Only), loan term and date of final payment (if any). Personal loan and credit cards – amount outstanding, name of lender, type of debt (e.g., loan, card), date of final payment (if any). Guarantees – amount of guarantee, name of debtor, name of lender and date of anticipated repayment of the loan. 12