Consumer Credit in the American

Consumer Credit

In the American financial system, banks are a specific type of financial intermediary. Distilled to their essence, the function that they perform is to accept deposits and then lend that money. They pay interest on the deposits, and receive interest on the money that they lend out. The difference between these interest rates -- the spread -- is the means by which banks derive their profit.

Consumer lending takes a number of different forms. These include mortgages, car loans, small business loans, credit cards, overdraft protection, lines of credit and other facilities. The industry is governed by regulations set out by the Federal Deposit Insurance Corporation (FDIC). Small business loans are subject to different sets of rules -- even those backed by the personal assets of the owners; mortgages are also subject to different rules. The FDIC sets out rules governing a wide range of practices with regards to lending. Almost every aspect of lending, from finance charges to Spanish language disclosures, is governed by the FDIC (FDIC, 2009).

Adherence to these rules is important for two reasons. One is that these rules provide a baseline level of consumer protection against exploitation. The lending industry has always been controversial, especially with respect to the concept of interest. The rules therefore are put into place to ensure that consumers have confidence in the system. The other reason is that rules create a level playing field. The government intervention in the consumer credit market credits a situation of almost perfect competition. Banks are forced to compete on slight rate differences and levels of service.

Credit policy not only varies from bank to bank but within the same bank through different time periods. The bank to bank variation is expected, as credit policy can be a form of competitive advantage. A loose (riskier) credit policy can expose the bank to higher risk but higher returns; a tight (less risky) credit policy provides greater stability of income flows. Although in theory banks should be rational actors with respect to credit policy, evidence shows that they often follow money supply stimulus and the lead of other banks. This results in banks supporting negative NPV projects during market upswings and rejecting positive NPV projects during market downswings (Rajan, no date).

Banks execute their credit policies by a number of means. As noted earlier, most banks have a wide range of products at their disposal. Credit officers must assess the client's need and find the right product. Choosing the right product should result in maximizing the profit for the bank and the benefit for the consumer. There can be significant differences between consumer credit products. Thus it is critical that banking officers understand each different product, the circumstances for which it is best used and the needs of the individual customer so that the recommended solution is the best one available for that customer.

The decision to grant credit is often based on programs that weigh a number of factors. At the core of these factors are the Five Cs of credit analysis: capacity, capital, collateral, conditions and character (Penwell, 2009). Capacity refers to the consumer's ability to repay the loan (i.e. income level). Capital refers to the degree to which the consumer has to back the loan -- the down payment, for example. Collateral refers to physical assets, such as a house, car or boat, that can be used to back the loan. Conditions refer to the purpose of the loan. This especially refers to mortgages, since they are subject to a slightly different set of rules. Character refers to the perceived integrity of the borrower. Credit score is typically used as a proxy for character.

To each variable a score will be assigned, and a weighting. When these scores are combined, the program will yield a recommendation with respect to the bank's acceptance or lack thereof. The precise inputs for each variable -- and the weightings -- will be different at each bank, within the bounds set by law.

When the decision is made to accept a loan, the next step is to close the loan. Closing the loan is also known as firm commitment, and involves the completion of all key paperwork within a designated time. A closing date is set, and the closing costs are established. When the client pays the costs and completes the paperwork, the loan is closed.

The next step is to service the loan. Servicing refers to the management of the payments. The loan creates an obligation on the part of the borrower to make payments as specified in the agreement. The role of the bank is to ensure that those payments are received. Servicing may be contracted out to a secondary party. In the U.S. that might be Fannie Mae or Freddie Mac, who provide a secondary market for mortgages. In a servicing arrangement, the bank would collect the payments and remit most of this money to the secondary market investor. The bank would keep a portion of the payment for itself. Occasionally the bank may keep and service the mortgage itself (AustinHomeLoan.com, 2009). The servicing function involves the management of the incoming payments, except in the instance of default or arrears. At that point, the firm responsible for servicing the loan must act in order to protect the investment.

The entire lending process is a risk-management activity. The interest paid should reflect the risk level of the debt obligation. Therefore, banks and other lenders pay specific attention to the risk evaluation process. The prospective borrower is investigated intently, according to the principles of the 5 C's. The bank evaluates a variety of factors. These include the credit score and current income level. The prospective borrower's ability to make a down payment is taken into consideration as well.

The character portion of the evaluation is critical. Having sufficient funds to make payment is important, but more important is the will of the borrower to make payment. The character component therefore not only includes the credit score but an interview as well. The lender sits down with the borrower(s) and attempts to determine the degree to which they are committed to the loan. Of special importance are the views that the borrower has with respect to the concept of credit.

Banks have long been the dominant players in the consumer credit business. As they face increasing competition from a variety of other financial intermediaries, it is more important than ever before that banks understand their role and the best practices with regards to consumer lending. Banks are strictly bound in terms of their lending practices by the FDIC. However, they are still able to offer a wide range of products. Bank staff needs to be sufficiently knowledge about each product in order to properly market their solutions. The credit policy of each bank is impossible to gauge as it is always changing. Indeed, there are instances where bank credit policy does not reflect ration decision-making on the part of bank managers.