Financial
Markets and
Institutions, 9e
Web Chapter 27 Finance
Companies
Chapter Preview (1 of 2)
• Suppose you need to buy a car, but don’t have the
$20,000 handy. Most dealers will help arrange
financing for you, using a finance company.
Along with consumer loans, finance companies are
involved in lease finance and other business
services.
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Chapter Preview (2 of 2)
• In this chapter, we examine how finance companies
evolved and what they do. Topics include:
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History of Finance Companies
Purpose of Finance Companies
Risk of Finance Companies
Types of Finance Companies
Regulation of Finance Companies
Finance Company Balance Sheet
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History of Finance Companies (1 of 2)
• Finance companies date back to the 1800s when
retailers started offering installment credit.
• Autos loans really developed the industry, since
banks didn’t offer car loans in the early 1990s.
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History of Finance Companies (2 of 2)
• By the end of 2015, banks held $1,271 billion in
consumer loans, while finance companies held
$895 billion.
• Finance companies moved into business financing
(lease financing, etc.)
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Purpose of Finance Companies
• Issue commercial paper and use the proceeds to
make loans.
• Largely unregulated, some states limit the size of a
loan contract to a consumer borrower.
• Service both consumers and businesses with
tailored products (usually not offered by banks).
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Risk in Finance Companies (1 of 2)
• Default risk is the greatest risk, and finance
companies often lend to those who can’t get
financing otherwise.
• Liquidity risk can be an issue, as their assets
(loans) are not easily sold. A need for cash can
cause problems.
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Risk in Finance Companies (2 of 2)
• Roll over risk refers to the need to continue to
borrow in the commercial paper market.
• Interest rate risk is also present. Assets are
medium-term loans, funded by short-term
commercial paper.
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Figure 27.1 Types of Loans Made by Finance Companies,
2016
Source: http://www.federalreserve.gov/releases/g20/current/g20.htm.
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Types of Finance Companies (1 of 2)
• Business Finance Companies offer loans secured
by accounts receivable and other business.
• They also factor accounts receivable - giving
companies, say, 90% of the book value of A/R.
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Types of Finance Companies (2 of 2)
• They also specialize in leasing, often buying the
asset and then lease it back to the company.
Possible tax play.
• Floor plans help, for example, car dealers pay for
all the cars on their lot.
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Figure 27.2 Types of Business Loans Made by Finance
Companies (end of 2016)
Source: http://www.federalreserve.gov/releases/g20/current/g20.htm.
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Figure 27.3 Finance Company Business Loans, 1994–2015
Source: http://www.federalreserve.gov/releases/g20/current/g20.htm.
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Consumer Finance Companies (1 of 2)
• Consumer finance companies offer consumer
loans to for furniture, home improvements, etc.
• Consumers often can’t get credit elsewhere.
• Two exceptions are home equity loans and retail
credit cards.
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Consumer Finance Companies (2 of 2)
• A home equity loans can reduce borrowing costs.
Suppose that the interest rate on a home equity
loan is 8% and that the marginal tax is 28%. What
is the effective after-tax cost of the loan?
• Answer = 8% × (1 − 28%) = 5.76%
• Why? Because home equity loans are tax
deductible.
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Sales Finance Companies
A sales finance company is owned by the
manufacturer to promote its sales.
• If you want to buy a GM car, GMAC will be happy to
assist with the financing.
• Also known as captive finance companies.
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Regulation (1 of 2)
• Since there are no depositors or government
insurance, regulation is limited.
• Regulation is typically designed to protect consumers.
For example, Regulation Z requires the disclosure of
the APR on loans.
• Usury laws limit the interest rate that can be charged.
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Regulation (2 of 2)
• State and federal regulation limit ability to collect
on delinquent or defaulted loans.
• Few regulations in the business loan market.
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Table 27.1 Consolidated Finance Company Balance Sheet,
2015 (1 of 2)
Millions of dollars
Percentage of
total
Consumer loans
895,456
48.90%
Business loans
423,521
23.10%
Real estate loans
119,526
6.50%
Less reserve for loan losses
(20,508)
(1.1%)
Other assets
412,747
22.50%
Total Assets
1,830,743
100.00%
Assets
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Table 27.1 Consolidated Finance Company Balance Sheet,
2015 (2 of 2)
Millions of dollars
Percentage of
total
Bank loans
152,659
8.30%
Commercial paper
115,228
6.30%
Owed to parent
156,290
8.50%
Notes, bonds, and debentures
956,594
52.30%
Other liabilities
203,742
11.10%
1,584,512
86.60%
246,230
13.40%
1,830,743
100.00%
Liabilities
Total Liabilities
Equity
Total Liabilities and Equity
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Finance Company Balance Sheet (1 of 3)
• Assets.
─ Primary asset is their loan portfolio
─ Must maintain a contra-asset account reserve for loan
losses to charge off expected loan defaults
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Finance Company Balance Sheet (2 of 3)
• Liabilities.
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Equity (about 12% of assets)
Loans
Active in the commercial paper market
Captive finance companies can borrow directly from their
parent company
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Finance Company Balance Sheet (3 of 3)
• Income. Their income comes from several
sources:
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Interest income from their loan portfolio
Loan origination fees
Credit insurance premiums
Some have also expanded into income tax preparation
services
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Figure 27.4 Growth of Finance Company Assets, 1980–2015
Source: http://www.federalreserve.gov/releases/g20/hist/fc_hist_q_levels.html.
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Chapter Summary (1 of 3)
• History and Purpose: the history and background
of these companies was presented - essentially,
how they filled the void left by banks.
• Risk: the essential risks faced by finance
companies was covered: roll over and interest rate
risk.
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Chapter Summary (2 of 3)
• Types: the basic classification of finance companies
was reviewed, primarily by the type of customer
served.
• Regulations: other than consumer protections laws,
we discussed why finance companies aren’t heavily
regulated.
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Chapter Summary (3 of 3)
• Balance Sheet: we reviewed the breakdown of the
assets and liabilities held by these companies.
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