Chapter Fourteen
Other Lending Institutions:
Finance Companies
Finance Companies: Overview
Activities similar to banks, but no depository function.
Initially owned by manufacturers (captive finance companies)
e.g. GMAC Canada (recently renamed as Ally Financial)
Relatively unregulated
Face default risk and liquidity risk
Market niche advantages: may specialize in installment loans
(e.g. automobile loans) or may be diversified, providing
consumer loans and financing to corporations, especially through
factoring
Major source of income comes from the loan interests
Commercial paper is the key funding source
Act as intermediaries in the money market: borrow large and loan
small
Industry is highly concentrated
Finance Companies (FCs)
Finance companies are renamed as non-depository
credit intermediaries in 1998
There are three major types of finance companies
Sales finance institutions specialize in loans to customers of a
particular retailer or manufacturer, e.g. Ford Motor Credit
Canada
Personal credit institutions specialize in installment and other
loans to consumers, e.g. Easyfinancial, iCash
Business credit institutions specialize in business loans,
especially through equipment leasing and factoring
Factoring is the process of purchasing accounts receivable
from corporations, usually with no recourse to the seller
should the receivables go bad, e.g. CIT Canada acquired by
Laurentian Bank in Oct 2016
Balance Sheet and Trends
Primary asset of a typical finance company is
the loan portfolio
Assets (Use of Finance Company Funds):
Consumer loans (58.5%)
Business loans (28.7%)
Mortgages (12.8%)
Increases in real estate loans and other assets.
Growth in leasing.
Finance companies face credit risk, interest rate
risk and liquidity risk.
Balance Sheet and Trends
Liabilities (Sources of Funds):
Commercial paper (77%)
Debt (longer-term notes & bonds) (23%)
Finance firms are largest issuers of commercial
paper (frequently through direct sale programs).
Commercial paper have short maturities with 30 days or
less.
CPs are short-term unsecured promissory notes sold by
high credit quality corporations
Have bank lines of credit as backup to commercial paper
Consequently, management of liquidity risk differs
from commercial banks relying on deposits
Interaction with Other FIs
Type of Financial Interaction with Finance Companies
Institution
Commercial Banks Compete with finance companies for consumer
loan business (including credit cards),
commercial loans, and leasing
Credit Unions Compete with finance companies for consumer
loan business
Securities Firms Underwrite bonds that are issued by finance
companies
Pension Funds Compete with insurance subsidiaries of finance
companies that manage pension plans
Insurance Companies Compete directly with insurance subsidiaries of
finance companies
Consumer Loans
Personal credit institutions make loans to riskier
customers at higher interest rates than banks
Subprime lenders are FCs that lend to high-risk
customers accepting items not taken by banks (e.g. old
cars) for collaterals
Loan sharks are subprime lenders that charge unfairly
exorbitant rates (i.e. more than 60% annually) to
desperate, subprime borrowers
Payday lenders provide short-term cash advances that
are often due when borrowers receive their next paycheck
80 companies listed in Canada offering payday loans
Effective Jan 1,2018, the maximum total cost of borrowing for a
payday loan is $15 per $100 advanced for two weeks
Average payday loan in Ontario is $435 over 16 days
Business Loans
FCs often have advantages over banks with respect
to business loans because FCs:
Are not subject to regulations that restrict the type of
products and services they can offer
Do not accept deposits—accordingly, bank-type regulators
do not monitor their behavior
Often have substantial industry and product expertise
Are more willing to accept risky customers
Generally have lower overhead than banks
Floor Plan Loans
Most common in the auto industry because cars have titles
that the finance company can hold to secure its loan. Exist
in other industries, e.g. construction equipment and boats
Finance company pays for the car dealership’s inventory of
cars received from the manufacturer and puts a lien on
each car on the showroom floor
When a car is sold, the dealer must pay off the debt owed
on the car before the finance company will provide a clear
title of ownership.
The dealer must pay the finance company interest on the
floor loans until the inventory has been sold off.
Curtailment schedules vary by floor plan providers, but
generally range from 5%-20% of the original loan proceeds
on each vehicle every 30-60 days.
Mortgages
Real estate loans
Second mortgages are in the form of home equity
loans, i.e., loans that let customers borrow on a line of
credit secured with a second mortgage on their home
Securitized mortgage assets are mortgages purchased
and used as assets backing secondary market securities
Mortgage servicing is a fee-related activity whereby the
flow of mortgage repayments is collected and passed on
to investors in whole mortgage loan packages or
securitization vehicles
Industry Performance
Strong loan demand
Strong profits for the largest firms
e.g. HSBC Finance, Associates First Capital,
Beneficial
Effects of low interest rates
Most successful finance companies have
become takeover targets
Citigroup: merged by Associates First Capital,
Household International: merged by HSBC Holdings
CIT: merged by Laurentian Capital
Government Finance Companies
The Business Development Bank of Canada (BDC):
support small businesses
Canada Mortgage and Housing Corporation
(CMHC): help first-time home buyers by providing
mortgage insurance, provide guarantees on MBS
Export Development Canada (EDC): advise
exports/importers
Farm Credit Canada (FCC): help farmers and report
to the Minister of Agriculture
None of them is large in size but providing supports
to parties who may not be served by other FIs
Regulation of Finance
Companies
Not subject to the Bank Act or CDIC as they do
not accept deposits.
Much lower regulatory burden than depository
institutions.
Subject to the Consumer Protection Act
Truth in leading legislation: disclose the APR charged
Usury statutes: set a ceiling on interest rates that can
be charged on finance company loan
Bankruptcy statutes: eliminate debt and retain
ownership of many assets
Regulation of Finance
Companies
Even with less regulatory scrutiny, finance
companies must signal safety and soundness
to capital markets in order to obtain funds.
Higher capital-to-total-asset ratio (8.6%) than
banks (4.52%)
Captive finance companies may employ
default protection guarantees or borrow
directly from parent company
Global Issues
Largest finance companies are in the US
Most Canadian finance companies are
subsidiaries of US companies
In foreign countries, finance companies are
generally subsidiaries of commercial banks or
industrials
In Japan, ownership of finance companies by
banks created opportunities when banks hit by
increase in nonperforming loans
GE Capital/Japan Leasing Corporation
