L1 Course in Retail Banking Banking
Version Date
: 1 .0 : 27-Jul-2004
Foundation Course in Banking
TABLE OF CONTENTS Introduction Introduction to Retail Banking......... Banking.................. ................. ................. ................................................5 .......................................5 Retail Products Products and Instruments...... Instruments............... .................. ................. ..............................................7 ......................................7 Deposits and Accounts ...................................................................................10 Bank Accounts..................................... ................................................................................ ..................................................................... .......................... 10 Type of Accounts......................................... ................................................................................... ....................................................... ................... ...... 11 Product Differentiators..................................... ............................................................................................. .......................................................... 16 Account Processing...................................... ................................................................................. .................................................... ................. ........ 18
Credit Cards.......................................................................................................29 Credit Cards – Basic Concepts........................................ ................................................................................. ......................................... 29 Credit Cards – Processes ..................................................................................... ........................................................................................ ... 31 Credit Cards - Sources of Revenue.......................................... ............................................................... ................................ ........... 33
Loans Overview......... Overview.................. ................. ................. .................. .................. .................. ...........................................34 ..................................34 Key Players.......................................... ................................................................................................. ................................................................. ............. ... 35 Generic Loan Process.......................................... ..................................................................................... .................................................... ......... 36
Mortgages..........................................................................................................39 Mortgage products......................................... .................................................................................... ........................................................... ................ 40 Key mortgage concepts..................................... ......................................................................................... ....................................................... ... 45 Mortgage Market....................................................................................................... Market....................................................................................................... 48 Mortgage processes........................................... ......................................................................................... .............................................. ........ 54 Regulations governing the mortgage industry..................................... ........................................................... ...................... 63 Market Landscape & Trends......................................... ..................................................................................... ............................................ 65
Auto Loans........................................................................................................69 Types of Financing options...................................... ....................................................................................... ................................................. 69 Players Involved........................................... ............................................................................................ ................................................. .......... ............ 77 Key Concepts.................................... ............................................................................... ....................................................... ...................... ................ ...... 77 Auto Loan Process........................................ ...................................................................................... .............................................. .......... ............. ... 79 Auto Leases ............................................. ........................................................................................ ................................................................. ...................... 83 IT Applications in Auto Loans .................................................................................. 91 Regulations governing the Auto Loan Industry............................................. ....................................................... ............ .. 95
Student Loans...................................................................................................97 Page 2 of 186
Foundation Course in Banking
TABLE OF CONTENTS Introduction Introduction to Retail Banking......... Banking.................. ................. ................. ................................................5 .......................................5 Retail Products Products and Instruments...... Instruments............... .................. ................. ..............................................7 ......................................7 Deposits and Accounts ...................................................................................10 Bank Accounts..................................... ................................................................................ ..................................................................... .......................... 10 Type of Accounts......................................... ................................................................................... ....................................................... ................... ...... 11 Product Differentiators..................................... ............................................................................................. .......................................................... 16 Account Processing...................................... ................................................................................. .................................................... ................. ........ 18
Credit Cards.......................................................................................................29 Credit Cards – Basic Concepts........................................ ................................................................................. ......................................... 29 Credit Cards – Processes ..................................................................................... ........................................................................................ ... 31 Credit Cards - Sources of Revenue.......................................... ............................................................... ................................ ........... 33
Loans Overview......... Overview.................. ................. ................. .................. .................. .................. ...........................................34 ..................................34 Key Players.......................................... ................................................................................................. ................................................................. ............. ... 35 Generic Loan Process.......................................... ..................................................................................... .................................................... ......... 36
Mortgages..........................................................................................................39 Mortgage products......................................... .................................................................................... ........................................................... ................ 40 Key mortgage concepts..................................... ......................................................................................... ....................................................... ... 45 Mortgage Market....................................................................................................... Market....................................................................................................... 48 Mortgage processes........................................... ......................................................................................... .............................................. ........ 54 Regulations governing the mortgage industry..................................... ........................................................... ...................... 63 Market Landscape & Trends......................................... ..................................................................................... ............................................ 65
Auto Loans........................................................................................................69 Types of Financing options...................................... ....................................................................................... ................................................. 69 Players Involved........................................... ............................................................................................ ................................................. .......... ............ 77 Key Concepts.................................... ............................................................................... ....................................................... ...................... ................ ...... 77 Auto Loan Process........................................ ...................................................................................... .............................................. .......... ............. ... 79 Auto Leases ............................................. ........................................................................................ ................................................................. ...................... 83 IT Applications in Auto Loans .................................................................................. 91 Regulations governing the Auto Loan Industry............................................. ....................................................... ............ .. 95
Student Loans...................................................................................................97 Page 2 of 186
Foundation Course in Banking Types of Student Loans........................................ ............................................................................................ .................................................... 98 key Players........................................ ................................................................................... ............................................................. .......................... ........ 108 Key Concepts.................................... ................................................................................................. ..................................................................... ........ 109 Loan Process...................................... ................................................................................ .................................................................... .......................... 111 Secondary Market................................................................................................... Market................................................................................................... 114 IT Applications in Student Loans..................................... ............................................................................. ........................................ 116 Regulations governing Student Loans........................................ ...................................................... ........................ .............. .... 116
Agricultural Loans..........................................................................................118 Types of Loans..................................... ................................................................................ ....................................................... ...................... ............ 118 Major Players Involved....................................... .................................................................................. ..................................................... .......... 118 Process........................................ ................................................................................... ........................................................................... ................................ 120 Secondary Market................................................................................................... Market................................................................................................... 122 Recent Trends...................................... ................................................................................. ....................................................... ...................... ............ 123 Technologies in Agricultural Loans .......................................... .............................................................. ............................... ........... 123 Regulations Governing Agricultural Loans...................................... .......................................................... ........................ .... 124
Retail Banking Channels................................................................................126 Branch Banking.......................................... ........................................................................................... ................................................. .......... ............ 127 ATM Banking....................................... ................................................................................. ......................................................... ......................... .......... 131 Internet Banking .................................................... ............................................................................................... .................................................. ....... 133 Telephone / Mobile Banking....................................... ................................................................. ..................................... .................. ....... 135
Fee based Services.........................................................................................136 Collection Services.................................... ........................................................................................... ............................................................. ...... 136 Payment Services........................................... ..................................................................................... ....................................................... ............... 138 Investment Advisory Services......................................... ................................................................................. ........................................ 140 Wires / Fund Transfer Services....................................... ............................................................................... ........................................ 142 Other Services......................................... .................................................................................... .......................................................... .................... ..... 143
Regulatory Requirements..............................................................................146 Truth in Lending Act (TILA) ......................................... ..................................................................................... ............................................ 146 Fair Credit Reporting Act (FCRA)......................................... .......................................................... ........................... ................. ....... 149 Equal Credit Opportunity Act (ECOA) ..................................... ................................................................ ................................ ..... 152 Check clearing for the 21st century act (check21 act)....................................... ............................................. ...... 154
Trends in retail Banking.................................................................................157 Multi Channel Integration........................................ ........................................................................................ ................................................ 159 Page 3 of 186
Foundation Course in Banking Bancassurance....................................................................................................... 161
Market Landscape...........................................................................................163 Key Players............................................................................................. ............... 163 Key Retail Banking corporations in the US............................................................. 164 Mergers & Acquisitions in Retail Banking................................................................ 165
Appendix – A Consumer Credit Rating Agencies ......................................167 Appendix – B Mortgage Backed Securities.................................................168 Appendix – C Costs associated with Mortgages........................................172 Appendix – D Securitization of Auto Loans.................................................177 Appendix – E Securitization of Auto loan backed securities.....................179 Securitization of Auto Lease Backed Securities...................................................... 180
Appendix – F Differences between Leasing and Financing.......................182 Appendix – G Student-loan ABS Structure..................................................186
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Foundation Course in Banking
INTRODUCTION TO RETAIL BANKING Retail banking is typical mass-market banking where individual customers use local branches of larger commercial banks. Services offered include: savings and checking accounts, mortgages, personal loans, debit cards, credit cards, and so forth. Retail banking can also be divided into various deposit products—including checking, savings, and time-deposit accounts such as certificates of deposit—as well as various asset-based products, such as auto lending, credit cards, mortgages, and home equity loans. Big banks are likely to be in all of these businesses, and smaller ones mainly focus on deposit gathering while offering mortgages and home equity loans. Industry experts estimate that there are about $5 trillion in deposits in the U.S. market. Since there is no credit risk associated with taking in deposits, banks need less capital to run this business than, say, mortgage lending. The proper amount of capital required, according to one of the estimates is about 1%, which translates to about $50 billion for the industry. The return on this relatively small investment, meanwhile, is 35% to 50%, or a minimum of $18 billion for the industry, making it a very profitable business. In contrast, the total outstanding balances in the credit card industry amount to about $1 trillion. Since this business is riskier, it requires more capital to run, and the resulting profits are about $12 billion to $13 billion for the industry. However, there is a reason why credit card lending appears to be more of a moneymaker than deposit gathering. The business is concentrated among the biggest banks: The top 10 lenders hold 85% of the credit card balances. The business of deposit gathering, meanwhile, is split up among a large number of banks. The numbers indicate there is ample opportunity to generate significant profits simply by gathering deposits— but it also means facing a lot of competition. While investment banking and commercial lending are related to high value deals, retail banking is less glamorous and is associated with low value transactions - the sums of money involved in any one transaction are likely to be in the hundreds—not tens of thousands, or millions—of dollars. For years, retail banking has been viewed as a commodity business. Interest rates paid on deposits often differ so little from bank to bank that they are almost meaningless to consumers. Also, aside from signage, most bank branches tended to look alike, with their teller windows on one-side and platform desks on the other.
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Foundation Course in Banking In the past couple of years, however, bank managers have been opening their eyes to greater possibilities in retail banking. A few factors have played into this new attitude. One is the huge hit to investment banking and trading that many banks took at the end of the dot-com boom. New York-based J.P. Morgan Chase & Co. is a prime example of an institution trying to decrease its reliance on investment and trading income by expanding into retail banking. Towards this, it also acquired Chicago-based Bank One Corp., a retail banking stalwart in the Midwest in 2004.
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Foundation Course in Banking
RETAIL PRODUCTS AND INSTRUMENTS Banks offer lots of financial products for their depositors. The checking account is one of the most common ones. It's USP is convenience as it lets people buy things without having to worry about carrying the cash -- or using a credit card and paying its interest. While most checking accounts do not pay interest, some do -- these are referred to as negotiable order of withdrawal (NOW) accounts. Aside from checking accounts, banks offer loans, certificates of deposits and money market accounts, not to mention traditional savings accounts. Some also allow people to set up individual retirement accounts (IRAs) and other retirement or education savings accounts. There are, of course, other types of accounts being offered at banks across the country, but these are the most common ones. Savings accounts - The most common type of account, usually require either a low minimum balance or have no minimum balance requirement, and allow people to keep their money in a safe place while it earns a small amount of interest each month. In standard practice, there are no restrictions on when the money can be withdrawn. Money market accounts - A money market account (MMA) is an interest-earning savings account with limited transaction privileges. The account holder is usually limited to six transfers or withdrawals per month, with no more than three transactions as checks written against the account. The interest rate paid on a money market account is usually higher than that of a regular passbook savings rate. Money market accounts also have a minimum balance requirement. Certificates of deposit - These are accounts that allow depositors to put in a specific amount of money for a specific period of time. In exchange for a higher interest rate, the depositor forgoes the option of withdrawing the money for the duration of the fixed time period. The interest rate changes based on the length of time the depositor decides to leave the money in the account. One cannot write checks on certificates of deposit. This arrangement not only gives the bank money they can use for other purposes, but it also lets them know exactly how long they can use that money. Individual retirement accounts and education savings accounts - These types of accounts require the account holders to keep their money in the bank until they reach a certain age or their child enters college. There can be penalties with these types of accounts, however, if the money is used for something other than education, or if the money is withdrawn prior to retirement age
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Foundation Course in Banking Apart from the various schemes like these to raise money, banks provide various kinds of credit products to the individuals. Credit products include loans for house financing, auto purchases as well as credit cards. The key types of credit cards include Bank cards, which are issued by banks (for example, Visa, MasterCard and Discover Card). These can either be debit or credit cards. In a credit card, the user has a limit up to which she can make purchases (or borrow) and the bank charges an interest on the used up sum. A debit card is used for making payments against existing balance in the users checking account. There are also the “Travel and entertainment (T&E) cards”, such as those issued by American Express and Diners Club. Loans – one of the key retail products from banks are loans made to the individuals. There are for various purposes including mortgages for real estate activity, auto finance for purchase of cars and automobiles, student loans to meet education expenses, and agricultural loans. Each of these loans are for a specific requirement and their repayment terms and criteria to provide the loans vary accordingly. Mortgages – Mortgages are loans given to individuals for the purchase, construction, or repair real estate property. Typically, the property is used up as an collateral. Auto Loans – These are loans given to individuals for the purchase of cars or automobiles. They are given against the security of the vehicle or in some cases with the homes as a security. Student Loans – These are loans provided to students who are pursuing undergraduate or graduate courses. A majority of them are made available at subsidized interest rates due to the insurance provided by the US Government to the lending banks. Agricultural Loans – Agricultural Loans are the loans granted to finance the agricultural industry. These are loans given to individuals towards acquisition of work animals, farm equipment and machinery, farm inputs (i.e., seeds, fertilizer, feeds), poultry, livestock and similar items. It also includes construction and/or acquisition of facilities for production, processing, storage and marketing; and efficient and effective merchandising of agricultural commodities. Fee based Services – Banks also provide various fee based services to the customers. These usually involve managing the payments that need to be made or to be collected. They also provide advisory services to help consumers manage their investments and meet the investment goals. Although most of these services are related to Payments they can broadly be categorized under the broad headings of Collections Services, Payment Services, Investment Advisory Services, and Fund Transfer Services. Page 8 of 186
Foundation Course in Banking
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Foundation Course in Banking
DEPOSITS AND ACCOUNTS Banks provide various kinds of deposits and accounts to the public and use this as the main source for raising capital. Nearly everyone needs an account to help him or her manage his or her day-to-day money. BANK ACCOUNTS
It is possible to manage money using just cash, but putting money in a bank account can have several advantages as described below •
•
•
•
A bank account enables one to access her money quickly and easily, such as by writing checks and by withdrawing money from an ATM A bank is the safest place to put money, because funds in U.S. bank accounts are insured against loss by the federal government for up to $100,000 per depositor Some accounts pay interest on the money deposited in them even though the interest rates may be low Most of these bank accounts are "free" accounts if the customer maintains a substantial balance
Where to Bank
Credit unions, savings and loans, mutual funds, and brokerages offer checking and savings services similar to what banks offer. Before we discuss banks in more detail, here is a brief discussion of these other options: Credit Unions
Credit unions are non-profit, member-owned, financial cooperatives. They are operated entirely by and for their members. When a customer deposits money in a credit union, she becomes a member of the union because her deposit is considered partial ownership to the credit union. To join a credit union, a customer ordinarily must belong to a participating organization, such as a college alumni association or labor union. While the accounts are similar to bank accounts, the names are different: share draft accounts (like checking accounts), share accounts (like savings accounts), and share certificate accounts (like certificate of deposit accounts). For nearly all credit unions, the National Credit Union Share Insurance Fund insures most of the deposits up to $100,000. Interest rates tend to be higher and fees tend to be lower than at commercial banks, because they exist to serve their member-owners rather than to maximize profits. On the downside, credit unions usually have very few branch offices and ATMs. However, to compensate for this, in most states credit unions have formed surchargefree ATM networks among themselves.
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Foundation Course in Banking Brokerage
Another substitute for a bank account is a cash-management account at a brokerage. A customer will earn money-market rates, which will usually be significantly higher than the interest the bank would pay. The fees will generally be less than what the bank would charge, and the fees might be waived entirely if the customer has a substantial portfolio at the brokerage. If the customer overdraws her account, the interest rate will be lower than what the bank would charge, and in addition it's usually tax-deductible because it's considered margin interest. The customer will be able to perform all the basic banking functions, such as check writing and using a Visa debit card at any ATM. However, there are a few downsides. Very few brokerages have ATM networks, so when the customer uses an ATM she will be charged by that ATM's owner and possibly also by the brokerage's bank partner (if the brokerage itself isn't a bank). Also, as with credit unions, brokerages lack some of the bells and whistles that commercial banks offer. Some brokerages don't allow the customer to drop by a branch to deposit checks, some don't offer automatic bill paying, and some don't accept checks written to the customer from someone else. Mutual Fund
A final banking alternative is a money market account at a mutual fund company. They offer basic features such as check writing, but lack a lot of the other services banks offer. The rates tend to be significantly higher than those offered by banks. However, the accounts aren't FDIC insured against losses. Banks
Although banks offer a wide variety of accounts, they can be broadly divided into the following categories: •
Savings accounts
•
Checking accounts
•
Money market deposit accounts, and
•
Certificates of deposit accounts
All these type of accounts are insured by the FDIC (in most cases, up to $100,000 per account).
TYPE OF ACCOUNTS
In this Section we list down the common types of accounts offered by Commercial Banks followed by a brief description of each type of account:
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Foundation Course in Banking Savings Accounts
The most common type of bank account, and probably the first account a person ever has, is a savings account. These are intended to provide an incentive for the customer to save money. These accounts usually require either a low minimum balance or may require no minimum balance at all. This depends on the bank and the type of account. Savings accounts allow the customer to keep her money in a safe place while it earns a small amount of interest each month. They usually pay an interest rate that's higher than a checking account, but lower than a money market account or a CD (Certificate of Deposit). The accountholder can make deposits and withdrawals, but usually can't write checks. Some savings accounts have a passbook, in which transactions are logged in a small booklet that the customer keeps, while others have a monthly or quarterly statement detailing the transactions. Some savings accounts charge a fee if the customer’s balance falls below a specified minimum. Besides the fact that the customer will be less likely to spend it, putting her money in a savings account is safer because it is insured (up to $100,000) through the Federal Deposit Insurance Corporation (FDIC). This means that even if the bank or credit union goes out of business (which is very rare!) the customer’s money will still be there. The FDIC is an independent agency of the federal government that was created in 1933 because thousands of banks had failed in the 1920s and early 1930s. Not a single person has lost money in a bank or credit union that was insured by the FDIC since it was constituted. Interest on savings accounts is usually compounded daily and paid monthly. Sometimes, but not always, banks charge fees for having a savings account. The fee may be low -like a dollar a month -- or it may be higher or it could even be based on the customer’s balance. Some of the characteristics of a savings account include: •
•
•
Fees and services charges on the account Minimum balance requirements (Some banks charge a fee only if the customer doesn't keep a certain amount of money in her account at all times.) Interest rate paid on the balance
Each month, the bank (or credit union) sends the customer a statement of her account either in the mail or by e-mail depending on her preferences. The statement will list all the transactions as well as any fees charged to the account and interest that the money deposited in the account has earned. Checking Accounts
A checking account is the primary reason why many people use a bank. Probably no other account offered has as many variables as a checking account. With a checking account the customer can use checks to withdraw her money from the account. She may use checks to pay bills, purchase products and services (at businesses that accept personal checks), send money to friends and family, and many other common uses. The customer can also use checks to transfer money into accounts at other financial institutions. The customer has quick, convenient, and, if needed, frequent-access to her money. Typically, the customer can make deposits into the account as often as she may choose. Many institutions enable the customer to withdraw Page 12 of 186
Foundation Course in Banking or deposit funds at an automated teller machine (ATM) or to pay for purchases at stores with her ATM card. Some checking accounts pay interest; others do not. A regular checking account frequently called a demand deposit account - does not pay interest, whereas a negotiable order of withdrawal (NOW) account does. Institutions may impose fees on checking accounts, besides a charge for the checks the customer orders. Fees vary among institutions. Some institutions charge a maintenance or flat monthly fee regardless of the balance in the account. Other institutions charge a monthly fee if the minimum balance in the account drops below a certain amount any day during the month or if the average balance for the month drops below the specified amount. Some charge a fee for every transaction, such as for each check the customer writes or for each withdrawal made at an ATM. Many institutions impose a combination of these fees. Although a checking account that pays interest may appear more attractive than one that does not, often checking accounts that pay interest charge higher fees than do regular checking accounts. The various kinds of Checking Accounts offered by Banks are: Basic Checking Account - Sometimes also called "no frills" accounts, these offer a limited set of services at a low cost. The customer will be able to perform basic functions, such as check writing, but they lack some of the bells and whistles of more comprehensive accounts. They usually do not pay interest, and they may restrict or impose additional fees for excessive activity, such as writing more than a certain number of checks per month. This account is for the customer who uses a checking account for little more than bill-paying and daily expenses, and does not maintain a high balance. Some basic accounts require direct deposit or a low minimum balance to avoid fees. Interest-Bearing Checking Accounts - In contrast to "no frills" accounts, these offer a more comprehensive set of services, but usually at a higher cost. Also, unlike a basic checking account, the customer is usually able to write an unlimited number of checks. Checking accounts, which pay interest, are sometimes referred to as negotiable order of withdrawal (NOW) accounts. The interest rate often depends on how large the balance in the account is, and most charge a monthly service fee if the balance falls below a preset level. This account usually requires a minimum balance to open, with an even higher balance to maintain in order to avoid fees. For example, a bank may require just $100 to open an account, but will charge $22 in service fees each month if the customer does not maintain a $10,000 balance. With some accounts, the higher the customer’s balance, the more interest is earned. Interest is paid monthly, at the conclusion of the statement cycle. Joint checking -- An account owned by two or more people, usually sharing a household and expenses. Each co-owner has equal access to the account. Most types of accounts, whether it's basic checking, savings or money market, allow for joint use. Page 13 of 186
