UNIVERSITI UTARA MALAYSIA

Corporate Financial Management (BWFF5013)

TITLE : Individual Concept Paper:- Consumer Retail Financing

PREPARED BY:

NORHISAM YUSOFF

810235

Contents
Introduction............................................................................................................3 References

Introduction

A credit market that functions properly contributes significant benefits to the economy, helping individuals to take advantage of economic opportunities and build wealth, and businesses to grow and create jobs.

While consumers must be responsible to make informed financial decisions that are in their own best interests, the combination of easier access to credit and an increasingly competitive and innovative credit market has made it more important to also ensure that financial service institutions (FSIs) adopts responsible financing practices in their dealings with retail consumers. In particular, there is a need to complement disclosure requirements and financial capability initiatives that support informed borrowing decisions by consumers, with clear expectations of FSIs to help consumers in this process by ensuring that financing product are suitable and affordable given a consumers financial circumstances. More broadly, responsible lending and borrowing behaviours will promote a resilient household sector which in turn contributes to economic and financial stability.

FSIs currently have considerable flexibility in assessing the suitability and affordability of financing products for retail consumers. This will be substantially preserved. However, observations of the varying practices among FSIs and in some cases, inadequate assessments of suitability and affordability, over-reliance on collateral and inadequate regard for consumer interests in promoting financing products to retail customers, support the need for expectations to be strengthened with respect to the overall conduct of business in retail financing.

This paper aims to promote a sustainable retail finance market by requiring FSIs to engage in prudent, responsible and transparent financing practices. While the focus is on the FSIs responsible financing behaviours, it is recognised that consumers also have, and must discharge, their responsibility for ensuring sound borrowing decisions that are appropriate to their financial circumstances and honouring their contractual obligations. This paper also promotes more effective engagements between FSIs and borrowers through better disclosures and advice to consumers.

Background Studies

Household loan increases from years to years, from as low as 16% of banking sector loan in 1998 to 55% in 2010. This was due to the substantial spike in corporate defaults resulted from the Asian crisis. The increase in the household income, shift in demographic profiles, and the willingness of consumer to borrow has also contributed to this (BNM, Marc).

The growth in 2010 shows an increasing number of 12.5% in 2010 to RM 581 billion, higher than the 9.4% increase in 2009 (BNM, Statistic Department). Bank Negara Malaysia has introduced several preventive measures to dampens the rate of expansion even though the household debt are still appears manageable especially if compared with countries like South Korea (BNM).

Although growth in household credit is important for the Malaysian economy, an excessive growth has the potential to destabilise any financial system. The preventive regulatory measures that were put action are likely to slower the growth but the continuous

acceleration in household sector debt cannot be control entirely unless there is a fundamental change in business approaches of the Malaysian Banks.

In RM

Loan Growth from 2007 to 2010 (Source- BNM)

The growth of loans in the household sector has been important in driving loan growth up over the past two years. Even when the economy was facing the impact of the economic downturn in 2009, 68% of total loans were given out to the household sector before reasonably decrease to 58% in 2010 (BNM). The rate of household loan growth is still the major concern with potential impacts on the broader stability of the financial system.

Even with the rising level of debt in the sector, the non-performing loan (NPL) ratio for the sector loans was low at 2.3% in 2010 if compared with 2009 that shows a ratio of 3.1%. These indicate that the sector loans have been relatively resilient and do not show any immediate problems. The NPL of 2.3% for the sector in 2010 was also lower than the combined NPL ratio of 3.1% posted by the banking sector (BNM).

Auto loans and mortgages accounted for about 74% of the sector loans in 2010, this were due to the improvement in the employment conditions for example higher paid in the public sector (BNM). The unemployment rate decline to 3.2% in 2010 from 3.5% in 2009 may also contribute to this (Department of Statistic). Credit cards and personal loan growth appear more susceptible, but the rates have been low so far.

NPL Ratio for Household Loans (Source - BNM)

The increased in debt in the household sector at such a high rate can eventually impact the debt settlement ability of households that will impact the economy with destabilise effect of the financial system. The example can be seen during the Korean credit card crisis in 2003. Ignoring the low NPL ratio, as the repayment disabilities will only can be viewed after a few month after a crisis hit with the various classification policies in place. Furthermore, the data reported by BNM are understated as it does not include financial providers that are not regulated by the central bank. For example, cooperative, schedule institutions and licence or illegal money lenders.

Recognizing the concern, BNM has put in place several measures over the past few months to rectify the problem. Some of the measures are: Minimum income requirement of RM24,000 per annum for individuals for credit card application, which is higher than the previous of RM 18,000. Individuals with annual income of less than RM36,000 is only allowed to hold 2 credit cards. Increases the Statutory Reserve Ratio and the Overnight Policy Rate that will increase the cost of lending for banks. This will in turn increase lending rates and slower credit growth.

All the measures that has been introduced are for the Financial Institutions to abide as the regulatory body will monitor their operations using the tools available to them, for example through a closed supervisory process that will cause a penalty or unfavourable reporting being presented to the board in any case of non-compliance. Leaving the above to rest, what about the institutions beyond the regulatory eyes of the central bank? Should a more holistic approach be introduced to address the issues? What about the consumer 6

themselves? Should they be allowed to make an informed financial decision without reading the fine print? This paper, in best possible ways to discuss the matters stated.

Literature Review

Hansen, Ryan in The Impact of the Equator Principles on Lender Liability: Risk of Responsible Lending, address that a financial service providers should be responsible in providing credit to customers. They should adapt to a voluntary set of environmental and social guidelines. In view of this, lender in this country should also try to adapt to the principles as a socially responsible financial provider will not view profits as their only motives, but the general well being of the community and the economic conditions in particular.

Sabato, Gabriele in Managing Credit Risk for Retail Low-Default Portfolios, introduced a methodology that can be used to manage credit risk for retail low default portfolios. The proposed methodology can be classified as a data enhancing tool with the main proposes of modelling credit risk low-default portfolios. He is very confident that the technique can develop a meaningful default prediction models to estimate or validate a probability of default for retail low default portfolios. This is an interesting model to adapt but it should also to take into consideration where behaviour finance is concern.

Avery et al. looks into the potential value associated with including situational data, such as economic condition, for example unemployment rate or personal situations, for example divorce into credit risk evaluation. Their finding shows that adverse, temporary economic or personal shocks are important factors influencing payment performance. Where

behaviour is concern, this model can be useful tool in addressing the issue of predicting defaulters probability provided in can be adapted in our country.

The Idea
Affordability
Financing that is based on inadequate suitability and affordability assessments expose the customer and the financial provider to increased credit risk. A financial institution shall perform suitability and affordability assessments for each new and additional financing facility offered.

A financial provider should ensure that a financing product suits the customers needs and clearly describe the type of customer that a financing product would be suitable for and clear lines of authority for approving a financing product to other than the targeted customer group. The financial institution should take reasonable steps to establish that consumers are offered financing products that are appropriate to their financial circumstances and affordability. A prudent Debt Service Ratio limit should be set to enable customer to reasonably meet the repayment obligations in full.

In assessing the income for determining the debt service ratio, the financial institution must enquire into the sources and amount of income. The income should include only the net income, after statutory deductions. For a variable income, such as overtime or commission, the financial institution must evaluate the variability of such income for a period of at least 6 months and only include the average amount as consistent income in assessing

affordability. The financial institution should exclude one-off variable income such as bonuses.

If the customer has no permanent employment or is self-employed, the financial institution should evaluate the stability of the sources of income by requiring the customer to provide evidence of income over a period of at least 12 months. The financial institution must verify the customers income against reliable sources which are independent of the customer and must not rely solely on the customers self-certification of income. This may include verifying income information against the customers EPF statement, bank statement or EA form from the LHDN. In view of this, the financial institution should work together with the relevant authorities or parties by linking together all the system involve. For example, by linking the EPF system and LHDN system with the banks system so that an online verifying process can be made without asking customer to provide the statements.

Debt obligations
The financial institution is required to conduct a comprehensive check on the customers overall indebtedness by obtaining information on the customers outstanding debt obligations, including both secured and unsecured financing from all financial institution and other entities that provide credit facilities. This should also include educational financing such as from PTPTN, JPA, MARA and etc.

The financial institution should refer to the Central Credit Reference Information System (CCRIS) to establish customers outstanding debt obligations, make specific inquiries from customer regarding financing from entities not covered by CCRIS and alert

customer of their duty to disclose adequate and correct information in the financing application as well as the consequences of providing incomplete or incorrect information.

The financial institution should set an appropriate level of debt service ratio in their financing decisions that should allow sufficient buffers for expenditures and contingencies, taking into consideration their circumstances. This may include appropriate consideration of the nature of employment, their location of residence, number of dependants and other relevant factors that have a bearing on the level of expenditures of the customer.

Marketing
The financial institution must ensure that advertisements and promotion materials on financing products are clear, fair and not misleading or deceptive. Critical information that is likely to affect consumers borrowing decisions must be clearly displayed. Sales and marketing staff should pay due regard to the interests of the customer by inquiring into the customers financial requirements and financial situation to ensure that the financing product offered is suitable in meeting the customers needs and circumstances.

The sales and marketing staff must draw the customers attention to the total repayment amount and total interest/profit cost for comparison with similar products offered by other institutions. Customer should be advised to read and consider the information and explanation given in order to satisfy themselves that they understand the key features of the financing product and the associated obligations, prior to entering into a financing contract.

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Customers must be given a reasonable opportunity to read the pre-contractual information and make enquiries about the financing product. The marketing staff should not be allowed to harass, pressure or inappropriately lure customers into signing up for a financing product. The telemarketing staff must not be allowed to contact prospective

customers at unreasonable hours, for example after 8 pm or before 9 am. They must also identify themselves and inform the purpose of the call and the financial institution being presented.

The marketing staff must be properly trained and competent to carry out their functions. They must be knowledgeable in the key features, risks and critical terms of the financing product. On-going training must be provided to them and such training must also cover marketing ethics and relevant regulatory obligations which must be observed in the marketing of financing products. A process must be established to periodically check that marketing staff remain competent to explain the products and comply fully with applicable regulatory requirements. Obtaining customer feedback on services rendered by the marketing staff can be a way of doing that.

In remuneration sales staffs, the financial institutions must establish and maintain remuneration policies and procedures that promote fair and responsible conduct. The reward system should not focuses solely on achieving sales targets without regard to the interest of the customer. Non-financial indicator should be put into place in monitoring the performance of sales staffs.

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Method to Redress or Assistance

Financial Institutions should provide a dedicated point of contact for customers facing repayment difficulties to seek assistance. The contact details should be clearly communicated to all customers. Appropriate training shall be provided for staff dealing with customers experiencing difficulties in repayment. Staff should be able to explain and provide advice on options and avenues available to assist the customer in resolving repayment difficulties.

Financial institutions must inform the customer of the services of Agensi Kaunseling dan Pengurusan Kredit (AKPK), so that customer should know the alternatives of solutions available in dealing with their issues.

Conclusion
The introduction of prudential policies coupled with an effective implementation is very important in order to avoid a sudden surge in personal financing. Their failures may cause an imbalance in the financial system. Timely introduction of these policies may safeguard the stability of the financial system.

We are glad to see that The Central Bank of Malaysia appears to be taking measures by taking to heart the dangers posed by an overextended household sector. For example, the credit card guideline introduced in March 2011, is a continuous effort by the central bank to inculcate sound financial and debt management among credit card users. In this regard, it should be noted that autonomy given to the central bank for prudential policy formulation and implementation will be critical. 12

References

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1. Allen, Linda, Gayle DeLong and Anthony Saunders. 2003. Issues in the Credit Risk Modelling of Retail Market. www.defaultrisk.com. 2. Altman, Edward I. 2004. Corporate Credit Scoring Insolvency Risk Models in a Benign Credit and Basel II Environment NYU Working Paper. 3. Avery Robert, Paul Calem and Glen Canner. 2004. Consumer Credit Scoring: Do Situational Circumstances Matter? BIS working paper. 4. BNM Statistical Bulletin. http://www.bnm.gov.my 5. Caire, Dean and Robert Kossmann. 2003. The Use of Judgemental Credit Scoring Models for SME Lending in Developing Market Bannock Consulting Working Paper. 6. Pluto, Katja. 2004. Estimating Probabilities of Default for Low Default Portfolios. www.defaultrisk.com. 7. Sabato, Gabriele. 2010. Managing Credit Risk for Retail Low-Default Portfolios Department of Banking, Faculty of Economics, University of Rome. 8. Uses of Credit Report. http://creditbureau.bnm.gov.my

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