9.1 Services for Personal Borrowers
Personal loan insurance
All banks now offer insurance s to customers for packaged personal lending. The types of lending under consideration here are personal loans, budgets accounts, revolving credit accounts, equity release loans and even credit card borrowing. A typical scheme may be called a ‘loan protection plan’ and would consist of a special insurance package providing
Death – loan (less arrears) repaid in full
Unemployment – repayments covered or up to 12 months.
Disability – repayments covered for the remaining period of the loan.
Premiums for the insurance may be paid from the borrower’s own cash resources or may be added to the loan account and paid in installments. On revolving credit plans and credit cards, premiums are often debited to the customer monthly based on a small
percentage of the outstanding borrowing.
Mortgage or home improvement loan protection plans
These policies offer protection against similar risks to those covered by package loan insurances above. As these loans are secured by mortgage over property, the premiums may be cheaper than that on unsecured loans.
All mortgages, of course, include insurance against death: with endowment mortgages, the endowment policy offers death cover, with other mortgages the lender will insist on low cost mortgage protection policy being taken out (premiums paid by the borrower) in
case of death during the term of the mortgage. With Pension Linked Mortgages, term assurance is compulsory unless the borrower already has appropriate life assurance policies he can charge to the bank in lieu.
Fixed rate mortgages
Mortgage lenders offer fixed rate or capped interest rates on mortgages, should customers wish to protect themselves against increases in interest rates, which may affect their ability to make repayments on the mortgages. Such mortgages are available for periods of
one to 10 years from most lenders at competitive rates. The borrower is guaranteed a fixed or maximum interests rate, and therefore knows that his mortgage repayments will not exceed certain figure. However, in the fixed rate mortgage, the borrower is tied in at a
certain interest rate, even if floating rates drop. There are no extra charges for fixed rate mortgage, but the rates offered may well be slightly high than the current floating mortgage interest rates.
Foreign currency mortgage
Borrowers with mortgages in foreign currency, taken out perhaps when UK interest rates were high and continental rates mainly low, can take advantage of the various currency hedging tools set out later in this section for use by exporters and importers. Such tools
enable the borrower to fix the exchange rate of his mortgage repayments against sterling. However, it would be unwise for a customer to take out a foreign currency mortgage without having income in that currency to cover the repayment. However, customers’
circumstances change and if such customers find themselves with income in a currency other than that of the mortgage, use of such tools can reduce their exchange rate risk and avoid a possible inability to meet increased (sterling equivalent) repayments.
9.2 Services for Business Borrowers
Income of assets
Most businesses are vulnerable to loss of assets by fire, accident or theft and such losses could possibly so harm their cash flow as to put them out of the business. The bank has an interest in this if it is lending to the business, particularly so if the bank has a charge over the assets as security for borrowing. If the assets are lost, the customer’s sales may well be interrupted, thereby reducing income. If this results in the business failing, the assets on which the bank was relying for security may have reduced in value by the loss
and the bank borrowing may no longer be fully covered by the remaining security.
All banks have departments or subsidiaries which deal in asset insurance, and which are only too pleased to arrange appropriate cover for customers. The banks will advice the insurers of its interest in the insured assets (if it hold a charge over them) and if claims
need to be made on the policy, the bank will receive the proceeds. Various other insurances are available to customers, for ex ample:
- Interruption of business (in case of fire, flooding etc)
- Keyman (loss of key directors, partners or employees.
- Bad dents (against non-payment by debtors, both domestic and foreign):
- Public liability (against claims from staff or customers)
- Employers liability (for accident, injury etc)
- Goods in transit e.g. shipping insurance
- Share protection (to buy out a partner’s or director’s share in a business if they die);
- Loan protection (as protection loan protection for the smaller business)
- Dread disease protection (particularly for sole traders).
Credit risk insurance
If the bank itself is unable to provide the necessary insurance cover, then most banks have insurance broking or factoring subsidiaries who will be pleased to arrange the necessary cover themselves or through outside insurers. Obviously, banks refer to sell their own products (and take the profit on them) buy they are perfectly happy to take the insurance commission on outside insurance.
An example of this is credit insurance, which consists of two main elements, the:
- Provision of insurance policies which ensure that the seller of goods or services gets money back if the buyer defaults or fails to pay for reasons specified in the policy.
- Credit reference information on which decisions are based and from which risk can be assessed.
Such insurance is available in the UK from commercial trade insurance companies such as Trade Indemnity, though some banks are now offering similar cover in-house. Similar cover for exporters, including country risk is available from specialist providers,
mainly NCM Ltd for short-term payment (under two years) or the Export Credit Guarantee Department (ECGD) for deals with longer payment terms (two to five years normally).
Country risk includes cover against loss of sales income due to:
- An overseas government moratorium banning payments in general or any specific loan by the foreign government.
- Political, economic or legislative changes taking place overseas which delay or prevent the payment.
- Loss arising from payment in foreign currency when payment should have been in sterling.
- War, civil disturbances etc.
Here again, some banks offer their own similar insurance cover and you should be aware of your own bank’s offerings.
ECGD also offer their Overseas Investments Insurance covering political risks for three to 15 years on British investment overseas. Risks covered here include expropriation, war and restrictions on remittances back to the UK.
Exchange rate risks
Every transaction in overseas trade involves an exchange risk. When a contract for import or export is agreed, it will stipulate whether payment is to be made in the currency of the buyer, or of the seller or in a third party currency. If the currency of the deal is that of the
buyer, the seller faces an exchange risk, because if the currency of the buyer falls in value the seller will receive less of his own currency when the funds are received and converted. If the currency is that of the seller, the buyer takes the risk. If the currency neither that of the buyer nor the seller, then both are at risk of adverse exchange rate fluctuation.
You can offer ‘hedging tools’ to protect your customers against such risks, but they need to be put in place at the time the contract is signed by your customer. Within the scope of the syllabus for this subject it is probably only necessary for you to be able to recognize the exchange rate risks involved, and in an answer to state that if the bank was to lend to a customer involved in foreign trade, it would recommend (or possibly insist) that the customer arrange suitable hedge-would recommend (or possibly insist) that the customer arrange suitable hedging tools to protect himself against the inherent exchange rate risk. Typical hedging tools available from most British banks would be:
- Forward contracts
- Currency options
- Foreign exchange accounts
There are irrevocable agreements between a bank and a customer for the purchase or sale of a fixed amount of a foreign currency at a specific rate of exchange agreed now. ‘Fixed’ forward contracts may be used on fixed future dates. ‘Option’ forward contracts may be
used at any time between two future dates. Remember that if the currency fluctuates in favour of your customer, he is obliged to deal
at the agreed rate, and may miss out on an extra profit opportunities, but at least he is protected against any unexpected loss on the deal due to currency changes.
These give a customer the right, but not the obligation, to deal in a certain amount of currency at an agreed rate at or between certain future dates. It follows that if the currency exchange rate moves in favour of the customer, he can choose to deal at the spot
rate, and is not obliged to deal at the agreed option rate. Currency options (not to be confused with an ‘option’ forward contract) attract an up-front premium based on the rate, period and currency of the option. The higher the perceived risk to the bank in
offering this option, the higher the premium. Banks do not normally charge for forward contracts.
Both forward contracts and currency options are available for periods up to one year and often for longer periods, depending on the currently involved. Foreign exchange accounts It is possible in the UK for customers to hold bank accounts with their own banks in
major foreign currencies and overdraft, loan and other facilities may be made available in specific foreign currencies, or a cocktail of several, e.g. £ +/ or US$ +/ or DM, so that the customer can draw on his facility in the currency of his choice subject to the overall
If a customer is expecting income in a foreign currency, it may then pay him to borrow from his bank in that currency (particularly if the interest rates for borrowing in that currency are lower than those for sterling borrowing), and to repay it on receipt of the foreign income. Similarly, a customer may wish to purchase foreign currency now to cover an anticipated future debt, and invest it in a currency account (particularly if the interest rate is higher than sterling) until needed. In both the above cases the exchange
rate for the foreign currency is fixed at an early stage for the customer, who can then budget accordingly. There are other forms of currently hedging tools, such as currently futures and swaps, but for the purpose of this syllabus it is important that you know that currently exchange risks can be covered to some extent, and the main methods available from banks.
Interest rate risks
As well as exchange rate risks, customers borrowing from banks will be vulnerable to interest rate risk. A customer who has borrowed money at a floating rate, linked to base rate of LIBOR for example, could face higher interest payments if interest rates generally increase. At the least this is going to affect his budget and cash flow forecast for the coming year and, of course, year end profit, but in some cases it could mean the difference between survival and failure. Often banks are prepared to offer fixed rate
packaged loans, e.g. personal loans for personal customers or small business loans for small businesses, with interest added to the loan up front and fixed repayment for the period of the loan. In addition banks are often prepared to offer fixed rate loan accounts
for usual business borrowing.
Some of the methods, available through banks, to fix or reduce interest rate risks are:
- Interest rate swaps
- Caps and collars
- Interest rate options
- Forward rate agreements.
Interest rate swaps
A payer (or receiver) of floating rate interest can agree (via a middleman, for example a bank) to exchange his floating rate commitment for a fixed rate of interest. The underlying loan is not touched – only the interest rate commitment changes.
Caps and collars
It is possible to purchase for a premium an interest rate cap, where the seller will undertake to reimburse a borrower for any interest paid over an agreed limit for a certain period of time. A cap and collar is a cheaper way of doing this whereby the borrower
purchases a cap, but agrees to pay over any interest saved if interest rates drop below a certain rate. With a cap alone, the borrower keeps the benefit of any fall in interest rates, however great, but he sacrifices some of this potential gain to benefit from a cap and
Interest rate options
Interest rate options giving the buyer the right but not the obligation to a fixed rate of interest for a given borrowed sum for a certain period may be purchased in standardized form from futures exchanges such as LIFE or tailor made to meet the buyer’s exact needs
by way of an OTC 9over counter) contract, usually from a bank.
Forward rate agreements
Forward rate agreements (FRAs) are a contract between two parties through which an interest rate is fixed to apply to notional amount of borrowing for a specific period, commencing on a stated future date. This enables interest rates to be fixed on borrowed
funds not yet drawn down.
Other interests rates hedging tools, such as financial futures or ‘forward forwards’ are available through banks or specific future markets, but would usually be available for the higher levels of borrowing. For this syllabus, you only need to know that such tools are
available and could be recommended or insisted upon when lending to customers who may have problems if interest rates increase. It is particularly important to bear this in mind when interest rates are low and the potential for increases is therefore greater..
9.3 Factoring and Invoice Discounting
What is involved in factoring?
The actual mechanics of factoring are simple. As soon as goods are delivered or services completed, the company issues an invoice to its customer, requesting payment to be made to the factor, sending a copy of the invoice to the factor. From that point on the factor
assumes responsibility for the collection of the invoiced debt, relieving the company of the cost and administration of running a sales ledger and chasing up payments. If needed the factor can, at this stage, make available to the seller up to 80% of the invoice value, the balance being paid over soon as the factor receives payment from the debtor.
Factoring has maintained remarkable growth since the 1980s.
By using factoring, businesses can concentrate upon selling their products, leaving the problems of collecting payments for completed orders to the bank’s specialist factoring arm. Simply put, factoring allows the business to sell on open account terms and at the
same time gain 100% credit cover, thus eliminating risks of non-payment and spending up inward cash flow.
If customers fail to pay after an agreed period, (say 90 days) past the invoice due date, then the seller is paid by the factor, without having to substantiate the loss or show compliance with bad debt insurance policies. Prior to the transactions, the factoring company will have vetted the purchasers and will have reserved the right to refuse to handle certain business. However, in general, it will wish to cover all a company’s sales to get good spread of risks as it guarantees the seller against buyer insolvency up to an
agreed limit. The factor’s customer can therefore trade safe in the knowledge that he will be free from bad debt losses. Factors normally expect to cover a minimum turnover of £100,000 per annum. Each debtor will be given a credit limit, which must be respected.
Customer benefits of factoring
The following are the main benefits.
- The customer gets immediate access to working capital which may otherwise not be received for two / three months.
- Finance available grows with turnover and therefore is available to fund rapid sales growth.
- The administrative burden of collecting dents is lifted.
- Finance id without recourse to the seller, so he can be sure of payment.
- Particularly when exporting, it enables the seller to offer open account terms which increases his competitiveness in the local market and protects him against exchange risk if invoicing in currency.
- Cash flow can be easily predicted.
- Even if advances are not drawn from the factor by the seller, debtors will usually pay promptly on invoice dates if they know they are dealing with a factoring company, thus speeding up cash flow.
Cost of factoring
The cost of factoring includes two elements
- Interest on finance provided – comparable with most overdraft rates.
- Management fee for sales ledger administration, credit management and collection of payments. This will vary depending on the number of accounts, the number of invoices processed and the type of customers. The management fee, typically
between 1 -3% of turnover, has to be weighed against the time, resource and financial savings offered.
The characteristics of forfaiting
Interest is at a fixed rate determined at the time the bills are bought.
1. The bank’s customer sends his invoices to the factor.
2. If required the factor will advance up to 80% of the invoice at once. The factor collects the debts.
3. The debtor pays the factor. i.e. the person who owes money to the seller receives an invoice from the factor and sends his
remittances to the factor
4. The factor then pays over the balance to the seller, less interest and charges.
5. The factor takes over the sales ledger administration of the seller.
6. Factoring is disclosed to the debtor.
7. Charges are between 1% and 3% of turn over, plus interest on any advances.
8. The factor will handle all the turnover.
9. Factoring would be applicable if the seller did not have the personnel to handle sales ledger.
10. Usually bad debts insurance is included as part of the package.
1. The bank’s customer sends his copy invoices to the factor (most factoring companies offer invoice discounting services.)
2. The factor will advance up too 75% of the invoice value. The customer collects the debts.
3. The client’s debtor pays the client in the usual way.
4. The client settles with the factor when the debtor’s remittance is received.
5. The seller is responsible for sales ledger administration.
6. Invoice discounting is not disclosed to the debtor.
7. Interest is charged on amounts advanced. The administration fee is relatively small, because the factor is not involved in any
sales ledger administration.
8. The factor only deals with invoices against which an advance is required.
9. Invoice discounting is applicable when the customer wishes to continue to handle sales ledger administration himself.
10. Usually bad debt insurance is included as part of the package.
Transactions appropriate for forfaiting are normally for capital goods. (Bills must relate to trade, and cannot be merely a means of raising finance.)
The normal period covered by forfeiting arrangements is from a few months up to about five years, sometimes as long as eight.
The bills or promissory notes are usually in a series with maturity dates at regular intervals e.g. every six months, expect where the full term of the arrangement is very short.
The costs to the customer are:
A commitment fee
Interest linked to rates in the Eurocurrency markets
A premium related to risk e.g. higher for unstable countries
The financial documents used are ‘guranteed’ either because they are promissory notes of a reputable financial institution or, if bills of exchange, because they are ‘avalised’ i.e. signed by a bank undertaking primary responsibility for payment (rather stronger than merely endorsing a bill, which makes the bank liable alongside any other endorsers).
Advantages for the customer
- Improves liquidity because cash if brought in quickly.
- Helps cash flow management because he discounted amount of the package of bills is received straightaway.
- Reduces need for other forms of credit.
- Reduces administrative work and the cost of collecting dents over a period of years.
- Can help with exchange risk by transferring it to the forfeiter as soon as paper is discounted.
- Avoids credit risk because payment is guranteed as soon as paper is discounted.
- Ensures that default by the buyer has no effect because the facility is non recourse.
- Enables indication rates to be obtained if required.
- Enables finance costs to be accurately included in the contract price a business quotes.
- Can eliminate interest rate risk (which is helpful if rates are volatile) because firm quotes on rates are usually held for 48 hours.
- Encourages investing banks to take paper as there is a secondary market between forfaitors to some extent.
- Offers a wide range of currencies possible (so forfeiting is suitable where ECGD cover is available.
- Entails less documentation than for ECGD.
9.4 Acceptance Credits
For first class customers banks will often arrange, if needed an acceptance loan or acceptance bill facility. The customers are allowed to draw bills of exchange on the bank, up to an agreed total amount at any one time. Bills are usually drawn at three month terms, and the maximum for each bill is £ 10 usually drawn at three month terms, and the maximum for each bill is £10 million, though more than one bill may be drawn if within the overall limit.