Retail Banking

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L1 Course in Retail Banking Banking Version : 1.0 Date : 27-Jul-2004

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L1 Course in Retail Banking BankingVersion Date : 1.0 : 27-Jul-2004

Foundation Course in Banking

TABLE OF CONTENTSIntroduction to Retail Banking..........................................................................5 Retail Products and Instruments......................................................................7 Deposits and Accounts ...................................................................................10Bank Accounts..........................................................................................................10 Type of Accounts......................................................................................................11 Product Differentiators..............................................................................................16 Account Processing..................................................................................................18

Credit Cards.......................................................................................................29Credit Cards Basic Concepts.................................................................................29 Credit Cards Processes ........................................................................................31 Credit Cards - Sources of Revenue..........................................................................33

Loans Overview................................................................................................34Key Players..............................................................................................................35 Generic Loan Process..............................................................................................36

Mortgages..........................................................................................................39Mortgage products....................................................................................................40 Key mortgage concepts............................................................................................45 Mortgage Market.......................................................................................................48 Mortgage processes.................................................................................................54 Regulations governing the mortgage industry...........................................................63 Market Landscape & Trends.....................................................................................65

Auto Loans........................................................................................................69Types 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...................................................................................................97Page 2 of 186

Foundation Course in Banking Types of Student Loans............................................................................................98 key Players.............................................................................................................108 Key Concepts.........................................................................................................109 Loan Process..........................................................................................................111 Secondary Market...................................................................................................114 IT Applications in Student Loans.............................................................................116 Regulations governing Student Loans....................................................................116

Agricultural Loans..........................................................................................118Types of Loans.......................................................................................................118 Major Players Involved............................................................................................118 Process...................................................................................................................120 Secondary Market...................................................................................................122 Recent Trends........................................................................................................123 Technologies in Agricultural Loans.........................................................................123 Regulations Governing Agricultural Loans..............................................................124

Retail Banking Channels................................................................................126Branch Banking......................................................................................................127 ATM Banking..........................................................................................................131 Internet Banking......................................................................................................133 Telephone / Mobile Banking...................................................................................135

Fee based Services.........................................................................................136Collection Services.................................................................................................136 Payment Services...................................................................................................138 Investment Advisory Services.................................................................................140 Wires / Fund Transfer Services...............................................................................142 Other Services........................................................................................................143

Regulatory Requirements..............................................................................146Truth 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.................................................................................157Multi Channel Integration........................................................................................159Page 3 of 186

Foundation Course in Banking Bancassurance.......................................................................................................161

Market Landscape...........................................................................................163Key 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.....................179Securitization 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 BANKINGRetail 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 productsincluding checking, savings, and time-deposit accounts such as certificates of depositas 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 hundredsnot tens of thousands, or millionsof 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 INSTRUMENTSBanks 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 ACCOUNTSBanks 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 customers 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 customers 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 customers 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 withdrawPage 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 customers 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

Foundation Course in Banking

Express -- Designed for people who prefer to bank by ATM, telephone or personal computer, this account usually boasts unlimited check writing, low minimum balance requirements, and low or no monthly fees. The catch? The customer pays fees for using a teller. These accounts are especially popular with students and younger customers who are on the go and don't want to spend a lot of time on banking transactions. Lifeline -- These "no-frills" accounts for low-income consumers are typically products with monthly fees ranging from zero to $6; require a low, if any, minimum deposit and balance; and allot a certain number of checks per month. Many banks, thrifts and credit unions offer such accounts. Lifeline accounts are required by law in Illinois, Massachusetts, Minnesota, New Jersey, New York, Rhode Island and Vermont. In those states, minimum terms, fees and conditions are set by law, not by individual banks. Senior/student checking -- Many institutions offer special checking deals if the customer is a student or age 55 or over. The perks vary from bank to bank, but may include freebies on checks, cashiers and traveler's checks, ATM use, better rates on loans and credit cards, or discounts on everything from travel to prescriptions. A typical Checking account provides some or all of the following features Online Banking Online Bill Payment Direct Deposits ATM Banking Telephone Banking Electronic Statements Cash Reserves Credit Line / Overdraft protection

Money Market Deposit Accounts (MMDAs) A money market account is a type of savings account offered by banks and credit unions just like regular savings accounts. These accounts invest the balance in short-term debt such as commercial paper, Treasury Bills, or CDs. The rates they offer tend to be slightly higher than those on interest-bearing checking accounts, but they usually require a higher minimum balance to start earning interest. These accounts provide only limited check writing privileges (three transfers by check, and six total transfers, per month), and often impose a service fee if the balance falls below a certain level. Another difference is that, similar to a checking account, many money market accounts will let the accountholder write up to three checks each month. Like other bank accounts, the

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Foundation Course in Banking Federal Deposit Insurance Corporation (FDIC) insures the money in a money market account. Interest on money market accounts is usually compounded daily and paid monthly. Interest rates paid by money market accounts can vary quite a bit from bank to bank. That's because some banks are trying harder to get people to open an account with them than others -- so they offer higher rates. Another difference that is sometimes found with money market accounts is that the more money a customer has in the account the higher the interest rate she gets. Like a basic savings account, money market accounts let the customer withdraw her money whenever required. However, the customer usually is limited to a certain number of withdrawals each month. Banks will usually charge a fee (typically around $5) if the customer doesnt maintain a certain balance in her money market account. There may also be a fee (typically around $5-10) for every withdrawal in excess of the maximum (usually six) the bank allows each month.

Certificates of Deposit Accounts (CDs) These are also known as "time deposits", because the customer has agreed to keep the money in the account for a specified amount of time, anywhere from three months to six years. Because the money will be inaccessible, the customer is rewarded with a higher interest rate, with the rate increasing as the duration increases. There is a substantial penalty for early withdrawal, so this type of account is generally not used if the customer thinks that she might need the money before the time period is over (the "maturity date"). Time deposits are often called certificates of deposits, or CDs. They usually offer a guaranteed rate of interest for a specified term, such as one year. Institutions offer CDs that allow you to choose the length of time, or term, that your money is on deposit. Terms can range from several days to several years. Once a customer has chosen the term she wants, the institution will generally require that she keeps her money in the account until the term ends, that is, until "maturity". Some institutions will allow the customer to withdraw the interest earned even though she may not be permitted to take out any of your initial deposit (the principal). Because the customer agrees to leave her funds for a specified period, the institution may pay a higher rate of interest than it would for a savings or other account. Typically, the longer the term, the higher the annual percentage yield. Sometimes an institution allows the customer to withdraw her principal funds before maturity, but a penalty is frequently charged. Penalties vary among institutions, and they can be hefty. The penalty could be greater than the amount of interest earned, so the customers could lose some of her principal deposit as well. Institutions will notify the customer before the maturity date for most CDs. Often CDs renew automatically. Therefore, if the customer does not notify the institution at maturity that she wishes to take out her money, the CD will roll over, or continue, for another term.

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Foundation Course in Banking PRODUCT DIFFERENTIATORS A list of features and services associated with a bank account are provided below: Features Interest Rate: If the account pays interest, what is the rate currently? Usually Banks signify this in terms of "Annual Percentage Yield", which makes it easier to compare banks that compound their interest at different frequencies. Convenience: How close is the nearest branch? How long are the lines when you go? Is the bank open when you need them, or do they open late and close early as many banks do? FDIC membership: Is the Bank a member of the Federal Deposit Insurance Corporation? If so, all deposits will be insured up to $100,000. Size: Is the bank large or small? Some people feel more comfortable with a larger bank, while others believe small banks can offer better customer service. Minimum deposit: What is the minimum deposit required to open an account (if any)? Limitations: Are there any limitations imposed on the account? (For example, the number of checks or transactions per month) Availability of Funds: How soon after you make a deposit are you able to withdraw against those funds? Different banks have different rules.

Services Direct deposit ATMs Banking by telephone Online banking Credit cards Debit cards Overdraft protection Canceled checks Loans and mortgages Stock and mutual fund trading Retirement planning services Small business servicesPage 16 of 186

Foundation Course in Banking Access to international money markets Copies of previous monthly statements Deposit slips and other slips Phone support Talking to a teller in person Debit card fees Traveler's checks Loan application processing Safe deposit box rental Stop payment Wire transfer

Fees Banking fees have risen significantly in recent years. The average price of maintaining a bank checking account is currently about $200 a year. Here are the most common fees that are charged for maintaining & running a Bank account. Maintenance fees: Banks charge a small fee for providing the customer with their service. The fee for a checking account might be waived, if the customer uses direct deposit for her paychecks, if she is a shareholder of the bank or if she limits her bank branch visits and/or transactions. Low-balance penalty: Most big banks offer "free" checking if the customer maintains a substantial balance, typically $2,000 to $4,000. There is a low-balance penalty in case the the balance goes below the required amount. The calculation could be based on the average daily balance, the lowest balance in the month, or the balance on a certain day of the month, so that she can work the system to her advantage. Sometimes, if the customer buys CDs from the bank (which yield higher rates than the checking account does), the bank might include that amount in its minimum balance requirement.

ATM surcharges, "Foreign" ATM fees: Many of the Banks charge the customer for ATM usage. Also, the customer can use ATMs of other banks at an additional fee from the Bank that owns the ATM. Returned check: Banks charge a penalty to customers who deposit bad checks.

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Foundation Course in Banking Bounced check: Banks charge an insufficient funds fee (NSF) if the customer doesnt have enough funds in her account to cover the checks she has written. To help customers avoid this fee, banks also provide overdraft protection (described below). Overdraft Protection: Banks can provide overdraft protection to a customers account. This is done by charging a high rate of interest on the overdrawn money. This is beneficial to the customers in the cases of a check bounce as well as in cases when the account balance goes below zero or the low-balance limit. Check printing: Some banks offer free checks for first-time customer, customer with a large minimum balance, senior citizens, students, and certain others. Other Banks charge for providing check leaves. Per-check charges: Some accounts include a certain number of checks per month and charge extra for more. Cancelled check return fees: If the bank doesn't include cancelled checks along with the monthly statement, they may charge a fee for any cancelled checks a customer requests. Closed account: Some banks charge a fee if the customer closes an account that hasn't been open for a sufficiently long time (such as one year).

ACCOUNT PROCESSING

Account Opening Process The following diagram depicts a typical Account Opening process with a Bank.S te p 1S TART

Cu stom e r

Cu stom e r co m e s to B ra nch Re p fo r a /c O pe n ing

C us to mer De t ail s St ep 2

A c c oun t D e t ail s Step 3Colle ct Initia l De po sit De ta ils

A TM C a rd P ro ce s sin g S te p 4ATM Ca rd Issua nce

C ro ss S el lin g S te p 5V e rify e ligibility for Cro ss se llin g

A cc ount O pe ning C on firma t io n S te p 6Applica tion / S ig na ture Ca rd P rinting

G a the r Cu stom e r De ta ils

Bra nch

Fra u d De te ction (S S N, Addre ss V e rifica tion )

Colle ct Che ck O rde r De ta ils

S e nd Inform a tio n to Ce ntra l Re po sito ry

EN D

Page 18 of 186Ex te rna l S yste m s S S N a nd Addre ss V e rifica tion S yste m Che ck Orde ring S yste m

Foundation Course in Banking

Account Management Transaction Processing - Tellers The teller is the person most people associate with a bank. Tellers make up approximately one-fourth of bank employees and conduct most of a banks routine transactions. Among the responsibilities of tellers are Cashing checks Accepting deposits and loan payments Processing withdrawals

They also may sell savings bonds, accept payment for customers utility bills and charge cards, process necessary paperwork for certificates of deposit, and sell travelers checks. Some tellers specialize in handling foreign currencies or commercial or business accounts. Before cashing a check, a teller must verify the date, the name of the bank, the identity of the person who is to receive payment, and the legality of the document. A teller also must make sure that the written and numerical amounts agree and that the account has sufficient funds to cover the check. When accepting a deposit, tellers must check the accuracy of the deposit slip before processing the transaction. Prior to starting their shifts, tellers receive and count an amount of working cash for their drawers. A supervisorusually the head tellerverifies this amount. Tellers use this cash for payments during the day and are responsible for its safe and accurate handling. Before leaving, tellers count their cash on hand, list the currency-received tickets on a balance sheet, and make sure that the accounts balance, and sort checks and deposit slips. In most banks, head tellers are responsible for the teller line. They set work schedules, ensure that the proper procedures are adhered to, and act as a mentor to less experienced tellers. In addition, head tellers may perform the typical duties of a teller, as needed, and may deal with the more difficult customer problems. They may access the vault, ensure that the correct cash balance is in the vault, and oversee large cash transactions. Technology continues to play a large role in the job duties of all tellers. In most banks, for example, tellers use computer terminals to record deposits and withdrawals. These terminals often give tellers quick access to detailed information on customer accounts. As banks begin to offer more and increasingly complex financial services, tellers are being trained to identify sales opportunities. This task requires them to learn about the various financial products and services the bank offers so that they can briefly explain them to customers and refer interested customers to appropriate specialized sales personnel.

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Transaction ProCustomer

Check Processing & Collection Checks are written orders the Bank customers use to tell the bank or other depository institution to pay money or to transfer funds from his account to the check holder. The check collection system in the United States is efficient, but the collection process a check goes through may be rather complicated. Funds on local checks must be made available within two business days according to the Expedited Funds Availability Act of 1987. Non-local checks must be made available within five business days. Certain circumstances permit longer holds due to the high risk of fraud, such as new accounts, deposits over $5,000, repeatedly overdrawn accounts and/or emergencies. A check written on a particular bank and cashed by or deposited into the same bank would be handled and processed within that bank. Checks of this typecalled on-us checksaccount for nearly one-third of all checks. The remaining two-thirds are known as transit checks because they must move between different banks, sometimes passing through several in different parts of the country. A check includes the names of the payer and the payee, the account number, amount of the check, and the name of the paying financial institution. The MICR line at the bottom of the check enables high-speed reader/sorter equipment to process checks. BeforePage 20 of 186

Foundation Course in Banking financial institutions process checks, they encode the amount of the check in magnetic ink at the bottom of the check. Check Clearing Check Clearing refers to the movement of a check from the depository institution at which it was deposited back to the institution on which it was written and the corresponding movement of funds in the opposite direction. Banks in large cities often form associations called clearinghouses for exchanging checks drawn against the members. A clearinghouse may have fewer than a dozen members, but these banks are usually the largest in the area. Clearinghouse members group the checks of other member banks, exchange them at a specified time each day, and settle accounts with each other. Clearinghouses can often collect and process locally drawn checks faster and more efficiently than do intermediary services, such as correspondent banks and the Federal Reserves check collection network. Financial institutions clear and settle checks in different ways depending on whether the checks are on-us checks (checks deposited at the same institution on which they are drawn) or interbank checks (the payer and payee have accounts at different financial institutions). On-us checks do not require interbank clearing or settlement. Interbank checks can clear and settle through direct presentment, a correspondent bank, a clearinghouse, or other intermediaries such as the Federal Reserve Banks. Financial institutions can also clear checks through a Federal Reserve Bank or an independent clearinghouse, where they have formed voluntary associations that establish an exchange for checks drawn on those financial institutions. Typically, financial institutions participating in check clearinghouses use the Federal Reserves National Settlement Service to effect settlement for checks exchanged each business day. There are approximately 150 check clearinghouse associations in the United States. Smaller depository institutions typically use the check collection services of correspondent banks or the Federal Reserve Banks. The following diagram depicts the typical interbank check clearing and settlement process through a Federal Reserve Bank or clearinghouse. The solid lines depict the flow of information and the dashed lines represent the flow of funds. In step 1 the consumer uses a check to pay a merchant for goods or services. The merchant, after authorizing the check, accepts the check for payment. At the end of the day, the merchant accumulates the checks and deposits them with its financial institution for collection (steps 2 and 3). Depending on the location of the paying institution, the funds may not be immediately available. For deposited checks payable at other financial institutions, the merchants financial institution uses direct presentment for processing or sends the checks to a Federal Reserve Bank, clearinghouse, or correspondent bank (steps 4 and 6). The check or an electronic presentment file is sent to the consumers financial institution, and the financial institutions account at the correspondent, clearinghouse, or Federal Reserve Bank is debited (steps 5 and 7).

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Correspondent Banks Most banks maintain accounts at other banks for the purpose of collecting checks. A correspondent bank accepts checks from the bank with which it has a relationship and processes those checks the same way it processes those for its depositors. It credits the depositing banks account and forwards the checks to the bank on which they were drawn. The Federal Reserves Check Collection Network The Federal Reserve is the largest nationwide processor of transit checks, handling about a quarter of all checks in the United States at 45 Federal Reserve checkprocessing facilities across the country. All financial institutions that accept deposits can purchase Federal Reserve check collection and other payments services. The Federal Reserve is required by law to charge these institutions a fee for its services to cover its expenses. But the Feds large volume of checks, extensive automation, and speedy processing allow it to keep check collection costs and prices low. Checks are moved efficiently across the country from one Federal Reserve check processing region to another using the Feds check relay network, an air and ground transportation network of private vendors managed by the Federal Reserve Bank of Atlanta. The Reserve Banks also are linked electronically to a settlement fund that keeps track of the districts net balances as they exchange checks for settlement. When a Check Is Returned Not all checks move easily through the check collection system, however. Sometimes a check is returned to the bank where it was first deposited. Approximately 251 millionPage 22 of 186

Foundation Course in Banking checks are returned or bounced each year, according to the Federal Reserve. This is 0.6 percent of total check volume. The average value per returned check is $701. A check may be returned for a number of reasons. Insufficient funds in the check writers account; An improper endorsement or date; An error in the magnetic ink code imprinted on the check when the check was first deposited; An alteration in the handwritten information on the check that is not initialed by the check writer; A stop-payment order issued on the check; A hold placed on the check writers account.

If a bank refuses to honor a check, the check must be returned to the bank where the check was first deposited within a certain period specified by law. Dealing with Problem Checks Every time a bank cashes a check or accepts a check for deposit, it is taking a risk. Some types of checkssuch as U.S. Treasury checkscarry a very high guarantee of payment and so pose little risk to the accepting bank, especially if an established customer presents these checks. The degree of risk to the bank is greater for checks presented by new customers because the risk of fraud is greater. Personal checks are riskier to banks than other types since they are more likely to bounce because of insufficient funds. Banks try to guard against fraud by following verification and identification procedures. They also establish policies to minimize losses from bounced checks. Banks are protected from some risks by a federal law that allows them to limit a customers access to funds for a specified period after a check is deposited. The maximum time a bank may limit access to these funds varies with the type of check. Except in certain circumstances, funds from U.S. Treasury checks and some types of on-us checks must be made available for withdrawal by the following business day. Next-day availability may also apply to state and local government checks and certified and cashiers checks if specified deposit requirements are met. For a personal check, the maximum time a bank can put a hold on the funds varies according to whether the check is drawn on a local or a nonlocal bank. Stop Payment Orders Under certain circumstances, a check writer may want to stop payment on a check. A stop-payment order is an instruction from the check writer to her or her bank that a particular checksuch as one that has been lost or stolen or was made in payment for a transaction that is now being disputedshould not be paid.Page 23 of 186

Foundation Course in Banking A check writer may request a stop payment in person, by telephone, or in writing. Many banks require written confirmation of a telephone request. The order should specify the check number and the exact dollar amount. Banks usually charge a fee, which varies from bank to bank, for this service. How to cash a Check without having a Bank Account People who dont have a bank account often have a hard time cashing checks they receive, even Social Security, unemployment, or other kinds of government checks. Although some states have laws requiring banks to cash such checks for anyone who provides proper identification, in most states banks have the right to refuse to cash any checks for non-customers. A person without a bank account has a few options for cashing checks. Providing proper personal identification, present the check at the bank on which it is drawn. The bank must either pay the check or refuse to pay it before the close of the business day. Ask a friend or relative who has a bank account to endorse the check and cash it. If the check is bad, though, your friend or relatives account will be debited for the checks amount. Use a check-cashing service. Many of these services will not cash personal checks, which they consider too risky. Most require a photo identification and will charge a fee, sometimes based on the type and amount of the check. Few states regulate check-cashing services, so fees can vary widely.

Electronic Checks An electronic check is a transaction that starts at the cash register with a paper check for payment, but the payment is converted to an electronic debit, which is processed via the ACH network. Thousands of retailers are offering this service, and hundreds of thousands of checks are being converted everyday from paper checks to electronic checks. This new electronic check conversion service offers retailers, financial institutions and consumers an efficient new method to handle payments at the point of purchase. The consumer still hands a check to the retailer but the retailer hands the check back after capturing payment information, obtaining authorization from the customer and stamping the check VOID. Then the payment flows through the national automated clearing house network (ACH) to the check writers account. Specifically, heres how an electronic check payment flows: The customer hands the retailer the check intended to pay for the purchase. Currently, only checks drawn on consumer accounts can be converted. The retailer determines that the check is eligible for conversion and then runs the check through a magnetic ink character recognition (MICR) reader.

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Foundation Course in Banking MICR encoded information, the routing number, account number and check serial number, is captured by the MICR reader. In addition, the retailer keys in the payment amount and the name of the retailer is either keyed in or added by the reader. The retailer may choose to run the payment information, including the retailers name, through an internal or external database to authorize, verify or guarantee the payment, to determine if the routing number can be used for ACH payments, or to determine if the customers address is on file. After the customer information is recorded and if used, approval by the database is obtained, the terminal prepares a written authorization, which is then signed by the customer. The authorization must contain specific information specified in the NACHA Operating Rules, which are the rules under which the ACH Network operates. The retailer or its processor formats the payment information as an ACH debit entry. The payment is included in a batch of ACH entries transmitted to the retailers bank. The bank transmits the batch of payments to the ACH Network, which routes each payment to the bank on which the converted check is drawn.

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Foundation Course in Banking The paying bank posts the check (debit) to the customers account, and the customer receives information about the payment on their statement.Point of Purchase (POP) Check Conversion

Customer Signs Authorization

Check Information Flows Through Retailers System

Retailers (Collecting) Bank (ODFI) Enters Information Into ACH Network

Stat

ACH Network

Consumer Receives Check Information on Statement

Consumers (Paying) Bank (RDFI) Posts ACH Entry to Consumers Account

The Electronic check service has several benefits both for the consumer writing it and for the financial institution processing it. Some of the major benefits are It results in faster and less paper-intensive collection of funds. It helps to improve efficiency in the deposit process for retailers and their financial institutions. It stems the growth of paper check processing. It benefits consumers by speeding checkout, providing more information about the transaction on their account statement, and removing the consumer from any negative file much quicker It enhances collection of checks that bounce for NSF or uncollected funds because collection can be started more quickly than with paper checks.

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CREDIT CARDSCredit Cards have become one of the most ubiquitous things in todays world and the preferred mode of payment for all kinds of transactions. As a substitute to money; credit cards offer to the user a huge amount of flexibility, ease of handling and an option to buy things from the convenience of your residence. To the various other participants like the issuers, acquirers etc. credit cards have become one of the biggest items of revenue and profitability. At the risk of overemphasizing the obvious, suffice it to say that credit cards have now become as integral a part of our everyday existence as money and the importance is increasing everyday. There are basically three types of credit cards: Bank cards, issued by banks (for example, Visa, MasterCard and Discover Card) Travel and entertainment (T&E) cards, such as American Express and Diners Club House cards that are good only in one chain of stores (Sears is the biggest one of these, followed by the oil companies, phone companies and local department stores.) T&E cards and national house cards have the same terms and conditions wherever you apply. Affinity card, this card -- typically a MasterCard or Visa -- carries the logo of an organization in addition to the lender's emblem. Usually, these cardholders derive some benefit from using the card -- maybe frequent-flyer miles or points toward merchandise. The organization solicits its members to get cards, with the idea of keeping the group's name in front of the cardholder. In addition to establishing brand loyalty, the organization receives some financial incentive (a fraction of the annual fee or the finance charge, or some small amount per transaction, or a combination of these) from the credit-card company.

We primarily discuss Bankcards here.

CREDIT CARDS BASIC CONCEPTS The credit card industry has become one of the most important revenue grosser for the financial services industry. The credit card industry revolves around various participants each of whom have a niche role to perform in the value chain. Given below is a comprehensive list of various participants in the industry: Cardholder - The customer who possesses a credit card and initiates financial transaction using it as a substitute for cash. Issuer - The financial institution that extends credit to customers through bankcard accounts. The bank issues the credit card and receives the cardholder's payment at the end of the billing period. This is also called the cardholder bank.Page 29 of 186

Foundation Course in Banking Merchant - A business establishment is considered a "merchant" once they have authorization from an acquiring bank, ISO or other financial institution to accept credit cards. Acquirer - The financial institution that does business with merchants who accept credit cards. A merchant has an account with this bank and at regular intervals of time deposits the value of the credit card sales. Acquirers buy the merchant's sales slips (ticket) and credit the ticket's value to the merchant's account. Independent Sales Organization (ISO) - In the credit card industry ISOs act as a third party between the merchant and the acquiring bank. Many businesses (home based/mail oders) are unable to obtain merchant status through an acquiring bank because the bank views them as too large a risk. Therefore they need to go through an ISO to obtain merchant status. Banks are afraid that these might not be able to handle any chargebacks that hit their accounts. Schemes (Mastercard & VISA) - These are represented by member financial institutions from around the world. They provide the operating infrastructure and brand management for their respective brands. They provide services such as conducting authorizations, clearing and settlement processing of transactions, supervising the bankcard processing within member banks and setting and enforcing the bankcard rules and regulations. Interchange - Interchange is a network operated by credit card schemes like Master Card/Visa. Through this network, all the transactions between the issuers and acquirers are settled. Hence interchange is the network that helps the issuers and acquirers in clearing and settlement. Through Interchange, Master Card and Visa are at the center of the transaction process. They maintain the flow of funds between issuers and acquirers and establish control over the entire transaction process. A typical process flow diagram involving the various participants is as follows:

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CREDIT CARDS PROCESSES The credit cards industry revolves around various processes that clearly define the tasks at each and every phase. Summary of the various processes and activities involved in a typical credit card transaction are as elucidated below: Application Processing Application Processing verifies the information provided in the Credit Card application, determines the credit worthiness of the applicant using credit scoring methods and Credit Bureau reports, approves the card and sets up the account for the customer. Transaction Processing The cardholder makes a purchase and pays for it using the credit card. The merchant sends the credit card transaction to the acquirer, who passes the financial transaction information to the issuer. The issuer posts the information to the cardholder's account. The issuer will pay the merchant for the cardholder's purchase. The issuer will settle the financial transaction by electronically purchasing the cardholder's charges from the merchant, the acquirer or their banks. The issuer periodically sends a statement to the cardholder asking for payment of full or partial balance. The cardholder repays the loan along with any interest or fees assessed.Page 31 of 186

Foundation Course in Banking The various activities in transaction processing are as follows: Authorization Authorization is the first phase in a credit card monetary cycle. A merchant can accept the card only when the validity of the card and the readiness of the issuer to pay for the purchase are assured. Authorization is usually performed using a huge network of telephone lines and computers connecting the merchants to the credit card processing center. Settlement Settlement is the second phase of the credit card monetary cycle. It is the process adopted between the merchant and the credit card company. The card issuer reimburses the money to the merchant for the merchandise supplied/shipped to the cardholder. Chargeback A chargeback is a reversal of a previous sales transaction resulting when a cardholder or card issuer disputes a charge posted to their account. Chargebacks generally occur after the established dispute resolution process has been completed and is found in favor of the cardholder or card issuer. Chargebacks happen when an issuer disputes a transaction (either at the request of the cardholder or for reasons of its own). Core data processing To collect the amount due from the cardholder, the credit card company has to keep track of the cardholder's transaction, balance and credit limit. It has to keep a log of all the monetary activities of the cardholder. In the case of partial payment or non-payment, the cardholder will be charged an interest on the accumulated balance. This is where credit card companies derive their major source of income. When a cardholder makes huge purchases and pays over a period of time, the interest on her balance increases proportionately. This process of core data processing is mostly handled by independent organizations such as First Data Resources (FDR). Every issuing bank prepares files, which contains all monetary, non-monetary transactions on each business day. Collections & Recovery Collections & Recovery helps collectors to obtain payments on cardholder accounts and fraud accounts. They help the credit grantors in controlling their bad-debt portfolios and increase recoveries. Balance Transfer This is an introductory incentive offered to customers by new credit card companies who want to acquire customers by weaning them away from their present credit card companies. A new credit card company may be willing to take over up to 75% of the amount outstanding on your old card to your new credit card account with them at a lower rate of interest. Normally you are given a time limit of six months at a lower rate of interest to clear this transferred amount. However you could possibly be charged a higher rate of interest for new purchases. If you are unable to clear your balance transfer amount within six months, you will end up paying a higher rate of interest with the new credit card Company.Page 32 of 186

Foundation Course in Banking CREDIT CARDS - SOURCES OF REVENUE Any credit card issuer has 3 sources of revenue, which are as follows: Annual Fees This is the amount paid by a customer to the credit card issuer every year for availing of the credit card Inter-exchange Fees This is the amount received by a card issuer from another card issuer on account of a customer swiping the card at the formers swiping machine. For e.g., if a customer holding an ABN AMRO credit card swipes the card at a Citibank machine, then ABN AMRO Bank pays Citibank a certain percentage of the transaction amount Interest income This is the interest amount paid by a customer to the credit card issuer for revolving the outstanding credit balance over different payment cycles

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LOANS OVERVIEWBanks traditionally raise funds from communities through deposits and savings accounts and make revenues by lending it to people to buy homes & cars, to put children through education, as well as to start and expand businesses.

These loans generally take care of immediate cash requirements for an interest charge; the repayment is usually in the form of periodic (Monthly, Quarterly etc.) payments. Some of the classifications for loans can be made based on term, amount or usage of collateral. Long term or Short-term credit: Term refers to the duration of time within which the loan needs to be repaid. Long-term credit refers to loans like mortgages, auto loans etc. which typically have longer repayment periods. Examples of short-term credit include credit cards and working capital loans. Open ended or Close ended loans: Close ended loans are when the amount of loan and the term are decided and fixed, as against open ended loans wherein the borrower takes as much loan as required against an upper limit on the amount. In this case, interest is charged on the outstanding balance. Examples for open endedPage 34 of 186

Foundation Course in Banking loans are credit cards and home equity line of credit7, while examples for close ended loans are auto loans and mortgages. Secured or Unsecured debt: A secured loan is the case in which the repayment of the loan is "secured" by a specific property (also called collateral). The lender can acquire this property in case the borrower fails to repay the loan.

There are many type of loans designed to meet specific requirements of people and businesses. The leading loans made to consumer in terms of number and volumes are mortgages, auto loans, credit card debt and student loans. The most common types of loans given by banks to businesses are: Working capital lines of credit for the ongoing cash needs of the operations Corporate Credit cards: higher-interest, unsecured revolving credit Short-term commercial loans: with a term of one to three years Longer-term commercial loans: term greater than three years, generally secured by real estate or other major assets Equipment leasing: when businesses want assets that they don't want to buy outright Letters of credit: for businesses engaged in international trade

KEY PLAYERS Key players in Loans process include the Borrower, Broker, Lender, Credit Rating agency, Insurance agency, Securitiser, Government entities and the investor.

Player Borrower Brokers

Function Borrower is the entity that requests and obtains a loan; this could either be an individual or a corporate. Brokers are intermediaries or middlemen who help borrowers in locating the appropriate product and the lender for their requirements. Lenders are the FIs providing the loan.

Lenders7

Home Equity Lines of Credit (HELOC): HELOC refers to the loans provided with home as the collateral. This is different from mortgage loans, which are for the purpose of purchase or construction of a home. The borrower is allowed to borrow amounts as per requirement (against a limit) and the interest is usually charged on the daily balance. Page 35 of 186

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Credit Agencies

Rating

Credit Rating Agencies provide credit reports on the borrowers to help lenders understand the default risk associated with the borrower. This is used in determining the conditions of the loan. Insurance Agencies are risk intermediaries who reduce the risk for the lenders by providing insurance. These include collateral insurance, default insurance, and title insurance. Securitisers use the loans as assets and issue securities against them. The market for securitization is known as secondary market. In some areas of priority including housing loans, agricultural loans, and student loans, the US government has established agencies that make the borrowing more affordable & convenient for the borrowers. These government backed entities typically provide guarantee against default when the borrowers meet certain predefined requirements. This guarantee decreases the risk for the lender, usually leading to a decrease in interest rates charged to the borrower. Investors are FIs who provide capital (funds) to the lenders. Investors provide capital by purchasing whole loans or securities backed by loans in the secondary market.

Insurance Agencies

Securitisers

Government entities

Investors

GENERIC LOAN PROCESS Lets look at a generalized loan process that captures the common entities and key functions involved with a loan process. Of course, the process varies based on the kind of loan.

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Lenders Borrowers Brokers

Foundation Banking Underwriting Course in GuaranteePre-qualification Processs

Credit Bureau Services

Loan Closed

Loan ApprovedAppraisa l Services

Sale in secondary market

In Lenders portfolio

The borrower goes to the lender directly or through a broker.

Based on information like current income, loan amount required, down payment willing etc. a pre-qualification is done so that the borrower can identify the products that suit their requirements Underwriting is the process by which the decision whether to make a loan to a potential borrower based on credit, income, employment history, assets, etc. is made. In some types of loans certain government (or government backed) agencies provide guarantees against default on part or the entire amount of loan. Credit Bureaus help the underwriting process by providing credit reports on individuals and businesses. Appraisal Service providers help in determining the value of the collateral in the loan (home in mortgages, car in auto finance in case its a used car etc.) After the underwriting process, the interest rate and other terms are negotiated between the borrower and the lender, necessary paperwork executed and the amount granted to the borrower. This process is called closing of the loan. Once the loan is closed, it can be either retained in the lenders portfolio, in which case the lender continues to own the loan. Alternately, certain types of loansPage 37 of 186

Foundation Course in Banking are put for sale in secondary market. In this case, the loans are sold to another entity so that the lender has money to make more loans.

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MORTGAGESMortgages are loans given to consumers for the purpose of purchase, construction or repair of real estate. Mortgages were started in the 1930s by insurance companies in the US, primarily with the hope of gaining ownership of properties if the borrower failed to make the payments on it. It wasn't until 1934 that mortgages, in their current form, came into being. The Federal Housing Administration (FHA) played a critical role in this process. In order to help pull the country out of its economic depression, the FHA initiated a new type of mortgage aimed at the folks who couldn't get qualify for mortgages under the existing programs. At that time, only four in 10 households owned homes, against the current homeownership levels of close to 70%. Mortgage loan terms were limited to 50 percent of the property's market value, and the repayment schedule was spread over three to five years and ended with a single lump sum payment that clears the total outstanding. Mortgages can broadly be classified into four categories Home, Multi-family, Commercial, and Farm mortgages. Home mortgage-Also known as 1-4 or single-family mortgages, these are the mortgages provided for purchase or construction of a home for occupancy of 1 to 4 families. These form the largest chunk of mortgages generated. Most of the subsequent discussion would be based on the single-family mortgages. Multi-family mortgage-Mortgages taken for apartment complexes, which house more than 4 families. Commercial mortgages-these are mortgages for development of commercial property including shopping complexes, hospitals, and office complexes. Farm mortgages-these are mortgages provided for purchase of farmlands.TOTAL MORTGAGES OUTSTANDING, 1997-2002($ billions, end of year)

1997

1998

1999

2000

2001

2002

Total mortgages $5,201.1 $5,712.5 $6,316.6 $6,890.3 $7,600.8 $8,486.0

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Home

3,978.3

4,362.9

4,787.2

5,205.4

5,738.1

6,460.0

Multifamily residential 300.1 331.5 369.1 405.0 453.3 498.4

Commercial

832.7

921.6

1,057.9

1,171.0

1,293.0

1,401.8

Farm

90.0

96.6

102.3

108.9

116.3

125.8

Source: Board of Governors of the Federal Reserve System.

MORTGAGE PRODUCTS There are many types of mortgages in the market. These are designed to suit various requirements of the borrowers including the length of mortgage, capability for initial payment, the other financial obligations. Mortgages can be broadly classified into Conventional and Government Insured Loans. Conventional Loans can be further classified into conforming and non-conforming loans. Government Loans These are loans either guaranteed/insured by the Federal Housing Administration (FHA), which is part of the U.S. Department of Housing andMortgages

Conventional Government

Non-Conforming

Conforming VA FHA RHS

Jumbo

Subprime

Alt A

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Foundation Course in Banking Urban Development, the Veterans Administration (VA), and the Rural Housing Service (RHS), which is a branch of the U.S. Department of Agriculture. These agencies do not typically originate loans (except for low income and other specific borrowers) directly but guarantee/insure loans originated by others provided they meet their underwriting norms. The FHA loans offer a mortgage-financing program that insures home loans. The financial requirements for FHA loans are relaxed compared to traditional commercial loans. So an individual with an adverse credit limit who is not eligible for a prime mortgage could be eligible for a FHA loan. Also, the interest rates charged on a FHA loan are lower than those for conventional loans. However the FHA loan requires an upfront mortgage insurance payment to be paid, thus leading to higher closing costs. Also, there are limits on FHA loan amount that vary based on the state & county and these limits are lower than those for conventional loans. Based on their requirements, individuals would need to decide between going for a FHA loan (lower interest rates, lower down payment) or a sub prime loan (lower closing costs, higher loan limits). o FHA requirements reduce the debt-to-income ratio from 28/36 to 29/418. o FHA loans also require a low down payment of 5 percent or less VA loans are designed for qualified veterans and offer more relaxed standards for qualification than either FHA loans or traditional loans. For example in 2002, loans can be for amounts up to $240,000 and require no down payment. RHS offers both guaranteed loans through approved lenders and direct loans that are government funded. These are offered to low-income families, living in rural areas or small towns for purchase, construction or repairing homes.

Conventional Loans - A conventional loan is one that is not insured by the Federal Housing Administration (FHA) or guaranteed by the Veterans Administration (VA). These are further classified into conforming and non-conforming loans. Conforming loans comply with the loan size limitations, amortization periods, and underwriting guidelines set by Freddie Mac and Fannie Mae in secondary market. Conforming loans may be sold to the Freddie Mac or Fannie Mae (Government-sponsored enterprises or GSEs), which, in turn, securitize, package, and sell these loans to investors in the secondary market.

8

28/36 refers to total monthly mortgage payment being less than 28% of monthly income AND total monthly debt payment less than 36% of monthly income. Page 41 of 186

Foundation Course in BankingConventional 75%

VA 3%

FHA 14%

Jum bo 8%

Non-conforming loans (like Jumbo Loans) are not eligible for purchase by a GSE, but can be sold in the secondary market as whole loans, or can be pooled, securitized, and sold as private-label mortgage-backed securities. Nonconforming loans comprise Jumbo loans, subprime loans and Alt A loans. Jumbo loans are the loans in which the loan amount is above the limit set by Freddie Mac & Fannie Mae. This limit changes annually based on the singlefamily home price survey done by the Federal Housing Finance Board. For example in 2002, a conforming loan limit was $300,700. Loans that are above that limit are called Jumbo loans. Jumbo loans have interest rates higher by about 0.25 percent to 0.50 percent than the conventional loans. Subprime loans are loans given to borrowers with poor credit history whose credit characteristics do not meet the requirements of Fannie Mae & Freddie Mac. These loans typically have higher down payment and higher interest rates. "Alt A mortgage loan is provided to borrowers who have good job stability, good income, but their credit scores don't fit the "A Credit" guidelines. This could either be due to a short credit history or due to a slight derogatory hit on the credit scores such as a 30-day late payment.

Classification of Mortgages based on applicable interest rates is given below. Each of the loan types discussed above can fall under any one of the following categories:

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Foundation Course in Banking Fixed-Rate Mortgage (FRM) - This mortgage comes with an interest rate that will never change over the entire life of the loan irrespective of changes in the market rates and economic trends. So, a mortgage with a rate of 7 percent that calculates a payment of $1,247 per month for a 20-year term would imply a monthly payment of $1,247 during the entire duration. However, there could be a change in the property tax and any insurance payments included in the monthly payment. The term of the fixed rate mortgage is usually 15, 20 or 30 years.Comparing ARMs and FRMs An FRM requires predetermined and fixed monthly payments, making budgeting far more predictable for the borrower as opposed to an ARM

In a FRM, the lender requires a premium for the commitment to keep interest rates fixed over the term of the loan. Longer the term of the loan, greater the premium. In an ARM, since the borrower takes the risk of fluctuating interest rates, the lender usually charges an initial rate, lower than the initial rate of an FRM of the same tenure. Such a rate is called the teaser rate of the ARM.

The major advantage of ARMS is that if interest rates decline and the borrower does not qualify for a refinance, an ARM will automatically adjust itself to a lower rate. The disadvantage could be in the rare case when interest rates decline too sharply, so as to fall below the limit set by the ARM cap (the lifetime cap or the periodic cap or both). In that case, the ARM interest rate stays above the interest rate of the FRM. The reverse holds good for rising interest rates, where the rates may rise beyond the lifetime cap of the ARM, making the ARM rates lower than those of comparable FRMs.

Adjustable-Rate Mortgage (ARM) - An adjustable-rate mortgage has an interest rate that changes based on changing market rates and economic trends. ARMs usually have an initial period of time during which the rate won't change. For example, a 5/1 year ARM would mean the initial interest rate would stay the same for the first five years and then would adjust each year beginning with the sixth year. A 3/3 year ARM would mean the initial interest rate would stay the same for the first three years and then would adjust once every three years beginning with the fourth year. Some of the other ARM products include 5/25 ARM, 7/23 ARM, and 7/1 ARM. The interest rates for ARMs can be tied to one-year U.S. Treasury bills, rates on certificates of deposit (CDs), the London Inter-Bank Offer Rate (LIBOR), COFI or other indexes. More details on these indexes are given in Appendix C. All Conventional and Government loans (with the exception of VA loans) are available as ARMs.Page 43 of 186

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Hybrid Loans - Hybrid loans combine features of a fixed rate mortgage (FRM) and an adjustable rate mortgage (ARM). The hybrid loans interest rate and monthly payments are fixed over a specified period of time beyond which the loan will convert into and stay as an ARM for the remainder of the loan term. The initial rate may be fixed for 3, 5 7 or even 10 years beyond which the ARM takes over. The ARM adjusts every 6 to 12 months. The longer the initial rate stays fixed, the higher will be the rate but the initial rate of a Hybrid loan is usually lower than that of a 30 year FRM. The initial interest rate will be higher than an ARM since the rate remains fixed for much longer than that of a normal ARM. A normal ARM would offer a fixed rate for say 6 to 12 months. The 7/23 loans may also be considered a form of Hybrid loans. These loans remain fixed for the first 7 years, then adjust once and remain at that rate for the remaining 23 years. Balloon Mortgage - A balloon mortgage offers an initial fixed interest rate for five to seven years and then requires a "balloon" payment. The balloon payment is the final payment of the loan and pays off the entire balance. Graduated Payment Mortgages (GPMs) - A GPM would have a fixed interest rate with monthly payments that gradually increase by predetermined amounts during the early years of the loan and then level off, say after 5 years. A GPM would be useful for borrowers who expect their incomes to increase significantly over a period of time. However, GPMs carry the risk of having the loan principal to actually increase during the early years when payments are low and inadequate to meet the entire interest payment. Reverse Mortgages - Reverse mortgages pay money to the borrower as long as the borrower lives in her/her home. These loans are designed for people aged 62 and above who own their homes and need an inflow of cash. The loan is against the equity of home and isn't paid off until the borrower sells or moves out of the home. The payment can be a single lump sum, regular monthly payments, or a as a "creditline" account that lets the borrower decide when and how much of the available cash is paid. Against this, the lender gets an equivalent amount of equity in the home, which they can claim once the home is liquidated after the borrower does or moves away. All types of Conventional and Government loans (except VA loans) are available with ARM options.

80-10-10 FinancingWhen the mortgage amount is more than 80 percent of the purchase price of the home, lenders require the borrowers to take insurance on the extra amount. It is called PMI (Private Mortgage Insurance) and the borrower pays for the premium. The cost varies but it can be equivalent of an additional 1/2 to 1 percent of the loan amount per year. Furthermore, this cost is not tax-deductible. With 80-10-10 financing, the borrowersPage 44 of 186

Foundation Course in Banking make cash down payment of 10 percent of the purchase price. They take out two mortgages: a new first mortgage for 80 percent of the price and 10 percent second mortgage. Often the first and second mortgages are from the same lender. The interest rate on the second mortgage will be about 2 percent higher than the going rate on first mortgages. This allows the borrowers to save money spent on the PMI. Bridge Loans - Borrowers who plan to take a new home before selling their current one can go in for a bridge loan to span the gap between the two transactions. Bridge loans can either be structured to completely pay off the old home's mortgage or to add the financial obligation of the new home to the existing mortgage. Typically, the loan is structured with a short term (often one year) and hefty prepaid interest (perhaps six month's worth). Most often, a bridge loan is used to pay off the existing mortgage, with the remainder (minus closing costs and prepaid interest) going toward the down payment on the new home. If after six months the old home has not sold, the borrower begins making interest-only payments on the loan. When the home sells, the bridge loan is paid off. If it sells within the first six months, any unearned interest payments will be credited to you. KEY MORTGAGE CONCEPTS

ConceptInterest Rate Closing costs

Definition This determines the amount of interest paid on the mortgage loan. The interest rates for loans of different terms are discussed in Appendix C. These are the costs, which are incurred by the borrower in order to obtain the mortgage. These may include points, taxes, settlement agent fees and more. The various costs that are a part of closing costs are discussed in Appendix C. APR is commonly used to compare loan programs from different lenders. The APR is the average annual finance charge (which includes fees and other loan costs) divided by the amount borrowed, and is expressed as an annual percentage rate. The APR will be slightly higher than the interest rate the lender is charging because it includes all the other fees that the loan carries with it, such as the origination fee, points, PMI premiums, etc. The various costs that are included in APR calculation are discussed in Appendix C. The down payment is the contribution of the borrower towards the home purchase or construction and is to be paid initially while taking the loan. The down payment can be anywhere from three to twenty percent of the home's value. Down payments can be lower for some special, first-time buyer loans,Page 45 of 186

Annual Percentage Rate (APR)

Down payment

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and veterans or those on active military service can obtain loans with no down payment at all. Mortgage payment Mortgage payment is the monthly payment made by the borrower towards the repayment of the mortgage. A mortgage payment is made up of three basic parts; A payment on the principal of the loan A payment on the interest, and Payments into the escrow account. These are payments towards various insurances (flood, title etc.) and the taxes that need to be paid for the property

Amortization

A mortgage payment has two parts (if we exclude insurance and taxes), the interest and the principal. The sum of these two make the EMI. A mortgage payment received is first applied to the interest and then to the principal. This causes the principal balance outstanding to decrease. For the next installment, the interest portion of the payment decreases since interest is always computed on the principal balance outstanding and the principal balance outstanding decreases with each

payment. So initial mortgage payments go more towards servicing the interest component and latter ones towards the principal component (assuming equal installments). This process of reduction in the principal balance outstanding is known as amortization.

Negative Amortization

If the payment structure is so designed that the installment payments are inadequate to meet the interest component, then the unpaid portion of the interest is added to the principal amount, causing the principalPage 46 of 186

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balance outstanding to actually increase. This would require an even greater interest component to be paid off in the next installment. With installment amounts remaining constant, an even great amount of the interest remains unpaid, causing the principal balance outstanding to increase with each successive installment. Such a loan, theoretically, can never be paid off (amortized) if the installment amounts remain constant. This is negative amortization. Lenders, who design such loans, ensure that installment amounts rise subsequently to break the negative amortization or design a balloon payment. Such a situation is not desirable for the borrower. Prepayment penalty Prepayment penalty is the charge or a fee for paying all or part of the l