FINANCE COMPANIES What are Finance Companies Finance Companies

FINANCE COMPANIES

What are Finance Companies?

Finance Companies can be partnerships or corporations which are organized to extend credit lines to customers and to industrial, commercial or agricultural companies by: -discounting and factoring commercial papers and account receivables -buying or selling contracts, bases, chattel mortgages and other evidences of indebtedness -lending motor vehicles, heavy equipment, office machines and appliances.

Finance companies in general tend to be interest rate-sensitive - increases and decreases in market interest rates affect their profits directly. For this reason, publicly held finance companies are sometimes referred to as money stocks.

Unlike a bank, it does not receive deposits but rather obtains its financing from banks, institutions, and other money market sources. Finance companies also grant small loans directly to consumers at a relatively high rate of interest. They typically enjoy high credit ratings and are thus able to borrow at the lowest market rates, enabling them to make loans at rates not much higher than banks.

Finance companies arose during the late 19 th century because some firms and consumers were refused bank credit. Until then, the need for consumer loans had been met primarily by illegal “loan shark” activities because it was unprofitable for banks to make small loans at rates below legally set usury levels. Today many companies engage both in the sales-finance business and in making loans directly to consumers.

Large-sales finance companies, which operate by purchasing unpaid customer accounts at a discount from merchants and collecting payments due from consumers, were a response to the need for installment financing for the purchase of automobiles in the early 1900 s. The General Motors Acceptance Corporation, for example, was established in 1919 to purchase automobile accounts receivable from car dealers who were themselves unable to finance time purchases.

Commercial finance companies have grown because they are more flexible in arranging loan repayment schedules than are banks.

Generally, finance companies fall into three categories:

CONSUMER FINANCE COMPANIES -also known as small loan or direct loan companies -make small loans against personal assets and provide an option for individuals with poor credit ratings.

SALES FINANCE COMPANIES -also called acceptance companies -purchase retail and wholesale paper from automobile and other consumer and capital goods dealers;

COMMERCIAL FINANCE COMPANIES -also called commercial credit companies -make loans to manufacturers and wholesalers; these loans are secured by accounts receivable, inventories, and equipment.

Commercial finance companies have in recent years become a favorite option for entrepreneurs seeking small business loans. These institutions generally charge higher interest rates than banks and credit unions, but they also are more likely to approve a loan request.

Larger commercial finance companies often offer small business owners a variety of lending options from which to choose. These include: factoring (buying a firm’s accounts receivables) working capital loans equipment financing and leasing specialized equity investments collateral-based financing cash-flow financing Some also offer additional services in connection with those loans, such as assistance with collections.

different finance company structures:

BANK AFFILIATED This finance company frequently can provide very competitive interest rates.

INDEPENDENT An independent finance company has the greatest flexibility, will finance almost any type of equipment, and can offer very competitive rates although not usually as low as the banks or the captives (equipment suppliers).

BROKERS This is generally considered the most expensive form of leasing as they typically turn a transaction around and sell it to an independent leasing company or bank affiliated company.

CAPTIVE These are owned by the equipment suppliers and can provide very low rates because of their familiarity with the product.

Finance Companies • Finance companies are non-depository lending institutions. • Some finance companies are independent corporations. Other “captive” finance companies are subsidiaries of bank or financial services holding companies or of manufacturers. • Because they do not issue deposits (else they would be considered banks), finance companies have the following disadvantages and advantages relative to banks. 20

DISADVANTAGEs Their liabilities do not have government (FDIC) insurance. Since deposit insurance is usually provided at subsidized rates, this implies that finance companies likely have a higher cost of funding. Finance companies pay competitive rates on their liabilities. Often, finance companies provide installment loans, which were viewed by society as immoral. Installment credit was thought to lead consumers to unmanageable debt burdens. 21

ADVANTAGES Because their liabilities are not government insured, they are subject to less government regulation than banks. In particular, they may be able to lend to riskier borrowers that regulators would not want banks to lend to. Captive finance companies have better access than banks to financing the goods and services sold by their parents. 22

• In recent years, finance companies were the major issuers of commercial paper. • Because finance companies do not issue deposits, they cannot provide the transactions services (e. g. , checking accounts) offered by banks. • Since finance companies lack a branch office network, they typically make loans to borrowers located farther away. 23

The typical practice of finance company lending is described as transaction lending. This involves: » making one-time secured loans, often where the collateral is the borrower’s accounts receivable, inventory, or an asset sold by the finance company’s parent or affiliate. » monitoring the value of the borrower’s collateral (asset-based lending), not his cash flow » foreclosing promptly on a loan should the borrower default (miss making a loan payment). » providing leases, especially to risky borrowers. A lease allows the finance company to easily repossess the leased asset if the borrower misses a lease payment. » factoring, which is buying a firm’s accounts receivable (at a discount) and then managing the bill collections. 24

Empirical evidence in Carey, Post, and Sharpe (1998) Journal of Finance also supports differences in lending due to reputational concerns and regulation differences. They find: » Relative to banks, a greater proportion of finance companies’ loans are to higher-leveraged corporations. » Finance company loans are, on average, longer maturity (3 vs. 2 years) and more frequently collateralized (92 vs. 70 %) compared to bank loans. 25