 "Overview of the modelling architecture")
 "Sample calculation for a consumer loan")
The Focus of the EU Directive
The EU Consumer Credit Directive and its integration into national law entail a number of new challenges that will affect several of a bank’s functional areas. The banks must then evaluate the effects, which depend heavily on their own business models, for themselves. For instance, a bank that is only responsible for its own branches has to consider other measures than one that employs agents. The distance-selling business, however, can expect a completely different set of effects.
The following article will focus on several of the directive’s points and describe their effects and possible reactions as well as the associated risks and opportunities.
New Directive sets Stage for Cancellation and
Repayment Conditions
One important point is the change in the right to termination as well as the possibility of early repayment. It directly affects contract specifications as well as the organisational processing of existing business and, thus, also affects procedures and data processing. The scope of this point is limited to those contracts in which a property lien has not been entered as collateral.
The applicable cash flow calculation for the entire lifecycle of a financial instrument is, in terms of the risk systems, a deciding factor for ensuring the various risks (e.g. credit risk, liquidity risk and also interest rate risk) are properly measured. Loans to private customers feature irregular payment rights, which introduce an optional element into product calculation. The appearance of these special payment rights in civil law makes it all the more important to calculate these optional cash flows. Customers have the option of making partial payments or even of repaying the loan in its entirety at different points in time. This option means banks are constantly faced with risks similar to those associated with a shortened deal term.
However, this will only apply to consumer loans and not to loans that are secured by real estate.
What Does This Mean for Credit Risk?
A reduction in the credit risk can be expected due to the shortened deal term. According to the following deal data, a special payment of €2,000.00 (10%) at the end of the first year leads not only to a reduction in the risk premium by €54.07 (13.55%), but also to capital costs of €11.53 (13.54%).
The special payments are reflected in a reduction on the asset side in the interest rate risk. In a normal interest structure, both the structural amount and the present value of the deal are reduced. The resulting risk can be seen as an unstable refinancing, in line with variable-rate deals. Risk continues to grow, albeit in a much smaller range. This leads to the same set of problems experienced when handling core deposits.
As far as liquidity risk of the first degree is concerned, unexpected, additional payments lead to a narrow liquidity gap with a marginal quantitative value. When estimating liquidity risk of the second degree, the situation is to be valuated in line with the interest rate risk. The risk is therefore in the insecurity of the refinancing that has yet to be established and of the structural funds it generates.
If one considers the individual risk values, it becomes clear that a model showing the early repayment (prepayment) is required for a resilient risk valuation and for a meaningful performance calculation.
The model is created by taking into account the causes that are similar to the variable products’ causes. The reasons for early repayment (prepayment) are different for each customer and unknown to the bank. These causes can also serve as an explanation for prepayment estimates, as they can for variable products whose volume has proven to be dependent on the interest level on both the asset and the liability side. In high-interest phases, high volumes are expected for variable asset products, just as their volumes can drop when interest rates are low. If this behaviour is applied to expected prepayments, then increasing special payments can also be expected. In addition to the interest rate as an explanatory variable, further approaches can be taken (i.e. special payments made in the past) to explain the model and to adapt it to any bank’s situation.
Segmentation according to the various products is absolutely necessary to ensure a solid estimate of special payments when modelling prepayments. Special payment rights should be modelled so that the information can be subsequently broken down to the individual deals.
The prepayment estimate architecture is based on the input data for each individual deal. It contains the general deal data and deal parameters including:
- Default rate
- Special payment right
- Customer interest rate
- Interest forecast for variable-rate deals (if available)
This information is used to determine the cash flows from special payments in the ‘Cash Flow Estimation’ step and to transfer them to the output layer. These synthetic cash flows are then transferred to the contractual cash flows, determining the total cash flow for each deal.
This representation and calculation can be generated using the FlexFinance Analytix Prepayment Estimation product.
Apart from taking prepayments (resulting from the rules on cancellation or early repayment) into account, banks can also calculate a compensation that is covered by 1% of the repayment amount if the remaining term is longer than 1 year; or by 0.5% of the repayment amount if the remaining term is shorter than 1 year. The processes for calculating the penalty for prepayment are, however, always applied when the percentages are used to cap most cases. In order for a prepayment penalty to be enforced, however, the borrower must be made aware of the calculation process, which must be presented in writing at the conclusion of the contract.
This places strict limitations on the alternatives for calculating prepayment penalties. If the capping limit is not observed, then banks can be faced with an increasing number of complaints, leading to bad publicity. Leaving the calculation process unspecified could also mean that no prepayment penalty can be enforced. The alternative courses of action are therefore reduced to waiving the penalties altogether or to properly presenting and documenting the process. The latter solution would lead to both contractual and technical (IT) changes. And FERNBACH’s complete range of functions for calculating prepayment penalties can be applied to these changes. The calculation is based on comparative calculations of the deal both with and without special payments.
Avoiding Unnecessary Process Steps
Regulations on premature repayments have influenced operations to the extent that lenders are restricted in accepting incoming payments. However, as far as processing is concerned, this means that the programs and procedures used for special payments have to be adapted to comply with the new requirements.
The processing sequences therefore help to avoid the unnecessary step of manually assessing an incoming payment and possibly returning the amount. Ultimately, because labour can be saved if processes are adjusted to this situation, it makes sense to adapt financial software to meet this regulation.
The EU Directive will also have a considerable effect on advertising and advertising strategies, with infringements of the Directive resulting in negative publicity for the company:
- Details of a loan have to be presented in the form of an example.
- Information on the term of a contract and its conditions is needed.
Problems will ensue if at least two-thirds of the contracts resulting from advertising have to be concluded in accordance with these conditions.
The question then arises as to how these two-thirds should be valuated. If a product with a twelve-month maturity is advertised to customers with an average credit standing so that roughly two-thirds of customers have this credit rating or better, then this form of advertising is not allowed if it is not standard practice to wind up this type of lending agreement for only twelve months. Although it is not possible to assess terms to maturity in the same way as credit standing, advertising should display terms that will result in a greater number of contracts. Of course, this strategy can only be used if interest rates are linked to maturity. Consequently, a legal assessment of advertising regulations is necessary and subsequent decisions will no doubt produce the clarity needed to apply this regulation correctly. Banks can only take precautions in their advertising to minimise the risk of immediate and/or future legal consequences or of making negative headlines in the press.
Adjusting the Calculation of the Effective Interest Rate –
Critical Factors
One issue that is generally assumed to be clearly regulated is the adjustment of the effective interest rate calculation. Including leap years in the calculation of interest days in broken interest periods is certainly not one of the more fascinating aspects of effective interest rate calculations. The calculation of charges is, on the other hand, more exciting, since all relevant costs have to be included. If banks fail to observe the regulation, they risk damaging not only their direct economic situation but also their image if and when the facts come to light.
Economic damage can amount to a considerable portion of the interest, since the debit interest rate is calculated from the specified interest rate and by taking relevant charges into account. The debit interest rate can be painfully low in this case.
An example of this would be a car finance loan in which the insurance premium for comprehensive insurance was not included in the effective interest rate calculation.
However, if the costs cannot be determined exactly, they can be omitted from the calculation. This example will, no doubt, provide a significant basis for legal debate. Therefore, it is advisable to examine such issues in advance in order to draw up a reliable strategy for calculating costs.
The requirement that a customer must be informed if a database query, e.g. with
credit reference agencies, has led to a refusal of the loan places demands on process design and hence entails changes to organisational processes or data processing.
Customers can be informed directly of the refusal if they are involved in an advisory interview on a bank’s premises. Other organisational requirements come into effect if a customer submits a loan application via the internet. In this case, the following questions have to be answered:
- Is the database query the reason for the refusal?
- How can the customer be informed?
In case of doubt, an applicant should be informed so that there is no cause for complaints that would result in negative press for the lender in question. In the above example, the loan applicant must be notified in writing so that data protection regulations are adhered to. This has a direct effect on a bank’s IT system, which has to deal with such measures.
Checking a customer’s credit standing is closely linked to the information on a lending refusal and this check is essential to concluding a contract:
- The check has to be documented and must be comprehensible. It is also advisable to have this credit check acknowledged in writing in order to minimise any legal problems in the current business relationship.
- Another option would be to carry out this step in the data processing system and to document it in the processing history.
Banks should not, however, forget that every cloud does have a silver lining. Correct analysis and strict implementation of the requirements can minimise time and effort invested while increasing revenues; as seen in the automation of incoming payment processing.
