Independent finance companies lend secured and unsecured loans to individuals (consumer financing companies) and institutions (commercial finance companies) using the revenues from issuance of debt securities. Unlike commercial banks, whose deposit collection ability greatly contributes to their ability to raise funds, financial companies rely almost entirely on corporate borrowing and access to public debt markets to reach fund. As a result, these companies' ability to access short, medium, and long-term financing markets is vital with competitive rates is very crucial.
Historically, the finance company industry has created small lending spaces in consumer and commercial markets, excluding widespread lending domination of commercial banks. However, as capital markets have developed and worldwide rivalry has increased, commercial banks have begun to engage in higher-profit lending activities that were formerly reserved for financial institutions. Other non-traditional competitors have joined the fight as a result of similar market constraints and opportunities. As a result of the battle over market share, pricing has been subjected to intense and often illogical pressures.
In response, financial companies have had to reassess their business strategies, and many have struggled to achieve optimal managerial and economic efficiency, which has accelerated the restructuring or sale of many companies.
Defending Small Market Spaces
With practically all financial company lines of trades exposed to increased competition, defending strategic initiatives and providing them with the resources they require has become a requirement for success. On the consumer side, company efficiency and economies of scale determine the ability to compete in the offering of a diverse range of products. The credit card industry, for example, is focusing on lower-cost manufacturers due to marketing and transaction costs. Similarly, the consumer finance industry's traditional distribution backbone – the store – the pre-credit office – must struggle with more effective methods such as telemarketing and postal sales management. Companies that choose to keep their extensive branch networks will face pressure to increase productivity.
In commercial finance, the growing popularity of focused marketing and the formation of narrow market niches, on the other hand, demonstrates the "randomized spread" approach against core businesses. Commercial finance companies are creating a strong presence and expertise in a specific industry or type of equipment as part of this strategy. As a result, the tiny market participant may provide a more customized service.
These commercial finance companies aren't always the cheapest when it comes to financing or leasing services. However, in most circumstances, prices are secondary to the consumer, and great quality and skilled service are paramount. Industry and equipment expertise in a leasing company also provides a more successful and effective remarketing capability, resulting in equipment values realized at a relatively higher ratio to the residual values recorded. These residual values enable them to price the leased product more aggressively than competitors or provide a higher level of service in order to increase or at least keep market share.
However, there are drawbacks to the narrow market area strategy, the most evident one is concentration risk. In the event of a decline in the industry or a decline in the value of related equipment, focusing on a specific industry or a specific type of equipment could result in significant losses that may limit the financial institution's ability to continue core operations or make significant changes in the risk profile of the company while jeopardizing its financial structure.
Asset quality is a primary consideration when assessing credit risk in a financial company, -as in banks-. However, because financial business assets often have greater margins and accordingly higher risk, it is impossible to separate asset quality from the total cost profitability of a particular asset or the capital required to prudently support the mentioned asset. Analyzing the financial company's receivables is the first step in understanding these crucial relationships.
JCR ER analyzes financial company portfolios on both a qualitative and quantitative basis. Assessment of the portfolio's composition in terms of kind, mix, and diversity of receivables, as well as analyzing growth expectations, are all part of qualitative analysis. JCR ER assesses receivables' main features, such as whether they are consumer or commercial, collateralized or non-collateralized. Another crucial evaluating factor is the portfolio's size, both in absolute and relative terms. A portfolio that is diverse in terms of geography, customer base, product type, manufacturer and supplier is less risky. The management’s concentration philosophy, is reviewed with growth plans. Finally, the portfolio's key characteristics are assessed during both expansion and contraction periods.
JCR ER assesses receivables via default, divestment, and recovery as part of the qualitative study. Because financial companies have a lot of leeway when it comes to defining these categories, detailed descriptions of payment definitions, divestitures, extensions, and restructuring procedures are required for meaningful comparisons. JCR ER compares reserve coverage levels and trends for specific portfolio characteristics to those of peer groups when measuring the adequacy of reserves for losses. The process of producing reserves is assessed. The standard for undertaking, portfolio composition, and economic environment are used to assess reserve adequacy.
Leverage i.e. debt amount of equity associated with capital base and reserves is an important factor in the rating process. JCR ER uses a building block approach to get at a hybrid asset risk profile for a given financial firm during leverage analyzes. Using industry-wide data, the relative risks of various proportional hazard are derived. As a result, for each rating category the leveraged feature of each sub-portfolio is revealed. It should be noted that leverage rules are general starting points. The actual firm-specific rules are based on all interrelated factors (qualitative and quantitative).
Assets - Debt Management
In analyzing the asset - debt function, JCR ER evaluates the level, trend and stability of flexibility of net interest margin and pricing structure. Management's methodologies for monitoring the impact of interest rate changes on profitability, its tolerances for acceptable levels of risk, and procedures for mitigating those risks are discussed and reviewed, just as they are in any financial institution.
Historically, financial companies have only borrowed from bond market and futures markets, mostly on a ladder-based debt structure in line with expected asset maturities. As interest rate cycles vary, changes in the debt structure are usually limited to movements in the mix of short- and long-term debt. In this aspect, the growth of the medium-term debt market has provided additional flexibility.
In terms of liquidity and financial stability, having a variety of funding sources is advantageous. Financial companies do not have investment portfolios and so do not have this component of asset management. To estimate the liquidity contained in the balance sheet, JCR ER compares debt structure maturities with both asset maturities and forecasted cash flows. A company's borrowing capacity such as ability of creating bank lines or securitized or collateralized borrowing arrangements, are examined.
Profits from operations of finance companies are driving down by increased competition and tax law changes. Profitability becomes increasingly reliant on operating efficiency, portfolio quality, and margin preservation in this way. Profitability is monitored on a historical basis and compared with peers. Growth rates, profits, spreads and returns are analyzed. The most important ratio called return on assets, should be reviewed within the framework of risk and reward. This is especially essential because business pressures are forcing many finance companies to expand their lending to higher-risk categories. Operating efficiency is becoming a more essential indicator of a company's capacity to make profits in a price-pressured economy. Eurasia Rating expects operating efficiency to become a more important variable in profitability analyses.
A non-dependent financial institution can assure that its rating is higher than it could achieve on its own, frequently at a level equal to the main company's rating, by making use of the parent company's strength through a support agreement. As a result, financial institution gains a competitive advantage over other finance companies that must adhere to tougher criteria to preserve their credit quality.
There aren’t any standard support agreements to guarantee a high rating. However, the most usual agreements include stipulations such as maintaining a certain level of net worth and income, as well as fixed fee coverage. The maximum debt-to-equity ratio and the minimum current assets-current liabilities (liquidity) ratio are usually determined by these agreements. There is also a guarantee that the main company will retain 100% ownership of the subsidiary.
Closed or open-ended agreements might be used to provide support. A maximum dollar contribution limit or a termination date included in closed-end agreements. On the other hand, open-ended deals do not limit dollar contribution and thus regarded more profitable. However, JCR ER understands that a main company's ability to provide direct money investments to its subsidiaries may be constrained by law.
Non-dependent financial institutions without formal support agreements but with a history of parent support may also achieve higher ratings than their own performance would provide.