The bank’s view on differences

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Frame of reference

Bank regulations

The bank’s operations are regulated in many ways. The Basel accords are recommendations on banking regulations made by the Basel Committee on Banking Supervision (BCBS). The committee seeks to improve banking supervision by informing and cooperating with banks on key issues concerning bank supervision. Three accords have been issued so far, namely Basel I, Basel II and Basel III. These regulations’ impact on the mortgage market in Sweden is through the recommendations from the Swedish Financial Supervisory Authority (SFSA), details are available on the authority’s Web site <http://www.fi.se/Regler/Kapitaltackning/>.
The BCBS acknowledge that credit concentration in industries such as commercial real estate is a common source of credit problems for banks (Panagopoulos et al. 2009). The Basel accords were developed to stabilise the relationship between the bank’s equity capital and risk-weighted assets.

Basel Accords

Basel I concerns recommendations about the banks minimum amount of retained capital. The target standard ratio of capital to weighted risk assets should be set at 8%, 4% should consist of core capital (Basel Committee on Banking Supervision, 1988). Basel I focus on the bank’s credit risk exposure which is seen as the most important element of risk. At a later stage the market risk exposure was also taken into consideration (Panagopoulos et al. 2009).
Basel II is focused on credit risk and is a revised framework of Basel I. Basel II continues to stress the minimum capital requirement of 8% but also focuses on decreasing financial and operational risk. The recommendation is focused on three pillars, minimum capital requirements, supervisory review and market discipline (Basel Committee on Banking Supervision, 2005). The intent of the BCBS recommendation is to support and improve banks risk management. The recommendation stresses the importance of retaining enough capital dependent on the amount of risk the bank is exposed to through its lending and investment practises.
Basel III is the latest recommendation and is the BCBS’s reaction to the financial crises of 2008. The recommendation tries to improve the banking sector’s ability to absorb shocks arising from financial or economic stress and strengthen the bank’s transparency and disclosures (Bank for International Settlements, 2010).

The Swedish Financial Supervisory Authority

Swedish banks are authorised, supervised and monitored by the Swedish Financial Supervisory Authority (SFSA). The SFSA is a public authority accountable to the Swedish Ministry of Finance. The aim of SFSA is to promote stability and efficiency in the Swedish financial systems and to ensure consumers protection (FI, 2010).
The SFSA monitors all companies operating in the Swedish financial markets. It monitors, analyse trends and assess the financial health within the market as a whole, sectors of the market and individual companies. This is done by assessing the risk, control systems and the compliance with rules and regulations (FI, 2010).
Besides monitoring the market the SFSA issues regulations and general guidelines and grants permissions for companies who offer financial services to operate in the Swedish market. The regulations and general guidelines are presented in the SFSA’s regulatory code (FFFS). The regulatory codes are in compliance with and based on the Swedish law, EU and international rules and regulations (FI, 2010).
The latest guideline concerning the Swedish banks are the limitation of loan-to-value ratios for mortgages on residential property (Finansinspektionen, 2010a). The guideline concerns new loans and replacing loans on previous issued loans by another credit institution with a property as collateral. These loans must not exceed 85% of the property’s market value. Mortgages make up the largest part of Swedish households indebtedness. This makes households sensitive to price-changes in the property market. The purpose of the new guideline is to prevent a too high loan -to-value ratio for private persons. If a mortgage is valued higher than the current market price of the property consumer will be exposed to high risks if it cannot meet its mortgage obligations. This can happen if for example the household will be troubled with the loss of a job. If the household loses its income it might have to sell the house and will not be able to cover the whole mortgage. The highest risk is taken by first-time buyers since they usually do not have a large amount of cash contribution which leads to a high loan-to-value ratio. The new guideline was put into force on the 1st of October this year (2010).
For the mortgages of real estate properties there are no external regulations. However the FSFA have found that the four main banks in Sweden have a credit granting policy of lending maximum 70-75% of a real estate property’s market value (Finansinspektionen, 2009:9).

The Swedish Consumer Credit Act

When granting a credit for households the banks operating in Sweden needs to conform to the Swedish law of consumer credit (Konsumentkreditlagen, 2010). The main purpose of the law is to protect the consumer and if the conditions of a contract are of disadvantage to the customer if compared to the law it becomes invalid according to the 4th paragraph. The law concerns parts which regulate the bank’s general obligations, the credit granting process, the credit contract, interest rate, fees and cash contribution. These parts are regulating the bank’s credit granting process for household mortgages. The referenced paragraphs in the next parts of this section refer to the Swedish Consumer Credit Act.
The banks need to apply sound credit granting procedures according to the 5th paragraph. This implies to take care of the customer and its interest into consideration. Before a mortgage can be granted the bank need to examine the consumer’s financial situation and its ability to fulfil the mortgage obligations (5a§).
The 9th paragraph covers the obligation needed to be fulfilled the bank concerning the credit contract. The bank is obligated to give the borrower the information concerning the credit contract in writing. The contract needs to be signed by the borrower, either in person or if applied on-line by the use of electronic identification. The borrower should also get a copy of the contract. If the contract is not signed it is valid except for conditions that are to the consumer’s disadvantage.
The 11th to 13th paragraph covers regulations about interest rates and fees concerning mortgages. The interest rate for a mortgage can be fixed or floating. The rate can only be fixed for a certain amount of time, at least three months. If it is floating it is constantly changing and if it is fixed it is determined from each fixed period to another. The rate should be set equal to the rate applied to new mortgages.
If the bank incurs costs because of the credit, the borrower might have to pay fees to cover those costs according to the 12th paragraph. Stated in the contract should be under what conditions the banks can change the fees for the credit. The fees can only be changed to the borrower’s disadvantage by the amount of increased cost for the bank.
Paragraph 13 states that the bank shall notify its customer about changes in the interest rate and fee for the mortgage. The customer should be notified about changes at the latest when the new change is in place. The notification should be done directly to the customer or by advertisement in the daily press. If the notification is done via the daily press a notification should be made on the next advice or bank statement as well. The exception is for changes in interest rates that are reliant on changes in the key interest rate. When such changes occur the customer should be notified at the latest when the next advice or bank statement.
According to the 14th paragraph the cash contribution for mortgages are determined by the SFSA since they determine the regulations for mortgages.

The Swedish Banking Business Act

Banks operating in Sweden needs to comply with the Swedish Banking Business Act (Bankrörelselag, 2010). The Act concerns among other things the credit granting process and the supervision of the banking industry. The paragraphs in the next part of this section refer to the Swedish Banking Business Act.
The second chapter, paragraph 13-17 concerns the credit granting process. The 13 § states that a bank can only grant a mortgage if the borrower is expected to be able to fulfil the obligations of the mortgage with certainty. The mortgage also needs to have a property that acts as collateral or another kind of security according to. If a part of the collateral is seen as unnecessary the bank can refrain from the excess security (15§). The bank cannot stipulate that mortgage obligations should be paid before other liabilities (16§). The bank is according to the 17§ not allowed to take on credits on other conditions than normally offered to key people within the bank or that person’s spouse/de-facto.
The seventh chapter in the Banking Business Act concerns the supervision of the banks operating in Sweden. The first paragraph in the chapter states that a bank is under the supervision of the SFSA. The bank needs to report information about their operations and the supervisory can conduct inspections of the bank at any time. The government or the SFSA (after the empowerment of the government) can communicate rules about what information the SFSA needs, how valuable document should be stored and how stock taking should be done and arrangements for preventing crimes at the bank (2§). The third paragraph declares that the SFSA should promote a sound development of the bank’s operations.

Assessment of applicants

Banks have to make sure the mortgage applicants are creditworthy and able to repay their loan (Roszbach, 2004). This is assessed by the use of a credit information agency and making a credit score. The first parts of this section concerns both households and companies unless stated. The assessments concerning only households or companies are under separate headings.

UC – Credit Information

UC AB is Sweden’s largest and leading business and credit information agency. The agency was formed in 1977 and its principal owners are the Swedish Banks Nordea, SEB, Handelsbanken and Swedbank (UC, 2010).
UC’s credit information is the basis of both credit and commercial decisions each day and its services are used worldwide. The credit information is retrieved from a database consisting of all companies registered in Sweden and all Swedish citizens over the age of 16. UC’s database is updated daily hence it consists of the latest information (UC, 2010).
UC also has a collection of scoring models that help calculate the viability of Swedish companies. The scoring models are used by banks and other credit institutions in their credit processes. UC has also developed a credit scoring models for consumers. These models help banks and other credit institutions in finding appropriate rejection limits and helps find the suitable interest rates and maximum amount for the loan in question (UC, 2010).
The information retrieved from UC’s database is the foundation of the scoring models. All information is entered in to the model and results in a single value. The end value, the score is used to rank the observation against others. The score determines the customers risk profile (low or high risk) and is used in the credit granting process. The terms and condition of a loan will be determined by the risk profile. The scoring process help banks and other credit institutions to put a price on their credit risk (UC, 2010).

Repayment ability (Risk)

When a mortgage is granted both the bank and the borrower incurs a risk of mortgage failure. A mortgage failure implies that the bank will not get their money back due to the inability of the borrower to repay. When a mortgage is granted it is based on the current ability of the borrower to repay the loan, but it is repaid with the borrower’s future income (Dolin & Horsewood, 2004). With time circumstances might change, e.g. if the household’s income change it might make the repayment impossible. The inability to pay puts the household in a difficult situation since the bank will need to sell the property to get their money back. The risk associated with the property which acts as a collateral is that it fluctuates in value. If the property is sold and it is valued lower than the mortgage amount it might become a problem to both the bank and the borrower. The bank might not get the full mortgage amount back and the borrower will still be in debt since the mortgage is not fully repaid (FSFA, 2010a).
According to the Basel committee (Basel Committee on Banking Supervision [BCBS], 2005) the banks need to assess the true risk profile of the borrower banks need to receive sufficient information. This is done by analysing different criteria in the credit granting process. There are many factors to take into consideration when approving a credit. The factors are dependent on the credit exposure, type of credit and the nature of the credit. The most important factors are the purpose of the credit, sources of repayment, the current risk profile of the borrower as well as the collateral’s sensitivity to changes in the economy and market. The current repayment capacity and financial history of the borrower also acts as a base for the credit decision. New customers will have an unknown financial history and should be treated with extra care. Commercial credits are also based on the company’s business expertise, cash flows and the state of the economic sector the company operates in. The size of borrower’s own financial contribution to the object is also an affecting factor. Macroeconomic factors plays a large part in the credit granting decision both for the private and commercial market since recessions and expansions in the economy effects the financial stability of both parties. In short the analysis should consist of a comprehensive description of the borrower, what the structure and purpose of the credit is and how the credit will be repaid (BCBS, 2000).
Sound credit giving is one of the most important principle for banks to conform to which include the analysis of the borrower. Sound credit giving is also to establish credit limits as well as develop credit granting process for approving new credits as well as renewal and re-financing of existing credits. Due to the 7:th principles in the report (BSCB, 2005) must all extensions of credit must be made on an arm’s- length basis, must be authorised and monitored with care to try control and minimise the risk (BCBS, 2000).

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Credit Scoring

The credit scores are used to support the decision of accepting or rejecting a new applicant for credit (Thomas et al. 2005). This is done for both private persons and companies. The scoring is a statistical model that evaluates the likelihood of applicants defaulting with their repayment (Roszbach, 2004). It classifies the applicants into different class of risks ranging from good to bad class of risk (Hand & Henley, 1997). The credit scoring model is based on the information given in the mortgage application, information retrieved from a credit bureau, UC and other information that can validate the information in the application such as a certificate of employment. The credit scoring model processes the information and assigns different weights dependent on importance to the different types of information. The weight adds up to a total score which is the end product of the model. The score represent the applier’s creditworthiness and influences the bank’s decision of accepted or rejected the application.
The credit scoring model is an important statistic method to measure creditworthiness since it decreases the amount of incorrectly classified loans and minimises default rates (Roszbach, 2004). However, the model ignore the fact that the loan is paid back over a long period, therefore it is important for banks to measure the probability of loan default.

Behaviour scoring

Behaviour scoring is an extension of credit scoring and the applicant’s risk of default (L. C. Thomas et al. 2005). The behaviour score analysis the customer’s previous payment and purchase behaviour as well as the customer’s social demographic. The model is the same as for credit scoring but includes more variables to determine the credit risk.

Assessment of households

This part only concerns the assessment of households.

Left-to-live-on computation

When banks try to estimate borrower’s repayment ability they use a left-to- live-on computation according to the SFSA’s report in February 2010. The model used in the computation consists of the household’s income and expenses. The living expenses, taxes, operating and maintenance costs, interest payment, amortisation and other expenses are deducted from the household’s disposable income. What remain after the expenses are deducted are the household’s funds left to live on. The expenses are based on the Swedish Consumer Agency’s estimations but certain banks modify some of the expenses to suit their judgements. The computation is used to try to evaluate the applier’s future repayment ability and sensitivity to changes in the interest rate. The model looks at the current disposable income and determines the household’s sensitivity to a decreased disposable income. The interest rates used in the model is higher than the current interest rate. This is done to examine the household’s sensitivity to higher interest rates (SFSA, 2010).
According to the SFSA’s report in February 2010 the Swedish banks use an interest rate between 6.5 and 8.0 percent in their computations and an amortisation period of 40-100 years. The living expenses for an adult varies from 6 000 – 8 000 per month and children from 2 000 – 3 000 per month. A household consisting of two adults and two children are estimated to be between 15 900 – 19 000 per month. The SFSA’s analysis shows that the amounts used in the banks left-to- live-on computations are higher than the ones estimated by the Swedish Consumer Agency.

Assessment of companies

The financial statements of a company act as a basis for evaluating the company’s repayment ability and financial health. To assess the company’s funds coming out and in of the business a cash flows analysis is made. To analyse and interpret financial statements is difficult but with the help of ratios it becomes easier. Important ratios for banks to use are liquidity ratios, solvency ratios and profitability ratios (Wood & Sangster, 2008)

Profitability ratios

It is very important for a company’s future to remain profitable. For banks this is equally important since profitability will secure repayments of the mortgage. Profitability ratios give an indication of how good the company is on generating earnings (Wood & Sangster, 2008).
Return on capital employed is the most important profitability ratio and gives an overall picture of the company’s profitability. It is also the most important for banks to look at. The ratio measures how well the company uses is capital; how much earnings (net profit) that is generated by the money invested in the company. The ratio will tell how high the percentage return is on the capital invested. The ratio can be compared to last year’s ratio or competitor’s ratio (Wood & Sangster, 2008).

Liquidity ratios

Without good liquidity a company will easily fail even though its profitability is high. This is of great importance to banks granting mortgages since a failure will unable a repayment of the loan but also in the short-term since the company needs to be able to pay interest.
The main liquidity ratios are the current ratio and the acid test ratio. The end value of the current ratio shows the company’s ability to pay off its short-term debts. The value measured is the company’s current assets over its current liabilities. The higher the value of the ratio the better, it can be seen as the number of times the current liabilities can be paid with the current assets (Wood & Sangster, 2008).
The acid test ratio is similar to the current ratio but subtracts inventory from the current assets. This can be useful if the company applying for a mortgage carries a high amount of inventory with low liquidity. The importance of liquidity is to be able to turn current assets such as inventory into cash quickly. Inventory that is custom made will be hard to turn into cash. The liquidity ratio will help banks to determine if the company will be able to continue as a going concern (Wood & Sangster, 2008).

Solvency ratios

The long-term solvency is very important to the bank since it will secure the repayment of the loan. The solvency ratios most used by banks are:
Operating profit/loan interest ratio indicates the proportion of interest paid compared to the operating profit. A high ratio will indicate that the company is borrowing too much money; a small decrease in operating profit might have devastating consequences for the company (Wood & Sangster, 2008).
Total external liabilities/shareholder’s funds ratio shows the amount of funding from share capital and retained profit compared to external sources. A high ratio will indicate that the company might experience problems with solvency due to the large proportion of external liabilities (Wood & Sangster, 2008).
Shareholders’ funds/total assets (excluding intangibles) ratio highlights the proportions of assets financed by the company’s own funds. If this ratio is low it is an indication of problems with long-term solvency. This ratio is usually compared to ratios from other companies to get a good indication of what the ratio actually shows (Wood & Sangster, 2008).
In general the lower the solvency ratios are the greater the risk of loan default is (Wood & Sangster, 2008).

Valuation of private properties

A private property is valued to the sales price. The sales price is usually the same as the market value which is the most probable price on a sale of the object in the open property market (Lind, 2004).

Valuation of real estate properties

There exist several methods to determine the value of a real estate property (SFI/IPD Svenskt Fastighetsindex, 2007). The difficulties in the valuation are to project the future cash flow the property will generate. This section will go deeper in to net capitalisation method and the location price method.

Net Capitalisation Method

To calculate the market value of the real estate a net capitalisation method can be used. The method uses the property’s net operating income divided by a required return. The net operating income is calculated as revenues from rent minus the properties operating and maintenance cost. The required return is based on the location of the property. When the market value is calculated it is then compared to the purchase price to determine the yield of the investment (Persson, 2003). The required return on the investment is dependent on the location of the property, anticipated market development, the property’s position in its economical lifecycle and anticipated development of rental income (SFI/IPD Svenskt Fastighetsindex, 2007).

Location Price Method

The location price method is a valuation method where the market value of a property is based on comparing previously paid prices in the open market for similar properties in the same area/city. The access to up to date market data is essential for a valid result (SFI/IPD Svenskt Fastighetsindex, 2007).
Datscha AB is Sweden’s leading supplier of web based services providing information and analysing tools for the Swedish property market (Datscha, 2010). Datscha AB retrieves its information with help of its partners: The Swedish mapping, cadastral and land registration authority, SCB-statistics Sweden and UC.
The service is divided into three functions which provides information about properties in the market, rents in different municipalities and enables analysis of the market values of different properties.
Market analysis offers the user instant information about who owns a certain property, rent and vacancy levels etc.
Location price analysis offers daily updates on registered purchases and pre-purchase information for Sweden’s larger cities.
Property analysis is the most important function for banks and is an efficient tool for valuing commercial properties. Datscha AB offers a template calculation that the banks or any other customer can use and change the figures to match different needs. The service also offers access to cash flow statements, excel reports, maps and sensitivity analysis.

Table of Contents
1 Introduction
1.1 Background
1.2 Problem discussion
1.3 Research questions
1.4 Problem
1.5 Purpose
2 Methods
2.1 Choice of method
2.2 Research Method
2.3 Data Collection
2.4 Data analysis
2.5 Method Problems
3 Frame of reference
3.1 Bank regulations
3.2 Assessment of applicants
3.3 Valuation of private properties
3.4 Valuation of real estate properties
4 Empirical data
4.1 Private market
4.2 Corporate market
4.3 The bank’s view on differences
4.4 The bank’s view on similarities
5 Summary of empirical data
5.1 Private market
5.2 Corporate market
5.3 The banks view on differences and similarities
6 Analysis
6.1 The credit granting process
6.2 Market value of property versus repayment ability
6.3 Interest rate and repayment period
6.4 Loan administration
6.5 Recommendations regarding lending ceilings
6.6 Market competition and recession/expansion
6.7 The need of differences
7 Conclusions
8 Reflections
List of references
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