Lesson 2: Financial Services: Finance Companies.

Question 1

How do finance companies make money?
What risks does this process entail?
How do these risks differ for a finance company versus a commercial bank?

Answer 1

Finance companies make a profit by borrowing money at a rate lower than the rate at which they lend. This is similar to a commercial bank, with the primary difference being the source of funds, principally deposits for a bank, and money and capital market borrowing for a finance company. The principal risk in relying heavily on public debt as a source of financing involves the continued depth of the commercial paper and other debt markets. As experienced during the financial crisis of 2008-2009, economic recessions
can affect these markets more severely than the effect on deposit drains in the commercial banking sector. In addition, the riskier customers may have a greater impact on the finance companies.

Question 2

Why do finance companies face less regulation than do commercial banks? How does this advantage translate into performance advantages? What is the major performance disadvantage?

Answer 2

By not accepting deposits, the need is eliminated for regulators to evaluate the potentially adverse safety and soundness effects of a finance company failure on the economy. The performance advantage involves the
avoidance of dealing with the heavy regulatory burden, but the disadvantage is the loss of the use of a relatively cheaper source of deposit funds. However, because of the impact that non-bank FIs, including finance companies, had on the U.S. economy during the financial crisis and as a result of the need for the Federal Reserve to rescue several non-bank FIs, regulators proposed that non-bank FIs receive more oversight.