Literature Review on Loan Elements and Bank Services

CHAPTER 2

LITERATURE REVIEW

2.1 Introduction

Housing loan is one of the services provided by mostly commercial institutions. In the current trend, banking institution is losing their market shares (Mylonakis, 2007). Due to technology advancement, information about every product and services in banking industry are transparency. Potential customers are able to compare the interest rates, packages and services offered by each and every bank. Likewise, internet banking had widely spread across the whole nation due to the convenient of places, time and cost saving (Arnold and Ewijik, 2011). Unfortunately, in the sense of technology wise and globalisation, banking institutions face more competitors compared to previously (Girardone et al., 2010). In such a situation, how commercial institutions will be able to be outstanding among all the institution lenders?

Factors affecting borrowers’ choice of housing loan package is the dependent variable in this research paper. The author would like to know about which factor contributes the highest in affecting borrowers’ choice. As from the past findings, there are more than 10 factors which will affect borrowers’ decision making (Ojo and Ighalo, 2008; Mylonakis, 2007; Tiwari and Moriizumi, 2003).

In this chapter, the author categorise independent variables into 2 major categories which are loan elements and bank’s services. Further on, loan elements consists of interest rate, repayment period, monthly payment, loan to value ratio and penalty; while bank’s services includes reputation, employee and promotion method. Each of the independent variables is discussed one by one based on the past findings. Moreover, only 1 moderating variables will be discussed after the independent variables. There is income, which indirectly affects borrowers’ choice in choosing a mortgage loan.

2.2 Government Efforts

Government plays an important role in leading its citizen across the transformation of becoming a developed country. In financial sector, Central Bank of Malaysia, which also known as Bank Negara Malaysia (BNM), was established in year 1959 under the Central Bank of Malaysia Act 1958 (CBA 1958). The CBA 1958 was later replaced by the Central Bank of Malaysia Act 2009 (BNM, 2010). BNM is 100% owned by Government of Malaysia with the increasingly paid-up capital around RM 100 million. Based on Figure 2.1, the central bank is the one and only statutory body that set the deposit interest rate, base lending rate (BLR), overnight policy rate (OPR) and the reserve requirement ratio (Shaari, 2008). Any changes of these interest rates will affect the amount of money available for loan lending. Thus, government controls ‘everything’.

Back to year 1980, a committee from the central bank of Malaysia, with representatives from the banking industry, suggested the creation of a secondary mortgage market (Cheng, n.d.). Due to the unstable market conditions and interest-rate trends at that time, the proposal had been turn down. Other than central bank, National Mortgage Corporation, also known as Cagamas Berhad, is a corporation that was established in 1986 (Cagamas Berhad, 2011). Currently, Cagamas Berhad serves as an intermediary in secondary mortgage market. In the same time, it also encourages home ownership and the selling and purchasing of bought houses (Davies et al., 2009).

Housing Loan Scheme is one of the programmes in helping lower income family with no other borrowing to build or buy a low-cost house. This programme is implemented by Ministry of Housing and Local Government, through a trust account named Housing Loan Fund (Ministry of Housing & Local Government, 2008). With this scheme, lower income family is able to finance a house and get a basic accommodation. Likewise, government help them to raise their living lifestyle.

Homeownership is a very important aspect to transform economy and empower the community (Harrison and Glover, 2008). Under Budget 2011, First Home Scheme was launched by Malaysia Prime Minister, Datuk Seri Najib Tun Razak. The objective of this programme is to help the Millennial Generation [1] to own a house. Government understand the problem face by this generation, such as high living cost and increase in property price, due to Malaysia economy and inflation rate (Bernama, 2011). This scheme only applicable to either these 4 conditions: (1) Family income less than RM 3000; (2) Property price should range between RM 100 000 to RM 220 000; (3) Maximum repayment period at 30 years tenure; (4) First time house buyer (Malaysia Housing Loan, 2011). Under 100% loan financing, first time buyer need not pay deposit. The government (Cagamas Berhad) will guarantee the 10% deposit to the financial institution, which means Cagamas Berhad is taking the risk in order to help the lower income group.

According to a study conducted by Malpezzi and Mayo (1997), Malaysia government launched a programme called Public Low Cost Housing Program (PLCHP) during the Fourth and Fifth Malaysia Plan. Unfortunately, the actual situation does not go as what the government planned. During Fourth Malaysia Plan, the actual construction is actually only 41% as planned. Besides that, only 10% of the production was met during Fifth Malaysia Plan. This is due to high housing price and low purchasing power. Although this program was highly subsidised, lower income group still not able to afford such a high price.

2.3 Banking Industry

During 19th century of Straits Settlement, a standalone British colony encompassing Penang, Singapore and Malacca was established. The strategic location and port facilities of Penang had quickly turned Penang into springboard for banks. Mercantile Bank (now known as HSBC) held their office in Penang. Later followed by Chartered Bank (now named as Standard Chartered) in 1875 and Hong Kong Bank in 1884 (The Association of Banks in Malaysia, 2009).

Banking industry in Malaysia had been through a few of transformation such as the increase in products and services, open up more branches, expand banking hall and now making transaction using computers and internet. The banking industry had grown up together with Malaysia.

As reference from the timelines of banking industry in Malaysia, Malaysia government controlled the expansion of foreign commercial banks since Malaysia’s independency. The last license granted was in year 1973. There is no any history about the starting of real estate loan. From the timelines above, we can assume commercial bank starts real estate loans before 1980 since in year 1980 itself, Bank Bumiputera made a huge loss on loans to Hong Kong SAR real estate developers. Overall, Bank Negara Malaysia is doing well in controlling the monetary and currency of Malaysia after the depression of economy in year 1997-98.

2.4 Construction Industry

Construction industry is one of the sectors which related to the mortgage loan. Construction industry had begun its journey since independence. The main aim for expanding construction industry is because the infrastructure during independence time is insufficient (Ibrahim et al., 2010). Malaysian Construction Industry (MCI) is divided into 2 areas, which are general construction (residential construction, non-residential construction and civil engineering construction) and special trade works (activities such as metal works, electrical works, plumbing and etc.). The aim of MCI is to develop the capacity and potential capability of construction industry by enhancing quality and productivity, such as professionalism, innovation and knowledge in order to improve life quality (CIDB, 2011).

Both of the graphs above showed the total number of projects and project value range between 2007 and 2010. These data are adapted from CIDB official website. The left graph shows that the numbers of project are decreasing even though there are some increments in year 2009. This would indicate that there are lesser projects in the construction industry. The project value range also decreasing since 2007. As for the decreasing in project value range, the reason would probably be government encourage housing developer to build more low cost houses in order to relief burden of the buyers. In such a way, houses would be more easily sell out because they are capable to buy or loan for a house.

2.5 Defining of Independent Variables

2.5.1 Loan Elements

2.5.1.1 Interest rate

Interest rate is more important than other factors such as employee behaviour, advanced facilities and drive-in-service (Boyd et al., 1994). The research paper (Kohn and Bryant, 2010) reaffirms the findings from earlier study. The authors discover that there is minimum impact of 30-year mortgage interest rate on house price increases. However, interest rate is one of the factors yet not the major contribution to the housing policy.

According to the research conducted by Huang (1969), housing loan tends to decrease when the interest rates increase; while it increases when the interest rates decrease. This is because when the interest rate is high, house owner prefer to renovate the existing house rather than purchase a new house (Quigley, 1987; Potepan, 1989). In addition, Silber (1970) discovered the public will react immediately if there are changes of mortgage interest rates. This study is similar with the later study by Huang (1971).

Szerb (1996) conducted a study about fixed rate mortgage (FRM) and adjusted rate mortgage (ARM). The paper extends the papers of Statman (1982) and Smith (1987) by adapting the Gray (1976) model to investigate the effects of nominal interest rate and real interest rate. The research paper shows that when the nominal interest rate (or inflation rate) is anticipated, the probability of taking on adjusted rate mortgage is higher, only if the amount of ARM more than expected real income growth. In another words, borrower tends to take on fixed rate mortgage when they are confident with the future market (inflation rate). In addition, the research paper conducted by Tiwari and Moriizumi (2003) found out that most Japanese borrowers choose fixed rate mortgage.

According to Eesswein (2009) from Kiplinger’s Personal Finance magazine, interest rates are relatively low. However, the bank requires more documentation from borrower compared to previous days in order to prove that they are financially stable and able to make the payment until the end of the contract (Kranacher, 2010). The writer suggested that this is the best timing to refinance your mortgage since the interest rate is at the lowest level. Since this magazine is published based on US, the author would like to refer to Malaysia’s base lending rate.

Line chart above shows Malaysia’s monthly base lending rate for the most recent 3 years. Based on the chart, Malaysia’s BLR is the lowest on March 2009 until February of 2010. To be more specific, the data actually shows that Malaysia’s base lending rate is the lowest between August 2009 and February 2010, which is 5.51% (BNM, 2011). So, the suggestion by Kiplinger’s Personal Finance magazine is applicable in Malaysia at that moment. The base lending rate on January 2011 is at 6.27%.

2.5.1.2 Repayment Period and Monthly Payments

Borrower would be surprise with minor changes in interest rates cause a big difference in repayment period (Yard, 2003) and monthly payments. The author combine repayment period and monthly payments for the reason of both of these variables are interrelated. Higher monthly payments would results in a shorter repayment period, ceteris paribus. The monthly payments are normally made up of interest and principal payment (Tiwari and Moriizumi, 2003). When borrower is under temporary financial problem, they will tend to delay a few months of monthly payment (Figueira et al., 2005). After borrowers’ financial ‘bottleneck’, they will resume in paying monthly payments.

In Japan, only Government Housing Loan Corporation (GHLC) able to offers up to 35 years’ repayment period. GHLC came out a step-up payment plan to lift homebuyer’s financial burden. GHLC will charge a lower interest rate up to 5 years and after that there will be some adjustment on interest rate for the remaining period (Tiwari and Moriizumi, 2003). The longer repayment period associated with higher interest rate (Scanlon et al., 2008). Based on Dijkhuizen (2005), most of the countries have an average of 25-30 years of repayment period on mortgage loan. Quite a big group of borrower found out that they are not able to follow the repayment schedule and end up the mortgage loan became a bad debt (Malpass and Murie, 1999).

Most of the financial institutions had successfully served its purpose in providing financial services to their customers for improving their living standard or aiding them. However, low income group found problem in seeking approver in loans. Papias and Ganesan (2008) conducted a survey among rural area in former Nyarubuye district. Study shows that high education level does not necessarily have higher repayment behaviour. This is because most of the low education level people is the old person with great and treasure-like experience in their working field. Thus, education level does not affect monthly payment.

Yard (2003) had found out that most of the banks do not gives full information about the loans. Adjustments of monthly payment to the different interest rate can be done in 2 different ways, which are changes the amount of monthly payment and prolonged or shorten the contract duration. The high interest rate with fixed monthly payment would results in progressive amortization pattern. This payment pattern composite most of the interest payment at the early payment period while principal is paid at later time. The author suggested banks should provide information about annual finance charges in order to gain better understanding on the impact of varies interest rates.

Low down payments on mortgage loan seems to be good things due to the borrowers are able to finance more money. With higher amount of loan borrowing, lenders can expand their business while government meet their goal in boosting up financial industry. Unfortunately, long run cheap mortgage does not exist in this real mortgage market because banks will charges interest rate as their compensation for lending out that amount of money to borrower. Thus, borrowers need to bear the cost of loan (commonly known as interest rate). If borrower has financial constraint or unstable income, the bank would allow a more flexible repayment patterns. Some investor might think they can get higher return with this amount of money by investing into other places (Scanlon et al., 2008).

2.5.1.3 Loan-to-value Ratio

Loan-to-value ratio acts as a protection to mortgage loan lender because it is widely used to judge the worthiness and risk of the loan. The study done by Epley et al. (1995) hypothesised and proved that the loan-to-value ratio still working well as a signal to the mortgage lender. The risk is detected by giving borrower a series of mortgage loan choice and let them to choose one of it. Every of the choice are categorise based on the loan-to-value in different risk classes. Normally, loan-to-value ratio is 80% of the mortgage price. Study also shows that borrower that having higher loan-to-value ratio tends to emphasise more on interest rate.

There are empirical and theoretical studies on mortgage default in primary and secondary mortgage market. A mixture of credit scoring, loan-to-value ratio and interest rates are screened. The author divides the respondent into subgroup after they chose their credit score. In the end of the research, empirical research found there are indecisive relationship between loan-to-value ratio and the probability of default loan. The author guesses that there should be similar and positive relationship within the same sub-group according to credit score. However, the analysis between loan-to-value ratio and default probability are ignored in this research paper (Shahar, 2008).

Down payment is the initial amount that borrower paid for the house price but how does it related to loan-to-value ratio? As down payment increase, loan-to-value ratio decreases, ceteris paribus. To get your mortgage loan approve by banks, firstly, banks will would like to know all of your equity, income and loan-to-value ratio. Through the research by Zorn (1991), public policy always only offers special loan requirements to the first-time homeowners. In another words, it means government offer higher loan-to-value ratio and lesser down payments in order to help their citizen in getting themselves a mortgage.

2.5.2 Bank’s services

2.5.2.1 Banks’ Reputation

Customers’ choice in choosing a bank is potential affected by its reputation (Ford and Jones, 2001). However, Devlin (2002) had discovered that image and reputation of a bank are less important in choosing a mortgage. This is because most of the previous studies focused primarily on banking and financial services. The author explained most of the mortgage loans are affected mainly by the product specific criteria rather than bank’s reputation. Besides that, customer can evaluate the prior purchase of mortgage.

Jagelaviciene et al. (2006) have analysed image factors which determine the choice of the bank. They followed USA scientist’s variable distribution in a group of 3 categories, which are search factors [2] , confidence factors [3] and experience factors [4] . After questionnaire is collected, data showed that bank reputation is positively significant to the bank’s activity. It also helps in adding competitive advantages to the banks. Although reputation has various conceptions, it is able to influence customer’s behaviour. The authors of this research paper advised that bank’s reputation has to be managed and strengthen within the heart of society in order to attract more clients.

Reputation and profitability of a bank are directly influence each other (Yeo and Youssef, 2010). From the research done by Corbett and Mitchell (2000), they proved that reputation of a bank is very important to a bank. Research investigated the bank behaviour in taking on rescue offers after the economy crisis in year 1997 and 1998. Due to the rescue offers will indirectly harmed bank’s reputation, regulator or policy maker may need to compensate bankers with extra recapitalization that well exceed the amount needed to restore banks insolvency. In not, bankers will actually refuse to accept the rescue offers and continue with loan rollovers.

Yeo and Youssef (2010) had done a research about corporate image in Saudi banking industry. The authors examine the factors that directly affect the perception corporate image. By that, they actually divided their questionnaire into financial prospect, corporate management, market presence and corporate communication. Research found out that corporate management has the highest influence on banks image. Saudi customers perceived banks’ image from their own experience with banks or suggestion and comment from their friends and family.

2.5.2.2 Employee Services Quality

In general, banking industry is partially differentiating their product by employee’s quality. There is a research paper regarding the relationship between management commitment to service quality and organizational outcomes (Cheung and To, 2010). Findings showed that customer perceive the service quality using employees’ involvement. By employee involvement, it also has significant relationship towards employee’s job satisfaction and customer perceptions of service performance. This research was conducted in random selected banks of Macao. For this research paper, the author would like to survey from the customer perspective about banks’ performance. It would be the opposite way of this past research.

There is a lot of research papers showed that employee is one of the factors affecting customer satisfaction. Sometimes, employee has to cope with the emotional expressions of customers, especially when customer becomes impatient during the waiting time (Rafaeli, 1989). Michel et al. (2008) conducted a research on why service recovery fails. The author examines the tensions among customer, employee and process perspective. Frontline service employees are able to produce quality service as customer expects (Heskett et al., 1997). Employee attitudes will have an effect on customers either positive or negative emotion (Schneider and White, 2004; Pugh et al., 2002). Yavas (2008) conducted a research on branch performance model in a New Zealand bank. The author found out that in order to achieve more sales, the branch’s service and employee’s image is taken into account of customer satisfaction.

Employee’s performances always become one of the critical factors in measuring banks’ service quality. Kumar et al. (2009) examines tangibility, reliability, competence and convenience of conventional banks versus Islamic banks using SERQUAL model. In each and every dimension, staffs are one of the attributes to be asked in the questionnaire except for convenience dimension. Questions, such as the appearance of staff, helpfulness and willingness of staff, behaviour of staff and staff’s ability to answer question, are being asked in the questionnaire as the attribute to analyse banks’ service quality. Hence, employee does affect the service quality of a bank.

Most of the bank’s effort can slightly raise customers’ awareness but had failed to maintain customer loyalty or to attract new customer. Herstein and Zviling (2010) conducted a case study on banking and financial-services industry by putting employee into strategy designing process. The authors believe banks’ identities needs to be penetrated through the frontlines employees since they are the one who have contact with customers. After direct banking relationship marketing strategy being launched in 2003, it successfully attracted 300 000 new customers in three years. All these customer were previously disappointed and at the very first time they felt the bank understood their needs.

Besides that, there is another research paper study about frontline bank employees (Yavas and Babakus, 2009). The research found out that it is important that frontline employee to maintain their emotion level during customer communication. Frontline employee need to treat customer kindly and with politeness (Gwinner et al., 2005). Banks should empower their employee by granting power or control over certain issues. Customers perceive service quality by judging from frontline employees’ attitudes ( Henning-Thurau, 2004; Yoon et al., 2001). Frontline employee is able to satisfy a customer even after a service failure happens (Yavas et al., 2004).

2.5.2.3 Marketing Methods

Since there are many kinds of marketing tools, the following literature review is divided into advertisement, promotion and relationship marketing.

The continuing of economy recession drives banks to find new method to expand their business. Marketing strategy had become more challenging to banks’ manager due to most of the customer does not practice loyalty in the transaction anymore. Advance technology had benefits most of the customers with convenience in checking out the price, interest rate and banks’ services. Thus, as one of the bank, they need to follow the pace of their competitor in order to position themselves in the market. Here there is a research about credit card web advertisement. Banks need to gives public a clear picture about its products, differentiate it from other competitor and understand customers’ needs and wants (Fu and Wu, 2010).

Based on Mullineaux (2011), there is an increase of 5% per year over the sample period of the research paper. The maximum promotional expense of a bank with more than $10 billion assets was $2.1 billion per annum while the minimum was $4.2 million. Banks spend billions of dollars in a year just for the marketing but do it worth the price? The findings reveal that every 10% increase in promotional expense will generates approximately 2.5% gain in operating income, 7% increase in market share, 10% increase in branch networking and 30% increase in deposit market share. The author also found out that the increase in branch number does not show significant gain in any aspects as above. Thus, promotion spending exhibits the increase in returns to scale.

Although relationship marketing is previous practice in industrial context, it had been adapted by service industry in order to create its competitive advantage. Relationship marketing is a long term commitment in maintaining existing customers and establishing relationship with customers. The competitive environment had force the bank to gives more concern about relationship marketing in order to compete with other banks. Research (Abratt and Russell, 1999) proves that respondents with relationship with their banks favour the individualised service and their banks understand what they want more than respondents without relationships. Through this statement, the author predicts there are room for improvements to improve client service by relationship marketing.

Thai bank also facing increasingly competition among financial institutions and other types of small business. Boonajsevee (2005) conducted an experiment on Thai banks about how to create and maintain long term customer relationship. It is almost the same as what had been mention in the previous paragraph. The author believes that Thai banks are changing from the purpose of transactional to customer retention. As mentioned, relationship marketing should concentrate on repeat purchase with cross-selling or up-selling. This would ensure the long term relationship with the customer. Moreover, this study also covered study about the factor that affecting relationship marketing. According to the study, trust and customer satisfaction can affects the building of relationship marketing with the banks. Customers who have strong relationship with bank will tend to be more loyal to the bank and less chances for switching to other banks.

2.6 Defining of Moderating Variable

2.6.1 Income Levels

Income is the main factors for determines the consumption spending of a family. In general term, students from poor families (low income) are more likely to take on study loan to finance their tertiary education. Students from poor families would take on study loan to solve short-term financial problem regardless the parameter of loan schemes (Birch and Miller, 2007). In this research paper, the author is going to conduct research only on mortgage loan, not study loan.

On the other hand, different sources of income affects the mortgage loan takes on by the specific families. Cai and Zeng (2011) conducted a research based on the willingness of a farmer to small forest tenure mortgage loans in Yibin of Sichuan. They found out that willingness for mortgage loan between income from deforestation, non-agricultural activities and breeding activities are difference. Forestry income families have the higher tendency to take on mortgage loan due to the high investment during reforestation; Non-agricultural income families would likely take on mortgage loan too since they need funds in other aspects; and breeding income families have low chances on taking on mortgage loan since they are able to afford themselves.

Abd. Rashid et al. (2011) analyse the income and expenditure pattern of households in Pahang, Terengganu and Kelantan according to urban and rural area. This research finding showed that there are strong relationship between income level and total expenditure of the households. In another means, when income level increases, the total expenditure of households will increase proportionately. The authors also analyse the effect of income level on housing loan. Research showed that most of the respondents felt the expensive housing loan has increased the total expenditure of the households, especially in urban area.

Devlin (2002) analyse the choice criteria of consumer and the differences of choice criteria in terms of demographic factors such as gender, class, household income, educational level ethnicity and financial maturity. Through the process of questionnaire and face-to-face interview, the author concludes that the high segment (higher household income, higher education level and higher class) are more likely to choose a financial institution same as the previous mortgage lender. In opposite, low segment (lower household income, lower education level and lower class) prefer to choose a mortgage lender which they have an account and also based on the bank’s location, professional advice and recommendation from friend and family.

The findings in previous paragraph are coherent to a previous research paper by Boyd et al. (1994). This author found out that white collar households emphasise more on bank’s reputation, variation in facilities and location convenience; high income households emphasise on interest rates, bank’s opening hours and employee’s friendliness; and low income households follows more on publicity and the word of mouth.

2.7 Summary

For Chapter 3, the author would like you to understand the method and analysis that will be used in later chapter. Theoretical framework will be discussed clearly in the next chapter.