copyright 2007 mcgraw-hill australia pty ltd ppts t/a mcgrath’s financial institutions,...

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger

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Chapter 2

Commercial Banks

Websites:www.apra.gov.auwww.asic.gov.auwww.accc.gov.au


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Learning Objectives

• Evaluate the functions and activities of commercial banks

• Identify the main sources and uses of funds for commercial banks

• Outline the nature and importance of banks’ off-balance-sheet business

• Examine the main risk exposures and consider related issues of regulation and prudential supervision of banks


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Chapter Organisation

2.1 Main Activities of Commercial Banking

2.2 Sources of Funds

2.3 Uses of Funds

2.4 Off-balance-sheet Business

2.5 Regulation and Prudential Supervision

2.6 Background to Capital Adequacy Standards

2.7 Basel II Capital Accord

2.8 Liquidity Management and Other Supervisory Controls

2.9 Summary


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• Three categories of banks– Incorporated banks—domestic and foreign– Unincorporated foreign bank branches– Foreign bank representative offices

• Importance of banks– High level of regulation prior to the mid-1980s

constrained their development and led to growth of non-bank financial institutions

– Largest share of assets of all institutions, but understated without considering off-balance-sheet transactions, managed funds, superannuation and subsidiary finance, insurance and companies


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2.1 Main Activities of Commercial Banking (cont.)

• Asset management (−1980s)– Loans portfolio is tailored to match the available deposit

base

• Liability management (1980s−)– Deposit base and other funding sources are managed to

fund loan demand Commercial bill market Provision of other financial services Off-balance-sheet (OBS) business


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2.3 Uses of Funds






2.9 Summary


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• Sources of funds appear in the balance sheet as either liabilities or shareholders’ funds

• Banks offer a range of deposit and investment products with different mixes of liquidity, return, maturity and cash flow structure to attract the savings of surplus entities


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2.2 Sources of Funds (cont.)

• Current deposits– Funds held in a cheque account– Highly liquid– May be interest or non-interest bearing

• Call or demand deposits– Funds held in savings accounts that can be withdrawn on

demand– e.g. passbook account, electronic statement account with

ATM and EFTPOS


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• Term deposits– Funds lodged in an account for a predetermined period at

a specified interest rate Term: one month to five years Loss of liquidity due to fixed maturity Higher interest rate than current or call accounts Generally fixed interest rate


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• Negotiable certificates of deposit (CDs)– Paper issued by a bank in its own name – Issued at a discount to face value– Specifies repayment of the face value of the CD at

maturity– Highly negotiable security– Short term (30 to 180 days)


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• Bill acceptance liabilities– Bill of exchange

A security issued into the money market at a discount to the face value. The face value is repaid to the holder at maturity

– Acceptance Bank accepts primary liability to repay face value of bill to

holder Issuer of bill agrees to pay bank face value of bill, plus a

fee, at maturity date Acceptance by bank guarantees flow of funds to its

customers without using its own funds


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• Debt liabilities– Medium- to-longer-term debt instruments issued by a

bank Debenture

• A bond supported by a form of security, being a charge over the assets of the issuer (e.g. collateralised floating charge)

Unsecured note• A bond issued with no supporting security


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• Foreign currency liabilities– Debt instruments issued into the international capital

markets that are denominated in a foreign currency Allows diversification of funding sources into international

markets Facilitates matching of foreign exchange denominated

assets Meets demand of corporate customers for foreign exchange

products


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• Loan capital and shareholders’ equity– Sources of funds that have the characteristic of both debt

and equity (e.g. subordinated debentures and subordinated notes)

Subordinated means the holder of the security has a claim on interest payments or the assets of the issuer, after all other creditors have been paid (excluding ordinary shareholders)


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2.3 Uses of Funds






2.9 Summary


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2.3 Uses of Funds

• Uses of funds appear in the balance sheet as assets

• The majority of bank assets are loans that give rise to an entitlement to future cash flows, i.e. interest and repayment of principal– Personal and housing finance– Commercial lending– Lending to government


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2.3 Uses of Funds (cont.)

• Personal and housing finance– Housing finance

Mortgage Amortised loan

– Investment property– Fixed-term loan– Credit card


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• Commercial lending (business sector and other financial intermediaries)– Fixed-term loan

A loan with negotiated terms and conditions• Period of the loan• Interest rates

– Fixed or variable rates set to a specified reference rate (e.g. BBSW)

• Timing of interest payment• Repayment of principal


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• Commercial lending (business sector and other financial intermediaries) (cont.)– Overdraft

A facility allowing a business to take its operating account into debit up to an agreed limit

– Bank bills held Bills of exchange (see slide 11) accepted and discounted by

a bank and held as assets A rollover facility is where a bank agrees to discount new

bills over a specified period as existing bills mature

– Leasing


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• Lending to government– Treasury notes

Short-term discount securities issued by the Commonwealth Government

– Treasury bonds Medium- to-longer-term securities issued by the

Commonwealth Government that pay a specified interest coupon stream

– State government debt securities– Low risk and low return

• Other bank assets (e.g. electronic network infrastructure and shares in controlled entities)


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2.3 Uses of Funds






2.9 Summary


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• OBS transactions are a significant part of a bank’s business

• OBS transactions include– Direct credit substitutes– Trade and performance-related items– Commitments– Foreign exchange, interest rate- and other market rate-

related contracts


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2.4 Off-balance-sheet Business (cont.)

• Direct credit substitutes– An undertaking by a bank to support the financial

obligations of a client (e.g. ‘stand-by letter of credit’) The bank acts as guarantor on behalf of a client for a fee Client has a financial obligation to a third party Bank is only required to make a payment if the client

defaults on a payment to a third party


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• Trade and performance-related items– A form of guarantee provided by a bank to a third party,

promising financial compensation for non-performance of commercial contract by a bank client, e.g.

Documentary letters of credit Performance guarantees


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• Commitments– The contractual financial obligations of a bank that are

yet to be completed or delivered Bank undertakes to advance funds or make a purchase of

assets at some time in the future, e.g.• Forward purchases• Underwriting


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• Foreign exchange, interest rate- and other market rate-related contracts– The use of derivative products to manage exposures to

foreign exchange risk, interest rate risk, equity price risk and commodity risk (i.e. hedging), e.g.

Futures, options, foreign exchange contracts, currency swaps, forward rate agreements (FRAs)

– Also used for speculating


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• Volume of OBS business– At June 2005, the notional face value of OBS business

undertaken by banks in Australia was almost six times the level of total assets

– Major commercial banks have largest share of OBS business

– Over 93% of OBS business is based on market rate-related transactions

Nature and size of contracts combined with the volatility and speed of contract repricing has resulted in extraordinary losses


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2.3 Uses of Funds






2.9 Summary


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• Reasons for regulation of banks– Importance of the banking sector for health of the

economy

• Prudential supervision– The imposition and monitoring of standards designed to

ensure the soundness and stability of a financial system


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2.5 Regulation and Prudential Supervision (cont.)

• Australian regulatory structure– Reserve Bank of Australia (RBA)

System stability and payments system

– Australian Prudential Regulation Authority (APRA) Prudential regulation and supervision of deposit-taking

institutions

– Australian Securities and Investments Commission (ASIC)

Market integrity and consumer protection

– Australian Competition and Consumer Commission (ACCC)

Competition policy


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2.3 Uses of Funds






2.9 Summary


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• Functions of capital– The source of equity funds for a corporation– Provides equity funding for growth– A source of profits– Write-off periodic loan losses of defaulting borrowers that

exceed profits

• Latter function and the evolution of the international financial system lead to development of international capital adequacy standards– 1988 Basel I capital accord and Basel II (2008) capital

capital adequacy guidelines


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2.3 Uses of Funds






2.9 Summary


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• Basel II extends Basel I to increase sensitivity to different levels of asset and OBS business risk

• Main elements of Basel II– Credit risk of bank’s assets and OBS business– Market risks of bank’s trading activities– Operational risks of bank’s business operations– Form and quality of capital held to support these

exposures– Risk identification, measurement and management

processes adopted– Transparency through accumulation and reporting of

information


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Capital adequacy standard

• Minimum capital adequacy requirement applies to commercial banks and other institutions specified by prudential regulator

• Capital adequacy standard– Minimum risk-based capital ratio of 8%

Minimum 4% held as Tier 1 capital• Highest quality core capital

Remainder can be held as Tier 2 (supplementary) capital• Upper – specified permanent hybrid instruments• Lower – specified non-permanent instruments

– Regulator can require an institution to hold a capital ratio above 8%


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Definition of capital


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Basel II structural framework


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Basel II structural framework (cont.)

• Pillar 1—Capital adequacy

– Credit risk—risk that borrower will not meet commitments when due. Three measures:

Standardised approach• Risk weights applied to balance-sheet and OBS items to

calculate minimum capital requirement• Risk weights derived from external rating grade or supervisor

(see www.apra.gov.au APS112)• For residential housing loans risk weight relates to loan-to-

valuation ratio (LTVR) and level of mortgage insurance


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• Pillar 1—Capital adequacy (cont.)– Credit risk (cont.)

Standardised approach (cont.)• OBS items converted to balance-sheet equivalents by

determining the credit conversion factor and multiplying by the applicable risk weighting

– Non-market related OBS transactions, e.g. documentary letter of credit

– Market-related OBS transactions—credit conversion factor can be determined by:

Current exposure method—current and potential credit exposures mark-to-market (contract revalued by its current quoted price)

Original exposure method—notional contract value multiplied by a credit conversion factor


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• Pillar 1—Capital adequacy (cont.)– Credit risk (cont.)

Internal ratings-based approach involves banks using some or all of their own risk measurement model factors, subject to supervisor approval. Two approaches available:

• Foundation internal ratings-based approach (FIRB)– Bank determines probability of default and effective maturity but

relies on supervisor estimates for other credit risk components

• Advanced internal ratings-based approach (AIRB)– Bank provides estimates of all credit risk components


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• Pillar 1—Capital adequacy (cont.)– Operational risk—risk of loss from inadequate or failed

internal processes, people and systems, or from external events

e.g. internal/external fraud, workplace safety, business practices, damage to physical assets, systems failure

Main operational risk management objectives:• Operational objectives—impact of loss of business function

integrity and capability• Financial objectives—losses due to operational risk exposure,

cost of recovering operations and ongoing financial losses• Regulatory objectives—prudential standards of bank

supervisors

Business continuity management and additional capital


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• Pillar 1—Capital adequacy (cont.)– Market risk—risk of losses resulting from changes in

market rates in FOREX, interest rates, equities and commodities

General market risk—changes in the overall market for interest rates, equities, FOREX and commodities

Specific market risk—changes in the value of a security due to issuer-specific factors. Affects only interest rate and equity positions of institutions

Two approaches to market risk capital requirements• Internal model—requires a statistical probability model that

measures financial risk exposures, i.e. value at risk (VaR)• Standardised approach


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• Pillar 2—Supervisory review– Intended to ensure banks have sufficient capital to

support all risks and encourage improved risk-management policies and practices in identifying, measuring and managing risk exposures such as:

Risks incompletely/not captured in Pillar 1 and factors external to the bank like a changing business cycle

Additional risk management practices such as education/ training; internal responsibilities, delegation and exposure limits; increase provisions and reserves; and improve internal controls and reporting practices

Four key principles of supervisory review


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• Pillar 3—Market discipline– Aim is to develop disclosure requirements that allow the

market to assess information on the capital adequacy of an institution, i.e increase the transparency of an institution’s risk exposure, risk management and capital adequacy

Prudential supervisors to determine minimum disclosure requirements and frequency

Basel II recommends a range of qualitative and quantitative information disclosure relating to principal parts of Pillars I and II


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2.3 Uses of Funds






2.9 Summary


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• Liquidity—access to sources of funds to meet day-to-day expenses and commitments– Banks have special liquidity problems due to:

Mismatch in maturity structure of balance sheet assets and liabilities and associated cash flows

Role of banks in the payments system

– Liquidity prudential standard APS210 The board of directors and management must implement a

liquidity management strategy, which is reviewed annually Must immediately advise APRA of any liquidity concerns Strategy must include a contingency plan Emphasis on bank’s internal liquidity management practices APRA reserves right to specify minimum level of liquid

assets


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2.8 Liquidity Management and Other Supervisory Controls (cont.)

• Other regulatory and supervisory controls– Risk management systems certification– Business continuity management– Audit– Disclosure and transparency– Large exposures– Foreign currency exposures– Ownership and control


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2.3 Uses of Funds






2.9 Summary


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2.9 Summary

• Banks are the dominant institution and have moved to liability management

• Sources of funds include deposits (current, call and term deposits) and non-deposit sources (bill acceptances, debt and foreign currency liabilities, OBS business and other services)

• Uses of funds include government, commercial and personal lending


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2.9 Summary (cont.)

• OBS transactions are a major part of a bank’s business and include– direct credit substitutes– trade and performance-related items– commitments– market rate-related transactions

• APRA’s bank prudential supervision requirements include capital adequacy, liquidity management and other controls

copyright 2007 mcgraw-hill australia pty ltd ppts t/a mcgrath’s financial institutions,...

Documents

mcgrawhill australia

activities of commercial

viney slides

anthony stanger

main sources

shareholders funds banks

balance sheet

commercial banks websites