FINS1612 SUMMARIES

Week 2
The Banking System
1/8 Overview and Main Activities of Commercial
Banking :
Authorised Deposit Taking Institutions ADIs

History and activities

o Large level of regulation prior to the mid 1980s which lead to growth
of non-bank financial institutions.
o BEFORE 1980s there was asset management, loans portfolios
tailored to match the available deposit base
o AFTER 1980s there is liability management, where deposit base and
other funding sources are managed to meet the loan demand.

Borrowing directly from domestic and international capital

markets

Provision of other financial services other than just asset

management

Off-Balance-Sheet business

Why are banks important?

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

They hold more than 50% of the money in Australia

Categories (according to APRA)

o Incorporated banks
o Unincorporated Foreign Bank Branches
o Foreign Bank Representative Offices

APRA protects the money in banks in that order (in situation of

financial sector failure)

2/8 Sources of Fund (9 Liabilities):

On the balance sheet the sources of funds appear as either liabilities or
shareholders funds
Banks offer a range of deposit and investment products with different mixes of
characteristics (Liquidity, Return, Maturity, Cash Flow structure) in order to attract
savings of surplus entities.

Current Account Deposits (Cheque) - Highly liquid funds held in cheque

account that may (/not) be interest bearing

Call or demand deposits (Savings) - Funds held in savings accounts to

be withdrawn on demand (accounts with ATM and EFTPOS)

Term deposits - Funds lodged in an account for predetermined period at

specific interest rate which loses liquidity in exchange for higher (generally
fixed) interest rate.

CDs Negotiable certificates of deposit; - short (30-180 days), highly

negotiable paper issued by a bank in its own name at a discount face value
which specifies repayment of the face value of the CD at maturity. (Can be
sold in secondary Market)

Transferable CD (3-5 years and over 100k)

Bill of Exchange Is a security issued into the money market at a

discount to the face value where the face value is repaid to the holder at
maturity.
o Bank / Non-bank (Hold = Asset) (sell = liability)
o Acceptance The bank accepts primary liability to repay face value of
the bill to the holder whilst the issuer of the bill agrees to pay the
bank face value of bill plus a fee at maturity date. >>>The
acceptance by the bank guarantees the flow of funds to its customers
without using its own funds.

Debt liabilities pay regular interest to the holder until maturity where
the principal is repaid.
o Debenture Bond supported by a form of security, being a charge
over the assets of the issuer (for example, collateralised floating
charge)
o Unsecured Note A bond issued without supporting security

Foreign Currency Liabilities Debt instruments issued into the

international capital markets that are denominated in a foreign currency.
(Aus banks credit rating lets them raise up to $1B)
o Allows diversification of funding sources into international markets
as well as facilitates matching of foreign exchange denominated

assets. It also meets corporate demand for foreign exchange

products.

Loan Capital and Shareholders Equity (hybrid but on BS as

liablility) Sources of funds that have characteristics of both debt and
equity (subordinated debentures and subordinated notes)
o Subordinated means the holder of the security has a claim on interest
payments or the assets of the issuer, after all other creditors
(excluding normal shareholders) have been paid.

3/8 Uses of Funds (Assets):

Uses of funds appear in the balance sheet as assets and the majority of
these assets are loans that give rise to an entitlement of future CF (interest
and repayment of principal)

Personal and Housing Finance

o Housing finance (Mortgage, Amortised loan) Live for 6months out of 7
years and investment becomes housing.
o Investment property (pay capital gains tax, unlike mortgage)
o Fixed-term loan
o Credit Card

Note on $2,000 CC if 800 is spent, that is the asset. 1200 is

OBS commitment

o Personal overdraft

Commercial Lending
Involves bank assets invested in the business sector and lending to other
financial institutions
o Fixed-term loan

A loan with negotiated terms and conditions (period, fixed vs.

variable interest rate and magnitude of rate, timing of interest
payments, repayment of principal)

o Overdraft

A facility allowing a business to take its operating account into

debit up to an agreed limit

o Bills of exchange

Bank Bills Held BOE accepted and discounted by a bank and

held as assets

Commercial Bills BOE issued directly by business to raise

finance

Rollover facility Bank agrees to discount new bills over a

specified period as existing bills mature

o Leasing

Lending to government (Low risk, Low Return)

o Treasury notes short-term discount securities issued by the
Commonwealth Govt.
o Treasury Bonds medium to longer-term securities issued by the
Commonwealth Gov. that pay a specified interest coupon stream
o State Govt. Debt Securities

Other bank assets (electronic network infrastructure, shares in

controlled entities)

4/8 Off-Balance Sheet Business (significant part):

At march 2008, OBS business was over four times the
value of the assets of banks in Australia.
94% of this is based on market-related transactions
Note: Bank-Book are detailed notes of change in security
prices when market rates change.

These include;
o Direct Credit Substitutes (financial obligations) - An
undertaking by a bank to support the financial obligations of a client
(stand-by letter of credit financial guarantee)
Bank acts as guarantor on behalf of a client (who has an
obligation to a third party) for a fee and is only required to
make a payment if the client defaults on payment to the
third party.
o Trade and performance related items (non-financial
obligations) 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.

Eg: Documentary letters of credit, performance guarantees

o Commitments The contractual financial obligations of a bank that

are yet to be completed or delivered (credit card limit approval)

The bank undertakes to advance funds or make a purchase of

assets at some time in the future (forward purchases,
underwriting for example)

o >>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)
-Also used for speculating / hedging

Examples include Futures, options, foreign exchange

contracts, currency swaps, forward rate agreements (FRAs)

Derivatives (forward, future, swap, option)

5/8 Regulation and Prudential Supervision:

The banking sector needs to be regulated for the health of the economy

Prudential supervision involves imposition and monitoring of standards

designed to ensure the soundness and stability of a financial system.

Australian Regulatory structure;

o The RBA (System stability and payments system)
o Australian Prudential Regulation Authority (Prudential regulation and
supervision of deposit-taking institutions and Superannuation
and super *contractual savings institution*) - APRA
o ASIC (Market integrity and consumer protection) corporation laws
(licenses, compliance)
o ACCC (Competition Policy and fair trading)

6/8 Background to Capital Adequacy Standards:

Functions of Capital;
o Source of equity funds
o Demonstrates shareholder commitment
o Provides funding for growth and source of future profits
o Write-off periodic abnormal business losses

Last-mentioned function and evolution of the international financial

system led to the development of international capital adequacy standards
o 1988 Basel 1 Capital Accord
o Basel II (2008) Capital Accord

7/8 Basel II Capital Accord:

Extends Basel I to increase sensitivity to different levels of asset and OBS
business risk.

Main elements;
o

Credit risk of banks assets and OBS business

Market risks of banks trading activities

Operational risks of banks 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

Pillar 1 Capital Adequacy

Capital Adequacy Standard - Overview
Minimum capital adequacy requirement applies to commercial banks and other
institutions specified by the prudential regulator (APRA)
o Minimum Risk-based capital ratio of 8%
(Regulator can require an institution to hold a capital ratio
above 8%)
o Minimum 4% held as Tier 1 Capital (Highest quality core capital)

Provide a permanent and unrestricted commitment of funds

Freely available to absorb losses

Do not impose any unavoidable servicing charge against

earnings

They rank behind the claims of depositors and other creditors in

the event of bankruptcy.

Examples include;
Paid-up ordinary shares, General reserves (excluding that
for credit losses upper tier 2), RE, Current years
earnings, foreign currency translation reserve, perpetualnon-cumulative preference shares that satisfy relevant
criteria, other innovative securities that satisfy the
criteria.

o Remainder can be held as Tier 2 Capital (Supplementary Capital)

Upper Tier 2 Specified permanent-in-nature hybrid
instruments
(Ordinated debt, Perpetual cumulative preference shares,
perpetual cumulative CN, Perpetual cumulative
subordinated debt,
Lower Tier 2 Specified non-permanent institutions
(Term subordinated debt, limited-life redeemable shares)

CBA holds about 11%, with

10% being tier 1 and 1% tier
Capital adequacy - Credit Risk
2.
Risk that the borrower will not meet commitments when due
o

Standardised approach;

Risk weights applied to balance-sheet and OBS items to

calculate minimum capital requirement. (Book value time
risk weight times 8%)

Risk weights derived from external rating grade or

supervisor (apra.gov.au)

For residential housing loans, risk weight relates to loanto-valuation ratio (LTVR) and level of mortgage
insurance.

OBS items converted to BS equivalents by determining the

credit conversion factor and multiplying by the applicable risk
weighting
(Book value times risk weight times 8% times conversion
factor)

Non-market-related OBS transactions (eg. 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)

o
o

Original exposure method notional contract

value multiplied by a credit conversion factor

Internal Ratings-based approach:

Banks using some or all of their own risk measurement

model factors (subject to supervisor approval)

Foundation internal ratings-based approach (FIRB) is

where the bank determines probability of default and
effective maturity but relies on supervisor estimates for
other credit risk components

 Advanced internal ratings-based approach (AIRB) is

where the bank provides estimates of all credit risk
components.

3 Recognised credit rating agencies in Australia

Capital adequacy - Operational Risk
Risk of loss from inadequate
failed
internal processes,
people and systems OR
(Sor&
P, Moodys,
Fitch)
external events
(Eg. Internal / external fraud, OH&S, systems failure)
o For retail and commercial (Adv loan times 3.5% times 15%) then find
net income times 18% (both divide by 6 to get average) then add.
o Then other
o Operational risk management has the following objectives;

Operational objectives impact of loss of business function

integrity and capability

Financial objectives losses owing to operational risk

exposure, cost of recovering operations and ongoing financial
losses

Regulatory objectives prudential standards of bank

supervisors

o Business continuity management and additional capital

Capital adequacy -

Market Risk

Risk of losses resulting from changes in market rates in FOREX, interest rates,
equities and commodities
o Internal (Variance) Confidence interval is 99%. HP is ten days,
Maximum loss is 1 million.
o General market risk: - Changes in the overall market for interest
rates, equities, FOREX and commodities
o Specific Market Risk: - Changes in the value of a security owing to
issuer-specific factors (Affects only interest rate and equity positions
of institutions themselves)

Two approaches to market risk capital requirements:

Internal Model: Requires a statistical probability model
that measures financial risk exposures (such as value at
risk, VaR)
Standardised Approach

Pillar 2 Supervisory review of capital

adequacy;
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 incomplete or not captured in Pillar one 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, increased provisions and
reserves, improved internal controls and reporting practices.
Four key principles of supervisory review

Pillar 3 Market Disciplinary;

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 institutions 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 related principal parts of Pillars 1 and 2

8/8 Liquidity Management and Other Supervisory

Controls:
Liquidity Access to sources of funds to meet day-to-day expenses and
commitments
o Banks have special liquidity problems owing to the

Mismatch in maturity structure of BS assets and liabilities

and associated cash flows

and Role of banks in the payments system

o APRA liquidity prudential standard (APS210)

The board of directors and management must implement a

liquidity management strategy, which is reviewed annually

Measure, assess and report liquidity

Manage liquidity related to BS AND OBS activities

Emphasis on banks internal liquidity management practices

Strategy must include contingency plan

APRA reserves right to specify minimum level of liquid assets

Going concern and crisis scenario liquidity management

strategy

o Other regulatory and supervisory controls include;

Risk management systems certification

Business continuity management

Audit

Disclosure and transparency

Large exposures

FOREX currency exposures

Ownership and control