Commercial Banks: Websites: WWW - Apra.gov - Au WWW - Asic.gov - Au WWW - Accc.gov - Au WWW - Rbnz.govt - NZ

Chapter 2
Commercial banks
Websites:
www.apra.gov.au
www.asic.gov.au
www.accc.gov.au
www.rbnz.govt.nz
www.anz.com.au
www.commbank.com.au
www.nab.com.au
www.westpac.com.au
Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd 2-1

Viney & Phillips, Financial Institutions, Instruments and Markets, 9e
Learning objectives
LO 2.1 Evaluate the functions and activities of commercial
banks.
LO 2.2 Identify the main sources and uses of funds for
commercial banks.
LO 2.3 Identify the main uses of funds by commercial banks.
LO 2.4 Outline the nature and importance of banks’ off-
balance-sheet business.
LO 2.5 Consider the regulation and prudential supervision of
banks.
LO 2.6 Understand the background and application of Basel III.
LO 2.7 Examine liquidity management and supervisory
controls applied by APRA in Basel III context.
(cont.)

Chapter outline
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 Evolution from Basel I to Basel III
2.8 Liquidity management and other supervisory
controls

2.1 Main activities of commercial
banking
• Overview:
– Commercial banks provide a full range of financial services
– In the modern financial system, the activities of commercial banks
are far less regulated than they have been historically
– In a less regulated environment, commercial banks practise
‘liability management’ whereby shortfalls in loan demand are
borrowed on the capital markets
– The regulation of the banking sector attracted renewed attention
following the Global Financial Crisis (GFC)
– Since then, the development of the Basel III accords have
concentrated on capital adequacy
– In 2018, Australian financial institutions came under scrutiny during
the Royal Commission into Misconduct in the Banking,
Superannuation and Financial Services Industry (cont.)

• Importance of banks
– A high level of regulation prior to the mid-1980s constrained
banks’ development and led to a growth of non-bank financial
institutions
– With deregulation in the period after 1980, banks began to
practise liability management, where demand for loans was
met by borrowing rather than from available deposits or equity
– Commercial banks hold the largest share of assets of all
institutions
– But even this understates the volume of business that
commercial banks undertake because it does not include off-
balance-sheet transactions
(cont.)

• Asset management (before the 1980s)
– Loans portfolio is tailored to match the available deposit base
• Liability management (1980s onwards)

– Deposit base and other funding sources are managed to meet
loan demand
 Borrow directly from domestic and international capital markets
 Provision of other financial services
 Off-balance-sheet (OBS) business

• 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
(cont.)

• Current account 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
 Includes passbook account, electronic statement account with ATM
and EFTPOS
(cont.)

• 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 owing to fixed maturity
 Higher interest rate than current or call accounts
 Generally fixed interest rate
• 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)
(cont.)

• 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
(cont.)

• 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
(cont.)

• 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
(cont.)

• Loan capital and shareholders’ equity
– Sources of funds that have characteristics 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)

Talking markets and strategy
• Are Australia’s big banks ‘blue chip’ investments?
• Following the Royal Commission in 2018 and uncertain
economic conditions, investors have turned their back on
the big banks
• According to Reuters, more than 31 institutional fund
managers with a ‘growth’ focus closed out their positions
in the major banks during 2018
• Part of the reason behind this falling out of favour is the
implications of the Royal Commission for banks’ business
models and organisational structures
• Organisational and cultural changes are set to cost more
than $6 billion and key aspects of formerly successful, but
unethical, business models are no longer viable

2.3 Uses of funds
• Personal and housing finance
– Housing finance
 Mortgage
 Amortised loan
– Investment property
– Fixed-term loan
– Credit card
(cont.)

2.3 Uses of funds
• Commercial lending
– Involves bank assets invested in the business sector and lending
to other financial institutions
– 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 payments
• Repayment of principal
(cont.)

2.3 Uses of funds
• Commercial lending
– Overdraft
 A facility allowing a business to take its operating account into debit up
to an agreed limit
– Bills of exchange
 Bank bills held
• Bills of exchange accepted and discounted by a bank and held as assets
 Commercial bills
• Bills of exchange issued directly by business to raise finance
 Rollover facility
• Bank agrees to discount new bills over a specified period as existing bills
mature
– Leasing
(cont.)

2.3 Uses of funds
• 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

– Include electronic network infrastructure and shares in controlled
entities

• 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
(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.
 The client has a financial obligation to a third party.
 The bank is required to make a payment only if the client defaults on a
payment to a third party
• 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, for example:
 documentary letters of credit
 performance guarantees
(cont.)

• Commitments
– The contractual financial obligations of a bank that are yet to be
completed or delivered
 The bank undertakes to advance funds or make a purchase of assets
at some time in the future, for example:
• forward purchases
• underwriting
(cont.)

• 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), for example:
 futures, options, foreign exchange contracts, currency swaps, forward
rate agreements (FRAs)
– Also used for speculating
(cont.)

• To the extent that these OBS activities involve risk taking
and positions in derivative securities, OBS activities
raise some concerns about bank regulation
• This is a particularly important concern when the size of
off-balance-sheet activities is considered
• The notional value of such activities is more than five
times the total value of assets held by the banks

2.5 Regulation and prudential
supervision
• The GFC focused attention on the regulation of the
financial system and triggered a decade-long program
of reform culminating in the finalisation of Basel III in
late 2017
• A number of financial institutions collapsed during the
crisis
• The amount of leverage on the balance sheets of these
institutions was a primary factor contributing to their
weakness
• Debate concerning bank regulation and prudential
supervision has concentrated on how regulators can
maintain a stable financial system
(cont.)

• Reasons for regulation of banks
– Importance of the banking sector for health of the economy
• Prudential supervision
– Imposition and monitoring of standards designed to ensure the
soundness and stability of a financial system
(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

2.6 Background to capital adequacy
standards
• The business activities of financial institutions will
inevitably involve the need to write off abnormal business
losses
• The capital held by financial institutions serves as the
‘buffer’ against such losses
• If capital is inadequate, a financial institution may face
insolvency. This has significant implications for the
stability of the financial system
• The capital adequacy standards set down in Basel III
define the minimum capital adequacy for a bank
• The standards are designed to promote stability within the
financial system
(cont.)

2.6 Background to capital adequacy
standards
• Functions of capital
– Source of equity funds
– Demonstrates shareholder commitment
– Provides funding for growth and source of future profits
– Write-off periodic abnormal business losses
• The evolution of the international financial system led to

development of international capital adequacy standards:
– 1988 Basel I
– 2004 Basel II
– Following the GFC, Basel II underwent serious review and change
(called Basel III)
– Basel III 2017 details enhanced capital, leverage and liquidity
standards

2.7 The Basel accords: evolution from
Basel I to Basel III
• Basel II extended Basel I to increase sensitivity to
different levels of asset and OBS business risk
• Main elements of Basel III

– 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
(cont.)

2.7 The Basel accords: evolution from Basel
I to Basel III
• The most important features of Basel III that enhance
Basel II are:
– Focus on the denominator of the capital ratio. Whereas Basel II
was focused on the numerator (capital), Basel III focuses more
attention on the risk-weighted assets (the denominator in the
ratio)
– Focus on the internal models that banks use to measure their
risk-weighted assets. It had been identified that significant
measurement differences can emerge from different models
– Additional capital set aside to support exposure to operational
risk
– Additional focus on defining the responsibility of the board of
directors and other executive staff to ensure that the prudential
regulations are satisfied
(cont.)

Capital adequacy standard
• The 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 Tier 2 – specified permanent hybrid instruments
• Lower Tier 2 – specified non-permanent instruments
– Regulator can require an institution to hold a capital ratio above 8%
– In Australia, APRA will require 10.50%
(cont.)

• Australian Prudential Standard (APS) 111 defines Tier 1
and Tier 2 capital
• Tier 1 capital includes common shares, retained
earnings and other reserves specified by APS111
• Tier 2 capital includes subordinated debt and general
loan-loss reserves
(cont.)

Basel III structural framework
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
(cont.)


• Credit risk
– Standardised approach
 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
(cont.)


• Credit risk
– Internal ratings-based approach involves banks using some or all
of their own risk measurement model factors, subject to supervisor
approval. Two approaches available:
i. Foundation internal ratings-based approach (FIRB)
• Bank determines probability of default and effective maturity but relies on
supervisor estimates for other credit risk components
ii. Advanced internal ratings-based approach (AIRB)
• Bank provides estimates of all credit risk components
– Basel III places additional emphasis on interest rate risk in the

banking book (IRRBB) and places restrictions on the types of
internal models that banks can use to measure the riskiness of
assets and other exposures
(cont.)

Talking markets and strategy
• The value at risk (VaR) model became widely used in the
banking sector over the past few decades
• Where did its use originate?
• Seemingly, the popularity of VaR began to grow when the
Securities and Exchange Commission (SEC), the US regulator,
set down a requirement that banks set aside enough capital to
cover losses that could be incurred in a 30-day period with
95% confidence
• The SEC set down this requirement in 1980
• Essentially, VaR provides an answer to the question, ‘How
much money could a bank lose?’
• The problem with VaR is that its answer to this question
depends on the available data and the specification of the
model. See the excellent discussion at NYU (Stern).
• Operational risk—risk of loss from inadequate or failed
internal processes, people and systems, or external events
– Includes 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 owing 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

– Basel III sets down a standardised approach to the calculation of
operational risk. This is based on a Business Indicator (BI) and Internal
Loss Multiplier (ILM)
(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 owing 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
 Under Basel III, restrictions are placed on the use of internal models.
Regulators found too much variation across model specifications
(cont.)

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 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; increased
provisions and reserves; and improved internal controls and
reporting practices
– There are four key principles of supervisory review
(cont.)

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

Basel III and bank liquidity
• In addition to the ‘three pillars’, Basel III sets down some
liquidity standards:
– liquidity coverage ratio (LCR)
– net stable fund ratio (NSFR)
• These liquidity standards are designed to ensure that
financial institutions can meet their obligations and survive
periods of acute stress. Once more, the focus is on
maintaining reserves of high-quality assets
• APRA and APS 210

2.8 Liquidity management and other
supervisory controls
• Liquidity—access to sources of funds to meet day-to-day
expenses and commitments
• Securities portfolio
• Liquidity management strategy:
– a liquidity management policy statement approved by the board of
directors
– a system for measuring, assessing and reporting liquidity
– procedures for managing liquidity relevant to balance-sheet and
off-balance-sheet activities on a group basis
– clearly defined managerial responsibilities and controls
– a formal contingency plan for dealing with a potential liquidity crisis

Contingency plan
• Prudential Standard APS 210 liquidity requirements
• Going concern and name crisis
• Exemptions
• Strategies to manage liquidity include:
– setting limits on maturity mismatches between assets and
liabilities
– holding high-quality liquid assets
– diversifying liability sources to maintain a stable funding base
– access to wholesale markets
– access to foreign currency markets for liquidity
– intra-group liquidity
– use of assets through sales, repurchase agreements and
securitisation to provide liquidity
– industry liquidity supports arrangements through the provision of
stand-by liquidity between banking institutions

Summary
• Banks are the dominant financial 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
(cont.)

Summary
• 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


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Chapter 2

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• Liability management (1980s onwards)

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• Banks offer a range of deposit and investment products

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• Call or demand deposits

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• Negotiable certificates of deposit (CDs)

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• Other bank assets

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• OBS transactions include:

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• Trade- and performance-related items

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– Australian Prudential Regulation Authority (APRA)

– Australian Securities and Investments Commission (ASIC)

– Australian Competition and Consumer Commission (ACCC)

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• The evolution of the international financial system led to

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• Main elements of Basel III

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• Capital adequacy standard

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Pillar 1—Capital adequacy

• Market-related OBS transactions—credit conversion factor can be

» original exposure method—notional contract value multiplied by a credit

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Pillar 1—Capital adequacy

– Basel III places additional emphasis on interest rate risk in the

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 Regulatory objectives—prudential standards of bank supervisors

– Business continuity management and additional capital

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Pillar 2—Supervisory review of capital adequacy