Chapter 2
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FINS1612...
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Financial Institutions, Institutions, Instruments and Markets 8th Edition Instructor's Resource Manual
Christopher Viney and Peter Phillips
Chapter 2 Commercial banks
Learning objective objective 2.1: Evaluate the functions and activities activities of commercial commercial banks within the financial system •
Commercial banks are the largest group of financial institutions within a financial system and therefore they are very important in facilitating the flow of funds between savers and borrowers.
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The core business of banks is often described as the gathering of savings (deposits) in order to provide loans for investment.
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The traditional image of banks as passive receivers of deposits through which they fund their various loans and other investments has changed since deregulation. For example, banks provide a wide range of offbalancesheet transactions.
Learning objective objective 2.2: Identify Identify the main main sources sources of funds funds of commercial commercial banks, including current current deosits, demand deosits, term deosits, negotiable certificates of deosit, bill accetance liabilities, debt liabilities, foreign currency liabilities and loan caital •
!anks now actively manage their sources of funds (liabilities).
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They offer a diversity of products with different return, risk, li"uidity and cashflow attributes to attract new and diversified funding sources.
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#ources of funds include current deposits, call or demand deposits, term deposits, negotiable certificates of deposit, bills acceptance liabilities, debt liabilities, foreign currency liabilities, loan capital and shareholder e"uity.
Learning objective objective 2.!: Identify the main uses of funds funds by commercial commercial banks, including ersonal
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and housing lending, commercial lending, lending to government, and other bank assets •
Commercial banks now apply a liability management approach to funding growth in their balance sheets.
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$nder this approach a bank will (%) encourage depositors to lodge savings with the bank, and (&) borrow in the domestic and an d international money markets mark ets and capital markets to obtain sufficient funds to meet forecast loan demand.
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The use of funds is represented as assets on a bank's balance sheet.
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!ank lending is categorised as personal and housing lending, commercial lending and lending to government.
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ersonal finance is provided to individuals and includes housing loans, investment property loans, fixedterm loans, personal overdrafts and credit card finance.
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!anks invest in the business sector by granting commercial loans. Commercial loan assets include overdraft facilities, commercial bills held, term loans and lease finance.
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hile banks may lend some funds directly to government, their main claim is through the purchase of government gov ernment securities such suc h as Treasury notes and Treasury bonds.
Learning objective objective 2.": #utline the nature nature and imortance imortance of banks$ off%balance%sheet off%balance%sheet business, including direct credit substitutes, trade% and erformance%related items, commitments and market%rate%related market%rate%related contracts •
*iewing banks only in terms of their assets and liabilities greatly underestimates their role in the financial system. !anks also conduct significant offbalancesheet business.
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The national value of offbalancesheet business is over four times the value of the accumulated assets of the banking sector.
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+ffbalancesheet business is categorised as direct credit substitutes, trade and performance related items, commitments, and foreign exchange, interest rate and other marketraterelated contracts.
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+ver - per cent of banks offbalancesheet business is in marketraterelated contracts such as foreign exchange and interestratebased futures, forwards, options and swap contracts.
Learning objective objective 2.&: 'onsider the the regulation and rudential rudential suervision suervision of banks •
+ne of the main influences of change in the banking sector has been the regulatory environment within which banks operate.
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Commercial banks are now said to operate in a deregulated market. /elative to previous regulatory periods this is a reasonable description0 however, there still remains "uite a degree of regulation that affects participants in the financial markets, including the banks.
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1ach nationstate is responsible for the regulation and supervision of its own financial system. 2n particular, central banks and prudential supervisors are responsible for the maintenance of financial system stability and the soundness of the payments system.
Learning objective 2.(: )nderstand the background and alication of *asel II and *asel III •
At the global level, the Bank for International Settlements takes an active interest in the stability of the international financial system. To this end, the Basel Committee on Banking Supervision has developed an international standard on capital adequacy for banks.
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$nder !asel 22 banks were re"uired to maintain a minimum riskbased capital ratio of 3.44 per cent. !asel 222 increased the amount of Tier % capital that must be included in a banks capital ratio.
!asel 222 enhances the capital re"uirements of !asel 22 and introduces additional li"uidity re"uirements. 2n particular, banks will be re"uired to maintain a ratio of 5igh 6uality 7i"uid 8ssets (5678) to net cash outflows per month of at least %44 per cent. This is called the 7i"uidity Coverage /atio (7C/).
Capital is categorised as either Tier % capital, $pper Tier & capital or 7ower Tier & capital. $nder !asel 222, at least 9.44 per cent of a banks 3.44 per cent riskbased capital re"uirement must be held in Tier % capital. This has been increased from -.44 per cent under !asel 22.
8s part of the calculation process, risk weights are applied to balancesheet assets using specified risk weights. These weights may be based on the counterparty to an asset, or on an external rating provided by an approved credit rating agency.
+ffbalancesheet items are converted to a balancesheet e"uivalent using credit conversion factors before applying the specified risk weights.
The !asel 22 capital accord comprises three pillars, which are enhanced under !asel 222.
illar % relates to the calculation of the minimum capital re"uirement. illar % considers three areas of risk: credit risk, operational risk and market risk. ithin each of these risk categories banks have a choice of applying a standardised approach or an internal approach to measuring their capital re"uirement. #ub;ect to approval from the bank 3
supervisor, an internal approach method allows a bank to use its own risk management models.
illar & provides for a supervisory review process and includes four basic principles: (%) the assessment of total capital re"uirements by a bank, (&) the review of capital levels and the monitoring of banks compliance by supervisors, (loans to purchase residential property such as a house or unit. #ecurity is a mortgage taken over the land and property thereon. ?ortgage registered on title of land. 7oan may have a fixed or variable interest rate. 7oan instalments paid periodically (monthly) and typically amortised (interest and principal components).
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2nvestment property finance>very similar to above, except property is usually leased to a third party. 2nterest rate generally higher reflecting higher risk of lease agreement.
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Fixedterm loans>used to finance nonproperty transactions such as buying a car. !ank will seek security such as a guarantee from the borrower or a third party. 5igher interest rate reflects higher credit risk associated with borrower and lower "uality security.
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ersonal overdrafts>allows an individual to place their account into debit up to an agreed limit. $sed for managing cash flow mismatches over time. #hould be fully fluctuating. ay interest on the debit amount0 also unused limit fee.
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Credit card finance>plastic card issued with an available credit limit, that is, the cardholder can make purchases or obtain cash advances up to the amount of the credit limit. 5igh interest rate charged on used credit.
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&6C +imited plans to purchase inection mouldin% euipment to manu(acture its ne
ran%e o( plastics products" 1he company approaches its bank to obtain a term loan" Identi(y and discuss important issues that the company and the bank ill need to ne%otiate in relation to the term loan" *+ 2"/-
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The bank and the borrow will structure the loan and negotiate the terms and conditions of the loan
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eriod of the loan>consider matching principal0 what are the funds being used for
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2nterest rate>fixed versus variable interest rate0 if variable, what is the reference interest rate (e.g. !!#) and the margin above the reference rate
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#ecurity>will the lender be able to take a mortgage over property or a charge over the other assets of the borrower
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Timing of repayments>how fre"uently will loan instalments occur0 will the loan be amortised (interest and principal components), or an interest only loan with principal repaid at maturity.
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1he o((3balance3sheet business o( banks has e0panded si%ni(icantly and, in notional
dollar terms, no represents o.er se.en times the .alue o( balance3sheet assets" *+ 2"4*a- $e(ine hat is meant by the o((3balance3sheet business o( banks" •
a transaction that is conducted by a bank that is not recorded on the balance sheet
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a contingent liability that will only be recorded on the balance sheet if some specified condition or event occurs.
*b- Identi(y the (our main cate%ories o( o((3balance3sheet business and use an e0ample to e0plain each cate%ory" •
Direct credit substitutes—support a client’s financial obligations, such as a stand-by letter of credit or a financial guarantee
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Trade and performance related items—support a client’s non-financial obligations, such as a performance guarantee or a documentary letter of credit
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Commitments—a financial commitment of the bank to advance funds or underwrite a debt or equity issue. For example, the unused credit limit on a credit card, or a housing loan approval where the funds have not yet been used
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Foreign exchange, interest rate and other market rate related contracts—principally derivative products such as futures, forwards, options and swaps used to manage f/x and interest rate risk exposures.
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Folloin% the FC, the o((3balance3sheet acti.ities o( commercial banks attracted a
%reat deal o( attention amon% commentators" :ith re(erence to the si;e and composition o(
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commercial banks) o((3balance3sheet acti.ities, outline some o( the possible reasons (or this concern" *+ 2"4•
The notional value of the offbalance sheet activities of banks is five times the total value of the assets held by the banks.
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!ecause this offbalance sheet activity is less transparent, it is difficult for regulators to assess the financial health of financial institutions.
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8lso of concern is the type of securities that constitute offbalance sheet activities. These may include the types of derivative securities that played such an important role in the @FC.
comprising instruments which are not permanent0 that is, dated or limited life instruments.
1xamples:
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!>"
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tier % capital: ordinary shares0 retained earnings
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tier & capital (upper): mandatory convertible notes0 perpetual subordinated debt
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tier & capital (lower): term subordinated debt approved by the regulator.
Pillar ! o( the 6asel II capital accord includes an operational risk component" *+ 2"7-
*a- $e(ine operational risk"
The !ank for 2nternational #ettlements categorises operational risk as: •
internal and external fraud
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employment practices and workplace safety
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clients, products and business practices
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damage to physical assets
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business disruption and system failures execution, delivery and process management.
*b- ?sin% the standardised approach, e0plain ho a commercial bank is reuired to measure the operational risk component o( its minimum capital adeuacy reuirement" •
!asel 22 re"uires banks to hold additional capital to support their exposure to operational risk
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ith the standardiAed approach to operational risk an institution is re"uired to map and divide its activities into two areas of business: o o
retailBcommercial banking all other activity. 10
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8n institution must document its mapping process, detailing the policy and procedures used to map the full range of business activities. This process must be sub;ect to independent review.
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The retailBcommercial banking area capital re"uirement is determined using a proportion of an institutions total gross outstanding loans and advances as an indicator of that areas operational risk exposure. This also includes the book value of securities held in the banking book.
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The operational risk capital re"uirement for the all other activity area of business is determined using a proportion of an institutions net income as an indicator of that areas operational risk exposure. et income is defined as profit from ordinary activities before goodwill, amortiAation and income tax.
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+perational risk capital for retailBcommercial banking is calculated by taking the last six consecutive halfyearly observations of total gross outstanding loans and advances, then multiplying a proportion, being •
Corporate governance is the framework of rules, relationships, systems and processes within and by which authority is exercised and controlled in corporations. It encompasses the mechanisms by which companies, and those in control, are held to account. Corporate governance influences how the objectives of the company are set and achieved, how risk is monitored and assessed, and how performance is optimised. 17
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8lthough corporate governance does not specifically concern Eethical behaviour, it may work handinhand with a firms statement of ethical or professional conduct.
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For 8=2s, where the confidence of customers and clients is of the utmost importance, demonstrating strong governance frameworks and ethical behaviour is a very important component of corporate strategy.
FI&CI&+ E:@ C&@E @1?$D 2n Chapter &, the latest addition to the !asel accords, !asel 222, was discussed. 8lthough the new !asel 222 capital ade"uacy re"uirements will be implemented very gradually, changes to capital ade"uacy can have a significant impact on financial institutions. 8ustralian banks weathered the global financial crisis and have tended to maintain capital ratios in excess of those re"uired by !asel 22. They should be well placed to make a smooth transition to !asel 222. 1lsewhere around the world, financial institutions confront more difficult challenges, particularly as they recover from the lingering effects of the @FC and the sovereign debt crisis. 2nterestingly, the approach that banks have taken has been different in different countries. 2n 1urope, banks have taken steps to raise cash in the form of e"uity capital to strengthen their balance sheets. 2n 8merica, leverage ratios remain relatively high. 8ccording to the Financial Times: Deutsche Bank recently completed a €2.96bn accelerated issue of new shares, fellow erman lender !ommer"bank in #arch said it would raise €2.$bn and reek banks are on the road to raise as much as they can from commercial in%estors to plu& a €2'.(bn e)uity shortfall.
This appears to be due to pressure to comply with !asel 222 sooner rather than later. 1ven though regulators will not re"uire full compliance, capital markets and investors have signalled strongly that healthy capital ratios are desirable. For example, =eutsche !anks share price increased by 9 per cent on the day that its latest e"uity capital raising was announced. +rdinarily, e"uity capital raisings dilute the ownership share of the existing shareholders and may be expected to depress rather than inflate the share price J particularly in the current environment where banks share prices are depressed. /aising capital at such low e"uity prices is a very expensive exercise. evertheless, the push for strong capital ratios
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dominates the other considerations. 2mportantly, though, the contrast between 1urope and 8merica on this point is stark. 8ccording to the Financial Times : *t is a %ery different story in the +, where bank in%estors ha%e been pressurin& the likes of -#or&an, oldman achs and !iti&roup to return capital to shareholders throu&h hi&her di%idends and share buybacks. Four of the best capitalised lar&e &lobal banks are now /uropean 0 +B, B1 aribas, B! and, post3capital raisin&, Deutsche Bank 0 while only one, #or&an tanley, is a + &roup. 4owe%er5 nalysts at !iti note that there is a persistent north3south di%ide across the re&ion. 7hile 1ordic lenders boast Basel *** core tier one ratios of up to '( per cent, e%en the stron&est panish banks are on 8 per cent or less.
#uccumbing to the markets demands for strong capital ratios does not necessarily mean that banks need to raise additional capital by selling shares and diluting the ownership shares of existing shareholders. !anks in both the $K and 1urope have begun raising capital by other means, including sales of convertible debt. +ther banks have raised capital by issuing dividends in the form of shares rather than cash. +thers have simply raised cash by selling off assets. !asel 222 is a common thread that explains many of the capital raisings being undertaken by banks around the world. 2t is clear, however, that whatever the regulatory pressu re may be, pressure stemming from the markets exerts a strong influence over bankers decisions. 2n 8merica, where investors appear to have different preferences, leverage ratios remain high. #+$/C1: 8dapted from atrick Lenkins and =aniel #chafer, E1uropes !anks Turn to Capital /aising to ?eet !asel 222, Financial Times, %< ?ay &4%
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