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Commercial Banks
Direct correlation between dominance of commercial banks (in terms of size and nature; in
controlling flow of funds) and level of regulation
o Commercial banks controlled largest amount of funds in financial system
o Bank regulation constrained development of commercial banks prior to mid-1980s
Reduction in dominance of commercial banks led to reduction in control of
flow of funds
New institutions evolving in competition
o Governments deregulated commercial banks significant growth of banking
sector
Consolidated corporate entities increases total asset share and dominance
Example: provision of risk management products, using over-the-counter and exchange-traded derivative
instruments
Main Activities of Commercial Banking
Banks have progressed from asset management to liability management
Due to regulation:
o
Asset Management: restricted their loan activity (assets) to match available amount of deposits
received from customers
Not uncommon for bank to run out of funds for lending expected that customers come
next month to obtain a loan
Liability Management: actively manage sources of funds (liabilities) in order to ensure they
have sufficient funds to meet loan demand and other commitments
If loan demand is forecast to increase
Banks enter capital markets and borrow necessary funds required
Example: plumber writes cheque to plumbing supplier, who obtains funds from plumbers bank by
lodging cheque
Note: business cheque account is referred to as operating account (pay periodic expenses as fall due)
2. Call or Demand Deposits
Held in savings accounts (rather than cheque accounts) where funds are available on
demand
Examples: traditional passbook account, electronic statement account (records transactions and sends
statements)
3. Term Deposits
Higher rate of return for savers (compared to call deposits and current accounts)
Compensates for loss of liquidity (Term deposit is fixed for time perid)
Safe and stable (attractive to conservative investors)
For aging population who seek secure investments)
Used as investment alternative for surplus fund
Term can range from one month to five years to maturity
Easier for banks to raise substantial amounts of debt often a net lower cost than
traditional, transaction-based depositor base
Types of debt issued are same as domestic market
Examples: discount securities, medium-term notes, debentures and unsecured notes
Holder of security will only be paid interest payments or principal repaid, after entitlements of
all other creditors (but before ordinary shareholders) have been paid
Equity
Majority are financial assets that create entitlement to future cash flows
Example: if bank gives customer a loan, then the amount outstanding appears as an asset
o
Housing Finance
Insurance offices and superannuation funds, mortgage originators also provide housing loan
finance creates competition
Lender sells existing house loans to obtain additional funds to provide new housing loans
Selling of class of assets e.g. housing loans into trust
Trustee issues new securities to investors
o Raises funds to pay for purchase of housing loan assets
o Securities can be bonds that are secured by housing loans held in trust
o Securities are lower-risk assets
Trustee uses interest and principal payments due from housing loans held to pay for
interest and repay principal on new securities issued
Bank provides funds to individual investor who purchases property for rental or leasing
purposes
o Takes registered mortgage over property as loan security
Fixed-term loan
Example: borrowers who want to purchase car or travel overseas
Personal overdraft
Note: fixed-term loan: loan provided for predetermined period used to purchase specified goods or
services e.g. car or travel overseas
2. Commercial Lending
Represents bank assets invested in business sector plus lending to other financial institutions
Recall: majority of business borrowers cannot access direct finance markets (only with good
credit rating) raise funds by borrowing from financial intermediaries
Commercial banks are principal lenders to small and medium-sized businesses
o Large corporations can still borrow but can borrow directly from markets
Overdraft
Rollover facility
Lease
Arrangement whereby owner of asset (lessor) allows another party (lessee) to use asset
Bank (lessor) finances purchase of asset and enters financial arrangement with lessee
Lessee makes lease payments in return for using asset
Borrowing asset rather than borrowing funds to purchase asset
3. Lending to Government
Why invest in government securities when higher returns could be obtained by giving loans to other
borrowers?
o
o
o
o
Bank makes payment to specified third party if banks client fails to meet financial obligations
Client able to issue securities and raise fund directly (as bank is undertaking)
Lender is assured that amounts will be either repaid by borrower or bank
Other Examples: guarantees, indemnities, letters of comfort (guaranteeing financial obligations of client)
o
Letter of comfort written by bank to confirm that customer has sufficient funding in place to
proceed with project
Examples:
o
Documentary letters of credit (bank substitutes credit standing for client and authorises
payment)
Bank executes documentary letter of credit to finance import of goods from overseas
(required by exporter)
Performance guarantees (bank agrees to provide financial compensation if client does not
complete terms and conditions)
Client fails to complete contract terms if inferior components are used in major
computer system upgrade
3. Commitments:
Examples:
4. Foreign exchange contracts, interest rate contracts and other market-rate related contracts
Use of derivative products to manage financial risk exposures of the bank and its customers
Facilitates hedging against risk e.g. effects of movements in exchange rates, interest rates,
equity prices and commodity prices
Examples:
Note:
o
o
o
Notional value of off-balance sheet business is greater than value of business-sheet assets for
banks
Off-balance sheet business is mainly market-rate-related contracts
Major commercial banks conduct the largest share of off-balance sheet business
Banks that adopt higher-risk lending strategies are required to have higher amounts of capital or
shareholders funds
Main Responsibilities:
1. Reserve Bank of Australia
o Maintenance of financial system stability, and soundness of payments system
o Can provide emergency liquidity support to financial system
o Does not regards its balance sheet as available to support solvency of individual
financial institution experiencing financial difficulty
2. APRA (Australian Prudential Regulation Authority)
Capital adequacy requirement: commercial banks are required to source minimum percentage
of funds from capital (to meet obligations)
o
o
Functions of Capital:
Basel I (1988)
Focused primarily on level of credit risk associated with banks balance sheet and off- balance
sheet business
o
o
Basel II (2008)
Main Elements
1. Credit risk
2.
3.
4.
5.
6.
Market risk
Operational risk
Form and quality of capital,
Risk identification, measurement and management
Transparency of related information and data
Examples: paid-up ordinary shares, general reserves, retained earnings, current years earnings
Tier 2 Capital:
1. Upper Tier 2: elements that are essentially permanent in nature, including some hybrid capital
instruments
Examples: perpetual cumulative preference shares, perpetual cumulative mandatory convertible notes,
perpetual cumulative subordinated debt
2. Lower Tier 2: instruments that are not permanent dated or limited-life instruments
Examples: term subordinated debt, limited-life redeemable preference shares
Reasons why commercial banks should be required to maintain capital buffer (excess of minimum)
1 20%
2 50%
3, 4 100%
5, 6 150%
Relationship between credit risk level and capital amount required:
Amount of capital required = book value x risk weight x 8% capital adequacy requirement
2. Internal Ratings-Based Approach to Credit Risk
o
Typically used by large commercial banks (especially those that operate in international
capital markets)
Have information systems and expertise that enable sophisticated approach
Receives approval from supervisor
Relies on internal estimates
Bank must provide own estimates of probability of default and effective maturity
Relies on supervisory estimates of other credit risk components e.g. loss being default
estimates, exposure at default estimates
2. Operational risk: risk of loss resulting from inadequate or failed internal processes, people and
systems or from external events (legal but excludes strategic and reputational risks)
Examples: internal and external fraud, employment practices and workplace safety, damage to physical
assets, execution, delivery and process management
o
Provision of additional capital will not protect bank from operational risk
Only supports survival of institution and stability of financial system after occurrence
of event
Map activities of institution and document process (e.g. policies and procedures)
Subject to independent review
Divide into two areas: retail/commercial banking and all other activity
For retail/commercial banking: uses proportion of institutions total gross outstanding loans and advances
to indicate risk exposure
For all other activity: uses proportion of institutions net income (profit from ordinary activities before
goodwill, amortisation and income tax)
o
Produces measure of value at risk (VaR) from all market risks over 10 trading days
Amount of capital = measure of VaR multiplied by factor set by regulator
VaR models estimate maximum potential gains or losses incurred over 10-day holding
period, based on 99% confidence levels
Ensures institution can meet operational liquidity demands as they fall due
Access to contingency liquidity in extreme situations
Commercial bank required to maintain minimum holding of 9% of liabilities in highly liquid
assets