FINS1612

CAPITAL MARKETS AND

INSTITUTIONS
Lecture 2
Commercial Banks

REVISION

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

Chapter Organisation
2.1
2.2
2.3
2.4
2.5
2.6
2.7
2.8
2.9

Main Activities of Commercial Banking

Sources of Funds
Uses of Funds
Off-balance-sheet Business
Regulation and Prudential Supervision
Background to Capital Adequacy Standards
Basel II Capital Accord
Liquidity Management and Other Supervisory Controls
Summary

26

Authorised Deposit-taking Institutions (ADIs)

In Australia, financial institutions that are approved to carry out

financial intermediation are authorised by the Australian

Prudential Regulation Authority (APRA), and labelled authorised
depository institutions (ADIs)

27

2.1

Main Activities of Commercial Banking

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

28

2.1

Main Activities of Commercial Banking (cont.)

Asset management (1980s)

Loan portfolio is tailored to match the available deposit base
Highly regulated environment

Liability management (1980s)

Less regulated environment
Deposit base and other funding sources are managed to fund
loan demand
Borrow directly from domestic and international capital market
Provision of other financial services
Off-balance-sheet (OBS) business

29

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
2.7
Basel II Capital Accord
2.8
Liquidity Management and Other
Controls
2.9
Summary

Standards
Supervisory

2
10

2.2

Sources of Funds

Sources of funds appear in the balance sheet as either liability

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

2
11

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

Stable funding

2
12

2.2

Sources of Funds (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 due to fixed maturity
Higher interest rate than current or call accounts
Generally fixed interest rate

History shows us that in times of volatility in the financial marekts,

especially the stock markets, investors tend to revert to the safe

haven of the bank term deposit

2
13

2.2

Sources of Funds (cont.)

Negotiable certificates of deposit (CDs)

Short term discount security
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)

2
14

2.2

Sources of Funds (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

The business that issues the bill will sell the bill to an investor

with banks guarantee to increase the creditworthiness of the bill.

The bank charges a fee for this service acceptor
The bank may agree to buy the bill from the drawer. The bank is

most likely to immediately sell the bill into the money market. The
bank has also been able to arrange finance for its business
customer without having to use its own funds - discounter

2
15

2.2

Sources of 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

2
16

2.2

Sources of Funds (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

Euromarkets : debt markets where instruments are issued into

another country but not denominated in the currency of that

country.

2
17

2.2

Sources of Funds (cont.)

Loan capital
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)

Shareholders Equity
Ordinary shares
Retained funds additional shareholders funds

218

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
2.7
Basel II Capital Accord
2.8
Liquidity Management and Other
Controls
2.9
Summary

Standards
Supervisory

219

2.3

Uses of Funds

Uses of funds appear in the balance sheet as asset

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

220

2.3

Uses of Funds (cont.)

Personal and housing finance

Housing finance
Mortgage
Amortised loan (Principal + Interest payment)

Investment property
Fixed-term loan
Credit card

221

2.3

Uses of Funds (cont.)

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

222

2.3

Uses of Funds (cont.)

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 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
Lease payments

223

2.3

Uses of Funds (cont.)

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)

224

Chapter Organisation
2.1
2.2
2.3
2.4
2.5
2.6
2.7
2.8
2.9

Main Activities of Commercial Banking

Sources of Funds
Uses of Funds
Off-balance-sheet Business
Regulation and Prudential Supervision
Background to Capital Adequacy Standards
Basel II Capital Accord
Liquidity Management and Other Supervisory
Summary

Controls

225

2.4

Off-balance-sheet Business

OBS transactions are a significant part of a banks business

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

226

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

227

2.4

Off-balance-sheet Business (cont.)

Trade and performance-related items

A form of guarantee provided by a bank to a third party, promising
financial compensation for non-performance contractual
obligations.
Documentary letters of credit
Performance guarantees

228

2.4

Off-balance-sheet Business (cont.)

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
Loans
creditcard

229

2.4

Off-balance-sheet Business (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), e.g.
Futures, options, foreign exchange contracts, currency swaps, forward
rate agreements (FRAs)

Also used for speculating

230

2.4

Off-balance-sheet Business (cont.)

To the extent that these OBS activities involve risk-taking and

positions in derivative securities, OBS activities raise some

concerns about bank regulation
The notional value of such activities is more than 5 times the total
value of assets held by the banks
A significant OBS business is based on market rate-related
transactions

231

Chapter Organisation
2.1
2.2
2.3
2.4
2.5
2.6
2.7
2.8
2.9

Main Activities of Commercial Banking

Sources of Funds
Uses of Funds
Off-balance-sheet Business
Regulation and Prudential Supervision
Background to Capital Adequacy Standards
Basel II Capital Accord
Liquidity Management and Other Supervisory Controls
Summary

232

Regulation and Prudential supervision

The GFC has focussed attention on the regulation of the financial

system
A number of financial institutions collapsed during the crisis
The five largest U.S. investment banks, with combined liabilities
or debts of $4 trillion, either went bankrupt (Lehman Brothers),
were taken over by other companies (Bear Stearns and
Merrill Lynch), or were bailed-out by the U.S. government (
Goldman Sachs and Morgan Stanley) during 2008
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

2.5

Regulation and Prudential Supervision

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

234

2.5

Regulation and Prudential Supervision (cont.)

Australian regulatory structure

Reserve Bank of Australia (RBA)
System stability and payment system

Australian Prudential Regulation Authority (APRA)

Prudential regulation and supervision of depository institutions,
insurance offices and superannuation funds

Australian Securities and Investments Commission (ASIC)

Market integrity and Investor protection

Australian Competition and Consumer Commission (ACCC)

Competition policy

2
35

Chapter Organisation
2.1
2.2
2.3
2.4
2.5
2.6
2.7
2.8
2.9

Main Activities of Commercial Banking

Sources of Funds
Uses of Funds
Off-balance-sheet Business
Regulation and Prudential Supervision
Background to Capital Adequacy Standards
Basel II Capital Accord
Liquidity Management and Other Supervisory
Summary

Controls

236

Background to Capital Adequacy Standards

The business activities of financial institutions will inevitably

involve the need to write-off of 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 II and III
define the minimum capital adequacy for a bank
The standards are designed to promote stability within the
financial system

2.6

Background to Capital Adequacy Standards

Functions of capital
The source of equity funds for a corporation
Provides equity funding for growth
Demonstrates shareholders commitment to the organisation
Write-off periodic loan losses of defaulting borrowers that exceed
profits

The evolution of the international financial system led to

development of international capital adequacy standards

1988 Basel I capital accord and Basel II (2008) capital adequacy
guidelines
Basel III (2010)

238

Basel 1
Globalisation of banking system i.e. Bank Capital adequacy

needed?
The committee (G10) worked on the adequacy of banks capital
and on the development of a common minimum standard of
capital adequacy that international bank should maintain The
international Convergence of Capital measurement and Capital
Standards
Basel 1 capital accord applied a standardised approach to the
measurement of the capital adequacy of banks

Tier 1 capital
Tier 1 capital or core capital, consists of the highest quality

capital elements which fully satisfy all the essential capital

characteristics:
Provide a permanent and unrestricted commitment of funds
Freely available to absorb losses
Do not impose any unavoidable servicing charge against earnings
Rank behind the claims of depositors and other creditors in the
event of winding up

Tier 1 capital must comprise at least half of a banks minimum

required capital

Tier 2
Tier 2 or supplementary, capital includes other elements which,

to varying degrees, fall short of the quality of Tier 1 capital. Tier 2

capital is divided into two parts
Upper Tier 2 capital, which consists of elements that are
essentially permanent in nature, including some hybrid capital
instruments
Lower Tier 2 capital, which consists of instruments that are non
permanent that is, dated or limited-life instruments

Definition of capital

242

Chapter Organisation
2.1
2.2
2.3
2.4
2.5
2.6
2.7
2.8
2.9

Main Activities of Commercial Banking

Sources of Funds
Uses of Funds
Off-balance-sheet Business
Regulation and Prudential Supervision
Background to Capital Adequacy Standards
Basel II Capital Accord
Liquidity Management and Other Supervisory
Summary

Controls

243

Basel II structural framework

244

2.7

Basel II Capital Accord

Basel I capital accord applied a standardised approach to the

measurement of the capital adequacy of banks. Basel I was

successful in increasing the amount of capital held by banks
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 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

245

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%

246

Basel II structural framework (cont.)

Pillar 1Capital adequacy

Credit riskrisk that borrower will not meet commitments when

due. Three measures:

Standardised approach
i.

Risk weights applied to balance-sheet and OBS items to calculate

minimum capital requirement

ii.

Risk weights derived from external rating grade or supervisor (see

www.apra.gov.au APS112)

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

2
47

Basel II structural framework (cont.)

Pillar 1Capital adequacy (cont.)
Credit risk (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 transactionscredit conversion factor can be
determined by:
current exposure methodcurrent and potential credit exposures markto-market (contract revalued by its current quoted price)
original exposure methodnotional contract value multiplied by a credit
conversion factor

2
48

Capital adequacy requirements (cont.)

Standardised approach -Risk Weighting of Balance Sheet Assets
Asset risk weightings are based on the counterparty to the transaction
0%
notes and coins, claims against central
governments and central banks
20%
claims against local governments,
domestic banks and international banks
50%

loans secured by residential mortgages

100%
all other assets and claims against
counterparties

249

Capital adequacy requirements (cont.)

Application of Asset Risk Weightings

Asset type

Cash and cwth govt

securities
Loans to local govt
Housing loans
Loans to corporations
TOTAL
47 000

Asset value

Risk weight

($billion)

(%)

2 000
1 000
24 000
20 000

Risk-weighted asset
value ($billion)

0
20
50
100

0
200
12 000
20 000
32 200

Total capital requirement:

8% x $32 200 billion = $2576 billion
Tier 1 capital requirement:
$32 200 x 4% = $1288 billion

To fund these assets, the bank requires $2576 in capital. The remaining $44 424 billion could be
raised as liabilities

250

Capital adequacy requirements (cont.)

OBS Credit Conversion

OBS items

Face value
of contract ($m) factor (%)

Credit conversion
Equivalent ($m)

Credit

Financial guarantees issued

on behalf of corporations
Performance bonds for
state governments
Housing loan approvals
Documentary letters of credit
issued for corporations
TOTAL
3450

700

100

700

500

50

250

2000
250

100
20

2000
50
3000

The asset risk-weightings are then applied to the credit equivalent column (as per the onbalance-sheet items)

251

Operational risk
Operational risk is defined as risk of loss from inadequate or

failed internal processes, people and systems or from external

events
Internal and external fraud
Employment practices and workplace safety
Damage to physical assets
Business disruption and system failure
etc

Market Risk
Market risk is split into two components
General market risk
Changes in the overall market for interest rates, equities, foreign
exchange and commodities

Specific market risk

The risk that the value of a security will change due to issuer specific
factors e.g. creditworthiness of the issuer

A measurement for market risk value at risk models

VaR a statistical probability model that measures financial risk
exposures.

Basel II structural framework (cont.)

Pillar 2Supervisory 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

2
54

Basel II structural framework (cont.)

Four key principles of supervisory review
Principle 1 : Banks should have a process for assessing their overall

capital adequacy in relation to their risk profile and a strategy for

maintaining their capital levels
Principle 2: Supervisors should review and evaluate banks internal
capital adequacy assessments and strategies, as well as their ability to
monitor and ensure their compliance with regulatory capital ratios.
Supervisors should take appropriate supervisory action if they are not
satisfied with the result of this process
Principle 3: Supervisors should expect banks to operate above the
minimum regulatory capital ratios and should have the ability to require
banks to hold capital in excess of the minimum
Principle 4: Supervisors should seek to intervene at an early stage to
prevent capital falling below the minimum levels required to support the
risk characteristics of a particular bank and should require rapid
remedial action if capital is not maintained or restored.

Basel II structural framework (cont.)

Pillar 3Market discipline
Aim is to develop discloure 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 relating to principal parts of Pillars I and II

2
56

Basel 3
Basel III was developed in 2010.
aims to enhance the risk coverage of the Basel II framework by
enhancing capital adequacy requirements

Basel II structural framework

258

Chapter Organisation
2.1
2.2
2.3
2.4
2.5
2.6
2.7
2.8
2.9

Main Activities of Commercial Banking

Sources of Funds
Uses of Funds
Off-balance-sheet Business
Regulation and Prudential Supervision
Background to Capital Adequacy Standards
Basel II Capital Accord
Liquidity Management and Other Supervisory
Summary

Controls

259

2.8
Liquidity Management and Other Supervisory
Controls
Liquidity risk unable to access 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 banks internal liquidity management practices
APRA reserves right to specify minimum level of liquid assets

260

Liquidity management strategy

APRA states that a liquidity management strategy must include

the following elements:

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

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
OBS transactions are a major part of a banks business and include
direct credit substitutes
trade and performance-related items
commitments
market rate-related transactions

APRAs bank prudential supervision requirements include capital

adequacy, liquidity management and other controls

262