Commercial Banks

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  2012 McGraw-Hill Australia Pty Ltd

PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips 2-1
Slides prepared by Peter Phillips
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
(cont.)

Learning objectives (cont.)
• Understand the background and application of the
capital adequacy standards
• Examine liquidity management and other controls
applied by APRA
• Understanding the standardised approach to credit risk
• Analyse business continuity risk
• Discuss the importance of corporate governance and
ethics in the context of Australian financial institutions

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 standards
2.7 Basel II capital accord
2.8 Liquidity management and other supervisory
controls
2.9 Summary

• 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 practice
‘liability management’ whereby shortfalls in loan demand are
borrowed on the capital markets
– The regulation of the banking sector attracted renewed
attention following the GFC
(cont.)

(cont.)
• 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
(cont.)

(cont.)
• Asset management (−1980s)

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

– 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

2.3 Uses of funds
controls
2.9 Summary

• 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.)

2.2 Sources of funds (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
– E.g. 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
(cont.)

• 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)

2.3 Uses of funds
2.5 regulation and prudential supervision
2.6 background to capital adequacy standards
controls
2.9 Summary

2.3 Uses of funds
• Uses of funds appear in the balance sheet as assets
• 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
(cont.)

2.3 Uses of funds (cont.)
• Personal and housing finance

– Housing finance
▪ Mortgage
▪ Amortised loan
– Investment property
– Fixed-term loan
– Credit card
(cont.)

• 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.)

• Commercial lending (cont.)

– 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.)

• 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

2.3 Uses of funds
controls
2.9 Summary

• 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.)

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 required to make a payment only if the client defaults on
a payment to a third party
(cont.)

• 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, e.g.:
▪ documentary letters of credit
▪ performance guarantees
(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
(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
(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 5 times the
total value of assets held by the banks

2.3 Uses of funds
controls
2.9 Summary

• The GFC has focussed attention on the regulation of
the financial system
• 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.)

(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.)

(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

2.3 Uses of funds
controls
2.9 Summary

2.6 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
(cont.)

2.6 Background to capital adequacy
standards (cont.)
• 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 capital accord and Basel II (2008) capital
capital adequacy guidelines
– Basel III (2010)

2.3 Uses of funds
controls
2.9 Summary

• 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

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 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%

Definition of capital
(cont.)

Definition of capital

Basel II structural framework
(cont.)

Basel II structural framework (cont.)
• Pillar 1—Capital adequacy
– Credit risk—risk 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
(cont.)

• Pillar 1—Capital adequacy (cont.)

– Credit risk (cont.)
▪ Standardised approach (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 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 (cont.)

▪ 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
(cont.)

– Operational risk—risk of loss from inadequate or failed

internal processes, people and systems, or external events
▪ E.g. 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

(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

i. Internal model—requires a statistical probability model that
measures financial risk exposures, i.e. value at risk (VaR)
ii. Standardised approach
(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
▪ 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 II recommends a range of qualitative and quantitative

information disclosure relating to principal parts of Pillars I and
II

Basel III
• Basel III was developed in 2010.

– aims to enhance the risk coverage of the Basel II framework
by enhancing capital adequacy requirements
– Banks will face their first tests under Basel III in 2013
– It is generally accepted that Australian ADIs are well-placed
to meet the requirements of the Basel III
• The exact nature of APRA’s treatment of Basel III is still
being worked out. Discussion papers and details are
available on the APRA website

2.1 Main Activities of commercial banking
2.3 Uses of funds
controls
2.9 Summary

2.8 Liquidity management and other
supervisory controls (cont.)
• Liquidity—access to sources of funds to meet day-to-day
expenses and commitments
– Banks have special liquidity problems owing 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 (APRA)
▪ 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 balance-sheet and OBS activities
▪ Emphasis on banks’ internal liquidity management practices
▪ Strategy must include a contingency plan
▪ APRA reserves right to specify minimum level of liquid assets
▪ Going concern and crisis scenario liquidity management strategy

• APRA’s liquidity standard APS210 aims to ensure that
banks to not face a situation where they have
insufficient funds to meet their obligations
• Basel III introduces a number of reforms to liquidity
standards. The first of these (the LCR) will become
effective in 2015
• The most important of these reforms are the Liquidity
Coverage Ratio (LCR) and the Net Stable Funding
Ratio (NSFR)
• The requirement will be for these ratios to exceed 100
percent. In the case of the LCR, this means that banks
will have to allow for a 30 day ‘survival horizon’

• This requirement will be several times stricter than the
existing APRA liquidity standards. APRA’s current
standards allow for a 5 day survival horizon (i.e.
Enough liquidity to survive a 5 day period of acute
stress)
• Other regulatory and supervisory controls:
– Risk management systems certification
– Business continuity management
– Audit
– Disclosure and transparency
– Large exposures
– Foreign currency exposures
– Ownership and control
2.3 Uses of funds
controls
2.9 Summary

2.9 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.)

2.9 Summary (cont.)
• 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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– High level of regulation prior to the mid-1980s constrained

– Largest share of assets of all institutions, but understated

Copyright  2012 McGraw-Hill Australia Pty Ltd

• Asset management (−1980s)

• Liability management (1980s−)

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• Sources of funds appear in the balance sheet as either

• Banks offer a range of deposit and investment products

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• Current account deposits

• Call or demand deposits

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• Negotiable certificates of deposit (CDs)

– Paper issued by a bank in its own name

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• Bill acceptance liabilities

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– Medium- to longer term debt instruments issued by a bank

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– Debt instruments issued into the international capital markets

▪ Allows diversification of funding sources into international

▪ Facilitates matching of foreign exchange denominated assets

▪ Meets demand of corporate customers for foreign exchange

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– Sources of funds that have characteristics of both debt and

▪ Subordinated means the holder of the security has a claim on

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• Personal and housing finance

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• Commercial lending (cont.)

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• Other bank assets

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• OBS transactions include:

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• Direct credit substitutes

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• Trade- and performance-related items

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▪ Bank undertakes to advance funds or make a purchase of

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• Foreign exchange, interest-rate- and other market-rate-

– Also used for speculating

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

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• Reasons for regulation of banks

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– Australian Prudential Regulation Authority (APRA)

– Australian Securities and Investments Commission (ASIC)