Chapter 2

1. 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

2. 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.)

3. 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

4. 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

5. 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 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.)

6. 2.1 Main activities of commercial banking (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.)

7. 2.1 Main activities of commercial banking (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

8. 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

9. 2.2 Sources of funds • 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.)

10. 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.)

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

12. 2.2 Sources of funds (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.)

13. 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 • 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.)

14. 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 (cont.)

15. 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 (cont.)

16. 2.2 Sources of funds (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)

17. 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

18. 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.)

19. 2.3 Uses of funds (cont.) • Personal and housing finance • Housing finance • Mortgage • Amortised loan • Investment property • Fixed-term loan • Credit card (cont.)

20. 2.3 Uses of funds (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.)

21. 2.3 Uses of funds (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.)

22. 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

23. 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

24. 2.4 Off-balance-sheet business • 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.)

25. 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.)

26. 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 of commercial contract by a bank client, e.g.: • documentary letters of credit • performance guarantees (cont.)

27. 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 (cont.)

28. 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 (cont.)

29. 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 • 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

30. 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

31. 2.5 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 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.)

32. 2.5 Regulation and prudential supervision (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.)

33. 2.5 Regulation and prudential supervision (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

34. 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

35. 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.)

36. 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)

37. 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

38. 2.7 Basel II capital accord • 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

39. 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%

40. Definition of capital (cont.)

41. Definition of capital

42. Basel II structural framework (cont.)

43. Basel II structural framework (cont.) • 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.)

44. Basel II structural framework (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.)

45. Basel II structural framework (cont.) • Pillar 1—Capital adequacy (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: • Foundation internal ratings-based approach (FIRB) • Bank determines probability of default and effective maturity but relies on supervisor estimates for other credit risk components • Advanced internal ratings-based approach (AIRB) • Bank provides estimates of all credit risk components (cont.)

46. Basel II structural framework (cont.) • Pillar 1—Capital adequacy (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.)

47. Basel II structural framework (cont.) • Pillar 1—Capital adequacy (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 (cont.)

48. Basel II structural framework (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.)

49. Basel II structural framework (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

50. 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