Chapter 2 Commercial Banks1

Chapter 2- Commercial Banks

Main activities of a Commercial Bank
Commercial bank products and services include balance sheet items and non-balance sheet items
(contingent liabilities- depending on the context).

Asset management: It is practised in a highly regulated environment. The banks restricted their loan
activity (assets) to match the available amount of deposits they received from customers.
Liability management: It is practised in a less regulated environment. Banks manage their liabilities
(sources of funds) and raise funds in the capital market to make sure they have sufficient funds to
meet future loan demands

Sources of Funds
This refers to where banks get their funds from. There are current, call, term, negotiable certificates
of deposit (CDs), bills acceptance, debt, foreign currency liabilities and loan capital/SE.
Current Account/call deposits (short-term and liquid sources)
Liquid funds that are held in a cheque account facility and can be used directly in the payment of
goods and services. This is a stable source of funds as individuals and businesses are continually
conducting transactions for goods and services and are not likely to switch to other banks. Call
deposits- funds are available in demand and this is usually known as the saving accounts.

Term deposits
Funds lodged in an account with a bank for a specified period of time, with a fixed interest rate
(higher than current account) to compensate the loss of liquidity.

Negotiable certificates of deposits (liquid)

It is a short term discount security issued by a bank to an investor and the bank will repay the face
value of the security at maturity. It is a negotiable security as the original purchaser of a CD may sell
it in the secondary market to other party, at anytime up to the maturity date.

Bill acceptable liabilities

The bank may act as acceptor to the bill or discount the bill. A bill s a discount security; sold at a
price that is less than the face value.
o The issuer of the bill may ask a bank to put its name on the bill (as guarantee) to increase the
creditworthiness of the bill in exchange for a fee. It is recorded as liabilities as the bank has the
responsibility to pay the $$ to the third party if the issuer of the bill couldn’t pay. Alternatively,
the bank can buy the bill and sell it to the market to earn revenue from interest differences.

Bank put name

Company A Sell to Market

Banks buy the bill to earn

interest differences

Debt liabilities
It is a medium-to-longer-term debt instruments issued by a bank. Debentures are bonds with a form
of security attached usually a collateralised floating charge over the assets of the institutions.
Unsecured notes is a bond issued with no supporting security
 Chapter 2 Commercial Banks2

Foreign currency liabilities

Large international markets are an important source of foreign currency liabilities as banks find it
easier to raise substantial amounts of debt in international capital markets at a lower price. It also
allows diversification of funding resources, facilitates the matching of foreign exchange
denominated assets

Loan capital
It is also known as hybrid capital. Instruments are subordinated which means that the holder of the
security will only be paid interest payments or have the principal repaid after the entitlements of all
other creditors have been paid.

Off-balance-sheet business
Direct credit substitutes
It is provided to support a client’s financial obligation. The bank does not provide the finance from its
own balance sheet but only effectively ensures that the client is able to raise funds direct from the
market by giving the third party its guarantee.
o The bank will have to make payment if the bank’s client fails to meet its financial obligation to
the party. Examples include guarantees, indemnities and letters of comfort issued by a bank that
have the effect of guaranteeing the financial obligations of a client.

Trade and performance related items

This is also guarantees made by a bank on behalf of its clients but they are made to support a client’s
non-financial contractual obligations. For example, documentary letters of credit: the bank authorise
payment to a third party against delivery and payments are made between the banks.
o Performance guarantee: the bank agrees to provide financial compensation to a third party if a
client does not complete the terms and conditions of a contract

Commitments
It refers to the contractual financial obligations of a bank that are yet to be completed or delivered.
This includes outright forward purchase agreements, repurchase agreements, underwriting facilities,
loans approved but not yet drawn and credit card limit approvals that have not been used by card
holders.

Foreign exchange contract, interest rate contract and other market rate related contracts
They involve the use of derivative products (e.g. futures, options, swaps and forward contracts)
which are designed to facilitate hedging against risk

Background to capital adequacy standards

The main assets accumulated by banks are its loans to customers and there is a possibility that
borrowers default in their loan payments. Loan losses are write off against capital and not liabilities.
Capital is important as it is the source of equity and enables growth in a business and is a source of
future profits

Basel I capital accord

It applied the standardise approach and was successful in increasing the amount of capital held by
banks and created a strong foundation to support the stability of the global financial system.
(focused more on credit risk)

Basel II capital accord- 3 Pillars

It extends Basel I further in which the new capital accord is much more sensitive to different level of
assets and OBS business risks that may exist such as credit risk, market risk, operational risk and the
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form/quality of capital held. The bank must maintain a minimum risk-based capital ratio of 8%, 4%
must be Tier 1 Capital (core) and the other 4% is Tier 2 (supplementary) – upper and lower Tier 2.

Pillar 1 Capital Adequacy

o Credit risk refers to the risk that borrower will not meet their commitments on loan repayments
when due. Basel II also applies a range of risk weightings that is based on an external rating
published by an agent or prudential supervisor
o Operational risk arises from day-to-day business activities such as internal/external fraud,
damaged to physical assets, business disruption and system failures. It is also defined as a risk of
loss from an inadequate or failed internal processes, people and systems.

o Market risk refers to risk of losses resulting from movements in market prices. Market risk can
be divided into general market risk (changes in overall market for interest rates etc) and specific
market risk. A measurement for market risk is VAR (value at risk model)

Pillar 2 Supervisory Review

o It ensures that banks have sufficient capital to support all the risk exposures and encourage
banks to develop and use improved risk management policies/practices in indentifying,
measuring and managing risk exposures.
o It encourages additional good risk management practice such as applying internal
responsibilities, delegations and exposure limits, increasing provision/reserves and
strengthening internal control and reporting procedures.

Pillar 3 Market Discipline

o Aim to develop a set of disclose requirements that allow market participants to assess important
information relating to the capital adequacy of an institutions. The other objective is to make
banks’ risk exposure, risk management and capital adequacy positions more transparent in order
to reinforce the regulatory process.