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Commercial Banks

Main type of financial institution

o Take deposits from customers and invest by making loans to customers
o Compete in global capital markets to raise funds in addition to depositor base liability
management (borrows funds to meet forecast loan demand)
Significant proportion of financial assets within financial system

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
Consolidated corporate entities increases total asset share and dominance

Products and services include:

Balance Sheet Transactions: assets (e.g. loans), liabilities (e.g. deposits) and shareholders
funds (equity)
Off-Balance-Sheet Items: contingent liabilities transactions that do not appear on the
balance sheet

Example: provision of risk management products, using over-the-counter and exchange-traded derivative
Main Activities of Commercial Banking
Banks have progressed from asset management to liability management
Due to regulation:

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

A result of removal of restrictive regulation:


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

No longer dependent on deposit base for lending

Can manage liability base by borrowing directly from domestic and international
capital markets
Can borrow substantially as major banks have high credit ratings

Sources of Funds (either liabilities or equity funds)

Commercial banks are highly leveraged organisations

Large percentage in form of debt liabilities must be repaid
Rest is equity

1. Current Account Deposits

One of most liquid instruments

Stable source of funds for banks
Continual transactions of goods and services
Deposits are maintained and create ongoing funding source
Interest paid is low reflects highly liquid nature
Funds held in cheque account facility
Deposits in cheque account provide liquidity used directly in payment for goods and
Holder can write order that instructs bank to pay funds to payee

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

Holders usually receive interest payments

Low rate of return as of highly liquid nature and low risk
Stable source of funds for banks (as individuals collective desire to hold funds in
Transaction and account service fees

Examples: traditional passbook account, electronic statement account (records transactions and sends
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

Funds lodged in account with bank for specified period of time

Funds receive fixed rate of interest for period of investment
Saver nominates term to maturity at time of investment

4. Negotiable Certificates of Deposit

CDs: Certificates issued by bank undertaking to pay bearer face value of CD at specified maturity date
(180 days)

Principal domestic money-market instrument term to maturity range up to 180 days

Source of short-term funding
No interest payments
Sold at discount to face value discount security
Does not directly affect amount of funds available to issuing bank as only repaid at
Selling during term is just change of ownership

Differences from other deposits:

1. Issue CD directly to money market
2. Negotiable security
Secondary market for CDs is deep and liquid in money markets
Ordinary CD purchaser sells CD in secondary market to another party
Holder of CD receives face value from bank at maturity date
3. Yields can be quickly adjusted as banks funding requirements change
o Useful for liability management
o Rate of return can be changed from one transaction to another flexible
5. Bills Acceptance Liabilities

Discount security sold at price less than face value

Does not pay interest
Return to holder = difference at which it is sold before maturity/face value at maturity
price at which bill is bought

Commercial banks have the roles as either:

1. Acceptor of Bill (bill of exchange becomes bank-accepted bill)
Business issues bill at discount
Bank puts name on the bill acceptor
Acceptor repays face value of bill at maturity to holder (on behalf of issuer)
Increases creditworthiness
Bank has separate arrangement to ensure it recovers funds from issuer on maturity date
Fee is charged
2. Bank discounts bill
Bank discounts and buys bills from issuer
Bank sells (re-discount) bill immediately into money market
Incurs liability
Acceptance commitment: agreement to repay face value to holder at maturity
By selling into money market, bank arranges finance for customer without
having to use its own funds****
6. Debt Liabilities

Longer-term debt instruments issued directly in local capital markets

Majority of banks assets are longer term loans
Banks must actively borrow from capital markets to fund part of lending

Medium to long-term instruments (that pay interest):

1. Debentures: bonds with form of security attached - collateralised floating charge over assets of
2. Unsecured notes: bond with no security attached
3. Transferable certificates of deposit: long-term fixed-rate instruments/ bonds issued with
minimum face value of $100 000 and terms to maturity of 3-5 years
Note that for bonds:

Bonds pay regular interest coupon to holder

Principal is repaid at maturity date
Periodic interest payments may be fixed interest rate or variable rate

7. Foreign Currency Liabilities

Note that: Deregulation of financial system

Floating of exchange rate of major currencies

Opening up of foreign exchange markets
Removal of most restrictions on flow of capital in international markets

Important source is large international capital markets

Issue foreign-currency denominated debt securities

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

8. Loan Capital and Shareholders Equity

Loan capital (includes hybrid securities):

Another source of funds

Characteristics of both debt and equity

Example: Bank issues subordinated 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


Important source of long-term funds for commercial banks

Main type: ordinary shares
Equity securities (e.g. ordinary shares) are issued on stock exchange or profits generated by
business activities
o Some profits paid as dividends or retained as additional shareholders funds

Uses of Funds (assets)

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

Receives periodic interest payments and repayment of principal

1. Personal and Housing Finance

Largest bank lending form is owner-occupied housing

Housing Finance

Bank registers a mortgage over property as security for loan

Risk of default by borrower is low
o Because: if borrower does not meet loan commitments, bank will take possession of house
and sell to recover amount owing
o Borrower will try to meet housing loan commitments
Interest rates are fixed or variable

Insurance offices and superannuation funds, mortgage originators also provide housing loan
finance creates competition

Securitisation: (Finances lending activities)

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

Investment Property Finance

Bank provides funds to individual investor who purchases property for rental or leasing
o Takes registered mortgage over property as loan security

Fixed-term loan
Example: borrowers who want to purchase car or travel overseas

Interest rates fixed or variable

Bank requires security e.g. guarantee to support loan

Personal overdraft

Allows individual to put nominated account into debt up to an agreed limit

Manage mismatch in timing of cash flows
o Personal overdraft allows them to pay expenses when due
Expects overdraft to be brought to credit when individual receives income

Credit card facility

More flexible alternative to personal overdraft

Credit card conducts electronic transactions e.g. ATMS and EFTPOS
Card user draws against predetermined credit limit
High interest rates on used credit, with transaction and other fees

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

Term Loan (main loan provided to firms)

o Maturities ranging from three to seven years

o Business borrowers negotiate terms and conditions with bank
Offers both short-term and long-term loans
Interest rates can be fixed or variable set to specific reference rate e.g. bank bill swap rate
BBSW (average midpoint of banks bid and offer rates in secondary bill market)


Enables business to manage mismatches in timing of cash flows

Businesses can place operating account into debit up to agreed amount
Fees and interest is charged (as funding is very flexible)
Overdraft expected to be brought into credit as revenues are received

Rollover facility

Commercial bills have terms ranging from 30 to 180 days

Extends overall term of commercial bills (that are short-term)
New commercial bills can be withdrawn after the days of original bill, with n-year rollover
Yield on bills changes to reflect market current rates
o Bonds are re-priced - protects the bank from risk of interest rates changing
Bank bills money market is deep and liquid
o Flexibility for bank as:
o 1) Provide funding to business borrowers (discounting bills)
o 2) Option to sell bills easily in money market to generate more funds


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

Commercial banks lend to governments directly

o By investing in government-issued securities (e.g. Treasury notes, Treasury bonds)
o By providing loans (e.g. term loans and overdraft facilities)
Low level of risk , low rate of return

Treasury notes: short-term securities

o Treasury bonds: longer-term budget capital expenditures

Why invest in government securities when higher returns could be obtained by giving loans to other

Investment alternative to surplus funds of bank

Source of liquidity
Easily sold in secondary markets when funds are needed for further lending

Provides income streams and potential capital gains

Holding cash does not


Used as collateral to support banks own borrowings in direct finance markets

Improve quality of balance sheet with assets with lower-risk attributes
Flexibility to manage overall asset portfolio
Manage maturity structure and interest rate risk by purchasing and selling securities of
different maturities and interest rates (e.g. fixed, variable)

Off-Balance Sheet Business

(The first two involve the bank supporting or guaranteeing the obligation of client to third party)
94% of banks off-balance-sheet business is in market-rate-related contracts
1. Direct credit substitutes

Supports clients financial obligations

Bank does not finance from own balance sheet
Ensures client is able to raise funds direct from markets

Example: Issuance of stand-by letter of credit

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)

Letter of comfort written by bank to confirm that customer has sufficient funding in place to
proceed with project

2. Trade and performance-related items

Guarantees made by bank on behalf of its client support non-financial contractual

obligations (agreements to provide goods or services)

Bank will make payment to third party if client cannot


Documentary letters of credit (bank substitutes credit standing for client and authorises
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:

Banks contractual obligations to customers that are yet to be completed

Situations include: undertaking to advance funds to client, underwrite debt and equity issues,
purchase assets at future date


Outright forward purchase agreements

Bank contracts to buy specified asset from client at agreed exchange rate on specified
Repurchase agreements
Bank sells assets (e.g. government securities) and expected to repurchase at specified
Underwriting facilities
Bank guarantees client that it will cover any shortfall in funds received from primary
market issue of debt or equity securities
Loans approved but not yet drawn down
Bank agreed to provide borrower with loan at future date upon completion of loan
Credit card limit approvals not used by card holders
Example: If bank authorises credit card limit of $4000 for client, client uses $1000
$1000 is loan (asset)
$3000 remains as off-balance commitment

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


Forward exchange contracts

Bank contracts to buy or sell at future date a specified amount of foreign currency at
exchange rate set today
Currency swap
Bank exchanges principal amount and ongoing associated interest payments denominated
in foreign currency
Forward rate agreements
Compensation agreement between bank and client based on notional principal amount.
One party compensates other party if interest rates move above or below agreed
interest rate
Interest rate futures contract
Exchange-traded agreements to buy or sell specified security at predetermined future date
Interest rate options contract
Provide right but no obligation to buy or sell a specified financial instrument at agreed
date or price
Equity contracts
Futures and options contracts based on specified stock prices or stock indices
Locks in equity price today that will apply at specified future date


Notional value of off-balance sheet business is greater than value of business-sheet assets for
Off-balance sheet business is mainly market-rate-related contracts
Major commercial banks conduct the largest share of off-balance sheet business

Regulation and Prudential Supervision of Commercial Banks

Mainly, to maintain soundness and stability of the financial system

Ensure savers have confidence in institutions

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)

Prudential regulation and supervision of authorised deposit-taking institutions, insurance

offices, superannuation funds
3. ASIC (Australian Securities and Investments Commission)
o Regulation and supervision of market integrity and consumer protection
4. ACCC (Australian Competition and Consumer Commission)
o Matters of competition policy

Capital adequacy requirement: commercial banks are required to source minimum percentage
of funds from capital (to meet obligations)


If there are loan losses, they need to be written off profit

If losses exceed profits, it needs to be written against capital (not liabilities as banks need to
repay liabilities when due)

Functions of Capital:

Source of equity funds

Demonstrates shareholders commitment to organisation
Enables growth in business and source of future profits
Necessary to write off periodic abnormal business losses

Basel I (1988)

Standardised approach to measurement of capital adequacy

Increased amount of capital held by banks

Focused primarily on level of credit risk associated with banks balance sheet and off- balance
sheet business


Credit risk: risk that counterparties to transaction will default on commitments

Market risk: exposure of institutions trading book to changes in interest rates and foreign
currency exchange rates

Basel II (2008)

More sensitive to different levels of risks

Requires 8% capital ratio of total risk weighted assets
At least half of the ratio must be Tier1 Capital, remainder is held as Upper Tier 2 and Lower
Tier 2 capital
Need to maintain level of capital above 8% to maintain and expand business activities
Minimum capital adequacy requirements apply to commercial banks and other institutions
specified by prudential regulator

Main Elements
1. Credit risk


Market risk
Operational risk
Form and quality of capital,
Risk identification, measurement and management
Transparency of related information and data

Tier 1 Capital: highest quality capital elements


Provide permanent and unrestricted commitment of funds

Freely available to absorb losses
Does not impose any unavailable serving charge against earnings
Rank behind claims of depositors and other creditors in event of winding up

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
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)

Require additional capital to achieve business growth

o Obtaining additional capital on short notice is more costly
International banks require higher level of capital to enhance credit ratings
Dynamic business changes will fluctuate capital requirements
o Can be exposed to specific risks not taken into account
Failure to maintain minimum capital requirement
o Can trigger legislative or supervisory corrective action

Basel II Structural Framework

Pillar 1: Capital adequacy minimum requirements
1. Credit risk: risk that counterparties to a transaction will default on commitments
o Relates to underlying counterparty to balance-sheet asset or off-balance sheet transaction
Methods to measure Credit Risk:
1. Standardised Approach (reflects regulators views about credit risk)
o Assign risk weight to each balance asset and off-balance-sheet item

Based on external rating published by approved credit rating agency, or fixed

weight specified by prudential supervisor
Off-balance sheet exposures converted to balance-sheet equivalents
Using specified credit conversion factors
Assigned risk weights
Risk-weighted amount = current book value x relevant risk weight
Risk weight derived from external rating grade or specified by regulator

External Credit Assessment Institutions

1. Standard & Poors Corporation

2. Moodys Investors Service
3. Fitch Ratings
(Credit rating: opinion of creditworthiness of issuer of debt or equity)

External Rating Grade & Risk Weight

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

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

1. Foundation Internal Ratings-Based Approach


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. Advanced Internal Ratings-Based Approach

Bank must provide own estimates of all credit risk components

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

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

Standardised Approach (in calculating amount of capital needed)


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)

Total operational risk capital requirement is sum of average results

3. Market risk: risk of losses resulting from movements in market prices

o Required to divide assets to banking book or trading book
o Must hold market risk capital against interest rate risks, equity risks, foreign exchange
and commodity risks, and credit derivatives arising from trading book
1. General market risk: changes in overall market for interest rates, equities, foreign exchange and
2. Specific market risk: risk that the value of security will change as a result of issuer-specific
factors e.g. change in creditworthiness of issuer
o Relevant to only interest rate and equity positions
Internal Model Approach (must be approved by supervisor)

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

Pillar 2: Supervisory review of capital adequacy


Ensures banks have sufficient capital to support all risk exposures

Encourage banks to develop improved risk management policies and practices

Especially for risks not covered in pillar 1

Compliance by banks with minimum standards and disclosure requirements

Pillar 3: Market discipline, incorporating disclosure and transparency requirements


Encourage market discipline developing set of transparent disclosure requirements

Allows all market participants to assess information relating to capital adequacy,
risk exposure and risk management of institution
Through transparency, market discipline can reinforce regulatory process
Example: market discipline reflected in rise or fall in share price

Liquidity Management and Other Supervisory Controls

Liquidity: access to funds that enable institution to meet business operating commitments
Example: bank approving loan to customer needs to provide funds at settlement date; bank must have
funds available for depositor of demand account
Liquidity Issues
1. Mismatch in terms to maturity of balance-sheet assets, liabilities and timing of cash flows
Sources of funds are relatively short term
Sources of funds need to be repaid sooner than loan assets liquidity risk exposure
2. Role of banks in payments system
Banks need funds available for transactions of customers
Must hold sufficient cash or access to sources of liquidity
Cash holdings do not provide return on funds no incentive to hold excess cash
Bank invests in securities provides return on investment, easily sold in secondary
market to convert to cash if needed
Examples of liquid securities: cash, government securities, semi-government securities, money market
Liquidity Management Strategy

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