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Chapter1: A modern financial system: an overview

Part Opener
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PART 1

FINANCIAL INSTITUTIONS

CHAPTER 1

A modern financial system: An overview

CHAPTER 2

Commercial banks

CHAPTER 3

Non-bank financial institutions

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Career opportunities in finance are enormous and they are available to you if you dedicate
yourself to learning and understanding how the financial institutions, instruments and
markets work. You should be excited that one day you may, for example, work in a
commercial bank in Hong Kong or Sydney, or an investment bank in London or New York,
or a multilateral government organisation in Paris or Washington, or a multinational
corporation anywhere in the world. Further, it does not matter where you live or study;
financial institutions, instruments and markets are essentially the same in all developed
countries. What you learn from this textbook will be relevant in the world of finance no
matter where your travels take you.

This textbook discusses the structure, functions and operations of a modern financial
system; that is, you are going to learn about financial institutions, financial instruments and
financial markets. Each nation-state is responsible for the structure and operation of its own
financial system; however, they form an integrated global financial system. Although
institutions, instruments and markets are fundamentally alike, they may be differentiated by
size, terminology, the level of government regulation and prudential supervision. For
example, in the UK the main type of financial instrument issued on the stock exchange is
called an ordinary share, whereas the same instrument issued in the USA is known as
common stock.

Internationalisation of the financial markets has, in part, occurred because of the


development of sophisticated technology-based information systems and product delivery
systems. This has allowed new products and markets to evolve, and an enormous increase
in the volume and speed of the flow of funds through the international financial markets. As
will be seen, the combination of globalisation, deregulation, technology and competition
has encouraged enormous innovation and change within financial institutions, instruments
and markets.

Much of what you will learn from this text is international in nature, but it will be
necessary at times to focus on the financial system of a particular nation-state. It is not
possible to look at the variations that occur in the financial systems of all nation-states.
Therefore, when necessary, reference will be made to the Australian financial system as it
has a modern, efficient and stable financial system that operates effectively within the
global financial system.

Think of a financial system as being a number of financial institutions and markets


through which funds move between lenders and borrowers. The institutions and markets
that facilitate this flow of funds develop the financial instruments and techniques that
encourage savings and investment. The financial system also provides the framework
through which central banks and prudential regulators influence the operations of
participants in the financial system. Most importantly, a central bank, through its monetary
policy initiatives, affects the level of interest rates, economic activity and business
performance.

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A financial system is essential in facilitating economic growth and future productive


capacity in a country. The provision of finance to business allows economic growth to
occur, which should lead to increased productivity, increased employment and a higher
standard of living. A modern, sound and efficient financial system encourages the
accumulation of savings that are then available for investment in productive capital within
an economy.

Chapter 1 presents an overview of a modern financial system and provides a context for
the more detailed studies that occur throughout the textbook. It introduces the main
categories of financial institutions, discusses the functions of financial markets and
provides an overview of the types of instruments that are created within the markets. At the
end of Chapter 1, three extended learning sections are provided: Globalisation of the
financial markets, The impact of the Asian financial crisis on the financial system and
Th e global financial crisis.

Chapter 2 provides a detailed analysis of the roles and functions of the commercial banks.
Commercial banks are the largest financial institutions providing savings, lending and a
wide range of other financial services for their customers. The assets, liabilities and off -
balance-sheet business of commercial banks are analysed in detail. At the end of the chapter
three extended learning sections are provided: The standardised approach to credit risk,
Business continuity risk management, and Corporate governance and ethics.

Chapter 3 extends the discussion of financial institutions further and looks at the
operations and significance of other types of financial institutions. In particular the chapter
considers investment banks, merchant banks, managed funds, superannuation funds, cash
management trusts, public unit trusts, life insurance offices, general insurance offices,
hedge funds, finance companies, general financiers, building societies, credit unions and
export finance corporations. At the end of the chapter an extended learning section is
provided: Project finance and structured finance.
Chapter1: A modern financial system: an overview

Chapter Opener
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LEARNING OBJECTIVES

LO 1.1 Explain the functions of a modern financial system.

LO 1.2 Categorise the main types of financial institutions, being depository financial
institutions, investment banks and merchant banks, contractual savings
institutions, finance companies and unit trusts.

LO 1.3 Define the main classes of financial instruments that are issued into the
financial system, that is, equity, debt, hybrids and derivatives.

LO 1.4 Discuss the nature of the flow of funds between savers and borrowers,
including primary markets, secondary markets, direct finance and
intermediated finance.

LO 1.5 Distinguish between various financial market structures, including wholesale


markets and retail markets, and money markets and capital markets.

LO 1.6 Analyse the flow of funds through the financial system and the economy and
briefly discuss the importance of stability in relation to the flow of funds.

EXTENDED LEARNING

LO 1.7 Appreciate the importance of globalisation of the international financial


markets.

LO 1.8 Understand the eff ects and consequences of a financial crisis on a financial
system and a real economy.

CHAPTER OUTLINE

1.1 Functions of a financial system


1.2 Financial institutions
1.3 Financial instruments
1.4 Financial markets
1.5 Flow of funds, market relationships and stability

Introduction
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The development of financial markets has made the exchange of value for goods and
services much easier. The introduction of money into the exchange process increases the
speed and efficiency with which transactions take place. The use of monetary value also
makes it easier to save surplus funds. In order to receive a return on these accumulated
savings, they are usually lent to individuals, businesses and governments to finance
investment in capital projects and/or for consumption spending.

Like the economic system in general, financial markets are sometimes characterised by
high levels of volatility. These periodic bursts of volatility send market participants running
for cover as the capital values of investments suddenly appear to have been overestimated.
The ensuing liquidation and crisis is the market's remedial action to correct the
miscalculations of the preceding economic boom. In the modern financial system, this
liquidation can take place at terrifying speed. Although the particular circumstances of each
crisis are unique, we can be sure that at the depths of a crisis there will be calls for a review
of the ways in which the financial system is regulated.

To ensure the soundness and stability of a financial system, nation-states establish


legislation and regulatory authorities responsible for the prudential supervision of the
financial system. The soundness and stability of the financial system and the role of
financial regulation are issues that have acquired even more significance following the
global financial crisis (GFC)the global financial crisis (GFC) refers to the financial
crisis of 2008 that has been traced to the collapse of the housing market in the United
States and the consequences of that collapse for the market for mortgage-related
securities . The GFC produced a number of regulatory and policy responses. Some of these
were directed to the problem of managing the ensuing economic recession while others
were directed at specific parts or activities of the financial system. As we shall see later in
this textbook, during the GFC the practice of short sellingthe sale of a financial product
that the seller does not own. The seller has a view to repurchasing the product at a lower
price was effectively banned in Australia for a period of time and only allowed to
recommence under a set of new and more restrictive regulatory guidelines. The response of
governments and their regulators to the GFC will be a topic of ongoing discussion for many
years. Anyone who doubts that this will be the case need look no further than the recent
intense focus on the role of central bankers' responses to the collapse of the dot-com boom
in 2000 in sowing the seeds for the GFC almost a decade later. The reduction of interest
rates and their maintenance at very low levels following the dot-com collapse has been
criticised for inflating values in the real estate market. The subsequent decline in real estate
prices from these over-inflated levels is widely viewed as the proximate cause of the GFC.

We have already introduced some very important issues. Before progressing further, we
should consider the evolution of markets. Markets are the process that facilitate the
exchange of things of value. These things of value are often categorised as real assets, such
as a house or a car, and financial assets, such as a loan to buy a house or a car. Although
such transactions can take place without a formal marketplace, non-market exchanges can
be very time consuming and difficult to carry out.

Imagine how difficult it would be to have to own a cow in order to obtain milk, or to have
to drive to a farm every morning to obtain milk. Consider the whole range of goods and
services that are consumed and used every day. Without markets, people could spend their
whole time seeking out those things they require but do not produce themselves. It would
be necessary to find someone who had produced a surplus of what we wanted and who, in
turn, wanted what we had produced in surplus amounts. The development of village and
regional marketplaces helped to overcome the problem. Markets brought people together
and enabled the double coincidence of wants that is necessary before an exchange can take
place.

The role of a marketplace extends beyond bringing people together who wish to exchange
one good or service for another. Having located the right person in the marketplace, the
next problem is the need to establish the rate of exchange (the price) at which the trade will
take place. This may cause a divisibility problem. What if a bag of potatoes that you want to
obtain from a trader is worth one-half of the left rump of a cow? It is simply not possible to
take a small piece of the cow and directly exchange it for the bag of potatoes. One way
around this problem is for the owner of the cow to specialiseto set up a butcher shop and
then hope that people will offer a range of products and services for parts of the butchered
cow.

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The evolution of financial markets solved the problem. Money, as a medium of exchange,
allowed markets in goods and services to become much more efficient. No longer was it
necessary to barter to exchange goods and services. Money can be defined as any
commodity that is widely accepted in a country as a medium of exchange.

The history of money is interesting. For example, when Australia was first settled by
Europeans, rum and tobacco were accepted as mediums of exchange. These days money
may be notes and coins issued by a nation-state as legal tender, a financial instrument such
as a cheque or digital money in the form of a credit card transaction or electronic funds
transfer.

The introduction of money has made it much easier for individuals to save their surplus
earnings. Saving may be defined as deferring consumption into the future. Therefore,
another attribute of money is that it can be used as a store of value. The funds saved by
surplus unitsthose savers with current excess fundscan be put to use by those whose
current demand for goods and services is greater than their current available funds. Such
users of funds are called borrowers or deficit units.

Just as the exchange of goods and services can be carried out more efficiently through
organised markets, so too can the exchange of money or value between surplus units and
deficit units. Financial institutions and markets facilitate financial transactions between the
providers of funds and the users of funds.

When a financial transaction takes place it establishes a claim to future cash flows. This is
recorded by the creation of a financial asset on the balance sheet of the saver. The financial
asset is represented by a financial instrument that states how much has been borrowed, and
when and how much is to be repaid by the borrower. For example, if you invested money in
a term deposit with a bank, the bank would issue a term deposit receipt to you. This is a
financial instrument. The receipt would specify how much you had invested, the rate of
interest to be paid, when interest payments are due, and when the amount invested had to be
repaid by the bank. The interest payments and principal repayment are claims to future cash
flows.

Buyers of financial instruments are lenders that have excess funds today and want to
invest and transfer that purchasing power to the future. The sellers of the instruments are
those deficit units that are short of funds today, but expect to have a surplus amount in the
future which will enable the repayment of the current borrowing.

A principal role of financial institutions and markets is to bring together providers of


funds (savers) with users of funds. The flow of funds and the relationship between savers
and users of funds, and the place of the financial markets in the flow, are shown in Figure
1.1. Once it is understood why financial markets have evolved, it is possible to consider the
major functions served by a modern financial system.

FIGURE 1.1 FINANCIAL MARKETS AND FLOW OF FUNDS


RELATIONSHIP
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REFLECTION POINTS

A financial system encourages savings, provides funds for investment and facilitates
transactions for goods and services.
Historically, financial markets have exhibited periods of extraordinary volatility. The
GFC is a recent and prominent example of the volatility that can characterise the
financial markets.
Economic and financial transactions are valued in money terms. Money is a universally
acceptable medium of exchange and a store of value.
A financial instrument establishes an entitlement to future cash flowsfor example,
the receipt of interest and return of principal on a bank term deposit.

1.1 Functions of a financial system


A financial systemcomprises a range of financial
institutions, instruments and markets; overseen by
LEARNING
central bank; supervised by prudential regulator OBJECTIVE 1.1
comprises a range of financial institutions,financial
instrumentsissued by a party raising funds, Explain the functions of a
acknowledging a financial commitment and entitling modern financial system
the holder to specified future cash flows and
financial markets which interact to facilitate the flow
of fundsmovement of funds through a financial
system through the financial system. Overseeing the
financial system, and sometimes taking a direct role,
is the central bank and the prudential supervisor.

The decision to save allows surplus units savers or providers of funds; funds are
available for lending or investment to transfer some of today's income to the future when it
can be used for consumption. Therefore, savings allow consumption in the future to be
independent of future levels of earned income. Surplus entities invest their savings through
the purchase of financial instruments which are expected to improve their overall wealth.

The expectation of the saver is to earn a positive rate of returnthe financial benefit
gained from investment of savings; expressed in percentage terms . However, there are
other factors that savers should consider; otherwise all savers would only purchase financial
instruments that offered the highest rate of return. Providers of funds should consider their
own particular needs when they purchase or invest in assets. This will affect the expected
rate of return. It is useful to think of an asset, whether it is a real asset such as an investment
property or a financial asset such as a bank term deposit, as being a package of four main
attributes:

return or yield the total financial benefit received (interest and capital gain) from an
investment; expressed as a percentage
riskthe possibility or probability that an actual outcome will vary from the expected
outcome; uncertainty
liquidity access to cash and other sources of funds to meet day-to-day expenses and
commitments
time-pattern of cash flows the frequency of periodic cash flows (interest and
principal) associated with a financial instrument

With a real asset such as an investment in a residential unit, return is the regular rental or
lease payments received, plus any increase in the value of the property over time (capital
gain). Risk relates to uncertainty and probabilities such as the failure of the tenant to make
rental payments or the possibility that the property may be burnt down. The liquidity of the
residential unit is the ease with which it can be sold. Finally, the time-pattern of the cash
flows will vary depending on the frequency of the rental payments, the cost of maintenance
and the payment of other expenses such as insurance and rates.

In the case of a financial asset, such as the purchase of shares in a corporation, return
consists of the dividends received and the capital gains or losses made through movements
in the share price on the stock exchange. Note that a dividend is the portion of corporation
profits periodically paid to the shareholder; a stock exchange is where corporation shares
are bought and sold. Risk is measured by the variability of the expected returns and, in the
extreme, the possibility that the corporation may fail.

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The liquidity of the shares relates to the ease with which they can be sold on the stock
exchange at the current market price. Finally, the time-pattern of the cash flows expected
from the shares depends on the profitability and dividend policy of the corporation.
Typically, a profitable corporation will pay dividends to shareholders twice a year.

It is reasonable to assume that the average person likes return and liquidity, dislikes risk
and prefers reliable cash flows. Fortunately, the preferences of savers with regard to these
four attributes are not identical. If they were, all savers would seek to place all of their
savings with very few borrowers. Since preferences are not identical, financial institutions
and markets provide an enormous range of investment opportunities that have different
levels of return, risk, liquidity and timing of cash flows.

Individuals and businesses may be categorised as being risk averse, risk neutral or risk
takers. More risk averse individuals will accept lower expected returns for bearing lower
levels of risk. If the level of risk increases, they expect to be compensated with higher
expected returns. It is usual to assume that individuals and businesses are risk averse to
some degree. They do not avoid risk entirely but they do demand a higher return for bearing
higher risk. Furthermore, savers will accept various levels of liquidity or different timings
of cash flows associated with financial instruments. Participants in the financial markets are
therefore able to alter the composition of their financial asset portfolioa combination of
assets, each comprising attributes of return, risk, liquidity and timing of cash flows by
changing their preferences in relation to the four attributes of return (yield), risk, liquidity
and the timing of cash flows. An asset portfolio is the list of assets held by a saver.

A major function of the financial system is to facilitate portfolio structuring the buying
and selling of assets and liabilities to best meet current savings, investment and funding
needs and restructuring through the buying and selling of a wide range of financial
instruments. Financial institutions and markets provide the potential suppliers of funds with
the combinations of risk, return, liquidity and cash-flow patterns that best suit each saver's
particular portfolio needs.

To support decisions taken by both the providers of funds and the users of funds, the
financial system is also a provider of financial and economic information to market
participants. Information affects price and investment decisions; therefore the provision of
timely and accurate information is essential for an efficient financial system.

If a financial system is successful in creating a range of financial instruments that possess


different combinations of the four attributes valued by savers, this will encourage an
increased flow of savings. By encouraging savings, the financial system is important to
economic growth as the savings are available for investment capital which can be used for
the improvement of the productive capacity of an economy.

Not only can it be expected that a well-functioning financial system will increase the flow
of savings, but it can also be argued that an efficient financial system should ensure that
savings are more likely to be directed to the most efficient users of those funds. This
outcome further enhances the rate of economic growth. Since typical savers will seek to
maximise their return, subject to their preferred level of risk, liquidity and the time-pattern
of cash flows, they should be expected to invest their funds with users that show a high
probability of meeting those expectations, for example by investing in corporations that use
funds to produce goods and services that are in demand in the marketplace.

Another important function of a financial system is its role in the implementation of


monetary policy. Monetary policy actions of a central bank that influence the level of
interest rates in order to achieve economic outcomes; primary target is inflation relates to
the actions of a central bank that are taken to influence the level of interest rates in the
financial system. The current monetary policy stance of central banks in developed
countries is to maintain the level of inflation within a specified level. Inflationan increase
in prices of goods and services over time; measured by the consumer price index (CPI) is
the increase in the price for goods and services within an economy. By targeting the level of
inflation, a central bank seeks to achieve a range of economic objectives such as increased
employment and the stability of the exchange rate of the currency.

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REFLECTION POINTS

A financial system comprises financial institutions, financial instruments and financial


markets. Overseeing a financial system are the central bank and prudential supervisor.
A financial asset incorporates four main attributes: return, risk, liquidity and time-
pattern of cash flows.
The wide range of financial products available in a financial system facilitates portfolio
structuring.
A financial system provides economic and financial information to the markets; that
information should be timely and accurate.
An efficient financial system rapidly absorbs and reflects new information into the
price of financial instruments.
A financial system encourages savings and allocates those savings to the most efficient
users of funds.
The central bank uses the financial system to implement monetary policy in order to
target the level of inflation and achieve certain economic objectives.
1.2 Financial institutions
Most of you have carried out transactions with one or
more financial institutions. For example, you may LEARNING
have opened a deposit account with your local bank, OBJECTIVE 1.2
applied for a loan from that bank or obtained a credit
card facility. Also, you may have entered into an Categorise the main types of
insurance contract for motor vehicle insurance, financial institutions, being
medical insurance, travel insurance or life insurance depository financial
with an insurance office. institutions, investment
banks and merchant banks,
contractual savings
institutions, finance
companies and unit trusts

There is a very wide range of financial institutions operating in the financial system.
While some institutions offer similar products and service, typically institutions tend to
specialise in areas where they have greater expertise. We will discuss the different types of
institutions in detail in Chapters 2 and 3. In this chapter we simply classify financial
institutions into five categories based on the differences between the institutions' sources of
funds and uses of funds.

1. Depository financial institutionsaccept deposits and provide loans to customers


(e.g. commercial banks, credit unions) obtain a large proportion of their funds from
deposits lodged by savers. Examples include deposits placed in demand deposit
accounts or term deposit accounts with commercial banks, building societies and
credit cooperatives. A principal business of these institutions is the provision of loans
to borrowers in the household and business sectors.
2. Investment banks and merchant banksspecialist providers of financial and
advisory services to corporations, high-net-worth individuals and government
generally focus on the provision of advisory services for their corporate and
government clients. This includes advising clients on mergers and acquisitions,
portfolio restructuring and financial risk management. These institutions may provide
some loans to clients but are more likely to advise and assist a client to raise funds
directly from the capital markets.
3. Contractual savings institutionsoffer financial contracts such as insurance and
superannuation; large investors are financial institutions such as life insurance
offices, general insurers and superannuation funds. Their liabilities are mainly
contracts which specify that, in return for periodic payments made to the institution,
the institution will make specified payouts to the holder of the contract if and when
an event specified in the contract occurs. The periodic cash receipts received by these
institutions provide them with a large pool of funds that they invest. Payouts made by
these institutions include payments for claims made on an insurance policy, or
payment to a superannuation fund member on their retirement from the workforce.
p. Finance companies and general financiersborrow funds direct from markets to
10 provide loans and lease finance to customers raise funds by issuing financial
instruments such as commercial paper, medium-term notes and bonds in the money
4. markets and the capital markets. They use those funds to make loans and provide
lease finance to their customers in the household sector and the business sector.
5. Unit trustsinvestors buy units issued by the trust; pooled funds invested (e.g. equity
trusts and property trusts) are formed under a trust deed and are controlled and
managed by a trustee or responsible entity. Unit trusts attract funds by inviting the
public to purchase units in a trust. The funds obtained from the sale of units are
pooled and then invested by funds managers in asset classes specified in the trust
deed. Trusts generally specialise in certain categories of investments, including
equity trusts, property trusts, fixed-interest trusts and mortgage trusts.
TABLE 1.1 ASSETS OF FINANCIAL INSTITUTIONS, AUSTRALIA
($ BILLIONS)

SOURCE: Reserve Bank of Australia, RBA Bulletin, various issues.

Table 1.1 shows the total assets of the various Australian financial institutions in June
1990, June 2008 and SeptemberDecember 2010. The Australian financial system has
rapidly evolved over this period in response to significant changes that have occurred,
including regulatory change, internationalisation of the financial markets and the
application of technology to the development of new financial products and information
systems. As can be seen, there has been an enormous growth in assets held within the
financial system. This is not restricted to the Australian market, as international markets
have also shown considerable growth. Some generalisations that emerge from Table 1.1
include:

Total assets of the financial institutions increased more than fivefold over the period, to
$4 594.2 billion.
Commercial banks account for the largest share of the assets of financial institutions, at
57.7 per cent. However, this figure does not fully represent the full extent of
commercial banks' influence, as these institutions also participate in a range of activities
that are not recorded directly on the banks' balance sheets (e.g. their managed funds
activities).
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The importance of building societies significantly declined as changes in regulation


allowed most of the larger societies to become commercial banks.
The percentage share of financial assets of investment banks and merchant banks
(officially known as money-market corporations) declined. This reflects the change in
focus of their business activities. Much of their business is based on the provision of
off-balance-sheet advisory services to their corporate and government clients.
Finance companies contracted as the impact of financial deregulation, greater
competition and the absorption of some finance companies into their parent banks took
effect.
The percentage of life insurance offices' share of total assets declined over the period.
However, this was offset by significant increases in their managed funds business,
particularly superannuation products.
The percentage share of superannuation assets increased to 19 per cent. Factors
influencing this growth were an ageing population saving for retirement, the
introduction of compulsory superannuation and the introduction of taxation incentives
for superannuation savings.
Another growth area was in managed funds, specifically in unit trusts. This sector of the
market increased tenfold over the period. Managed funds provide investors with the
opportunity to use the specialist skills of funds managers, particularly in investment
categories which are more difficult for the individual investor to access, for example the
international equity markets.
Securitisationnon-liquid assets are sold into a trust; the trustee issues new securities;
cash flows from the original securities are used to repay the new securities vehicles
showed enormous relative growth up until the onset of the GFC. The ensuing severe
tightening of the availability of credit in the capital markets resulting, in part, from
problems with securitised assets that were backed by sub-prime mortgage assets, has
seen new securitisation issues subsequently almost disappear and the percentage share
of securitised assets decline to just 3.10 per cent. However, once the sub-prime
problems have been resolved it is to be expected that this sector of the market will grow
again. Securitisation is discussed in the extended learning section at the end of Chapter
10, but can be briefly described as a process whereby an organisation, such as a bank,
sells existing balance-sheet assets, for example housing loans, thereby generating new
cash flows.

REFLECTION POINTS

Financial institutions may be classified into five categories based on their sources of
funds and uses of funds.
Depository financial institutions, such as commercial banks, gather savings from
depositors and provide loans to customers. (Commercial banks also provide a wide
range of other financial services.)
Investment banks and merchant banks do not have a depositor base; they specialise in
the provision of advisory services to clients (e.g. merger and acquisition advice).
Contractual savings institutions, such as insurance offices and superannuation funds,
gather savings from the sale of insurance contracts and from superannuation
contributions respectively, and make payouts on the occurrence of specified events
(e.g. a car accident or retirement from the workforce).
Finance companies raise funds directly from the money markets and capital markets
and provide loans and lease finance to customers.
Unit trusts sell units in a trust and invest those funds in assets specified in the trust
deed; for example, an equity trust would invest in certain types of shares.

1.3 Financial instruments


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LEARNING
When a user of funds obtains finance from the OBJECTIVE 1.3
provider of funds, the user must prepare a legal
document that clearly defines the contractual Define the main classes of
arrangement. This document is known as a financial financial instruments that are
instrument and acknowledges a financial commitment issued into the financial
and represents an entitlement to future cash flows. system, that is, equity, debt,
The financial instrument becomes a financial asset on hybrids and derivatives
the balance sheet of the provider of funds. If the
financial asset represents debt that will be repaid then
it also appears as a liability on the balance sheet of the
borrower; however, if it represents equity it will
appear as part of shareholder funds.

For example, if a bank customer deposits funds in a term deposit, the bank will
acknowledge this deposit and issue a receipt that will specify the amount of funds provided,
the maturity date when the funds will be repaid, the rate of interest to be paid and the timing
of interest payments. The terms and conditions specified in a financial security can vary
significantly. For example, a loan agreement may include an interest rate that is fixed for
the term of the loan, while another loan may have a variable rate of interest that can change
on certain dates. One loan may require monthly payments of interest and principal, while
another loan may require half-yearly interest payments with principal only repaid at
maturity. Savers, as the providers of funds, will purchase financial assets that have
attributes of risk, return, liquidity and cash flows that meet their particular needs. In the
financial markets, the saver is said to buy the paper of the issuer.

Financial instruments may be divided into three broad categories: equity (including
hybrid instruments), debt and derivatives. These three categories reflect the nature and main
characteristics of financial instruments.

1.3.1 EQUITY
Equitythe sum of the financial interest an investor has in an asset; an ownership
position can take a number of forms. For example, if you buy a new car by paying a deposit
from your own funds and borrowing the remainder from a bank, your equity in the car is
the amount of the deposit paid. As you progressively repay the loan to the bank, your level
of equity in the car will increase. Equity can therefore be described as an ownership interest
in an asset.

Within the context of the discussions in this text, equity in a business corporation is
represented through the ownership of shares issued by a corporation. The principal form of
equity issued by a corporation is an ordinary share or common stockthe principal form
of equity issued by a corporation; bestows certain rights to the shareholder. As we will
discuss in detail in Part 2, larger corporations list their shares on the stock exchange.
Ordinary shares have no maturity date; they continue for the life of the corporation.
However, as the shares are listed on the stock exchange they may be sold to other investors
at the current market price.

An ordinary shareholder is entitled to share in the profits of the business. Shareholders


generally receive a portion of the profits of the company in the form of dividendthat part
of a corporations profit that is distributed to shareholders payments. (This is discussed in
Part 2.) The value of a corporation's shares may increase over time, representing a capital
gain. In the event of the failure of a corporation, however, shareholders are entitled to the
residual value of the assets of the corporation (if any remain), but only after the claims of
all other creditors and security holders have been paid.

The owners of ordinary shares have the right to vote at general meetings, in particular for
the election of members of the board of directors of the company.

Another form of equity is known as a hybrid securitya financial instrument that


incorporates the characteristics of both debt and equity (e.g. preference shares). A hybrid
security may be described as having the characteristics of both equity and debt (see below).
Preference shares are an example of hybrid securities. Preference shares, while being a
form of equity finance, have many characteristics in common with debt instruments. For
example, the holders are entitled to receive a specified fixed dividend for a defined period,
similar to a fixed-interest payment. The fixed dividend must be paid before any dividend is
made to ordinary shareholders. Preference shareholders also rank ahead of ordinary
shareholders in their claim on the assets of the corporation should the company be wound
up or placed into liquidation.the legal process of winding up the affairs of a company in
financial distress.

p. 13

The issue of hybrid securities, or quasi-equity instruments, has become an increasingly


important means by which corporations raise additional equity funding. These instruments
are discussed in detail in Chapter 5.

The equity markets are discussed in much more detail in Part 2.

1.3.2 DEBT
A debt is a loan that must be repaid. Debt instruments represent a contractual claim against
an issuer, and require the borrower to make specified payments, such as periodic interest
payments and principal repayments over a defined period.

The types of debt instruments issued by a corporation include debentures, unsecured


notes, term loans, commercial bills, promissory notes, overdrafts and mortgage loans.
These types of debt instruments are discussed in detail in Part 3 of the text. However, when
we discuss the financial markets later in this chapter, we will introduce the money markets
and the capital markets. Debentures and unsecured notes are longer-term debt instruments
issued into the capital markets, while commercial bills and promissory notes are short-term
instruments issued into the money markets. Term loans, mortgage loans and overdrafts are
generally provided by financial institutions.

Government debt instruments are Treasury bonds and Treasury notes (T-notes); these are
examined in Part 4.

Debt instrumentsspecify conditions of a loan agreement; issuer/borrower, amount,


return, timing of cash flows, maturity date; debt must be repaid entitle the holder to a
claim (ahead of equity holders) to the income stream produced by the borrower and to the
assets of the borrower if the borrower defaults on loan repayments. Debt can be divided
into two sub-categories on the basis of the nature of the loan contract: secured debta debt
instrument that provides the lender with a claim over specified assets if the borrower
defaults and unsecured debt. A secured debt contract will specify the assets of the
borrower, or a third party, pledged as security or collateral. If the borrower defaults on the
loan the lender is entitled to take possession of those assets to recover the amount owing. In
other cases a loan may be made on an unsecured basis.

Another subdivision of debt is based on the transferability of ownership of the instrument.


Negotiable debt instrumentsa debt instrument that can be sold by the original lender
through a financial market are those that can easily be sold and transferred from one
owner to another. Commercial bills are an example of negotiable debt instruments that can
be sold in the money markets (Chapter 9). Non-negotiable instruments are instruments that
cannot be transferred from one party to another. A term loan obtained through a bank is
generally non-negotiable.

Corporate debt is discussed in Part 3 and government debt in Part 4.


1.3.3 DERIVATIVES
A third class of instrument has become significant in the financial markets: the derivative
instrumenta synthetic security that derives its price from a physical market commodity or
security; mainly used to manage risk exposures.

Derivatives contracts are primarily used to manage an exposure to an identified risk. For
example, a borrower might be concerned that interest rates on existing debt funding may
rise in the future. The borrower can accept this forecast risk, or seek to reduce that risk
exposure by locking in an interest rate today. One way the borrower can lock in an interest
rate is through the use of derivative contracts.

There is a wide range of derivatives contracts for the management of risk exposures
related to commodities (such as gold and oil) and financial instruments (such as interest-
rate-sensitive debt, currencies and equities). Therefore, financial derivatives may be used to
manage risk exposures related to both equity and debt.

There are four basic types of derivatives contracts: futures, forwards, options and swaps:
1. A futures contractan exchange-traded agreement to buy or sell a specific
commodity or financial instrument at a specific price at a predetermined future
date is a contract to buy (or sell) a specified amount of a commodity or financial
instrument at a price determined today for delivery or payment at a future date.
Futures contracts are standardised contracts that are traded through a futures
exchange. Futures contracts are discussed in Chapters 18 and 19.
p. A forward contractan over-the-counter agreement that locks in a price (interest
14 rate or exchange rate) that will apply at a future date is similar to a futures contract
but is typically more flexible and is negotiated over the counter with a commercial
2. bank or investment bank. A forward foreign exchange contract establishes a foreign
currency exchange rate that will apply at a specified date. A forward rate agreement
is used to lock in an interest rate today that will apply at a specified date. Forward
contracts are discussed in Chapters 17, 18 and 19.
3. An option contractthe right, but not the obligation, to buy or sell a commodity or
security at a predetermined exercise price; the option buyer pays a premium to the
option writer gives the buyer of the option the rightbut not an obligationto buy
(or sell) the designated asset at a specified date or within a specified period during the
life of the contract, at a predetermined price. The fact that the buyer is not obliged to
proceed with the contract is valuable, and therefore the buyer must pay a premium to
the writer of the option. Option contracts are discussed in Chapters 18 and 20.
4. A swap contractan agreement between two parties to swap future cash flows;
interest rate swaps and currency swaps is an arrangement to exchange specified
future cash flows. With an interest rate swap there is an exchange (swap) of future
interest payments based on a notional principal amount. A currency swap is
denominated in a foreign currency and fixes the exchange rate at which the initial and
final principal amounts are swapped. Ongoing interest payments are also swapped at
the same exchange rate. Swap contracts are discussed in Chapters 18 and 21.

Derivative instruments are different from equity and debt in that they do not provide
actual funds for the issuer. Funds need to be raised in either the equity or debt markets.
Risks associated with equity or debt issues may be managed using derivative contracts. For
example, an investor might be concerned that the value of shares held in an investment
portfolio might fall. The investor might enter into a derivative contract that gives the
investor the option to sell shares at a specified date at a price that is agreed today. If the
share price does fall, the investor will exercise the option and sell at the agreed higher price.
REFLECTION POINTS

The principal form of equity issued by a publicly listed corporation is the ordinary
share or common stock.
Ordinary shares entitle the shareholder to share in the profits of the company, either
through the receipt of dividends or through capital gains, and provide certain voting
rights.
A hybrid security, such as a preference share, incorporates the characteristics of both
debt and equity.
The basic characteristic of debt is that is must be repaid. The debt holder is entitled to
receive cash flows specified in the debt instrument (e.g. interest payments and principal
repayment). Debt may be secured or unsecured.
A derivative contract is designed to facilitate the management of risk (e.g. interest rate
risk). Types of derivative products are futures, forwards, options and swaps.

1.4 Financial markets


p. 15
LEARNING
We now introduce the third component of a financial OBJECTIVE 1.4
system, being the financial markets. You gained a
basic understanding of the financial institutions and Discuss the nature of the
instruments earlier in the chapter; now, once you flow of funds between savers
understand the structure of the financial markets, you and borrowers, including
should have a good grasp of the integrated functions primary markets, secondary
of the markets and the importance of the financial markets, direct finance and
system to economic growth within a country. In this intermediated finance
chapter we begin by categorising the markets
according to the types of transactions that occur
within each market. Later in the textbook we will
discuss in detail the institutions and instruments that
prevail in each of the financial markets. This section
considers:
the matching principle
primary and secondary markets
direct and intermediated financial flow markets
wholesale and retail markets
money markets
capital markets
1.4.1 MATCHING PRINCIPLE
The matching principleshort-term assets should be funded with short-term liabilities;
longer-term assets should be funded with longer-term liabilities and equity is one of the
fundamental reasons for the existence of a wide range of financial instruments and markets.
The principle contends that short-term assets such as working capital and inventories
should be funded with short-term liabilities. For example, if a company is purchasing stock
(asset) that will remain in the company for just a short period of time before the product is
sold, the company should need only a short-term loan (liability) to fund the purchase of the
stock. An example of a short-term loan that can be used for this purpose is an overdraft
facilitya fluctuating credit facility provided by a bank; allows a business operating
account to go into debit up to an agreed limit (see Chapter 9).

The matching principle goes on to state that longer-term assets should be funded with
equity and long-term liabilities. For example, a company may purchase a new factory and
manufacturing equipment, and it is expected that these assets will generate income for the
next 10 years. To fund the purchase, the company should issue equity and/or long-term debt
such as bondsa long-term debt instrument issued directly into the capital markets that
pays the bond-holder periodic interest coupons and the principal is repaid at maturity
(see Chapter 10).

The money markets and capital markets trade short-term and long-term financial
instruments respectively, and therefore allow borrowers to apply the matching principle in
relation to funding. A borrower is able to match the cash flows associated with a source of
funds (liabilities) closely with the cash flows generated from the use of funds over the life
of a particular asset.

While the matching principle may be regarded as a fundamental principle of finance, it is


interesting to note how often this principle is disregarded. For example, at the onset of the
GFC, short-term finance available through the money markets virtually ceased as a result of
uncertainty in relation to risk deriving from the so-called sub-prime market collapse. Quite
a number of financial institutions had been funding longer-term instruments with short-term
finance in the money markets. When this source of finance was suddenly no longer
available the institutions experienced a significant liquidity problem and some institutions
failed or were taken over. They forgot the fundamentals!

1.4.2 PRIMARY AND SECONDARY MARKET


TRANSACTIONS
The concept of primary markets and secondary markets is quite simple, but their role in
ensuring the efficiency of the financial markets is very important indeed.

p. 16

A primary market transactionthe issue of a new financial instrument; funds are


obtained by the issuer occurs when businesses, governments and individuals issue financial
instruments in the money markets and capital markets. For example, when a corporation
issues additional ordinary shares to raise equity funding for a proposed investment project,
it is conducting a primary market transaction in the capital markets. Similarly, if the
government sells new long-term bonds in order to finance spending on capital works, health
or education, this is a primary market transaction. Individuals who borrow moneya
commodity that is universally accepted as a medium of exchange from a bank to finance
the purchase of a house are also participating in a primary market transaction. The
distinguishing characteristic of a primary market transaction is that it creates a new
financial instrument. Primary market flows and relationships are illustrated in Figure 1.2.

FIGURE 1.2 PRIMARY MARKET TRANSACTIONS


In contrast, secondary market transactionsthe buying and selling of existing financial
securities; transfer of ownership, no new funds raised by issuer involve transactions with
existing financial instruments. Instruments traded in the secondary markets are those that
were initially created in primary market transactions. For example, consider an investor
who buys shares (equity) issued by a corporation. These primary market flows are shown in
Figure 1.2. If the holder of those shares now decides to sell them, the sale of the shares is
regarded as a secondary market transaction. Figure 1.3 illustrates the flows involved in
secondary market transactions.

FIGURE 1.3 SECONDARY MARKET TRANSACTIONS

Secondary market transactions have no direct impact on the amount of funding raised or
available to the company that was the initial issuer of a financial instrument; that is, the
company receives no extra funds from the secondary market transaction. A secondary
market transaction is simply a transfer of ownership from one party to another party.

However, the existence of well-developed secondary markets has important impacts on


the marketability of new primary market financial instruments or securities.

Secondary market transactions help overcome two potential obstacles that may stand in
the way of savers providing funds for the financing of long-term capital investment. These
are the savers' preferences for liquidity and their aversion to risk. Without an active
secondary market, purchasers of new-issue instruments would be required to hold those
long-term instruments until they mature. In the case of equity, the problem would be even
greater as there is generally no maturity date. A deep and liquid secondary market solves
this problem by providing markets where these instruments can be bought and sold. A deep
and liquid secondary market is one where there are many buyers and sellers in the market.

Economic growth (and the benefits, such as increased employment, that flow to the
community from that growth) is critically reliant on the existence of strong primary
markets. Primary market transactions allow corporations and government to raise new
funding that leads to increased capital and productive investment. Secondary markets, while
not directly involved in the process of channelling funds from savers to users of funds,
encourage both savings and investment because they enhance the marketability and
liquidity of primary-issue instruments, thus making them more attractive to savers.

p. 17

It will be useful to introduce and explain some market terminology at this stage. A
financial asset has already been defined as an entitlement to future cash flows. A financial
instrument is the more general term used in the markets to describe instruments where there
is no organised secondary market where that instrument can be traded. The market also
describes a number of financial instruments as securities. A securityfinancial assets that
are traded in a formal secondary market (e.g.stock exchange) is the term used to describe
a financial asset that can be traded in an organised secondary market such as a stock
exchange or a futures exchange. An example of a financial instrument is a bank term
deposit, and an example of a security is an ordinary share in a publicly listed company.
Both are financial assets.

1.4.3 DIRECT FINANCE AND INTERMEDIATED


FINANCE
The issue of new financial instruments generates a flow of funds through the primary
markets from the provider of funds to the user of those funds. This flow can occur in two
ways:

The funds may flow through a direct relationship from the provider of funds to the user
of funds.
The flow of funds may occur through a financial intermediary such as a bank.
Within the financial markets each form of financial flow is an important source of
finance.

Direct finance

When funds are raised in the primary markets using direct financefunding obtained direct
from the money markets and capital markets, the contractual agreement is between the
provider of funds and the user of funds. The funds are not provided by a financial
institution. The relationships that exist between savers and the users of funds in the
provision of direct finance are shown in Figure 1.4.

FIGURE 1.4 DIRECT FINANCIAL FLOWS

The brokers and dealers included in Figure 1.4 may act as agents through which the
instructions of the providers of funds and users of the funds are carried out. The brokeran
agent who carries out the instructions of a client does not provide the finance, but receives
a fee or commission for arranging the transaction between the two parties. The broker has
no rights to the benefits that may flow from the purchase of the security. It is not necessary
for a broker or dealermakes a market in a security by quoting both buy (bid) and sell
(offer) prices to be involved at all in the transaction.

An investor seeking to purchase shares in a company will generally arrange the


transaction through a stockbroker. The stockbroker acts only as an agent to the transaction
and, on behalf of a client, facilitates the direct purchase or sale of shares by accessing the
electronic share trading systems of the stock exchange.

Examples of direct financing include share issues, corporate bonds and government
securities. These securities are discussed further in various chapters of the text.

p. 18

The benefits and disadvantages of direct finance


Direct finance is generally available only to corporations and government authorities that
have established a good credit ratingthe assessment by a credit rating agency of the
creditworthiness of an obligor to a financial obligation. A credit rating is an assessment of
the creditworthiness of an issuer of paper. As the contractual relationship in direct finance
is directly between the provider of funds and the issuer of paper, the risk that the issuer may
default is an important consideration. Therefore, borrowers that do not have an established
good credit rating generally are not able to borrow direct. The credit rating process is
discussed in Chapter 11.

The main advantages of direct finance are as follows:

It removes the cost of a financial intermediary. If a borrower obtains a loan from a


financial institution, the borrower will pay a profit margin to the intermediary. Should a
corporation or government authority have an investment-grade credit rating (e.g.
Standard & Poor's BBB and above), it may well be able to raise funds directly from the
domestic or international markets at a lower total cost than borrowing through a bank.
It allows a borrower to diversify funding sources by accessing both the domestic and
international money and capital markets. This reduces the risk of exposure to a single
funding source or market. Economic and financial conditions change from time to time,
and a user of funds may suddenly find that a traditional source of funds is no longer
willing to provide further funding. For example, this situation was evident in Thailand
and Indonesia as a result of the Asian financial crisis of 199798, and was repeated in
Argentina after the collapse of the country's financial and economic systems in 2002.
Following the onset of the GFC, large increases in default rates associated with so-
called sub-prime market securities made raising funds in the global money markets and
capital markets very difficult.
It enables greater flexibility in the types of funding instruments used to meet different
financing needs. More sophisticated funding strategies may be used to raise funds. For
example, a corporation may obtain a US dollar (USD) loan in the international capital
markets and then use USD export income to repay the loan.
An organisation may enhance its international profile by carrying out transactions in the
international financial markets. An increased profile in the financial markets may be
beneficial in establishing a reputation in the markets for the firm's goods and services.

There are some disadvantages that may, at times, be associated with direct financing.
These include:

There can be a problem of matching the preferences of lenders and borrowers. For
example, a lender may have a certain amount of funds available for investment, but this
amount may not be sufficient for the needs of the borrower, who would then need to
seek out and enter into funding arrangements with additional suppliers of funds. There
may also be a mismatch in the maturity structure of the funding as the borrower may
need to borrow for a longer period than the risk-averse investor is willing to lend.
The liquidity and marketability of a direct finance instrument may be of concern. How
easy is it for the holder of an instrument issued by direct finance to sell at a later date?
Is there a deep and liquid secondary market in that instrument? Not all financial
instruments have an active secondary market through which they may be sold.
The search and transaction costs associated with a direct issue can be quite high. These
might include advisory fees, the cost of preparing a prospectus, legal fees, taxation
advice, accounting advice and specific expert advice (such as a geologist's report). On
very large direct finance transactions the fees and costs may run into the millions of
dollars.
It can be difficult to assess the level of risk of investment in a direct issue, particularly
default riskthe risk that a borrower may not meet financial commitments such as
loan repayments when they are due. Accounting and reporting standards may vary
between nation-states, and information about an issuer may be limited to the prospectus
and the issuer's credit rating.
p. 19

Intermediated finance

The critical difference between direct and intermediated finance is to be found in the
relationships that exist between the saver, the intermediary and the user of funds. With
intermediated financefinancial transaction conducted with a financial intermediary (e.g.
bank deposits and bank loans); separate contractual agreements, as illustrated in Figure
1.5, the intermediary has an active role in the relationship. The intermediary, in providing
finance to deficit units, acquires the ownership of the financial instrument that is created as
part of the transaction. It also obtains the rights to the benefits and risks associated with the
ownership of that asset. The benefits include the receipt of interest payments and the
repayment of principal. On the other hand, a significant risk accepted by the intermediary is
default or credit riskthat is, the risk that the borrower may not make all loan repayments.

FIGURE 1.5 INTERMEDIATED FINANCIAL FLOWS

In order to be able to provide loans to its customers, an intermediary obtains its funding
from savers. Savers receive financial instruments issued by the intermediary, such as a term
deposit receipt issued by a bank. A contractual agreement then exists between the saver and
the intermediary in relation to the term deposit. The intermediary creates a separate
contractual agreement with the borrower (the ultimate user of funds). The saver has no
claim on the income or assets of the ultimate borrower. Those entitlements reside with the
bank as the intermediary. The saver only has a claim for the payment of interest and the
return of principal at maturity from the bank. On the other hand, under a separate loan
contract, the intermediary relies on the borrower for repayment of the loan. Failure of the
bank to recover the funds from the borrower does not change the contractual relationship
the bank has with its depositor.

The benefits of financial intermediation

Very often the portfolio preferences of savers and borrowers differ. For example, a risk-
averse lender may be prepared to receive a lower rate of return in exchange for maintaining
funds at call. On the other hand, a borrower may be prepared to pay a higher rate of return,
but may want to have the funds available for a number of years. It is likely that many savers
and borrowers would find it difficult to meet their investment and funding needs if only
direct finance was possible.

An intermediary is able to resolve this problem and satisfy the preferences of both parties,
and at the same time make a profit. An intermediary is able to transform short-term deposit
funds into longer-term loan funds. An essential economic role of an intermediary is to
resolve the conflicting preferences of surplus units and deficit units, and thus encourage
both savings and productive capital investment.

In carrying out the role of offering instruments with varying financial attributes (risk,
return, liquidity, timing of cash flows), intermediaries perform a range of functions that are
important to both savers and borrowers. These are:
asset transformation.

maturity transformation.

credit risk diversification and transformation.

liquidity transformation.

economies of scale.
p. 20

Asset transformation

Financial intermediaries engage in asset transformationthe ability of financial


intermediaries to provide a range of products that meet customers portfolio preferences
by offering their customers a wide range of financial products on both sides of the balance
sheet, including deposit, investment and loan products.

Without intermediation, surplus units that could generate only small levels of savings
would not have any incentive to save; and users of funds, such as individuals and small
businesses, would find the cost of obtaining loans too great to be worthwhile.
Intermediaries specialise in the gathering of savings and can achieve economies of scale in
their operations. They can profitably receive small amounts from many savers, pool them
into larger amounts and make them available as loans to borrowers.

Financial intermediaries provide a range of deposit products which meet the varying
preferences and need of their customers. These include demand deposit accounts, current
accounts, term deposits and cash management trusts. At the same time, financial
intermediaries provide a range of loan products, including overdraft facilities, term loans,
mortgage loans and credit card facilities.

Maturity transformation

Most frequently, savers prefer great liquidity in their financial assets, while borrowers tend
to prefer a longer-term commitment in the funds they borrow. By managing the deposits
they receive, intermediaries are able to make loans of a longer-term nature while satisfying
savers' preferences for shorter-term savings. This is referred to as maturity
transformationfinancial intermediaries offer products with a range of terms to maturity.

Banks provide a good example of the maturity transformation function of intermediaries.


The deposits they receive are generally quite short term in nature (typically less than five
years), yet a large proportion of their lending is for home loans that frequently have a
maturity of 30 years. The banks therefore have a mismatch between the terms to maturity of
a large proportion of their sources of funds and their loan liabilities.

Financial intermediaries are able to perform such extremes of maturity transformation for
two reasons. First, it is unlikely that all savers would choose to withdraw their deposits at
the same time. Deposit withdrawals during any particular period are generally more or less
matched by new deposits. Second, and more importantly, financial intermediaries that
engage in maturity transformation rely on liability managementwhere banks actively
manage their sources of funds (liabilities) in order to meet future loan demand (assets).

Should a bank's deposit base (liabilities) begin to decline below the level necessary to
fund their forecast loan portfolio (assets), then the bank may adjust the interest rates that it
offers in order to attract the necessary additional deposits. More probably, the bank will
issue further securities (liabilities) directly into the money or capital markets to raise the
additional funds required.
Credit risk diversification and transformation

Credit risk transformationa savers credit risk exposure is limited to the intermediary;
the intermediary is exposed to the credit risk of the ultimate borrower occurs through the
contractual agreements of intermediation. A saver has an agreement with the financial
intermediary, and therefore the credit risk exposure of the saver is limited to the risk of the
intermediary defaulting. The financial intermediary has a separate loan agreement with the
borrower and is exposed to the credit risk of the borrower.

Financial intermediaries have two advantages over most individual savers in managing
investments. First, intermediaries specialise in making loans and therefore develop an
expertise in assessing the risk of potential borrowers. This expertise comes from the
technical skills of the employees and systems in assessing and monitoring loan
applications, and also from the information that is acquired through prior dealings with the
borrower.

Liquidity transformation

Savers generally prefer more, rather than less, liquidity in their investments. One reason for
this is that the timing of a saver's income and expenditure flows will not perfectly coincide.
There are times when income is higher than expenditure and savings are available for
investment purposes. On the other hand, there are times when expenditure exceeds income.
In order to try and manage this timing problem, savers will tend to hold at least some of
their financial assets in a very liquid form that can easily be converted to cash.

p. 21

Liquidity transformationmeasured by the ability of a saver to convert a financial


instrument into cash is measured by the ability to convert financial assets into cash at
something close to the current market price of the financial instrument. However, liquidity
has another dimension: the transaction costs associated with acquiring and disposing of the
financial asset. Transaction costs can often be quite high. However, a financial intermediary
may have the capacity to lower transaction fees by spreading fixed costs across a large
number of transactions. The time involved in carrying out a transaction may also be an
important component of the total transaction cost.

Many intermediaries provide highly liquid accounts in which individuals may store some
of their wealth. For example, a demand (at-call) account with a bank represents complete
liquidity. The depositor has the right to withdraw funds without notice. There is zero risk
that the value of the asset, when it is converted into cash, will be less than the value of the
deposit in the demand account. In addition, the transaction costs associated with converting
the credit balance into cash are limited to transaction fees imposed by the bank.
Intermediaries such as commercial banks can offer highly liquid assets to savers, which the
ultimate users of funds would be most unlikely to be able to do.

Banks have further extended liquidity arrangements by adopting systems such as


electronic networks: automatic teller machines (ATMs) and electronic funds transfer at
point of sale (EFTPOS) arrangements.

Economies of scale

Financial intermediaries gain considerable economies of scalefinancial and operational


benefits gained from organisational size, expertise and volume of business due to their
size and the volume of business transacted, and therefore have the resources to develop
cost-efficient distribution systems. Banks maintain extensive branch networks as their
primary distribution mechanism. At the same time they also provide extensive technology-
based distribution systems such as ATMs, EFTPOS, telephone banking and internet
banking.

The cost of the sophisticated computer and communication systems required to support
such distribution networks is spread over the millions of transactions processed.

Intermediaries also obtain cost advantages through effective knowledge management and
the accumulation of financial, economic and legal expertise. For example, a bank will
typically use standardised documentation for its deposit and lending products. The bank
knows that these documents will comply with regulatory and legal requirements. Other cost
advantages include a reduction in search costs for both savers and borrowers; that is, savers
do not need to investigate the creditworthiness of the ultimate borrower; the intermediary
will have that data available before making a loan decision.

In a competitive market, financial intermediaries should pass on efficiency gains in the


form of reduced interest margins and fees.

1.4.4 WHOLESALE AND RETAIL MARKETS


Direct financial transactions between institutional
investors and borrowers are described as wholesale LEARNING
marketdirect financial flow transactions between OBJECTIVE 1.5
institutional investors and borrowers transactions.
Institutional investors include commercial banks, Distinguish between various
insurance offices, superannuation funds, investment financial market structures,
banks, merchant banks, fund managers, finance including wholesale markets
companies, building societies, credit unions, and retail markets, and
government authorities and large corporations. money markets and capital
Transactions conducted in the wholesale markets markets
typically range from the tens of thousands of dollars
to the millions of dollars. For example, a portfolio
manager may purchase a $50 000 wholesale managed
fund for a client while a financial institution might
sell $10 million worth of commercial bills into the
money market.

The cost of wholesale funds is determined by a range of factors, such as the level of
liquidity (surplus funds) within the financial system, future interest rate expectations and
the maturity structure of investment opportunities. For example, large amounts of short-
term funds are invested overnight in the money markets. Generally, wholesale investors are
able to accumulate large quantities of surplus funds and use their market power and
investment skills to obtain higher returns than would normally be available in the retail
market. At the same time, wholesale market borrowers are able to use their good credit
standing in the markets to obtain access to those funds.

p. 22

The retail marketfinancial transactions conducted with financial intermediaries


mainly by individuals and small to medium-sized businesses, on the other hand, comprises
transactions primarily of individuals and small to medium-sized businesses. Transactions
are principally conducted with financial intermediaries. Market participants are price takers;
that is, the financial intermediary is able to set both deposit and lending rates of interest.
Retail market participants are not totally excluded from the wholesale markets. They are
able to gain indirect access to the wholesale markets through managed investment products
such as cash management accounts and unit trusts. These are discussed in Chapter 3.
1.4.5 MONEY MARKETS
The financial markets may be categorised according to the characteristics of the financial
instruments that are traded in the markets. Within the debt and equity markets, the two main
market classifications are the money markets and the capital markets. The money markets
and the capital markets include a number of submarkets (see below). Other markets, such as
the foreign exchange market and the derivatives market, also form part of the financial
system.

Money marketwholesale markets in which short-term securities are issued and traded
transactions involve wholesale short-term-to-maturity securities of less than 12 months. As
discussed below, medium- to long-term-to-maturity transactions are referred to as capital-
market transactions. Figure 1.6 depicts the structure of the money markets and the capital
markets. You will note that each market incorporates primary and secondary markets within
both the domestic and the international markets.

FIGURE 1.6 STRUCTURE OF THE MONEY AND CAPITAL


MARKETS

The money markets bring together institutional investorsparticipants in the wholesale


markets (e.g. funds managers, insurance offices, banks) that have a surplus of funds and
those with a short-term shortage of funds. The money markets are attractive to institutional
investors for short-term financing arrangements as the markets are (normally) highly liquid
and the securities issued in the market are standardised and have well-developed secondary
markets. At the time of writing, the money markets around the world are still experiencing
some liquidity problems stemming from the GFC. What is more, as the GFC recedes into
the past, new storm clouds are appearing on the horizon. The problems in the sub-prime
mortgage markets and credit markets have been overtaken by concerns about the sovereign
debt of number of nation-states, particularly Spain, Portugal, Greece, Ireland and Italy, and
their ability to meet their debt obligations to investors. New rumours of weaknesses in the
banking sector, particularly in France, shook the markets in the middle of 2011 along with a
down-grading of the credit rating of the US government. All of this is taking place amid
ongoing concerns about the health of the US and world economy despite continued efforts
by governments and central banks to stimulate economic activity.

p. 23
As mentioned, the money markets allow institutional investors, such as commercial
banks, insurance offices, superannuation funds, investment banks, merchant banks, funds
managers, finance companies, other finance institutions, government authorities and large
corporations to manage their short-term financing needs. For example, a large retail sales
store may accumulate surplus funds from sales. In order to gain a return the store needs to
invest the surplus funds. However, the store may need to use the funds in a few days to buy
more stock. The store knows that it is able to purchase short-term securities in the money
markets today that can easily be sold again in a few days when the cash is needed.

From the point of view of borrowers, one of the principal functions of the money markets
is to enable them to bridge the mismatch between their cash expenditures and their cash
receipts. A large corporation may need to raise short-term funds to cover its forecast
working-capital requirements over the next three months. The corporation could borrow the
funds from a bank, but it may also find that it is able to borrow at a lower yield by issuing
short-term securities directly into the money markets. The securities issued may be repaid
as the company generates income from its products or services.

The money markets have no specific trading location. Money market transactions are
conducted from the business offices of the market participants using computer networks.
The money markets operate both as primary markets in which new securities are issued and
as secondary markets in which existing securities are bought and sold. The major money-
market participants and securities issued and traded are listed in Figure 1.7.

FIGURE 1.7 MONEY-MARKET PARTICIPANTS AND


INSTRUMENTS

Money-market submarkets

As indicated in Figure 1.7, the money markets comprise a number of submarkets,


including:

central bank: system liquidity and monetary policy.

inter-bank market.

p. 24

bills market.
commercial paper market.

negotiable certificates of deposit market.


Central bank: system liquidity and monetary policy

Central banks use the money markets to carry out transactions that will maintain, or change,
the amount of liquidity that is available within the financial system. The amount of daily
liquidity in the financial system is affected mainly by government budget surpluses or
deficits, official foreign exchange transactions and net sales of government securities. The
amount of liquidity in the financial system directly impacts on interest rates in the market.
The central bank implements its monetary policy by targeting the cash rate, hence the
central bank carries out money market transactions so that the cash rate remains at its target
level.

For example, in Australia the central bank is the Reserve Bank of Australia. The Reserve
Bank deals regularly, usually daily, in the money markets for the purpose of managing the
supply of liquid funds (cash) available to the financial system. The Reserve Bank deals in
(buys and sells) Commonwealth Government Securities (CGS) and certain other specified
securities of up to one year to maturity, and in repurchase agreements (repos). The Reserve
Bank conducts these market operations with members of the Reserve Bank Information and
Transfer System (RITS), principally commercial banks and other institutions that
participate in the wholesale market for CGS. RITS is an electronic settlement system.

Furthermore, the Reserve Bank is responsible for the implementation of monetary policy.
Briefly, the main monetary policy objective is to maintain an economic environment
whereby inflation remains within a desired range of 2 per cent to 3 per cent over time. To
achieve this, the Reserve Bank seeks to influence the level of interest rates by targeting the
cash rate in the money markets. As at February 2012 the target cash rate was 4.25 per cent.
In an efficient market, it is expected that if the cash rate changes then this will flow through
over time to changes in other interest rates. Changes in interest rates will then impact on
economic activity and the level of inflation.

System liquidity and monetary policy issues are discussed in Chapter 12.

Inter-bank market

The inter-bank marketthe lending and borrowing of very short term funds by banks
operating in the payments system facilitates the management of the short-term liquidity
needs of the commercial banks.

Banks carry out transactions on behalf of their customers and also on their own behalf.
Settlement of transactions between the banks occurs through the payments system. In order
to effect settlement, each member of the payments system is required to maintain an
exchange settlement account with the central bank.

An important role of the inter-bank market is the lending of surplus exchange settlement
account funds. These cleared settlement funds are known as same-day funds and are
required by the banks to maintain their exchange settlement accounts in credit. The
introduction of real-time gross settlement for the clearance of large-value transactions has
increased the profile of the inter-bank market. The operation of the payments system is
discussed in Chapter 12.

Bills market

Bills of exchange are short-term discount securities.short-term securities issued with a


face value payable at maturity; doesnot pay interest; sold today at a discount to the face
value. A discount security is issued today with a face value that is payable at the maturity
date. A discount security does not pay interest, but is sold to investors at a price less than
the face value. Therefore, the holders of these securities obtain their return on investment
from the difference between the price that they pay for the security and the price for which
they sell it, or the face value if held to maturity. For example, if a borrower issues a bill
with a face value of $1 million, payable in 90 days, and sells the bill today for $980 000,
then the return to the investor will be $20 000 if the bill is held to the maturity date. The
issuer of the bill has effectively borrowed $980 000 for 90 days at a cost of $20 000.

p. 25

The commercial bills marketan active money market for the issue and trading of bills
of exchange (discount securities) is the largest component of the money markets, and
involves the trading of bank bills and non-bank bills. There is an active secondary market in
commercial bills. This allows market participants to manage their maturity preferences. For
example, an investor can buy a 90-day bill but sell it after seven days. The same bill might
be sold several times during its short 90-day life.

Commercial bills are discussed in Chapter 9.

Commercial paper market

Another important segment of the money markets is the issue and trading of promissory
notes. It is a market convention to refer to promissory notes as commercial
paperpromissory notes (discount securities) issued into the money market by
corporations with a good credit rating.

A promissory note is a discount security (similar to a commercial bill). It is issued with a


face value that is payable at maturity. As the promissory note does not pay interest, it is
sold today for less than the face value. Refer to the example given in the bills market
(above).

The strength of this market tends to fluctuate with the overall performance of the
economy. As promissory notes are often issued on an unsecured basis, only corporations
with a good credit rating are able to issue into the market. However, a segment of the
market comprises the issue of secured commercial paper supported by asset-backed
securities. As mentioned above, this segment of the commercial paper market virtually
ceased to operate as a result of the credit crisis associated with the GFC. This occurred
because a portion of the asset-backed securities turned out to be sub-prime securities with a
high risk of default. Promissory notes (commercial paper) are discussed in Chapter 9.

Negotiable certificates of deposit market

Negotiable certificates of deposita discount security issued by a bank, more commonly


referred to as CDs, are short-term discount securities issued by banks. An example of a
discount security is given in the bills market (above).

The CD segment of the money markets is a source of liquidity funding for the banks. As a
result of increased levels of funds under management, the CD market has become an
increasingly important source of liquidity funding, giving the banks flexibility to manage
the short-term maturity structure of their balance sheets.

1.4.6 CAPITAL MARKETS


Capital marketsmarkets for longer-term funding; includes equity, corporate debt and
government debt, and is supported by the foreign exchange and derivatives markets
channel savings to finance the longer-term investment plans of businesses, individuals and
governments. Therefore, financial instruments are defined as capital-market instruments if
they have an original term to maturity in excess of one year. Capital-market instruments
include both debt instruments and equity, and encompass both the domestic and
international markets.

The capital markets are extremely large and offer a wide range of products to meet the
needs of both lenders and borrowers. For example, loans may be obtained through direct or
intermediated finance for periods ranging up to 30 years. Loans may be secured or
unsecured, have a fixed interest rate or a variable interest rate, and different repayment
structures and timing of cash flows.

The development of domestic capital markets is extremely important for economic


growth as they provide the long-term funds necessary for productive investment. Further,
the international capital markets offer enormous opportunities for investing and borrowing
funds in a range of countries, markets and currencies. We will explore the diverse nature of
the capital markets by looking at the following markets:

equity market.

corporate debt market.

government debt market.

p. 26

foreign exchange market.


derivatives market.

Equity market

The principal characteristic of the equity marketfacilitate the issue of financial securities
that represent an ownership interest in an asset (e.g.stock market) is that the provider of
equity finance obtains an ownership interest in an asset.

Within the context of a corporation, the main form of security issued is the ordinary
share, sometimes referred to as common stock. The shareholder has an entitlement to
participate in the profits of the business, by way of receiving either dividend payments or
capital gains (losses) in the value of the shareholding.

From the perspective of the business, equity provides a source of long-term funding that
does not have to be repaid. Equity is available to:

finance physical infrastructure such as buildings and equipment.

provide creditor confidence in dealing with the firm.

ensure the availability of funds to absorb abnormal losses.

improve the liquidity of the business.

This text focuses mainly on equity issued by publicly listed corporations on a stock
exchange. Chapter 4 considers the share market and the corporation, Chapter 5 explores a
range of issues that a corporation needs to consider when issuing equity, Chapter 6
examines equity financing from the point of view of an investor and Chapter 7 provides a
detailed analysis of share prices. As you can see, there is a lot to learn about the equity
markets. However, it is easy to become addicted to the stock market, particularly if you
become an investor.
Corporate debt market

Longer-term debt is an important source of funding for the growth of business corporations.
Capital-market debt represents a financial commitment that typically requires periodic
interest payments to be made during the term of the debt arrangement, and repayment of
principal (amount borrowed). The principal may be amortisedthat is, repaid in periodic
instalments over the period of the loanor repaid in a lump sum at the maturity date.

Medium-to-longer-term debt instruments issued into the corporate debt marketfacilitate


the issue and trading of debt securities issued by corporations (e.g. discount securities,
bonds) include:

term loans: provided by commercial, merchant and investment banks.

commercial property finance: loans secured by a registered mortgage over the business
property being financed.
debentures: a corporate bond, where security is given in the form of a charge over the
assets of the borrower.
unsecured notes: a corporate bond with no security attached.

subordinated debt: where the claims of the debt holder are subordinated against other
debt lenders.
lease arrangements: periodic lease payments made in return for borrowing an asset.

securitisation: the sale of existing assets, such as mortgage loans, to generate new
funds..

These capital market products are discussed in Chapter 10.

With the deregulation of the financial system, the international capital markets are also an
important source of funding for corporations with good credit ratings. Chapter 11 examines
offshore funding, focusing on the euromarkets and the US markets and the various
instruments available within those markets. While the types of products offered in the
international markets are fundamentally the same as those listed above, the main variable is
the currency in which they are issued. For example, a euromarket instrumentfinancial
transactions conducted in a foreign country in a currency other than the currency of that
country is issued by a borrower into another country, and the instrument is denominated in
a currency other than the currency of the country in which it is issued. An example might
be an Australian company issuing corporate bonds into the Singapore market that are
denominated in USD (borrowing USD).

p. 27

Government debt market

Governments also need to budget with regard to their cash flows and capital expenditures.
A government may budget for a surplus, a deficit or be in balance. If a budget is in deficit,
the government will need to borrow funds to cover the forecast deficit. If a budget is in
surplus, the excess funds can be used to repay existing government debtgovernment
borrowing for short-term liquidity needs, or longer-term budget capital expenditures (T-
notes, Treasury bonds).

Governments fund budget deficits through long-term borrowings in both the domestic and
the international capital markets. If a government has a short-term liquidity funding need
due to a mismatch of cash inflows from taxation and cash outflows to meet commitments
such as pension payments, this may be managed by issuing short-term securities.
For example, if the Australian Government has a short-term funding need it will issue
Treasury notes. (The Australian Government has not needed to issue Treasury notes since
2003.) It issues Treasury bonds to raise longer-term funds. The Reserve Bank acts as
banker to the government and therefore issues government securities as required to meet the
government's funding needs.

Treasury notes are discount securities issued in the money market with maturities up to
six months.

Treasury bonds are issued in Australia with maturities ranging up to 10 years. They are
mainly issued as fixed-interest securities for which half-yearly interest payments are made
for the term of the bond and the principal is repaid at maturity. The bonds may be issued at
a discount or premium over face value depending on the yield of the fixed-interest coupon
relative to the issue tender price. The bonds are sold periodically by tender to members of
RITS. Government funding is discussed in Chapter 12.

The extent of government borrowing has an impact on the private sector. If the
government increases its borrowing in the market, it will crowd outgovernment borrowing
that reduces the net amount of funds available for other lending in the financial system
or reduce the amount of funds available to corporate borrowers.

Foreign exchange market

The foreign exchange marketmarkets that facilitate the buying and selling of foreign
currencies forms an important component of the capital markets, especially since the
floating of exchange rates by the majority of nation-states and the deregulation of the
financial systems of the major economies of the world.

Corporations, financial institutions and governments all access funds in the international
capital markets, which provide a range of funding instruments and a diversity of funding
sources that otherwise may not be available within domestic capital markets.

Financial instruments issued in the international capital markets are usually denominated
in a foreign currency. Therefore interest payments and principal repayments related to
international debt commitments require the borrower to purchase the necessary foreign
currency in order to make those periodic payments.

The foreign exchange market facilitates the buying and selling of foreign currencies
necessary for the conduct of international capital-market transactions. The exchange rate is
the price of one currency against another. Foreign exchange risk is the risk that the
exchange rate between currencies will change. Other issues that have an impact on the
exchange rateand therefore the cost of funding in the international capital marketsare
relative inflation, relative interest rates, relative national income growth, government
intervention and exchange rate expectations. The foreign exchange market is discussed in
Part 5.

p. 28

Derivatives market

Within the context of the capital markets, the derivatives marketmarkets in synthetic risk
management products; futures, forwards, options, swaps provides a range of risk
management products that are available to borrowers to manage risks associated with
capital-market transactions. The principal risks to be managed include interest rate risk,
foreign exchange risk and price risk. For example, a borrower with an existing loan that has
a variable interest rate might be concerned that the rate will increase in the future. The
borrower might use a derivative product to manage that risk. The same principles apply for
the risk that the exchange rate might change or that share prices may rise or fall.

Derivative products available to manage these risks are discussed in detail in Part 6. They
include futures contracts, forward rate agreements, forward foreign exchange contracts,
options, interest rate swaps and currency swaps. A brief introduction to the different types
of derivative contracts was given in Section 1.3.3.

The derivatives market, through the provision of a range of risk management products,
supports and encourages capital-market transactions. Risk management through the use of
derivatives contracts is a complex area of finance and will represent a challenging part of
your later learning.

REFLECTION POINTS

The matching principle contends that short-term assets should be financed by short-
term liabilities, and longer-term assets financed with longer-term liabilities and
shareholder funds.
Within the context of financial markets, primary markets are those markets where new
financial instruments are issued.
Secondary markets are those markets where existing securities are bought and sold.

Direct finance occurs when a provider of funds contracts with a user of funds. Benefits
can include lower cost of funds, access to diverse funding sources and greater
financing flexibility. Disadvantages involve matching funding preferences, liquidity
and marketability of instruments issued, search and transaction costs and risk
assessment.
Intermediated finance occurs when the provider of funds contracts with a financial
intermediary, such as a commercial bank, and the financial intermediary contracts
separately with the user of funds (borrower). Benefits include asset transformation,
maturity transformation, credit risk diversification and transformation, liquidity
transformation and economies of scale.
Wholesale market transactions are large direct transactions carried out by institutional
investors. Retail market transactions are usually greater in number but smaller in size,
and are typically carried out with a financial institution by individuals and small to
medium-sized businesses.
Money markets are direct finance wholesale markets for the issue of discount securities
such as bills of exchange, promissory notes (commercial paper) and negotiable
certificates of deposit. These short-term markets allow participants to manage their
day-to-day liquidity requirements.
Money markets experienced significant liquidity problems during the GFC. The
lingering effects of the crisis and new concerns about the economic stability of many
developed nation-states continue to weigh on the financial markets.
The capital markets provide long-term finance, including equity, corporate debt and
government debt. The capital markets are supported by the foreign exchange market
and the derivatives markets.

1.5 Flow of funds, market relationships and


stability
p. 29
LEARNING
This chapter has introduced many issues in relation to OBJECTIVE 1.6
the flow of funds through the financial system, so it is
worthwhile at this stage to summarise the main points. Analyse the flow of funds
through the financial system
A principal function of the financial system is to and the economy and briefly
facilitate the flow of funds between suppliers of funds discuss the importance of
and users of funds. stability in relation to the
flow of funds

The flow of funds to deficit units involves the creation of financial instruments that are
exchanged for money in the primary markets. The flow may be directthat is, directly
between the lender and the user. Alternatively, the flow can be indirectthat is,
intermediated by financial institutions. With intermediated flows, financial institutions
gather together the savings of surplus units and provide loans from the pooled savings to
deficit units.

For a number of financial instruments issued in the primary markets there are secondary
markets in which those securities are traded. Transactions in the secondary markets do not
provide additional funding for the issuer, but rather they involve a flow of funds and a
change of ownership between the two parties concerned. A function of the secondary
markets is to add marketability and liquidity to primary market securities. In particular, this
allows the holders of securities to restructure their portfolios by buying and selling at
current market prices. Most importantly, secondary market liquidity makes the issue of new
primary market securities much easier and reduces the returns that savers would otherwise
require if those securities were less liquid.

The discussion to date on the flow of funds relationships in the financial system has
referred to two major categories: the ultimate savers or surplus units, and the ultimate
borrowers or deficit unitsborrowers or users of funds. We should now consider sectorial
flows of fundsthe flow of funds between surplus and deficit sectors in an economy; the
business, financial, government, household and rest-of-the-world sectors in terms of the
savings and borrowing patterns of the key sectors of an economy.

The domestic economy can be divided into four sectors:

business corporations

financial corporations

government

household sector

To these four sectors, the rest-of-the-world sector is added. This sector may be a source of
surplus funds flowing into a nation-state plus an outward investment destination for surplus
funds within an economy.

Net borrowing and net lending of the major sectors of the economy vary between nation-
states. The flow of funds between sectors also varies from year to year, depending on
factors such as government budgetary actions, the level of economic activity and the state
of the business cycle.

As a broad generalisation, the business sector will, on average, be a deficit sector. Most
business enterprises need to borrow in order to fund their business activities.
The financial corporations sector also tends to be a deficit sector; financial institutions
fund the growth in their balance sheets by borrowing in the capital markets.

The government sector may fluctuate between being a deficit sector and a surplus sector,
depending on budget policy objectives. For example, governments that spend large amounts
on capital works programs may need to fund those programs by borrowing in the markets.

The household sector is typically a surplus sectorthat is, a net saver of funds. In
particular, the accumulated savings of an ageing population should ensure that this sector
remains in surplus.

The rest-of-the-world sector may be likened to a balancing item. A nation-state that has a
stable political environment and an economy that is strong and offers good growth potential
would expect to attract savings from overseas investors. Deregulation of the global capital
markets has allowed the rest-of-the-world sector to become more sensitive to sudden shifts
in the flow of funds, as investors are able to move funds from one market to another quite
quickly and with relative ease.

p. 30

While each sector has been identified as being either in surplus or in deficit, it should also
be recognised that not every participant within a particular sector will behave in the same
way. For example, even though the household sector may be a surplus sector, not every
individual is a net saver of funds. Whether an individual is a net saver depends on the stage
of the individual's life cycle; that is, individuals who have been in the workforce for longer
typically have a greater capacity to save.

Finally, it is important to study the sectorial flow of funds to gain some insight into the
effects of government policy on savings and investment decisions. At one level it is
necessary to understand the effects of fiscal policythe management of annual revenues
and expenditures of a government and monetary policy decisions. At another level, policy
decisions on issues such as compulsory superannuationemployers must contribute
minimum specified amounts into retirement savings for employees (Australia) have
obvious impacts on increased levels of savings within that sector of the market and
therefore on the investment decisions that will flow from an increase in retirement savings.
Government guarantees provided to bank deposits and bank borrowings vary from country
to country and are designed to increase confidence and stability in the nation-state's
financial system.

The GFC reinforced the importance of stability within the financial system. According to
the Reserve Bank of Australia, a stable financial system is characterised by the smooth flow
of funds between surplus and deficit units so that the advantages of a well-functioning
financial system that have been outlined in this chapter, including economic growth, have
the best chance of being realised. The GFC has had a significant impact on the flow of
funds in the global financial system. Government policy responses varied, but included the
provision of deposit and borrowing guarantees, the injection of an enormous amount of
liquidity into the financial system and the provision of additional capital for some
struggling financial institutions.

In some notable cases, especially Greece, Spain, Portugal, Ireland and Italy, the GFC,
combined with specific circumstances in each case, impacted severely on the financial
health of the government sector of these nation-states. The management of these sovereign
debt crises required the combined actions of the European Union (EU) through the
European Central Bank (ECB) and the International Monetary Fund (IMF). The support
packages provided to some nation-states, especially Greece and Spain, helped to support
their financial sectors. Significant uncertainties still cloud the global financial markets. The
task confronting governments, central banks and other regulators who wish to maintain the
stability of the financial system is very challenging.

The current challenges facing regulators are particularly acute. While the GFC has
receded into the recent past, residual aftershocks continue to be felt. Adding to the
challenge is the fact that new economic or financial shocks, only indirectly associated with
the GFC of 2008, have continued to emerge quite frequently since the main events of the
GFC subsided. This adds to the difficulty in focusing regulatory and policy initiatives.
These shocks include not only a growing list of European nation-states that are rumoured to
be experiencing sovereign debt problems (or are actually experiencing them) but ongoing
concerns about the US economy. During the middle of 2011, the world's financial markets
were gripped by levels of volatility not seen since the depths of the GFC when Standard &
Poor's downgraded the credit rating of the US government. In an interconnected modern
financial system this volatility is transmitted almost instantaneously around the world's
financial markets. Nation-states, of course, cannot single-handedly regulate globalised
financial markets.

For those who wish to extend their understanding of the financial system further, there are
three extended learning sections at the end of the chapter. Extended learning A considers
the globalisation of the financial markets, Extended learning B examines the impact of the
Asian financial crisis on the financial system and Extended learning C considers the GFC.

The remainder of Part 1 is devoted to an examination of the main financial institutions.


The role of commercial banks in the flow of funds, and explanations for their importance in
the financial system, are considered in Chapter 2. The main non-bank financial institutions
are examined in Chapter 3.

p. 31

REFLECTION POINTS

A modern financial system facilitates the efficient flow of funds from providers of
funds to users of funds.
A strong financial system will encourage savings and investment, which should lead to
economic growth.
The sectorial flow of funds in a domestic economy can be divided into four sectors:
business corporations, financial corporations, government and households. An
additional sector is the rest-of-the-world sector.
A sector may be a surplus sector or a deficit sector depending on whether it is a net
provider of funds or a net user of funds.
Financial crises, such as the GFC, have a significant disruptive impact on the flow of
funds in the financial system and highlight the importance of stability within the
financial system.

Financial news case study


In Chapter 1 and in the Extended learning sections, the GFC and the importance of regulation
are discussed. In many ways, Australia's economic performance and the stability of its
financial system during and after the GFC demonstrates the importance of strong regulation.
Why were Australian banks able to withstand the GFC without suffering the devastating
runs that beset many overseas banks? Why have scandals and corporate collapses not
reached the degree of notoriety of Bernard Madoff's Ponzi scheme in the USA? No doubt,
good fortune played a role but the strength of financial regulation in Australia is also an
important factor. Apply what you know about the financial system, regulation and the GFC to
the following extract from a speech by the Chairman of ASIC, Tony D'Aloisio.

There are many reasons why the GFC had less impact on the securities and investments
markets in Australia, but prominent among them is the architecture of the financial
regulatory regime and oversight role played in those markets by ASIC.

First, the regulatory architecture: since the GFC, it has not been necessary for Australia to
implement the kind of regulatory changes that have been necessary in other countries. This is
because of the more robust regulatory system we have in place.

The reason we have it in place does not necessarily lie in greater foresight of the GFC.
Rather, it lies in the fact that Australia went through a series of mini-crises since floating the
currency in 1983 (as did Canada, which for similar reasons had a sound financial and
oversight system going into the GFC). The difficulties of the state banks, the insurance
collapse of HIH and the collapse of Estate Mortgage brought with them the Wallis inquiry
and changes that strengthened Australia's regulatory architecture (e.g. the twin peaks
model).

These regulatory changes provided important safeguards in minimising the excesses that
we witnessed in other places during the GFC. Let me explain:

From 2002, we had introduced a strong regulatory regime and licensing system for
financial sales, advice and dealings in relation to financial products under the Financial
Services Reform Act 2001. This system assisted in maintaining market integrity.
Our Product Disclosure Statement (PDS) disclosure regime helped highlight the downside
of riskier product offerings to retail investors. The marketing arms of global investment
banks (many of which had extensive operations in Australia) would not have ordinarily
missed the opportunity to bring these products into Australia. Part of the reason for less
attraction to marketing these products may well have been our disclosure laws (e.g. the
PDS).
The regulatory framework around managed investment schemes discouraged Ponzi-type
schemes, like Madoff, and made it difficult for them to go undetected, as all schemes
offered to retail investors had to be registered and faced additional compliance and risk
management obligations.
p. 32

The regulatory oversight for gatekeepers such as auditors, financial advisers and other
intermediaries provided important protections.

As part of these reforms, ASIC had its oversight powers strengthened in the period prior to
the GFC. Under the chairmanship of Jeff Lucy, ASIC moved more heavily into surveillance
and compliance activities.

Its surveillance and shadow shopping initiatives and the FIDO website [replaced with
MONEYSMART] were all important contributors in better understanding risk and bringing
about greater transparency and disclosure of risk. Important examples in this regard were
improved auditor oversight arrangements, closer review of financial statements and the
formation of a compliance and surveillance directorate.

While there were other factors to explain why Australia fared better in the GFC, like a
strong economy, a strong banking sector, and a positive corporate ethical culture, the
strength of the financial regulatory architecture and ASIC's role in oversight were important
contributors to why Australia fared better and should not be underestimated.

SOURCE: D'Aloisio, T. (2010), Responding to the Global Financial Crisis: The ASIC
Story, Speech to the Trans-Tasman Business Circle, ASIC, 30 November 2010.

DISCUSSION POINTS

ASIC has replaced the FIDO website with MONEYSMART. Visit the MONEYSMART
website (www.moneysmart.gov.au) and see what advice you can find for investors
looking to invest in shares, futures and options. In particular, do you think that the website
will help investors to better understand the risks involved in these types of investments?
The ASIC chairman attributes part of Australia's relatively better performance during the
GFC to a positive corporate ethical culture. Do you believe that Australia does have a
positive corporate ethical culture? How significant a role do you think it played in helping
Australia avoid even more serious economic damage during and after the GFC?
What is a PDS? (Check the MoneySmart website if you are unsure.) Do you think that the
PDS requirement is an important contributor to the stability of Australia's financial
system?

Summary
LEARNING OBJECTIVE
Explain the functions of a modern financial system
1.1

The introduction of money and the development of local markets to trade goods were the
genesis of the financial system of today.
Money is a medium of exchange that facilitates transactions for goods and services.

With wealth being accumulated in the form of money, specialised markets developed to
enable the efficient transfer of funds from savers (surplus entities) to users of funds
(deficit entities).
A modern financial system comprises financial institutions, instruments and markets that
provide a wide range of financial products and services.
A financial system encourages accumulated savings which are then available for
investment within an economy.
Financial instruments incorporate attributes of risk, return (yield), liquidity and time-
pattern of cash flows. Savers are able to satisfy their own personal preferences by
choosing various combinations of these attributes.
By encouraging savings, and allocating savings to the most efficient users, the financial
system has an important role to play in the economic development and growth of a
country.

Categorise the main types of financial institutions, being LEARNING OBJECTIVE


depository financial institutions, investment banks and 1.2
merchant banks, contractual savings institutions,
finance companies and unit trusts

A range of different financial institutions has evolved to meet the needs of financial
market participants and to support economic growth. Chapters 2 and 3 examine the major
types of financial institutions. At this stage the institutions are categorised by the nature
of their principal activities.
p. 33
Depository institutions, such as commercial banks, building societies and credit unions,
specialise in gathering savings in the form of deposits and using those funds in the
provision of loans to customers.
Investment banks and merchant banks tend to specialise in the provision of advisory
services to clients (e.g. merger and acquisition advice).
Contractual savings institutions, such as insurance offices and superannuation funds,
enter into contracts in which they receive funds on the undertaking that they will pay a
policy holder, or member of a fund, a specified sum when a nominated event occurs.
Finance companies sell debt instruments directly to surplus entities and then use those
funds to provide loans and lease financing to borrowers.
Unit trusts sell units in a trust. The accumulated funds in the trust are pooled and invested
in asset classes specified within the trust deed.
Commercial banks dominate in terms of their share of the assets of financial institutions.

LEARNING OBJECTIVE
Define the main classes of financial instruments that are
issued into the financial system, that is, equity, debt,
1.3
hybrids and derivatives

Financial instruments are central to any financial relationship between two parties.

Where the saver acquires an ownership claim on the deficit entity, the financial
instrument is referred to as equity.
Where the relationship is a loan, the financial instrument is referred to as a debt
instrument.
A financial instrument that incorporates the characteristics of both debt and equity is
known as a hybrid.
Another category of instruments is derivatives (futures, forwards, swaps and options).
The main use of a derivative is in the management of commodity and financial risks.

LEARNING OBJECTIVE
Discuss the nature of the flow of funds between savers
and borrowers, including primary markets, secondary
1.4
markets, direct finance and intermediated finance

Financial markets and instruments allow borrowers to meet the requirements of the
matching principle; that is, short-term assets should be funded by short-term liabilities
and long-term assets should be funded by long-term liabilities and equity.
The markets in which new debt and equity securities are issued are known as primary
markets.
Markets that facilitate the sale of previously issued securities, such as a stock exchange,
are called secondary markets.
By providing a market for the trading of existing securities, secondary markets serve the
most important function of adding liquidity to financial instruments.
Where an active secondary market exists for a financial instrument, the instrument is
usually referred to as a security.
In the primary market, surplus entities may acquire assets directly from the issuer.

Alternatively, the flow of funds may be through a financial intermediary, in which case
the surplus entity establishes a financial relationship with the intermediary rather than
with the ultimate borrower.
Intermediated flows are attractive to many savers since the intermediary provides a range
of financial attributes that may not otherwise be available.
The advantages of financial intermediation include asset transformation, maturity
transformation, credit risk diversification and transformation, liquidity transformation and
economies of scale.

LEARNING OBJECTIVE
Distinguish between various financial market structures,
including wholesale markets and retail markets, and
1.5
money markets and capital markets

The financial markets are categorised as money markets (short-term securities) and
capital markets (longer-term securities).
Submarkets in the money markets include central bank transactions, the inter-bank
market, the bills market, the commercial paper market, the government securities market
and the CD market.
The capital markets include the equity market, the corporate debt market, the government
debt market, the foreign exchange market and the derivatives market.
Within the money and capital markets there are also the wholesale markets (institutional
investors) and the retail markets.
Money markets experienced significant liquidity problems during the GFC. The lingering
effects of the crisis and new concerns about the economic stability of many developed
nation-states continue to weigh on the financial markets.
p. 34

LEARNING OBJECTIVE
Analyse the flow of funds through the financial system 1.6
and the economy and briefly discuss the importance of
stability in relation to the flow of funds

Sectorial flow of funds may be observed within an economy.

Sectors include the business corporations sector, the financial corporations sector, the
government sector, the household sector and the rest-of-the-world sector.
These sectors may be net surplus sectors (providers of funds) or net deficit sectors (users
of funds).
Factors that affect these sectors are government policy initiatives and economic
performance.
A stable financial system is characterised by the smooth flow of funds between surplus
and deficit units. The GFC highlighted the importance of maintaining stability in the
financial system.

Extended learning A
Globalisation of the financial markets LEARNING
A nation-state's financial system is an integral part of
OBJECTIVE 1.7
the global financial system. An important relationship
exists between an efficient financial system and growth Appreciate the importance of
in the real economy within a nation-state. (This was globalisation of the
discussed earlier in the chapte.) Similarly, as production international financial
and international trade between multinational markets
corporations and governments expanded, so too did the
need for a global financial system to support that
expansion.
Essentially, globalisation the integration of financial institutions, instruments and
markets into an international financial system refers to the process whereby financial
markets are interconnected, interdependent and integrated. The rapid development and
adoption of technology-based information systems, communication systems and product
delivery systems has facilitated globalisation of the financial markets and the standardisation
of the financial instruments used in the global markets. At the same time, technology has
enabled the development of a whole new range of sophisticated financial instruments that
facilitate the movement of funds between surplus units and deficit units in different nation-
states. New markets in risk management products, in particular those using derivative
products, have also evolved.

While the role of technology in the development of global financial markets is critical, it
should be noted that there are a number of other important factors and relationships that
impact upon globalisation. These include:

Unrestricted movement of capital around the world. Theoretically, the global market will
encourage savings and allocate those savings efficiently to the most productive purposes
without regard to national boundaries.
Deregulation of nation-state financial systems, including the removal of significant
regulatory constraints that restrict financial markets, products, participants and pricing.
Financial innovation, to develop new systems, products and services.

The need of corporations and governments to diversify their funding sources on a global
scale.
Increased competition between financial markets and institutions for the provision of
financial products and services.
Exchange rate, interest rate and price volatility within the international markets and the
associated increase in demand for risk management products.
Changing demographic and savings patterns. For example, the ageing of populations of
many economies has resulted in the accumulation and mobilisation of greater levels of
savings.
The development of emerging markets, in particular, parts of Asia, South America and
Eastern Europe.

Rapid technological innovation and a more sophisticated business environment, together


with longer-term changes in the financial needs of market participants, are reshaping the
financial system. A progressively greater array of participants, products and distribution
channels has developed (and will continue to develop) the financial system. Competition is
emerging from new providers of financial services and through the increasing globalisation of
financial markets. Nation-states are striving to achieve improved market efficiency and
performance.

To help understand the drivers for change in a modern financial system, it is beneficial to
refer to the report of an Australian review of the financial system. The Wallis Report a
committee report, Financial System Inquiry Final Report, AGPS, Canberra, March 1997
(www.treasury.gov.au), released in 1997, considered the international nature of financial
systems and identified four principal areas that directly affect an evolving financial system.
These are:

changing customer needs

technology-driven innovation

p. 35

regulation as a driver of change


the changing financial landscape

Changing customer needs

It is evident that changing population demographics have a major influence on the evolution
of a financial system. A significant number of nation-states are moving into an extended
period in which populations are ageing. At the same time fertility rates have fallen, which in
turn will result in higher dependency ratios; that is, a smaller workforce will need to support a
larger retired population. This will also place a greater strain on the provision of services by
government.

The resultant financial system issues that are apparent include:

the need for greater asset accumulation by individuals

the implementation of adequate superannuation and retirement savings initiatives and


strategies
a significant shift to funds under management, particularly market-linked investments

increased financial advisory services for business and individuals

Changing work patterns are also evident, with workforces generally becoming more
educated as individuals strive to achieve higher qualifications to meet the expectations of the
business sector. Individuals are tending to work longer hours in an environment in which
there is lower job security. A higher percentage of the workforce may be in part-time
employment or self-employed. For many, retirement is occurring at an earlier age, either
through choice or by forced redundancy.

The implications for the financial system are that there is a need for:

more convenient electronic product delivery systems

financing products that allow for low-income periods and smooth out cash flows over
the life cycle of an individual

Another aspect of changing customer needs is an evolving awareness of value and an


increasing accumulation of both financial assets and liabilities by the household sector. In an
information age, individuals are more educated and seek more financial information in order
to ensure future financial security. The extent and quality of publicly available financial
information has multiplied, as has the provision of financial planning services. Participants
are more aware of, and sensitive to, price competitiveness and changes.

At the same time, two contradictory portfolio structural developments have been occurring.
First, there has been significant growth in asset accumulation through superannuation saving
and property and share ownership. Second, there has been an enormous increase in household
debt to support higher living standards and more expensive lifestyles. Each of these factors is
increasing the need for financial innovation, greater competition and prudent supervision of
the financial system.

Technology-driven innovation

Clearly, improvements in communications infrastructure and technology are breaking down


the physical constraints and cost barriers to the transmission, storage and use of information.
Examples of the expansion of electronic information and product delivery systems include
ATM and EFTPOS networks, internet and telephone services and the efficiency of the
payments system.

Many financial institutions and markets have developed proprietary information networks
within a context of external pressure for standardisation, access, ease of use, cost
effectiveness and, importantly, secure information transmission and user authentication.
Technology is being used to gain a competitive advantage as the physical location of
customers becomes less important. Technology enables new competitors to enter the financial
markets, but the capital cost of technology is rising and driving a move towards greater
rationalisation of institutions and markets on a global scale.

Regulation as a driver of change

Changes in the structure of, and responsibility for, regulation and prudential supervision have
been a significant driver of change within the financial systems of nation-states. For example,
in Australia the Reserve Bank is responsible for the soundness of the payments system and
overall financial system stability. The Australian Prudential Regulation Authority (APRA) is
responsible for the prudential supervision of authorised deposit-taking institutions, the
Australian Securities and Investments Commission (ASIC) is responsible for market integrity
and the Australian Competition and Consumer Commission (ACCC) is responsible for
competition policy and consumer protection.

Examples of some of the major regulatory changes that have occurred have been the
floating of exchange rates of many nation-states, the removal of barriers to the flow of
capital, the removal of interest rate and product controls and the granting of authorities for
foreign banks to operate within nation-states. Other regulatory changes, such as the
implementation of capital adequacy standards, are discussed in Chapter 2.

p. 36

The changing financial landscape

The breaking down of barriers within nation-state financial systemsthat is, between
institutions, instruments and marketshas increased competition. Globalisation has had a
similar impact on the international financial system. The traditional roles of financial
institutions have become blurred as commercial banks, investment banks, insurance offices
and other financial institutions provide a much wider range of products and services. The
changing financial landscape has produced significant outcomes: more competitive pricing of
financial products and services, the rationalisation of market participants, and product
innovation (in particular, financial risk management products). International competition
continues to grow as market participants pursue new international opportunities.

The linkages between economic growth and a modern and efficient financial system have
been well established. As a nation-state's economic performance becomes more tied to the
international economy, so too will the international financial system need to respond to those
dynamic forces.

Extended learning B
The impact of the Asian financial crisis on the LEARNING
financial system OBJECTIVE 1.8
This chapter has recognised the importance of a
modern, efficient and stable financial system as a Understand the effects and
critical component of sustained economic and social consequences of a financial
growth. This fundamental principle applies to nation- crisis on a financial system
states, geographic regions and, ultimately, the global and a real economy
economy. The proposition is aptly demonstrated by the (Extended learning B and
so-called Asian financial crisis that became manifest Extended learning C).
from mid-1997.

While the Asian financial crisis occurred some time ago, it is an excellent learning case
study. The crisis was more than a financial crisis; it extended into a major economic and
social crisis as well. Nation-states and the global financial system are periodically adversely
affected by financial crises, the most recent being the so-called sub-prime market crisis in the
USA which evolved into a global credit crisis. The interesting, but unfortunate, observation
of financial crises is that they tend to repeat themselves over time. The lessons learned from
one crisis are eventually thought to be irrelevant to the current market environment. This
leads to an environment where a new crisis can grow. The reality is that the fundamentals of
risk management don't change. Managers and regulators need to understand risk and who is
actually holding (or exposed to) risk. Within the context of the financial system, risk needs to
be identified, measured and managed.

Much has been written about the Asian financial crisis. Here, only a brief analysis and
discussion of events is provided. After gaining some understanding of the complexity of the
factors that precipitated the crisis, and of the inevitable flow-on effects that proceeded from
it, students are advised to read papers published on the topic. These include various issues of
the Reserve Bank of Australia's RBA Bulletin, the Bank for International Settlements BIS
68th Annual Report (1998) (www.bis.org) and papers published by the Federal Reserve Bank
of New York (www.ny.frb.org).

The 1980s and early 1990s were a period of enormous economic growth and prosperity
within what was often described as the tiger countries of Asia, in particular Hong Kong,
Singapore, Malaysia, Thailand, South Korea and Indonesia. However, the late 1990s saw the
bubble burst, and the region experienced severe economic, financial and social reversals.

Prior to mid-1997, Thailand maintained a fixed exchange rate regime whereby the Thai
baht was pegged to a basket of currencies, predominantly the US dollar, the Japanese yen and
the German deutschmark. The currency came under sustained pressure and the central bank
of Thailand was unable to continue to support the fixed exchange rate. On 2 July 1997
Thailand floated its currency, and this essentially became the trigger for the Asian currency
crisis, as other fixed exchange rate regimes, including the Philippine peso, the Malaysian
ringgit and the Indonesian rupiah, all fell victim to the foreign exchange market.

The situation rapidly evolved into a financial and economic crisis, initially encompassing
Thailand, Indonesia, the Philippines and Malaysia but eventually extending to Japan, South
Korea, Russia and Brazil. The contagion effects of the ever-expanding crisis were not
restricted to these countries. Other countries in the regionSingapore, Hong Kong, Australia
and New Zealandall experienced negative consequential effects of the crisis, as did the
majority of global economies, including the USA.

In order to understand the flow-on effects of the crisis, it is important to understand the
relationships that exist between risks associated with foreign exchange, interest rates,
liquidity, price, credit and capital. For example, there is a statistical relationship between
interest rates and exchange rates. Normally, if an exchange rate depreciates significantly,
domestic interest rates will rise. The rise in interest rates will affect the profitability of the
business sector, and therefore stock prices will fall. If asset price inflation has also been
evident, then asset prices would be expected to fall. The combined effect so far will cause a
lack of confidence in the economy and a fall in business activity.

p. 37

Higher interest rates and lower economic activity will lead to businesses defaulting on
credit, which will place pressure on the capital ratios of financial institutions. Also, as with
the Asian crisis, a large portion of a country's debt may be denominated in unhedged foreign
currencies, and depreciation of the domestic currency will result in higher real interest and
principal repayments. While this is happening, liquidity in the market disappears as financial
institutions and investors withdraw. All these risk factors occurred with the Asian crisis.

In its 1998 annual report, the Bank for International Settlements identified the following
weaknesses that were common in the Asian crisis countries:

Excessive bank credit was available, which encouraged over-investment in industrial


capacity (in particular, office buildings and condominiums) and an asset price boom and
bust.
There was no recognition of the fragility of domestic financial systems, because of
historic monetary and exchange rate stability, coupled with an extended period of
economic growth. As financial risks increased in the overheated economies, lending
margins actually fell. Moral hazardthe taking of excessive risk in the belief that losses
will be diminished by regulation or insurance risk existed in that there was an
expectation that government would always support major financial institutions. Capital
ratios were also relatively low.
There was a reliance on potentially volatile external finance, particularly short-term
funding. Much of the external borrowing was not hedged against foreign exchange risk,
as it was perceived that such risk did not exist in the fixed exchange rate regime.
Enormous capital inflows were suddenly exposed to foreign exchange risk when
currencies were floated. At the same time, external investor confidence dissipated and
there were significant capital outflows, as indicated in Table 1B.1.
TABLE 1B.1 NET PRIVATE CAPITAL FLOWS, ASIA* (USD
BILLIONS)

* India, Indonesia, South Korea, Malaysia, the Philippines, Singapore, Taiwan and Thailand.
SOURCE: Bank For International Settlements, BIS 68th Annual Report, Basel, June 1998, p.
133.

Central banks in the region, in an effort to support their depreciating currencies and stem
capital outflows, raised overnight interest rates significantly. The effects on interest rates,
stock market prices and exchange rates are shown in Table 1B.2.

TABLE 1B.2 INTEREST RATES AND EXCHANGE RATES DURING


THE CRISIS
* Percentage change in the US dollar/local currency exchange rate since June 1997.
SOURCE: Bank For International Settlements, BIS 68th Annual Report, Basel, June 1998, p.
136.

p. 38

The global financial crisis that resulted from the Asian financial crisis caused regulators,
government policy makers, academics and market participants to exercise their collective
minds to reconsider issues of signals, cause, effect, regulation and financial system
architecture.

While changes in the structure, regulation and operation of the global financial system have
occurred, and will continue to occur, history indicates that change is usually a very slow
process. The lessons of the Asian financial crisis have prompted the Reserve Bank (RBA
Bulletin, April 1998, p. 2) to identify a list of questions to ask about a country's financial
system if there is the likelihood of a currency crisis or a wider economic crisis.

Does the country have a fixed exchange rate and free movement of international capital

Is the exchange rate overvalued?

Has a country with similar economic characteristics recently experienced a currency


crisis?
Is there a large budget deficit and a lot of government debt outstanding?

Is there loose monetary policy and high inflation?

Is the domestic economy in, or at risk of, a recession?

Is there a large current account deficit?

Is there a large amount of foreign debt?

Is there an asset price boom (especially credit driven) occurring?

Are there a lot of bad debts in the banking system, or is there a poor system of bank
supervision?
Has there been a lot of unhedged foreign currency borrowing?

Are there poor accounting standards, few disclosure requirements or ambiguous


bankruptcy procedures?

These 12 points form a strong starting point for financial crisis analysis. However, you
should be aware that all of the factors will not always be evident, and that the existence of
some factors does not by itself imply an imminent crisis situation. Also, as with past financial
crises, each future crisis will have its own particular set of defining characteristics.
Extended learning C
The global financial crisis LEARNING
The GFC has been described as the most significant
OBJECTIVE 1.8
economic crisis since the Great Depression in the
1930s. In 2007, realisation that house prices in the USA Understand the effects and
had begun to fall and mortgage defaults were consequences of a financial
increasing, particularly in sub-prime mortgages loans crisis on a financial system
to borrowers that under normal credit assessment and a real economy
standards would not have the capacity to repay which
had been issued to low-income individuals and
sometimes without a documented ability to meet the
monthly repayments, initiated a liquidation of trading
positions in the mortgage markets which quickly
evolved into a banking crisis. Uncertainty about the
value of assets posted as collateral and the solvency of
counterparties significantly disrupted the financing
arrangements upon which financial institutions relied to
fund their activities. Uncertainty about the solvency of
financial institutions flowed through the financial
system. Unable to fund their activities through the usual
channels, some financial institutions were forced to seek
equity capital injections from investors or obtain
emergency funding from central banks. Some were
bailed out by the government. Others were forced to sell
themselves to stronger financial institutions. Many
others were forced to file for bankruptcy.

The effects of the crisis flowed into the real economy. Economic growth in the USA
slowed considerably. According to the Bureau of Economic Analysis (www.bea.gov), from
the second half of 2008 through the first half of 2009, the USA experienced four consecutive
quarters of negative economic growth (falling gross domestic product or GDP). Contributing
to this were severe declines in private investment, including back-to-back declines of 36 per
cent and 42 per cent in 2009. The Bureau of Labor Statistics (www.bls.gov) records a steep
increase in the unemployment rate in the USA, which doubled from 5 per cent in 2007 to just
over 10 per cent in 2009. Amid the uncertainty and economic turmoil, financial markets
continued to reel. Share markets in most of the advanced economies experienced precipitous
falls and at the depths of the crisis had recorded losses of more than 50 per cent. The USA
stock market alone experienced losses in 2008 of $8 trillion. Currency markets were not
immune from the volatility. The Australian dollar experienced depreciations of more than 30
per cent against the major currencies.

During the crisis, a number of prestigious Wall Street firms lost their independence or
failed completely. Bear Stearns was purchased by JPMorgan Chase for just $10 per share in
March 2008 after trading at $150 per share a year earlier. In July, the mortgage broker,
IndyMac, was placed in conservatorship by the government. In September, two
government-chartered mortgage lenders, Freddie Mac and Fannie Mae, were similarly placed
in the care of the government. Lehman Brothers collapsed in mid-September. At the same
time that Lehman tried in vain to arrange a bailout or takeover, Merrill Lynch sold itself to
Bank of America and managed to avoid a worse fate. Lehman's collapse created enormous
market volatility as market participants struggled to predict the effects of Lehman's failure on
the intertwined network of trades that characterises the financial markets. Governments and
central banks desperately tried to stabilise the markets. Meanwhile, other financial
institutions found themselves under tremendous pressure. Washington Mutual was placed in
receivership. Wachovia was purchased by Wells Fargo. AIG was effectively taken over by
the Federal Reserve the central bank of the USA.

p. 39

Banks and financial institutions are always vulnerable to runs. These are situations where
many customers all at once demand their money back from a financial institution. Financial
institutions do not operate with 100 per cent reserves and cannot possibly meet all of these
demands. Before the GFC, financial institutions, which are always vulnerable, became more
vulnerable because of maturity mismatching in their financing arrangements. Most financial
institutions had become reliant on very short-term or over-night financing to finance their
operations. Repurchase agreements or repos are very short-term funding arrangements and
financial institutions had come to rely very heavily on over-night repo financing in the decade
before the crisis. During the crisis, when financial institutions became wary about the
solvency of their counterparties (and themselves, of course), repo financing became either
very much more expensive or impossible to secure. Without the over-night repo markets,
financial institutions did not have the capital to sustain their operations for any length of time.
This was exacerbated by the redemption and withdrawal requests being received from
investors and depositors. Bear Stearns, for example, found that it was unable to secure repo
financing once doubts surfaced about its solvency. Although Bear had more than $18 billion
in capital, this fell far short of what was required to finance its day-to-day operations. Bear
Stearns was taken over by JPMorgan Chase just a few days after its repo financing
evaporated. With Bear Stearns gone, the financial markets awaited the next domino to fall.

When the crisis hit, information about the market value of the securities traded among
financial institutions and the magnitude of financial obligations of particular institutions was
difficult or impossible to obtain. Collateralised debt obligations (CDOs), which are portfolios
of mortgages and other loans arranged into tranches according to levels of risk, are complex
by nature because it is very difficult to determine the quality of the numerous individual loans
in each of the tranches. This complexity and the absence of liquid secondary markets for the
securities led to large write-downs in the estimated values of these securities when financial
institutions realised that there were no buyers willing to engage in transactions at prices even
close to the previously recorded selling prices. With prices falling, write-downs in the value
of positions in these markets spiralled downwards. Uncertainty about which institutions held
the riskiest CDO tranches contributed to financial institutions' unwillingness to extend
financing to their counterparties. To make matters even worse, buyers of CDOs had usually
entered into credit default swaps (CDSs) with other financial institutions. CDSs were
designed to insure their buyers against default on bonds, tranches or by institutions. As CDOs
fell rapidly in value and financial institutions reeled, the large outstanding liabilities
potentially facing the sellers of CDSs and the uncertainty over how much insurance had
been sold by which institutions contributed further to the spiral in valuations, balance-sheet
write-downs and the viability of financial institutions.

A number of explanations for the GFC have been proposed. These include greed,
irrationality, fraud, the inherent instability of capitalism, the disproportionate size of the
financial sector compared to the manufacturing or real sector of the economy, shadow
banking, lax lending standards, deregulation and free-market policies, the over-reliance on
badly designed mathematical models for measuring risk, inappropriate incentives structures
within financial institutions, captured ratings agencies that were too lenient in rating
mortgage debt, out-of-control financial innovation and misguided government or central bank
policy. There are many different points of view and strong and convincing arguments can be
made for each of the possible explanations for the GFC. Whatever role each of these factors
might have played, the fundamental explanation for the GFC is quite straightforward.
Throughout the early 2000s, central banks, particularly the Federal Reserve, set interest rates
at very low levels. This created a boom in consumption, housing and other asset prices driven
by the easy credit available throughout the economic system. In the absence of increasingly
intense credit expansion, sooner or later, the credit-driven boom had to come to an end. The
larger and longer the boom, the more catastrophic the ensuing recession or depression must
be. Despite the unique circumstances of each individual case, all economic crises can be
traced to this same root cause.

p. 40

Following the onset of the crisis, governments and central banks around the world
undertook unprecedented interventions in the financial and economic systems. In the USA,
for example, the federal government arranged a $700 billion bailout plan and, as we have
seen, even took ownership of some financial institutions. In Australia, the federal government
implemented a guarantee on deposits with banks, building societies and credit unions to
prevent runs on these institutions by their customers. As the banking crisis gave way to
concerns about economic growth, governments turned their attention to fiscal stimulus to
encourage economic activity and prevent recession. In Australia, the government
implemented two stimulus packages totalling more than $50 billion in late 2008 and early
2009. In Australia, various factors contributed to greater stability during the crisis and a
mitigation of its effects on the real economy. In the USA, the story is much different. Even
some years after the crisis, the Federal Reserve is engaged in quantitative easing (credit
easing) designed to encourage economic activity by pumping billions of dollars into the
financial sector. It will remain to be seen whether such policies can restore the economy to
normal business conditions.

Many lessons might be learned from the GFC. A stable financial sector is vital to the health
of the overall economy. Perceived mistakes by regulators, including allowing interest rates to
remain at very low levels for long periods of time, along with perceptions that the crisis was
caused by a financial sector that is out of control, have sparked calls for strong regulatory
reforms. Innovative financial products and securities, such as CDOs and CDSs, present a
challenge to regulators. New products do not always fall within the scope of existing
regulations. The incentive arrangements and governance within financial institutions is
another factor that attracted the attention of critics before, during and after the GFC.
Regulations that limit compensation packages within the financial sector or realign incentive
structures such that they do not encourage large amounts of risk taking represent attractive
options to those who are critical of perceived excesses within the financial sector. Finally, the
way that risk is managed within financial institutions has emerged as a very prominent
subject. Risk is intertwined and interrelated. The existence of one risk will change the
dynamics of other risk exposures. With the GFC, it appears that there was a lack of
understanding of who was ultimately holding risk and the impact on the markets if the
ultimate risk holder failed. For example, CDOs simply moved the risk exposure from one
party to another party. Everyone made money along the way, including the mortgage brokers,
the banks, the credit rating agencies and the fund managers, but the risk was still in the
financial system. The process of risk shifting was also often made easier by implicit or
explicit guarantees given by governments, often with limited or no regulatory oversight.

The following major risk exposures have all been evident in the sub-prime credit crisis:

credit risk

liquidity risk

capital risk

foreign exchange risk

interest rate risk

investment risk
country and sovereign risk

As a challenge, consider each of these risks and their relationships within the context of the
above crisis.

Key terms
asset portfolioa combination of 8
assets, each2 comprising attributes of
return, risk, liquidity and timing of
cash flows
asset transformationthe ability of 20
financial intermediaries to provide a
range of products that meet
customers portfolio preferences
bills marketan active money market 25
for the issue and trading of bills of
exchange (discount securities)
bondsa long-term debt instrument 15
issued directly into the capital
markets that pays the bond-holder
periodic interest coupons and the
principal is repaid at maturity
brokeran agent who carries out the 17
instructions of a client
capital marketsmarkets for longer- 25
term funding; includes equity,
corporate debt and government debt,
and is supported by the foreign
exchange and derivatives markets
commercial paperpromissory notes 25
(discount securities) issued into the
money market by corporations with a
good credit rating
compulsory 30
superannuationemployers must
contribute minimum specified
amounts into retirement savings for
employees (Australia)
contractual savings institutionsoffer 9,10
financial contracts such as insurance
and superannuation; large investors
corporate debt marketsfacilitate the 26
issue and trading of debt securities
issued by corporations (e.g. discount
securities, bonds)
credit ratingthe assessment by a 18
credit rating agency of the
creditworthiness of an obligor to a
financial obligation
credit risk transformationa savers 20
credit risk exposure is limited to the
intermediary; the intermediary is
exposed to the credit risk of the
ultimate borrower
crowding outgovernment borrowing 27
that reduces the net amount of funds
available for other lending in the
financial system
dealermakes a market in a security by 17
quoting both buy (bid) and sell (offer)
prices
debt instrumentsspecify conditions of 13
a loan agreement; issuer/borrower,
amount, return, timing of cash flows,
maturity date; debt must be repaid
default riskthe risk that a borrower 18
may not meet financial commitments
such as loan repayments when they
are due
deficit unitsborrowers or users of 29
funds
depository financial 9
institutionsaccept deposits and
provide loans to customers (e.g.
commercial banks, credit unions)
derivative instrumenta synthetic 13
security that derives its price from a
physical market commodity or
security; mainly used to manage risk
exposures
derivatives marketsmarkets in 28
synthetic risk management products;
futures, forwards, options, swaps
direct financefunding obtained direct 17
from the money markets and capital
markets
discount securitiesshort-term 24
securities issued with a face value
payable at maturity; does not pay
interest; sold today at a discount to
the face value
dividendthat part of a corporations 12
profit that is distributed to
shareholders
economies of scalefinancial and 21
operational benefits gained from
organisational size, expertise and
volume of business
p. 41 12

equitythe sum of the financial interest


an investor has in an asset; an
ownership position
equity marketsfacilitate the issue of 26
financial securities that represent an
ownership interest in an asset (e.g.
stock market)
euromarket instrumentsfinancial 27
transactions conducted in a foreign
country in a currency other than the
currency of that country
Federal Reservethe central bank of 39
the USA
finance companiesborrow funds 10
direct from markets to provide loans
and lease finance to customers
financial instrumentsissued by a 7
party raising funds, acknowledging a
financial commitment and entitling the
holder to specified future cash flows
financial systemcomprises a range of 7
financial institutions, instruments and
markets; overseen by central bank;
supervised by prudential regulator
fiscal policythe management of 30
annual revenues and expenditures of a
government
flow of fundsmovement of funds 7
through a financial system
foreign exchange marketsmarkets 27
that facilitate the buying and selling of
foreign currencies
forward contractan over-the-counter 14
agreement that locks in a price
(interest rate or exchange rate) that
will apply at a future date
futures contractan exchange-traded 13
agreement to buy or sell a specific
commodity or financial instrument at
a specific price at a predetermined
future date
general financiersborrow funds 10
direct from markets to provide loans
and lease finance to customers
global financial crisis (GFC)the 5
global financial crisis (GFC) refers to
the financial crisis of 2008 that has
been traced to the collapse of the
housing market in the United States
and the consequences of that collapse
for the market for mortgage-related
securities
globalisationthe integration of 34
financial institutions, instruments and
markets into an international financial
system
government debtgovernment 27
borrowing for short-term liquidity
needs, or longer-term budget capital
expenditures (T-notes, Treasury
bonds)
hybrid securitya financial instrument 12
that incorporates the characteristics
of both debt and equity (e.g.
preference shares)
inflationan increase in prices of 8
goods and services over time;
measured by the consumer price index
(CPI)
institutional investorsparticipants in 22
the wholesale markets (e.g. funds
managers, insurance offices, banks)
inter-bank marketthe lending and 24
borrowing of very short term funds by
banks operating in the payments
system
intermediated financefinancial 19
transaction conducted with a financial
intermediary (e.g. bank deposits and
bank loans); separate contractual
agreements
investment banksspecialist providers 9,10
of financial and advisory services to
corporations, high-net-worth
individuals and government
liability managementwhere banks 20
actively manage their sources of funds
(liabilities) in order to meet future
loan demand (assets)
liquidationthe legal process of 13
winding up the affairs of a company in
financial distress
liquidityaccess to cash and other 7,8
sources of funds to meet day-to-day
expenses and commitments
liquidity transformationmeasured by 21
the ability of a saver to convert a
financial instrument into cash
matching principleshort-term assets 15
should be funded with short-term
liabilities; longer-term assets should
be funded with longer-term liabilities
and equity
maturity transformationfinancial 20
intermediaries offer products with a
range of terms to maturity
merchant banksspecialist providers 9,10
of financial and advisory services to
corporations, high-net-worth
individuals and government
monetary policyactions of a central 8
bank that influence the level of
interest rates in order to achieve
economic outcomes; primary target is
inflation
moneya commodity that is universally 16
accepted as a medium of exchange
money marketswholesale markets in 22
which short-term securities are issued
and traded
moral hazardthe taking of excessive 37
risk in the belief that losses will be
diminished by regulation or insurance
negotiable certificate of deposita 25
discount security issued by a bank
negotiable debt instrumenta debt 13
instrument that can be sold by the
original lender through a financial
market
option contractthe right, but not the 14
obligation, to buy or sell a commodity
or security at a predetermined
exercise price; the option buyer pays
a premium to the option writer
ordinary share or common stockthe 12
principal form of equity issued by a
corporation; bestows certain rights to
the shareholder
overdraft facilitya fluctuating credit 15
facility provided by a bank; allows a
business operating account to go into
debit up to an agreed limit
portfolio structuringthe buying and 8
selling of assets and liabilities to best
meet current savings, investment and
funding needs
primary market transactionthe issue 16
of a new financial instrument; funds
are obtained by the issuer
rate of returnthe financial benefit 7,8
gained from investment of savings;
expressed in percentage terms
retail marketfinancial transactions 22
conducted with financial
intermediaries mainly by individuals
and small to medium-sized businesses
return or yieldthe total financial 7,8
benefit received (interest and capital
gain) from an investment; expressed
as a percentage
riskthe possibility or probability that 7,8
an actual outcome will vary from the
expected outcome; uncertainty
secondary market transactionthe 16
buying and selling of existing
financial securities; transfer of
ownership, no new funds raised by
issuer
sectorial flow of fundsthe flow of 29
funds between surplus and deficit
sectors in an economy; the business,
financial, government, household and
rest-of-the-world sectors
secured debta debt instrument that 13
provides the lender with a claim over
specified assets if the borrower
defaults
securitiesfinancial assets that are 17
traded in a formal secondary market
(e.g. stock exchange)
securitisationnon-liquid assets are 11
sold into a trust; the trustee issues
new securities; cash flows from the
original securities are used to repay
the new securities
short sellingthe sale of a financial 5
product that the seller does not own.
The seller has a view to repurchasing
the product at a lower price
sub-prime mortgagesloans to 38
borrowers that under normal credit
assessment standards would not have
the capacity to repay
surplus unitssavers or providers of 7
funds; funds are available for lending
or investment
swap contractan agreement between 14
two parties to swap future cash flows;
interest rate swaps and currency
swaps
time-pattern of cash flowsthe 7,8
frequency of periodic cash flows
(interest and principal) associated
with a financial instrument
unit trustsinvestors buy units issued 10
by the trust; pooled funds invested
(e.g. equity trusts and property trusts)
Wallis Reporta committee report, 34
Financial System Inquiry Final
Report, AGPS, Canberra, March 1997
(www.treasury.gov.au)
wholesale marketdirect financial 21
flow transactions between
institutional investors and borrowers

True/False Questions
QUESTIONS

Answer TRUE or FALSE to the following statements. To assist in your review, you
might also write brief notes explaining your response.
1. Money is a medium of exchange that includes attributes of divisibility and a store
of value.
2. A modern financial system may be said to comprise three major components:
financial institutions, instruments and markets.
3. The time-pattern of the cash flows attribute of a financial asset refers to the term to
maturity of an instrument.
4. A well-functioning financial system is expected to allocate savings to the most
efficient users of the funds.
5. Financial assets incorporate a number of attributes. The risk attribute refers to the
probability that suppliers of funds will not purchase a particular asset when it is
issued.
6. Monetary policy is the actions of a central bank that influence the level of interest
rates in order to achieve certain economic objectives.
7. A principal role of investment banks is to gather deposit savings from customers
and provide loans to their retail clients.
8. Finance companies are examples of contractual savings institutions.
9. The matching principle contends that short-term assets should be funded with
equity.
10. Equity in a corporation represents an ownership position that is represented by the
issue of ordinary shares.
11. Debt differs from equity in that debt normally has a specified life and pays some
form of return to the debt holder.
p. A derivative contract is a hybrid security that incorporates the characteristics of
42 both debt and equity.

12.
13. The issue of new shares by a corporation provides the firm with additional equity
funding and is an example of a primary market transaction.
14. The issue of new money-market debt securities by a borrower is said to be a
secondary market transaction.
15. In a direct financial flow the surplus entity provides funds to the deficit entity and
acquires a primary claim from the user of the funds.
16. Three advantages of intermediated finance are asset transformation, liquidity
transformation and maturity transformation.
17. Money-market securities are exclusively debt instruments, and capital-market
instruments are exclusively equity securities.
18. Bills of exchange and promissory notes are discount securities that may be traded
in the money markets.
19. Borrowers in the international markets obtain long-term loans from the foreign
exchange market.
20. The corporate sector borrows to fund business activities and therefore is typically a
deficit sector within the economy.

Essay Questions
Write short essay-type responses to the following questions. Make sure that you are
able to explain in your own words the points you raise in relation to each question.

1. A highly developed and efficient financial system is essential to ongoing economic


growth and prosperity. Discuss the component parts that form a financial system and
the relevance of the above statement. (LO 1.1)
2. Discuss the role of information in a financial system. (LO 1.1)
3. Explain why an investor should consider the time-pattern of cash flows and the
variability of the cash flows associated with a multi-period investment rather than
simply assessing the investment on the basis of the total cash flows received. (LO 1.1)
4. The major financial institutions within the international markets fall into five
classifications. Identify and briefly explain each of these classifications. Give an
example of different types of institution that operate within a classification. (LO 1.2)
5. The financial institutions in Australia hold a considerable amount of assets. Over time,
the distribution of these assets among the financial institutions exhibits some
substantial changes. For example, between 1990 and 2008 securitisation vehicles
experienced substantial growth only to suffer a considerable decline after the GFC.
Identify and discuss the three most significant changes in the distribution of assets
among the financial institutions that have occurred in each of the two time periods
1990 to 2008 and 2008 to 2010 covered by Table 1.1(LO 1.2)
6. Financial instruments may be categorised as equity, debt or derivatives. Discuss each
category. In your answer, make sure you explain the differences between debt, equity
and derivatives. (LO 1.3)
7. During the GFC, the funding of longer-term assets with short-term borrowing was
identified as a point of weakness in the operations of financial institutions. Discuss this
statement with reference to the matching principle. (LO 1.4)
8. (a) What are the differences between primary market and secondary market financial
transactions?
(b) Why is the existence of well-developed secondary markets important to the
functioning of the primary markets within the financial system? (LO 1.4)
9. Explain the meaning of the terms financial assets, financial instruments and
securities. What is the difference between these terms? Give examples of financial
instruments and securities. (LO 1.4)
10. Banks are the major providers of intermediated finance to the household and business
sectors of an economy. In carrying out the intermediation process, banks perform a
range of important functions. List these functions and discuss their importance for the
financial system. (LO 1.4)
p. The development of domestic capital markets is extremely important for economic
43 growth as they provide the long-term funds necessary for productive investment.
Discuss this statement using the equity market and the corporate debt market as
11. examples. (LO 1.5)
12. Corporations often issue long-term debt instruments into the international capital
markets to raise funds. Explain the relationship between the issue of paper into the
international capital markets and the foreign exchange market and the derivatives
market. (LO 1.5)
13. Discuss the sectorial flow of funds. In your answer, identify five sectors that are
representative of the sectorial flow of funds. Why is an understanding of the sectorial
flow of funds important for economic policy determination? (LO 1.6)

EXTENDED LEARNING QUESTIONS

14. The evolution of nation-state financial systems into an integrated global financial
system has occurred, and continues to occur, due to a number of specific factors.
Identify and discuss the factors that have influenced the development of the global
financial system. (LO 1.7)
15. (a) The Asian financial crisis provided some valuable lessons about nation-state and
global financial systems. What are some of those lessons?
(b) The GFC has had a significant impact on the stability of international financial
markets. Discuss the implications of the crisis for the real economy and evaluate
the regulatory responses that have been implemented in an attempt to stabilise the
financial system.(LO 1.8)
Chapter2: Commercial banks

Chapter Opener
p. 44

LEARNING OBJECTIVES

LO 2.1 Evaluate the functions and activities of commercial banks within the
financial system.

LO 2.2 Identify the main sources of funds of commercial banks, including current
deposits, demand deposits, term deposits, negotiable certificates of deposit,
bill acceptance liabilities, debt liabilities, foreign currency liabilities and
loan capital.

LO 2.3 Identify the main uses of funds by commercial banks, including personal
and housing lending, commercial lending, lending to government, and other
bank assets.

LO 2.4 Outline the nature and importance of banks' off-balance-sheet business,


including direct credit substitutes, trade- and performance-related items,
commitments and market-rate-related contracts.

LO 2.5 Consider the regulation and prudential supervision of banks.

LO 2.6 Understand the background and application of the capital adequacy


standards.

LO 2.7 Examine liquidity management and other supervisory controls applied by


APRA.

EXTENDED LEARNING

LO 2.8 Understand the standardised approach to credit risk and compute the capital
requirements for particular transactions.

LO 2.9 Analyse business continuity risk and construct an education and training
framework for operational risk management for commercial banks.

LO 2.10 Discuss the importance of corporate governance and ethics in the context of
Australian financial institutions.
CHAPTER OUTLINE

2.1 The 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 of commercial banks
2.6 A background to the capital adequacy standards
2.7 Basel II capital accord
2.8 Liquidity management and other supervisory controls
Introduction
.
p. 45

There are many different types of financial institutions. Some types of institutions, such as
commercial banks, are to be found in virtually all countries, while others, such as building
societies, may not. Each nation-state is responsible for the regulation and supervision of
financial institutions within its own financial system. For example, in order to operate as a
commercial bank within most developed countries, an institution generally must obtain an
authority from the prudential supervisor. A list of Authorised Deposit Taking Institutions
(ADIs) operating in AustraliaAustralian-owned banks, foreign subsidiary banks, building
societies, credit unions and branches of foreign bankscan be found on the web-site of the
Australian Prudential Regulation Authority (www.apra.gov.au). There are four major
commercial banks in Australia.

Commercial banks are the main type of financial institution operating in all major
international financial systems. They control a significant proportion of the financial assets
within the financial system. As we saw in Chapter 1, commercial banks hold more than 50
per cent of the total assets of financial institutions in Australia. Therefore, because of the
absolute size of the commercial banks, and their importance as the principal institutions in
the flow of funds between savers and borrowers, it is important that we understand in detail
the functions and operations of commercial banks.

There is a direct correlation between the dominance of the commercial banks and the
level of regulation within a financial system. For example, prior to the mid-1980s there was
a high degree of bank regulation in most countries. At that time, a major purpose of bank
regulation was to ensure that economic objectives could be achieved by controlling the flow
of funds within an economy. It was argued that as the commercial banks controlled the
largest amount of funds in the financial system, if the commercial banks were controlled
through regulation then economic objectives could effectively be targeted. However, the
extent of the regulation constrained the development of the commercial banks and led to a
wide range of new financial institutions evolving in competition with the commercial
banks. Regulation resulted in a reduction in the dominance of the commercial banks, and
therefore, a reduction in the control of the flow of funds in the financial system to achieve
economic objectives. Governments at that time had two basic options: either regulate all
financial institutions or deregulate the commercial banks. The governments of most major
economies eventually decided to deregulate the commercial banks and this has resulted in
significant growth of the banking sector. Following the GFC, this deregulatory phase was
criticised for having contributed to the crisis.

These days, commercial banks are consolidated corporate entities with operations that
may include subsidiary finance companies, managed funds, insurance companies,
superannuation funds and other financial services. This significantly increases their total
share of assets and their dominance in the financial system.

The financial system is dynamic and, over the years, the environment in which the banks
operate has experienced considerable change. We start our study of commercial banks by
looking at their main activities.

REFLECTION POINTS
Commercial banks are the main type of financial institution that operates within a
financial system.
There is a direct correlation between the nature of commercial bank business, the
relative size of the banks and the level of bank regulation within a nation-state.
The majority of developed economies have significantly reduced the level of bank
regulation and there has therefore been considerable growth in the commercial bank
sector.

2.1 The main activities of commercial


banking
p. 46
LEARNING
Before we start, think about this question: What is a OBJECTIVE 2.1
commercial bank and what do banks do? You were
correct if you said that commercial banks take Evaluate the functions and
deposits from customers and then invest those activities of commercial
deposits by making loans to their customers. Although banks within the financial
these two functions represent a large proportion of system
their activities, commercial banks' activities are much
more complex than this, in that they provide a full
range of financial services.

Commercial bank products and services include balance-sheet transactions and off-
balance-sheet transactions. Briefly, balance-sheet transactions are assets (e.g. loans),
liabilities (e.g. deposits) and share-holders' funds (equity). Off-balance-sheet items are
contingent liabilities; that is, they are transactions that do not appear on the balance sheet.

In a highly competitive global market, banks must compete aggressively to obtain the
funds necessary to provide loans and other products and services. For example, bank
customers request loans from banks. The banks try to forecast future loan demand to ensure
they have the funds available to meet the forecast loan demand. As the banks lend hundreds
of millions of dollars in a short-term planning period, ensuring the availability of funds is a
critical issue. To do this, the banks have moved from a practice known as asset
management to the practice of liability management.

In the highly regulated banking sector, asset management a bank restricts growth in its
lending to the level of funds available from its depositor base was practised. Because of
regulation, the banks restricted their loan activity (assets) to match the available amount of
deposits they received from customers. It was not uncommon for a bank to run out of funds
for lending by the end of the month. It was expected that customers would come back next
month to try again to obtain a loan.

Liability managementwhere banks actively manage their sources of funds (liabilities)


in order to meet future loan demand (assets) developed with the removal of restrictive
regulation and is the normal practice today. Commercial banks now actively manage their
sources of funds (liabilities) in order to ensure they have sufficient funds available to meet
loan demand and other commitments. If loan demand is forecast to increase, banks enter the
capital markets and borrow the necessary funds required to meet their forecast loan
demand. Banks are no longer dependent on their deposit base for lending. They manage
their liability base by borrowing directly from the domestic and international capital
markets. As the major banks typically have high credit ratings, they are able to borrow
substantial amounts, especially within the international capital markets.
As mentioned above, banks also undertake a substantial volume of business that is not
recorded as assets or liabilities on their balance sheets. This is referred to as off-balance-
sheet businesstransactions that represent a contingent liability and therefore are not
recorded on the balance sheet. For example, commercial banks have developed expertise
in the provision of risk management products, using a range of over-the-counter and
exchange-traded derivative instruments. They also provide products and services that assist
their customers to carry out import and export business. These types of business are
discussed later in the chapter.

We begin with an analysis of the commercial banks' main sources of funds, and then
examine how the banks use those funds. This is followed by a detailed look at the off-
balance-sheet business of the commercial banks.

REFLECTION POINTS

A core function of commercial banks is to gather savings from depositors and investors
and use those funds in the provision of loans to customers.
p. 47

Commercial banks also conduct off-balance-sheet business. These are contingent


liabilities such as the promise to finance future trade transactions.
Banks compete in the global capital markets to raise funds in addition to their depositor
base. This is known as liability management, whereby a bank borrows sufficient funds
(liabilities) direct from the capital markets to meet forecast loan demand.

2.2 Sources of funds


If the major part of a commercial bank's business is
the provision of loans to customers, then the first LEARNING
question must be: where does the bank obtain the OBJECTIVE 2.2
funds that it lends?
Identify the main sources of
Sources of funds appear on a bank balance sheet funds of commercial banks,
either as liabilities that the bank will eventually repay including current deposits,
or as equity funds provided by shareholders. demand deposits, term
deposits, negotiable
certificates of deposit, bill
acceptance liabilities, debt
liabilities, foreign currency
liabilities and loan capital

In order to attract the savings of surplus entities, commercial banks offer a range of
instruments with different terms to maturity, liquidity, rates of return and cash-flow
attributes. The main sources of commercial bank funds considered in this section are:

current account deposits

call or demand deposits

term deposits

negotiable certificates of deposit


bills acceptance liabilities
debt liabilities
foreign currency liabilities
loan capital and shareholders' equity
2.2.1 CURRENT ACCOUNT DEPOSITS
One of the most liquid instruments offered by a bank is a current account depositliquid
funds held in a cheque account; cheques drawn to purchase goods and services . These
funds are held in a cheque account facility. Deposits in a cheque account provide liquidity
in that they can be used directly in payment for goods and services. The current account
holder is able to write an order on a cheque that instructs its bank to pay funds to the named
payee. For example, a plumber may need to pay a plumbing supplier for copper pipe and
fittings. The plumber may write a cheque for the amount due and give the cheque to the
plumbing supplier. The plumbing supplier will lodge the cheque with its bank, which will
then obtain the funds from the plumber's bank. This financial settlement occurs through the
payments system and is discussed in Chapter 12.

Even though current account deposits are liquid funds, they also provide a stable source
of funds for the banks. This stability occurs because current account deposits can be used to
pay for goods and services. The dynamics of an economy means that individuals and
businesses are continually conducting transactions for goods and services and therefore
current account deposits are always being maintained for this purpose, thereby creating an
ongoing funding source for the banks.

A business cheque account is usually referred to as its operating account. An operating


account is used by a business to pay periodic expenses as they fall due. (This is discussed
further in Chapter 9.)

A cheque account will generally pay interest on credit funds in the account. The level of
interest paid is usually quite low and reflects the highly liquid nature of current account
deposits.

p. 48 CALL OR DEMAND DEPOSITS


2.2.2
Call depositsfunds held in a savings account that can be withdrawn on demand are held
in accounts other than a cheque account where the funds are available on demand. These
types of accounts are generally referred to as savings accounts. They may take the form of
the traditional passbook account, whereby the depositor holds a physical passbook that
provides a record of all transactions and funds held. More probably, the savings account
will be an electronic statement account, whereby the bank will record transactions and
periodically forward a statement to the depositor.

Call deposit account holders usually receive interest payments, but the return on funds
invested is low. As with the current account, the low rate of return represents the highly
liquid nature and low risk attached to this type of account.

Banks typically charge transaction and account service fees on savings-type accounts. It
may be argued that the lower rates of return plus the fee structures tend to discourage
customers from maintaining excess funds in this type of account. Nevertheless, call or
demand deposits have historically represented a stable source of funds for the banks. This
stability derives from individuals' collective desire to hold some funds in an account that
can easily be used to meet forecast expenses and unexpected contingencies.

2.2.3 TERM DEPOSITS


Term depositsfunds lodged in an account for a predetermined period and at a specified
fixed interest rate are funds lodged in an account with a bank for a specified period of time.
Such funds receive a fixed rate of interest for the period of the investment. The saver
nominates the term to maturity at the time the funds are invested. Commercial banks
typically offer term deposits that range from one month through to five years to maturity.

Term deposits offer savers a higher rate of return than is available on current accounts or
call deposits. The higher return compensates the saver for the loss of liquidity with this type
of deposit; that is, the term deposit is fixed for the nominated period. Savers often use term
deposits as an investment alternative for surplus funds that are not immediately required for
consumption.

The term deposit is a safe and stable investment that is particularly attractive to a
conservative investor. Term deposits are popular in countries that have an ageing
population. Often these investors seek secure investments that produce known income
streams.

History shows us that in times of volatility in the financial markets, especially when the
stock markets are more volatile, investors tend to revert to the safe haven of the bank term
deposit. In Australia, even a number of years after the GFC, investors continue to allocate
large amounts of funds to the relative safety of demand and term deposits.

2.2.4 NEGOTIABLE CERTIFICATES OF DEPOSIT


Another source of short-term funding used by banks is the negotiable certificate of
deposita short-term discount security issued by a bank; face value repayable at maturity ,
referred to in the market as the CD. The CD is a certificate issued by a bank undertaking to
pay to the bearer the face value of the CD at the specified maturity date.

A CD is different from other forms of deposit in that a bank may issue a CD directly into
the money market. The CD does not include any interest payments. It is sold by the issuing
bank to an investor at a discount to the face value of the certificate. The CD is therefore
known as a discount security. The term to maturity of CDs typically range up to 180 days.

For example, if the face value of a 180-day to maturity CD is $100 000, the buyer may
pay $96 755.38 to the issuing bank. On maturity of the CD, the holder of the certificate will
receive $100 000 on presentation of the CD to the issuer bank. Had the original owner of
the CD held it until maturity, such an investment would represent a dollar return of
$3244.62, which is a yield of 6.80 per cent per annum. The structure and pricing of a CD is
discussed further in Chapter 9.

p. 49

Another feature of the CD that distinguishes it from other, more standard, types of bank
deposits is that it is a negotiable securitya financial instrument that can easily be sold
into a deep and liquid secondary market. In the money markets there is a deep and liquid
secondary market in CDs. The original purchaser of a CD may sell the CD in the secondary
market to any other party, at any time up to the maturity date. The subsequent owner
similarly may sell the CD. At the maturity date, it is the holder of the CD who receives the
face value of the security from the issuing bank. The CD is a liquid instrument, but the
liquidity does not directly affect the amount of funds available to the issuing bank because
the CD is only repaid at maturity. Selling the CD during its term is simply a change of
owner-ship.

Another attribute of the CD is that the yield offered on new CDs can be adjusted quickly
as the banks' funding requirements change. CDs have become important in the liability
management approach of banks. Effectively, the rate of return can be changed from one
transaction to another. This flexibility is not as easily achieved on the more standard bank
deposits.

2.2.5 BILL ACCEPTANCE LIABILITIES


A business may seek to raise funds through the issue of a bill of exchangea short-term
money-market discount security; face value repayable at maturity . A commercial bank
may take two different roles in this type of funding arrangement. First, the bank may act as
acceptor to the bill and, second, the bank may discount the bill. If a bank takes on the
acceptancea bank puts its name on a bill issued by a third party; bank accepts primary
liability to repay the face value of the bill at maturity role then the bill of exchange is said
to be a bank-accepted bill.

Bank bills are discussed in detail in Chapter 9; a brief description is provided here. A bill
is a discount security; that is, it is issued today and sold at a price that is less than the face
value. The bill does not pay interest. The face value of the bill is repayable at the maturity
date. Therefore, the return to the holder is the difference between the price at which the bill
is bought and the price at which it is sold before maturity, or the face value at maturity.

A business that issues a bill will sell the bill at a discount to the face value. In order to
encourage an investor to buy the bill, the issuer may ask a bank also to put its name on the
bill. If a bank puts its name on the bill, the bank is said to be the acceptor. The acceptor, on
behalf of the issuer, will repay the face value of the bill to the holder at maturity. By acting
as the acceptor, the bank increases the creditworthiness of the bill. The bank will have a
separate arrangement in place to ensure that it recovers the funds from the issuer on the
maturity date. The bank charges a fee for this service.

The bank may also agree to discount and buy the bill from the issuer. Rather than hold the
bill to maturity, the bank is most likely to sell (re-discount) the bill immediately into the
money market. In this situation the bank has incurred a liability on its balance sheet because
of the acceptance commitment, that is, the agreement to repay the face value to the holder
at maturity. By selling the bill into the money market, the bank has been able to arrange
finance for its business customer without having to use its own funds.

2.2.6 DEBT LIABILITIES


As part of their strategic management of liabilities, banks issue debt instruments into both
the money markets and the capital markets. The principal domestic money-market
instrumentthe negotiable certificate of deposit (CD)has been discussed above.
However, the majority of banks' assets are longer-term loans; therefore banks must actively
borrow in the capital markets in order to fund part of their lending.

Medium- to long-term instruments issued by banks include debentures, unsecured notes


and transferable certificates of deposit.

Debenturesa form of security attached to a corporate bond; a fixed and/or floating


charge over the assets of the issuer and unsecured notesa corporate bond issued without
any form of underlying security attached are bonds issued by corporations, including
banks. Bonds pay a regular interest coupon to the holder, usually semiannually or annually.
The principal is repaid at the maturity date. The periodic interest payments may be a fixed
interest rate, or based on a variable rate that may change from time to time.

p. 50

Debentures are bonds with a form of security attached. The security for a bank-issued
debenture is usually a collateralised floating charge security attached to a loan; if
borrower defaults, the lender will take possession of the borrowers assets over the assets
of the institution. An unsecured note is a bond with no security attached.

Transferable certificates of deposit are long-term fixed-rate instruments typically issued


with a minimum face value of $100 000 and with terms to maturity of three to five years.

2.2.7 FOREIGN CURRENCY LIABILITIES


Deregulation of the financial system opened up enormous opportunities for commercial
banks to expand their activities and fund their balance sheets from international sources of
funds. For example, deregulation included the floating of the exchange rate of major
currencies, the opening up of the foreign exchange markets and the removal of most
restrictions on the flow of capital in the international markets.

The large international capital markets are an important source of foreign currency
liabilitiesdebt instruments issued into the international capital markets that are
denominated in another currency for commercial banks. Banks find it easier to raise
substantial amounts of debt in the international capital markets, often at a net lower cost,
than in their traditional, transaction-based depositor base. For example, the major
Australian banks (National Australia Bank, Westpac Banking Corporation, Commonwealth
Bank and ANZ Banking Group) periodically issue debt instruments into the international
capital markets to raise amounts ranging from $500 million to $1 billion. These funds may
then be used over the next three to six months to fund the demand for loans from
customers.

Chapter 11 will offer a more detailed study of the types of debt issued into the
international capital markets, in particular those issued into the euromarketsdebt markets
where instruments are issued into another country, but not denominated in the currency
of that country and the US markets. International debt issues are typically denominated in a
foreign currency such as the US dollar, the yen, the pound sterling or the euro. The types of
debt issued are essentially the same as those issued in the domestic markets and include
discount securities (Chapter 9), medium-term notes, debentures and unsecured notes
(Chapter 10).

Globalisation means that the banks' major corporate clients have become more
internationalised. This has increased business demand for financial services denominated in
the currencies of their commercial and financial transactions. That demand provides a
further reason for the banks to seek foreign currency liabilities.

2.2.8 LOAN CAPITAL AND SHAREHOLDERS'


EQUITY
Another source of funds, which has the characteristics of both debt and equity, is described
as loan capitalsources of funds that have the characteristics of both debt and equity or
hybrid securities. For example, a bank may issue subordinated notes. These 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 (but
before ordinary shareholders) have been paid.

Commercial banks are listed corporations; that is, the institution issues equity securities
such as ordinary shares that are quoted on a stock exchange. Also, banks typically generate
profits from their business activities. Some of the profits are paid to shareholders as
dividends; some are retained as additional share-holders' funds. Equity is an important
source of long-term funds for the commercial banks. In fact, banks are required by the bank
regulator to hold minimum levels of equity (capital). Capital adequacy requirements for
banks are discussed later in the chapter.

REFLECTION POINTS

Commercial banks are highly lever-aged organisations; that is, a large percentage of
their funds is in the form of debt liabilities that must be repaid; the remainder is
different types of equity.
p. 51

Current account deposits are liquid funds held in a cheque account; a cheque is a
written instruction to the bank to pay the specified sum to the payee shown on the
cheque. Businesses use cheque accounts as their operating accounts.
Call or demand deposits are liquid funds held in a savings-type account. They represent
a stable source of funds for banks. They typically pay a low rate of interest, and
account fees may be charged.
Term deposits are savings lodged for a specified period of time that pay a fixed rate of
interest. The higher interest rate compensates for the loss of liquidity.
Negotiable certificates of deposit are short-term discount securities issued by a bank
and sold into the money market. They are issued today with a face value payable at
maturity, and no interest is paid.
Bill acceptance liabilities are a commitment by a bank, on behalf of the bill issuer, to
pay the face value of a bank-accepted bill to the bill holder at maturity.
Debt liabilities are longer-term debt instruments issued directly into the local capital
markets. They include interest-paying bonds such as debentures, unsecured notes and
transferable certificates of deposit.
Commercial banks issue foreign-currency-denominated debt securities into the
international capital markets to raise foreign currency liabilities.
Loan capital includes hybrid securities issued by a bank such as subordinated notes.
The main type of equity issued is ordinary shares. Shareholder funds are an important
source of long-term funding.

2.3 Uses of funds


Funds used by commercial banks appear as assets on
their balance sheets. The majority of bank assets are LEARNING
financial assets that create an entitlement to future OBJECTIVE 2.3
cash flows; for example, if a bank gives a customer a
loan then the amount outstanding on the loan will Identify the main uses of
appear as an asset on the bank's balance sheet. The funds by commercial banks,
bank is entitled to receive periodic interest payments including personal and
plus repayment of the principal in accordance with the housing lending, commercial
terms and conditions of the loan contract. A bank will lending, lending to
also accumulate other assets such as branch premises government, and other bank
and electronic systems. assets

In this section we categorise commercial bank assets into the following categories:

personal and housing finance


commercial lending
lending to government
other bank assets
2.3.1 PERSONAL AND HOUSING FINANCE
Banks are the principal providers of finance to individuals. The type and amount of bank
lending to individuals will vary between banks, and often between countries, and will
reflect the specific priorities of both lenders and borrowers. In Australia, for example, the
largest form of bank lending is for owner-occupied housing. Other forms of personal
finance include investment property finance, fixed-term loans, personal overdrafts and
credit card finance.

p. 52

Housing financethe provision of long-term funds to enable the purchase of residential


property, where the bank registers a mortgagea form of security whereby a lender
registers an interest over the title of a property over the property as security for the loan, is
an attractive form of lending as the risk of default by the borrower is normally low. In
theory, borrowers will always try and meet their housing loan commitments, because if they
don't the bank will take possession of the house and sell it to recover the amount owing.
The sale of a house under these circumstances certainly will not be in the best interests of
the borrower. However, these circumstances do not always hold. The GFC was precipitated
by falling home values and increasing rates of default on home loans. When house prices
fell below the value of their loans, homeowners, particularly in the USA, had weaker
incentives to continue to meet their housing loan commitments. Instead, many borrowers
simply walked away. As we have seen, this had catastrophic effects for the value of
mortgage securities and the financial system.

Commercial banks have traditionally dominated the residential housing loan market.
However, many new providers of housing finance have entered the market, significantly
increasing competition. For example, insurance offices and superannuation funds now
provide housing loan finance. Also, specialist providers of housing finance, referred to as
mortgage originatorsspecialist mortgage lenders that typically refinance their lending
through securitisation, have grown in the deregulated financial market.

Both mortgage originators and commercial banks often use the process of
securitisationnon-liquid assets are sold into a trust; the trustee issues new securities;
cash flows from the original securities are used to repay the new securities to finance
their lending activities. Briefly, a lender may seek to obtain additional funds in order to
provide new housing loans by selling existing housing loans. Securitisation can be
described as the selling of a class of assets, such as housing loans, into a trust. The trustee,
in order to raise funds to pay for the purchase of these housing loan assets, will issue new
securities to investors. The securities issued by the trustee may be bonds that are secured by
the housing loans held in the trust. Investors like the securities because, under normal
circumstances, they are lower-risk assets. The trustee will use the interest and principal
payments due from the housing loans held in the trust to pay interest and repay principal on
the new securities issued.
The term of a housing loan will vary quite considerably between countries. The major
determinant of the term of housing loans in a country is the average cost of housing coupled
with the level of interest rates. In countries where property prices are very high, the term of
the housing loan will be longer. If this was not the case, individuals would not be able to
afford to repay their loan commitments. For example, in Australia the average term of a
housing loan is 30 years.

Housing loan repayment schedules may also differ. A typical owner-occupied housing
loan will require regular amortised loan instalmentsregular and equal loan instalments
that comprise the current interest payment due, plus part repayment of the loan principal
outstanding over the period of the loan. Each loan instalment with an amortised loan
comprises an interest component and a part repayment of principal component. Banks offer
housing loans with either a fixed interest rate or a variable interest rate. However, a fixed-
rate loan will usually be reset every five years or less. The interest rate on variable-rate
loans will move from time to time in accordance with changes in interest rates in the
markets.

Another significant form of housing finance is known as investment property


financefunding that enables a borrower to purchase property to rent or lease to a third
party. In this situation the bank provides funds to an individual investor who purchases a
property for rental or leasing purposes. Again, the bank will take a registered mortgage over
the property as security for the loan.

Individuals borrow for a range of reasons, for example to purchase a car or travel
overseas. In these circumstances the bank may provide the borrower with a fixed-term
loana loan provided for a predetermined period; used to purchase specified goods or
services. Typically, the term loan will have a term to maturity of up to five years. As with
housing finance, interest rates may be fixed or variable. The bank will require some form of
security, such as a guarantee, to support the loan. Housing (mortgage) finance and term
loans are discussed further in Chapter 10.

Banks provide personal overdraft facilities for individuals. The personal overdraft allows
an individual to put a nominated account into debit from time to time up to an agreed limit.
Often, individuals need to manage the mismatch in the timing of their cash flows and the
personal overdraft allows them to pay expenses when they are due by putting the overdraft
account into debit. The bank expects that the overdraft will be brought back into credit
when the individual receives income.

p. 53

A more flexible alternative to a personal overdraft is a credit carda card facility that
provides access to funds through electronic distribution systems: ATMs, EFTPOS
facility. A credit card typically is used to conduct electronic transactions, for example using
automatic teller machines (ATMs) or electronic funds transfer at point of sale (EFTPOS),
by drawing on a predetermined credit limit provided by the card issuer. The bank as the
credit provider will allow the card user to draw against a predetermined credit limit. Credit
cards typically have high interest rates on used credit, and a range of transaction and other
fees might also apply.

2.3.2 COMMERCIAL LENDING


Commercial lending represents bank assets invested in the business sector plus lending to
other financial institutions. Bank lending to business is essential if economic growth is to
be achieved within a nation-state. Economic growth generates benefits such as increased
production, higher levels of employment and better living standards within a country.
In Chapter 1 we discussed the concept of direct finance and intermediated finance, and
noted that only those corporations with a good credit rating are able to raise funds through
direct finance. Therefore, in numeric terms, the majority of business borrowers do not have
access to the direct finance markets. These firms raise funds by borrowing from financial
intermediaries. Commercial banks are the principal lenders, particularly to small and
mediumsized businesses. It is worth noting that larger corporations may still borrow from
the commercial banks, but they are also able to borrow direct from the markets.

The main type of loan provided by the banks to firms is the term loan. Typically, term
loans are for maturities ranging from three to seven years. Business borrowers negotiate the
terms and conditions of a loan with their bank. Conditions will include the period of the
loan, the interest rate, security provided to support the loan and the timing of interest
payments and the repayment of principal.

Commercial banks offer borrowers both short-term and long-term loans. Interest rates
may be based on a fixed interest rate or a variable rate set to a specified reference interest
ratea benchmark interest rate published daily and used for pricing variable-rate loans.
For example, in Australia a reference rate that is often used is the bank bill swap rate, or
BBSWthe average mid-point of banks bid and offer rates in the bank bill secondary
market. The BBSW is the average midpoint of banks' bid and offer rates in the secondary
bill market and is calculated and published daily. International reference rates such as
LIBOR and USCP are discussed in Chapter 11.

Loan instalments may be required monthly and may include both interest and part
repayment of principal outstanding. On the other hand, the borrower may be required to
make only the interest payments, and the principal is repaid in one lump sum at the maturity
date. Loan repayments may be deferred for a period before regular instalments commence.
Term-loan financing is discussed in Chapter 10.

Banks provide overdraft facilities to businesses. The main purpose of an overdraft is to


enable a business to manage mismatches in the timing of its cash flows. Businesses
typically need to pay out funds for expenses before they receive funds back from their
business operations.

An overdraftan arrangement with a bank that allows a business to place its operating
account into debit up to an agreed limit facility allows a business to place its operating
account into debit up to an agreed amount. Of course, the bank charges fees and interest for
this very flexible funding arrangement. The bank also expects that the firm will bring the
overdraft back into credit as revenues are received by the business. Therefore, an overdraft
will normally fluctuate between being in debit and being in credit. The discussion of
overdraft facilities is extended in Chapter 9.

Bills of exchange were discussed earlier in the chapter. Commercial billsa bill of
exchange issued direct to raise finance for a business; a discount security; may be sold
into the money market are discount securities. We noted above that a bank may act as an
acceptor to a bill issued by a client, and that the bank will often discount the bill (buy it at
less than the face value). The bank will then generally sell the discounted bills into the
money market, but if the bank decides to hold the bills as assets on its balance sheet, these
are described as bank bills heldbills that have been accepted and discounted by a bank
and are held as a balance-sheet asset.

Commercial bills are normally drawn for terms ranging from 30 to 180 days. In order to
extend the overall term of this type of short-term financing, a bank may provide a customer
with a rollover facilityan arrangement whereby a bank agrees to discount new bills over
a specified period as existing bills mature. For example, if a business has issued 90-day
bills with a two-year rollover facility, the customer is able to redraw new bills every 90
days for the next two years. When the new bills are drawn, the yield on the bills will change
to reflect current rates in the market. This means the bills are repriced every 90 days, thus
protecting the bank from the risk that interest rates might change. The bank bills money
market is deep and liquid. This allows banks the flexibility initially to provide funding to
business borrowers by discounting bills, but with the option to sell those bills easily into the
money market to generate more funds for further lending.

p. 54

Another important category of bank finance is leasing. A leasean arrangement in which


the owner of an asset, the lessor, allows a lessee to use the asset in return for periodic
lease payments is an arrangement whereby the owner of an asset (the lessor) allows another
party (the lessee) to use that asset subject to the terms and conditions of the lease contract.
A bank, as lessor, will finance the purchase of an asset and will enter into a financial
arrangement with the lessee whereby the lessee will make lease payments in return for
using the asset. Essentially, the lessee is borrowing the asset rather than borrowing the
funds to purchase the asset. Leasing is discussed further in Chapter 10.

2.3.3 LENDING TO GOVERNMENT


Governments generally borrow direct from the markets. Commercial banks lend to
government directly by investing in government-issued securities, such as Treasury notes,
Treasury bonds and other public sector securities. Banks may also provide some loans to
government agencies in the form of term loans and overdraft facilities.

Governments need to manage their short-term and longer-term cash flows. Short-term
funds are required to meet regular commitments such as social security benefits and the
salaries of government employees. Longer-term funding is required for capital expenditures
such as building hospitals and water storage facilities. If the timing of taxation and other
income receipts does not cover intra-year expenses, a government may issue short-term
securities such as Treasury notesshort-term discount securities issued by the government;
face value payable at maturity to raise the necessary short-term funds. Longer-term budget
capital expenditures will be funded through the issue of Treasury bondsmedium- to long-
term securities issued by the government; pay regular half-yearly interest, principal
repaid at maturity. Banks purchase a proportion of these securities issued by government.
Government borrowing and debt instruments are discussed further in Chapter 12.

Securities issued by governments are usually regarded as having a very low level of risk
and therefore yield a low rate of return. Why do banks invest in government securities
when they could obtain a higher return by giving more loans to other borrowers? There are
a number of reasons. Government securities:

are an investment alternative for surplus funds that a bank is holding

are a source of liquidity as they can be easily sold in the secondary markets when funds
are needed for further lending
provide income streams and potential capital gains, whereas holding cash does not

may be used as collateral to support the bank's own borrowings in the direct finance
markets
may be used for a repurchase agreement with the central bank in order to raise cleared
funds for payments system settlements (Chapter 12)
improve the quality of the balance sheet by holding a group of assets (government
paper) with lower-risk attributes
enable a bank to manage the maturity structure of its balance sheet by purchasing
securities with a range of maturities and cash flows
allow a bank to manage its interest rate risk by buying or selling securities with
different interest rate structures (fixed or variable interest rates).

Therefore, lending to government, particularly through the purchase of government


securities, provides a bank with the flexibility to actively manage its overall asset portfolio,
while at the same time lowering the overall levels of risk in its asset portfolio.

p. 55 OTHER BANK ASSETS


2.3.4
Bank lending is the core business of commercial banks and the largest allocation of their
assets. However, banks accumulate a range of other assets, including receivables, shares in
and loans to controlled entities, goodwill, property, plant and equipment and unrealised
gains from their trading activities in derivative products.

Banks are highly dependent on their information systems and product delivery systems.
Therefore they invest heavily in technology, property, plant and equipment. Nevertheless,
there has been a shift away from the accumulation of physical assets, including a
contraction of branch networks. The reduction in the branch networks has been offset by an
increase in the use of electronic products and service delivery systems, such as phone and
internet banking, ATMs and EFTPOS. Apart from direct branch closures, the divesting of
physical assets has taken several other forms. For example, some banks have sold a
proportion of their branch premises and entered into lease-back arrangements. Others have
outsourced their computer centre operations to specialist providers.

You can test your understanding of the sources and uses of funds by commercial banks by
examining the balance sheet of a major bank. The notes to the accounts reveal the details of
the various sources and uses of funds. Banks publish their financial statements on their
websites; for example:

Australia and New Zealand Bank Group Limited at www.anz.com

Commonwealth Bank of Australia Limited at www.commbank.com.au

National Australia Bank Limited at www.nab.com.au

Westpac Banking Corporation at www.westpac.com.au

REFLECTION POINTS

The major business of commercial banks is the provision of loans to customers.

Personal finance includes housing loans, term loans and credit card facilities.

Housing finance is the provision of loans to purchase residential property. As security,


the bank will register a mortgage over the property.
Loan repayments may be amortised; that is, each loan instalment includes both interest
and principal repayments.
A bank may securitise part of its loan portfolio; that is, sell a group of loans into a trust
in order to raise additional funds for new lending.
Commercial lending is loans provided to the business sector, including overdrafts, term
loans and mortgage finance.
Loans may have a fixed interest rate, or a variable interest rate based on a reference
rate such as the BBSW.
Businesses establish overdraft facilities which allow a firm to put its operating account
into debit up to an agreed limit. This fluctuating facility allows a business to manage
the timing of its cash flows.
Banks are providers of lease finance, whereby the bank purchases an asset which is
leased to a customer.
Banks mainly lend to government by purchasing government securities. These
securities allow banks to invest surplus funds and manage interest rate risk and
maturity risk in the asset portfolio.
Banks also accumulate other assets such as physical infrastructure, for example,
branches, and electronic information and product delivery systems.

2.4 Off-balance-sheet business


p. 56
LEARNING
The focus of the discussion above has been on the OBJECTIVE 2.4
balance sheetspecifically, the acquisition and uses
of funds by the commercial banks. Such an emphasis Outline the nature and
understates the role of a modern bank. It was noted at importance of banks' off-
the beginning of the chapter that banks undertake a balance-sheet business,
substantial volume of business that, by its nature, is including direct credit
not recorded as an asset or liability on the balance substitutes, trade- and
sheet. Such offbalancesheet transactions represent performance-related items,
an important source of income for the banks, and are commitments and market-
most important in the financial life of businesses and raterelated contracts
governments.

The main types of off-balance-sheet business conducted by commercial banks can be


divided into four major categories:

direct credit substitutes

trade- and performance-related items

commitments

foreign exchange contracts, interest rate contracts and other market-rate-related


contracts.

Direct credit substitutes and trade- and performance-related items generally involve the
bank in supporting or guaranteeing the obligation of a client to a third party. Normally the
bank will make a payment to that third party only if a specified event occurs. Commitments
relate to a bank's contractual obligations to customers that are yet to be completed. Finally,
market-rate-related contracts involve the use of derivative products to manage financial risk
exposures of the bank and its customers.

The large commercial banks also provide a wide range of advisory services to business
and government. These advisory services include risk management advice and portfolio
restructuring advice. Much more detail is provided on these types of advisory services in
Chapter 3, Section 3.1.2 (Off-balance-sheet business).

2.4.1 DIRECT CREDIT SUBSTITUTES


Direct credit substitutesan undertaking provided by a bank to support the financial
obligations of a client are provided by a commercial bank to support a client's financial
obligations. In this situation the bank does not provide the finance from its own balance
sheet. The direct credit substitute effectively ensures that the client is able to raise funds
direct from the markets.

For example, the direct credit substitute may take the form of a stand-by letter of credit.
This is an undertaking by a bank to make payment to a specified third party if the bank's
client fails to meet its financial obligation to that party. With the bank undertaking in place,
the client is able to issue securities and raise funds directly in the markets, since the lender
is assured that amounts due will be repaid by either the borrower or the bank that issued the
letter of credit.

Other examples of direct credit substitutes include guarantees, indemnities and letters of
comfort issued by a bank that have the effect of guaranteeing the financial obligations of a
client. For example, a bank's client, when submitting tender documents for a major
construction project, may need to provide, with the tender documents, a formal assurance
that it has the financial capacity to complete the project. It would be expected that if the
client wins the tender the bank will provide finance for the project.

2.4.2 TRADE- AND PERFORMANCE-RELATED


ITEMS
Trade- and performance-related itemsan undertaking provided by a bank to a third
party promising payment under the terms of a specified commercial contract are also
guarantees made by a bank on behalf of its client, but in this case they are made to support
a client's nonfinancial contractual obligations.

The obligations may include trade-related undertakings or contractual agreements to


provide goods or services. In these circumstances, the bank provides a guarantee on behalf
of its client that it will make a payment to the third party subject to the terms of the specific
commercial contract.

p. 57

Examples of trade- and performance-related items include:

Documentary letters of credit (DLCs). These are where a bank substitutes its credit
standing for that of its client. The bank, on behalf of its client, will authorise payment to
a named party against delivery by that party of a shipment of goods (evidenced in
specified documents). For example, an exporter of goods will usually require the
importer of the goods to arrange for its bank to provide a documentary letter of credit to
the exporter's bank. Once the imported goods arrive in the country, the associated
documents are inspected and payment is made between the banks immediately. The
DLC will be irrevocable; that is, it cannot be cancelled.
Performance guarantees. These are where a bank agrees to provide financial
compensation to a third party if a client does not complete the terms and conditions of a
contract. For example, a client may be deemed to have failed to complete the terms of a
contract if inferior components are used in a major computer system upgrade.
2.4.3 COMMITMENTS
Commitmentsthe contractual financial obligations of a bank that are yet to be completed
or delivered involve a bank in an undertaking to advance funds to a client, to underwrite
debt and equity issues or to purchase assets at some future date.
Examples of commitments include:

Outright forward purchase agreements. These are where a bank contracts to buy a
specified asset, such as foreign currency, from its client at an agreed exchange rate on a
specified date.
Repurchase agreements. A bank sells assets, such as government securities, on the
understanding that the bank will repurchase them at a specified date.
Underwriting facilities. A bank guarantees a client that, subject to a range of conditions,
it will cover any shortfall in funds received from a primary market issue of debt or
equity securities.
Loans approved but not yet drawn down. For example, a bank has agreed to provide a
borrower with a loan at a future date upon completion of the loan documentation.
Credit card limit approvals that have not been used by card holders. For example, a
bank may authorise a credit card limit of $4000 for a client. If the client uses $1000 of
the available credit, then that amount will appear on the balance sheet as an asset (loan),
and the remaining $3000 credit remains as an off-balance-sheet commitment.
2.4.4 FOREIGN EXCHANGE CONTRACTS, INTEREST
RATE CONTRACTS AND OTHER MARKET-
RATE-RELATED CONTRACTS
Foreign exchange, interest rate and other market-rate-related contractsderivative
products; allow management of exposures to interest rate, foreign exchange, equity and
commodity price risks principally involve the use of derivative productsthat is, futures,
options, swaps and forward contracts.

These instruments are primarily designed to facilitate hedgingimplementing strategies to


protect against an identified risk exposure against risk, for example the effects of
movements in exchange rates, interest rates, equity prices and commodity prices.
Derivative contracts are also bought and sold by traders in an attempt to make profits from
movements in contract prices. Details of each of these instruments and their use for risk
management are provided in Parts 5 and 6.

Examples of foreign exchange, interest rate and other market-rate-related contracts


include:

Forward exchange contracts. A bank contracts to buy or sell at a future date a specified
amount of a foreign currency at an exchange rate that is set today.
Currency swap. A bank exchanges a principal amount and ongoing associated interest
payments that are denominated in a foreign currency.
p. 58

Forward rate agreements. A compensation agreement between a bank and client based
on a notional principal amount. One party compensates the other party if interest rates
move above or below an agreed interest rate.
Interest rate futures contracts. These are exchange-traded agreements to buy or sell a
specific security at a specific price at a predetermined future date.
Interest rate options contracts. These provide the right, but not the obligation, to buy or
sell a specified financial instrument at an agreed date and price.
Equity contracts. These include futures and options contracts based on specified stock
prices or stock indices. These contracts lock in the equity price today that will apply at a
specified future date.
2.4.5 VOLUME OF OFF-BALANCE-SHEET BUSINESS
There are two outstanding features of the banks' off-balance-sheet business. The first is the
magnitude of the notional face value of the off-balance-sheet contracts written by banks.
This will vary between countries, but an examination of the volume of off-balance-sheet
business within the Australian market gives a good indication of the size of the markets.

In Australia the face value of banks' off-balance-sheet business as at December 2010


stood at $14 855 593 million. This compares with a March 2008 figure of $9 841 618
million. In December 2010, the total value of banks' assets stood at $2 649 200 million.
That is, the notional value of off-balance-sheet business is over five times the value of total
assets held by the banks. As described in Part 6, the notional value of many derivative
products is significantly greater than the actual associated cash flows. Comparing the
notional value of derivatives with the value of balance-sheet assets does overstate the
relationship.

The second characteristic of the off-balance-sheet business is that it is mainly market-


rate-related contracts. The proportions of the various types of off-balance-sheet business are
shown in Table 2.1. As at December 2010, market-rate-related business represented 92.33
per cent of the total and commitments 4.34 per cent.

TABLE 2.1 BANK OFF-BALANCE-SHEET BUSINESS, AUSTRALIA,


AS AT DECEMBER 2010

SOURCE: Reserve Bank of Australia, 2011.

Another aspect of off-balance-sheet business is that its composition varies greatly from
bank to bank and between categories of bank. The major commercial banks conduct the
largest share of the off-balance-sheet business; however, a number of the foreign banks are
particularly prominent. This is to be expected given their expertise in the international
financial markets.

p. 59

The nature and size of market-rate-related contracts, combined with the volatility and
speed at which contracts are repriced in the market, has resulted in a number of
extraordinary losses being incurred by both financial institutions and their clients. The
threat to the stability of domestic and global financial systems that may result from large
losses in the derivatives markets has been the subject of much discussion by regulators and
prudential supervisors.

One high-profile example (which has since been depicted in the movie Rogue Trader)
was the loss of $1.5 billion by the UK bank Baring Brothers plc. Speculation on price
movements of derivative contracts on the Singapore and Osaka exchanges by one of its
traders, Nick Leeson, brought about the loss, which resulted in the eventual failure of the
bank. Of course, during the financial crisis a number of institutions, including Lehman
Brothers and Bear Stearns, collapsed as the direct or indirect result of excessive trading in
mortgage-related derivatives. In the end, it is the responsibility of each bank to ensure that
it establishes and documents objectives, policies and procedures in relation to its use of
derivative products.

REFLECTION POINTS

Direct credit substitutes are provided by a bank to support a customer's financial


obligations to a third party (e.g. a letter of comfort written by the bank confirming that
a customer has sufficient funding in place to proceed with a project).
Trade- and performance-related items are guarantees given by a bank to support a
customer's nonfinancial obligations; for example, a bank will execute a documentary
letter of credit to finance the importation of goods from overseas.
Commitments are yet-to-be-completed financial agreements made by a bank to its
customers (e.g. the approval to provide a loan in the future to purchase a house, or a
credit limit on a credit card).
Foreign exchange, interest rate and other market-rate-related contracts are typically
derivative contracts, such as futures, forwards, options and swaps, used to manage risk
exposures.
The notional value of the off-balance-sheet business of banks is much greater than the
value of balance-sheet assets.

2.5 Regulation and prudential supervision


of commercial banks
We have highlighted the essential role that the
financial system plays in facilitating financial LEARNING
transactions that enable economic growth and OBJECTIVE 2.5
prosperity. Therefore, governments and regulators
have sought to maintain the stability and soundness of Consider the regulation and
the financial system in order to achieve both prudential supervision of
economic objectives and social outcomes. The GFC banks
has cast a spotlight on the issue of regulation. In
particular, the leverage that characterised the financial
system in the years before the crisis attracted much
attention. Many of the major financial institutions in
the USA held assets with a value more than 30 times
larger than the banks' underlying capital reserves. This
leverage was supported by short-term financing and
innovative capital instruments that evaporated during
the crisis. Financial institutions that had argued so
strenuously for a relaxation in banking regulations in
the two decades before the crisis failed to demonstrate
an ability to regulate their own activities in the
absence of government regulatory intervention.
Because financial institutions do not keep reserves
that exactly match their liabilities, the danger of some
type of a bank run is ever-present in the financial
system. Regulators must be vigilant.
p. 60

The primary purpose of this section is to consider issues arising from bank
regulationconstraints on banking activities through prescriptive legislation and
prudential supervision and prudential supervisionthe imposition and monitoring of
standards designed to ensure the soundness and stability of a financial system. Each
nation-state is responsible for the regulation and prudential supervision of its own financial
system. This will vary between countries, but it is interesting to note that the principles and
functions of bank regulation and supervision have changed in similar ways and at a similar
pace in all developed economies. Much of the theory of bank regulation and supervision is
the same internationally; variations exist to a degree but mostly in the detail of the
application.

It may be argued that a banking sector regulatory and supervisory framework should:

ensure a regulatory framework that is able to adjust regulation to maintain the cost
effectiveness of the financial system in a dynamic environment
provide a focused and accountable structure that facilitates community expectations for
consumer protection and financial safety
provide efficient and effective regulation of financial conglomerates

establish consistent regulation and competitive neutrality across the financial system

contribute to effective monitoring and review with the aim of establishing more
contestable, efficient and fair financial markets.

A pre-eminent area of concern for regulators is that of maintaining the soundness and
stability of the financial system, and ensuring that savers have confidence in the
institutionsin particular the commercial banksas safe repositories for their funds. Bank
regulation no longer relies (as it once did) on heavily prescribing the asset composition of a
bank's balance sheet. Rather, it now imposes guidelines that allow the banks a wide range
of options in their lending decisions, but forces those banks that adopt higher-risk lending
strategies to support their activities with higher amounts of capital or shareholders' funds.
The main features of the current system, designed to encourage prudent lending behaviour
by the banks, are outlined below.

The structures of nation-state financial systems have evolved principally in response to


regulatory change. Regulation directly influences the structure, scope and scale of financial
institutions, instruments and markets. The institutional framework for regulation and
supervision of a nation-state's financial system varies between countries. In some countries
the central bank acts as the banking sector regulator and supervisor; in other countries the
central bank has responsibility for the stability of the financial system and the soundness of
the payments system, while a separate authority has responsibility for the regulation and
supervision of financial institutions. Generally, other authorities will be responsible for
competition law, consumer protection and Corporations Law supervision.

By way of example, Australia has implemented a regulatory structure with the following
features.

Overall responsibility for the maintenance of financial system stability, and soundness
of the payments system, is the responsibility of the central bank (Reserve Bank of
Australia).
Prudential regulation and supervision of authorised deposit-taking
institutionsfinancial institutions authorised by APRA to accept retail deposits in
Australia (i.e. commercial banks, building societies and credit unions), insurance
offices, superannuation funds and friendly societies is the responsibility of the
Australian Prudential Regulation Authority (APRA).
Regulation and supervision of market integrity and consumer protection, within the
context of the Corporations Law, is the responsibility of the Australian Securities and
Investments Commission (ASIC).
p. 61

Matters of competition policy (Trade Practices Act) are the responsibility of the
Australian Competition and Consumer Commission (ACCC). Within this context, the
government has implemented a four-pillars policy, which currently restricts mergers
between the four major commercial banks in Australia.

A basic principle of APRA's approach to bank supervision is that the primary


responsibility for a bank's sound operation rests with the bank's own management and
board of directors. However, there are some aspects of banking operations where APRA is
more intrusive and has implemented prudential guidelines and standards, for example with
the imposition of minimum capital requirements.

In the event of a threat to the stability of the financial system, the Reserve Bank is
responsible for determining whether, and how, it might provide emergency liquidity
support to the financial system. The Reserve Bank, however, does not regard its balance
sheet as available to support the solvency of an individual financial institution that may
experience financial difficulty. Ultimately, each commercial bank must rely on the strength
of its own balance sheet.

Nevertheless, some depositor protection may be provided by government supported


deposit insurance. For example, limited deposit insurance has been provided in the USA for
many years. This played a major role in preventing bank runs for a very long period of
time. Deposit insurance, in the form of a Financial Claims Scheme (FCS) was introduced in
Australia in October 2008 during the GFC. Part of the scheme protects depositors in ADIs,
including commercial banks. The current FCS guarantees deposits up to an accumulated
value of $1 million with an ADI. Special conditions apply for amounts above this limit. The
scheme was reviewed in October 2011. More details are available at www.apra.gov.au.

In order to ensure that banks have sufficient strength in their balance sheets, bank
regulators require commercial banks to source a minimum percentage of their funds from
certain forms of capital. This prudential standard is known as the capital adequacy
requirement.

REFLECTION POINTS

The important role of the financial system, in particular the commercial banks, in
supporting economic growth means that each nation-state has established a regulator
that sets prudential standards for the supervision of the banking sector.
The GFC has highlighted the importance of effective regulatory frameworks.

The regulator may be the central bank, a specialist supervisory authority or a


combination of both.
In Australia, the central bank is the Reserve Bank of Australia while the authority
responsible for financial institution supervision is APRA. The ACCC is responsible for
competition and consumer protection and ASIC is responsible for Corporations Law.
Government guarantees may be provided for certain bank deposits.
A principal international standard applied to commercial banks is the capital adequacy
requirement. This standard is designed to ensure that banks have sufficient capital to
meet their obligations.

2.6 A background to the capital adequacy


standards
p. 62
LEARNING
The balance sheet of a corporation, including a OBJECTIVE 2.6
commercial bank, comprises a range of assets that are
funded from liabilities and shareholders' funds. Understand the background
Shareholders' funds represent equity and may be and application of the capital
referred to as capital. The main assets accumulated by adequacy standards
commercial banks are its loans to customers.
Typically, a percentage of borrowers will default on
their loan repayments. Under normal circum-stances
these loan losses are written off against profit in the
relevant accounting period. However, if loan losses
increase above the level of profits, then the losses
must be written off against capital. They cannot be
written off against liabilities because the bank must
still repay its liabilities when due.

Capital has a number of important functions, including:

It is the source of equity funds for a corporation.

It demonstrates shareholders' commitment to the organisation.

It enables growth in a business and is a source of future profits.

It is necessary in order to write off periodic abnormal business losses.

It is this last function of capital that is the basis upon which international capital adequacy
standards for banks have evolved.

Deregulation and globalisation of the international financial system, coupled with rapid
advances in technology and the development of sophisticated financial products, created an
environment in which there was the potential for instability or failure of the global financial
system.

Therefore, the governors of the central banks of the major industrialised countries, who
meet monthly at the Bank for International Settlements (BIS) in Basel, Switzerland,
established a new standing committee in 1974 which is now known as the Basel Committee
on Banking Supervision. The committee comprises the senior bank regulators of the G-
10Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, the UK
and the USA group of countries, plus Luxembourg and Switzerland. The committee
recognised the problems involved in regulating internationally diversified banks and
recommended that such banks should be treated on a globally consolidated basis but should
come primarily under the regulatory powers of the home country.

The committee presented a paper to the governors of the central banks in which it
expressed concern about the erosion of banks' capital bases and recommended that these
should be rebuilt. The committee continued to work on the adequacy of banks' capital and
on the development of a common minimum standard of capital adequacy that international
banks should maintain. The overriding purpose of the committee's work was to develop a
framework that would maintain the soundness of the international financial system and that
would, at the same time, allow individual banks to make their own portfolio choices and
promote a greater competitive equality between banks in the international markets.

The committee's work culminated in a document, The International Convergence of


Capital Measurement and Capital Standards (Basel Committee Publication No. 4,
published in July 1988). These capital adequacy requirements, currently referred to as the
Basel I capital accord, were adopted by most countries that have commercial banks
operating in the global financial system.

The 1988 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 and therefore created a strong foundation to support the stability of the global
financial system. However, over time, it became apparent that Basel I did not fully account
for the diversity, sophistication or innovation of the changing financial markets. The
committee conducted a major review of the capital adequacy guidelines, which culminated
in the Basel II capital accordthe standard that defines the minimum capital adequacy
requirement for a bank guidelines.

Basel II capital adequacy guidelines have been adopted by bank regulators in most major
industrial countries and implemented by commercial banks since January 2008. Note that in
some countries, including Australia, other regulated financial institutions are also required
to meet the Basel II capital adequacy requirements. Following the GFC, Basel III set down
enhanced capital reserve requirements. The goal of Basel III is to make financial
institutions more resilient to the economic shocks that occur periodically within an
economic system that is characterised by financial institutions that do not hold reserves that
match their liabilities. When banks' reserves are less than liabilities, the nature of those
reserves is of critical importance. Basel III proposes enhancements to the quantity and
quality of banks' capital reserves. Basel III is still in its infancy and will take almost a
decade to fully implement. Banks in Australia report their first capital adequacy ratios
under Basel III in mid-2013.

p. 63

REFLECTION POINTS

An international capital adequacy standard for banks was developed to strengthen the
global financial system.
Banks need sufficient capital to expand their business and also periodically to write off
abnormal losses.
The Bank for International Settlements established a permanent committee, the Basel
Committee on Banking Supervision, to develop capital standards. The Basel I accord
was introduced in 1988; the Basel II capital accord had been implemented in most
countries by January 2008.
Basel III introduces enhanced capital requirements. Following APRA's finalisation of
the nature of Basel III adoption within Australia, the new regime will be gradually
implemented during the next decade.

2.7 Basel II capital accord


Basel I developed a measure of capital adequacy that
principally focused on the level of credit risk LEARNING
associated with a bank's balance-sheet and off- OBJECTIVE 2.6
balance-sheet business. Credit riskthe risk that an
obligor will not make future interest payments or Understand the background
principal repayments when due is the risk that and application of the capital
counterparties to a transaction will default on their adequacy standards
commitments. At the same time, bank supervisors did
not wish to restrict the asset choices of banks or to
stifle banks' participation in off-balance-sheet
business. An extension of the original guidelines
introduced a capital requirement for market risk.
Market riskthe exposure of a bank's trading book to
changes in interest rates and exchange rates is the
exposure of an institution's trading book to changes in
interest rates and foreign currency exchange rates.

Basel II was a major extension of Basel I and much more sensitive to different levels of
risk that may exist within an institution and to the sophistication of modern risk
management practice.

The Basel II approach focuses on:

the credit risk associated with a bank's balance-sheet and off-balance-sheet business

the market risks associated with a bank's trading activities

the operational risk evident in a bank's business operations

the form and quality of capital held by a bank to support these exposures

the risk identification, measurement and management processes adopted by banks

transparency, through the accumulation and reporting of related information and data.

While the Basel II capital accord was developed by the Bank for International
Settlements, it is the responsibility of a nation-state's banking sector prudential regulator to
implement the standard. The main components of Basel II have been adopted by those
countries that have financial institutions operating in the global financial markets; however,
there are often minor variations in the detail of each country's application of the accord. In
this text we will look at the application of Basel II in Australia by APRA. While our study
of capital adequacy is quite comprehensive, the relevant prudential standards run into
hundreds of pages. APRA will finalise the details of the Basel III capital accorda set of
reform measures addressing regulation, supervision and risk measurement of the
banking sector that builds on the guidelines set in Basel II in Australia in mid-2012. Like
Basel II, its application in Australia will likely diverge to some degree from its application
in other countries. You can view updates on Basel III as well as the full Basel II prudential
standards at www.apra.gov.au.

p. 64 MINIMUM CAPITAL ADEQUACY


2.7.1 REQUIREMENT
Minimum capital adequacy requirements apply to commercial banks and any other
institutions specified by a nation-state's prudential regulator. Australian Prudential Standard
APS 111 states that for capital adequacy purposes authorised deposit-taking institutions
(commercial banks) must hold a minimum amount of Tier 1 capital and capital base on both
an individual institution (Level 1) basis and consolidated banking group (Level 2) basis. In
addition, they may include an amount of Tier 2 capital as part of their required capital
holdings, up to the limits specified in the prudential standard.

The prudential standard requires an institution, at a minimum, to maintain a risk-based


capital ratio of 8.00 per cent of total-risk-weighted assets at all times. At least half of the
risk-based capital ratio must take the form of Tier 1 capital. The remainder of the capital
requirement may be held as Upper Tier 2 and Lower Tier 2 capital. Where considered
appropriate, a regulator may require an institution to maintain a minimum capital ratio
above 8.00 per cent. After the GFC, Australian banks acted to strengthen their capital
ratios. As a result, their holdings of Tier 1 capital rose to approximately 10.00 per cent and
their total capital ratios (including Tier 1 and Tier 2 capital) to approximately 12.00 per
cent. This position is relatively strong but still serves to highlight the leverage inherent in
the banking system and the need for vigilant regulation.

In effect, each commercial bank will actually need to maintain a level of capital above the
minimum requirement so that the bank is able to maintain and expand its business
activities. For example, whenever a bank approves a loan to a customer, the bank must
ensure that it has sufficient capital, as defined in the capital accordthat is, the loan (asset)
must be funded by the bank from a combination of capital and debt. Therefore, increased
capital requirements such as those set down in Basel III have substantial implications for
banks' business activities.

2.7.2 THE DEFINITION OF CAPITAL


Capital, within the context of the Basel II capital accord, is measured in two tiers, Tier 1
and Tier 2 capital.

Tier 1 capitalhighest quality; core capital for capital adequacy purposes , or core
capital, consists of the highest quality capital elements which fully satisfy all the essential
capital characteristics:

They provide a permanent and unrestricted commitment of funds.

They are freely available to absorb losses.

They do not impose any unavoidable servicing charge against earnings.

They 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 bank's minimum required capital base.

Tier 2, or supplementary, capital includes other elements which, to varying degrees, fall
short of the quality of Tier 1 capital, but nonetheless contribute to the overall strength of an
institution as a going concern. Tier 2 capital is divided into two parts:

Upper Tier 2 capitalspecified acceptable capital adequacy instruments, including


hybrids, of a permanent nature , which consists of elements that are essentially
permanent in nature, including some hybrid capital instruments.
p. 65

Lower Tier 2 capitalspecified acceptable capital adequacy instruments that are not
permanent, which consists of instruments that are not permanentthat is, dated or
limited-life instruments.
The different types of Tier 1 and Tier 2 capital are shown in Table 2.2. More detailed
information is available at the internet sites of bank supervisors (e.g. www.apra.gov.au). A
number of bank supervisor internet addresses are provided at the front of the book.

TABLE 2.2 BASEL IIREGULATORY CAPITAL(a)

SOURCE: APRA, Prudential Standard APS 111, January 2008 (www.apra.gov.au).

p. 66 BASEL II STRUCTURAL FRAMEWORK


2.7.3
The Basel II capital accord framework is shown in Figure 2.1 and is based on three
integrated pillars:

Pillar 1: the capital adequacy minimum requirements

Pillar 2: the supervisory review of capital adequacy

Pillar 3: the market discipline, incorporating disclosure and transparency requirements

Pillar 1: Credit risk component


As shown in Figure 2.1, Pillar 1incorporates components of credit risk, operational risk
and market risk within the Basel II capital accord incorporates three risk components:
credit risk, operational risk and market risk.

FIGURE 2.1 OVERVIEW OF BASEL II CAPITAL ACCORD


FRAMEWORK

Credit risk relates to the underlying counterparty to a balance-sheet asset or an off-


balance-sheet transaction. Basel II applies a range of risk weightings based on the
counterparty to an asset or off-balance-sheet transaction. If an asset is secured by eligible
collateral or certain forms of guarantee, it is risk-weighted according to the risk weight
appropriate to the counterparty to that collateral or guarantee.

p. 67

Basel II provides three alternative ways for a bank to measure credit risk:

1. the standardised approach


2. the foundation internal ratings-based approach (FIRB)
3. the advanced internal ratings-based approach (AIRB)

The standardised approach to credit riskprovides risk weights to be applied to


balance-sheet assets and off-balance-sheet items to calculate minimum capital
requirement requires banks to assign each balance-sheet asset and off-balance-sheet item a
risk weight that is based on an external rating published by an approved credit rating
agency, or is a fixed weight specified by the prudential supervisor. Extended Learning A
provides an example of the calculations involved. Off-balance-sheet exposures that give
rise to credit risk are first converted into so-called balance-sheet equivalents according to
specified credit conversion factors prior to allocating the relevant risk weight.

With regard to market-related off-balance-sheet transactions a bank has the choice of two
methods for determining the credit conversion factor: the current exposure methodoff-
balance-sheet capital calculation based on the current and potential credit exposures
mark-to-market or the original exposure methodoff-balance-sheet capital calculation
based on the notional contract value multiplied by a credit conversion factor. The current
exposure method (mark-to-marketthe revaluation of a contract based on its current
quoted price on an exchange) is the sum of the current credit exposure and the potential
future credit exposure of a contract. The current credit exposure is defined as the sum of the
positive mark-to-market value (or replacement cost) of a contract. The potential future
credit exposure is determined by multiplying the notional principal amount by the relevant
credit conversion factor. Each of these market-related off-balance-sheet transaction
methods has its own set of credit conversion factors. The original exposure method applies
a different set of credit conversion factors to the notional value of the contract.

Larger commercial banks, in particular those that operate in the international capital
markets, will generally apply to the supervisor to use the internal ratings-based approach
to credit riskfor capital calculations a bank may use some or all of its own risk
measurement model factors; supervisor approval required (see Figure 2.1). These banks
have the information systems and expertise that enable a more sophisticated approach to the
measurement and management of risk. A commercial bank that receives approval from the
supervisor to use the internal ratings-based approach to credit risk may rely on its own
internal estimates of some or all of the necessary credit risk components in determining the
regulatory capital requirement for credit exposures.

There are two internal ratings-based approaches available:

1. the foundation internal ratings-based approach (FIRB)


2. the advanced internal ratings-based approach (AIRB)

Under the FIRB approach, a bank must provide its own estimates of probability of default
and effective maturity, but must rely on supervisory estimates for other credit risk
components, being the loss given default estimates and exposure at default estimates. Under
the AIRB approach, a bank must provide its own estimates of all of the credit risk
components.

The internal ratings-based approach requires institutions to categorise their banking book
exposures into six broad asset classes: corporate, sovereign, bank, retail, equity and a
residual class.

Pillar 1: Operational risk component

In recent years banks have gained a greater understanding and awareness of operational
risksexposures that may impact on the normal day-to-day business functions of an
organisation that may result in the loss of business functions. The reality of disaster was
particularly evident following the terrorist attacks on New York on 11 September 2001.
The US financial system was severely tested as financial institutions and markets closed
and struggled to recover their critical business operations. The direct and consequential
operational and financial losses associated with that disaster were significant.

p. 68
The Bank for International Settlements categorises operational risk as:

internal and external fraud

employment practices and workplace safety

clients, products and business practices

damage to physical assets

business disruption and system failures

execution, delivery and process management

The categorisation of operational risk is very wide ranging and indicates that all aspects
of an organisation's day-to-day business activities are exposed to operational risk.

The Australian prudential supervisor, APRA, defines operational risk as the risk of loss
resulting from inadequate or failed internal processes, people and systems or from external
events. This definition includes legal risk, but excludes strategic and reputational risks.

The rapid advance in technology, together with globalisation of the international financial
system, has increased the time sensitivity of banks to operational risk. For example, a
bank's derivatives transactions, foreign exchange trading and payments system settlements
are clear examples of critical business functions that are time sensitive within very short
time-frames.

The loss by a bank of its critical business operations due to a disaster may severely
challenge its operational and financial survival. For example, such disasters may include
the loss of computer or communication systems, or severe damage from fire or earthquake.
Further, operational risk contagion is an extended risk to which a country's financial system
is exposed. It is possible that contagion effects may result in instability within the global
financial system.

Principally, the management of operational risk requires the development and


maintenance of defined strategies that will enable a bank to recover its functionality and
resume critical business operations within predetermined time-frames. There are three
overarching objectives of operational risk management:

1. Operational objectives. These are associated with the impact on a bank of the loss of
business function integrity and capability.
2. Financial impact objectives. These relate to direct losses incurred as a result of an
operational risk exposure, the cost of recovering normal business operations and
consequential financial losses due to reduced business effectiveness.
3. Regulatory objectives. These derive from prudential standards established by bank
supervisors.

It might be argued that the prevailing risk management regime within a bank will ensure
that exposures to operational risk are identified and managed through a structured decision
process. However, it became apparent to bank regulators that theoretical drivers of risk
management were often impeded by operational and financial imperatives that limited the
development of risk management objectives, policies and practice. For example, failures
within a bank's operational risk management process may result from a lack of
understanding of this risk by the board of directors and executive management, inadequate
budget allocations, poor risk management leadership and procedures and weak or non-
existent education and training programs.
It is within this context that the Basel Committee on Banking Supervision incorporated an
operational risk component into Pillar 1 of the Basel II capital accord (Figure 2.1).

The first, and most important, requirement is that commercial banks establish and
maintain a comprehensive risk management framework for operational risk. It must be
clearly understood that the provision of additional capital in the capital accord will not
protect a bank from operational risk. The capital will only support the survival of the
institution and the stability of the financial system after an event has occurred.

p. 69

Business continuity managementmaintenance of strategies to ensure the continuance


of critical business functions, or disaster risk management, is a significant component of
operational risk management. At the end of this chapter, Extended learning B provides a
business continuity risk management structure consisting of a disaster recovery planning
process and a disaster recovery response process and applies these processes to an
education and training framework for commercial banks. This is essential reading for those
responsible for the management of business continuity risk.

Basel II requires banks to hold additional capital to support their exposure to operational
risk. In order to calculate the amount of capital needed, banks may use the standardised
approach or may apply to the regulator to use an advanced measurement approach. This
section considers the standardised approach.

In the standardised approach to operational risk an institution is required to map its


activities and divide them into two areas of business: retail/commercial banking, and all
other activity.

An institution must document its mapping process, detailing the policy and procedures
used to map the full range of business activities. This process must be subject to
independent review.

The operational risk capital requirement for the retail/commercial banking area of
business is determined using a proportion of an institution's total gross outstanding loans
and advances as an indicator of that area's operational risk exposure. This also includes the
book value of securities held in the banking book.

The operational risk capital requirement for the all other activity area of business is
determined using a proportion of an institution's net income as an indicator of that area's
operational risk exposure. Net income is defined as profit from ordinary activities before
goodwill, amortisation and income tax.

The operational risk capital requirement for the retail/commercial banking area of
business is calculated by:

taking the last six half-yearly observations of total gross outstanding loans and
advances,
multiplying a proportion (being 3.5 per cent of total gross outstanding loans and
advances at each observation point) by a factor of 15 per cent, to produce a result in
respect of each observation, and
determining an average result for the six observations.

The operational risk capital requirement for the all other activity area of business is
calculated by:
taking the last six half-yearly observations of net income earned over a six-month
period
multiplying net income at each observation point by a factor of 18 per cent to produce a
result in respect of each observation
determining an average result for the six observations.

The total operational risk capital requirement under the standardised approach to
operational risk is the sum of the two average results determined above.

Pillar 1: Market risk component

Market risk is the third component of Pillar 1 shown in Figure 2.1 and is defined as the risk
of losses resulting from movements in market prices.

Commercial banks that operate in the foreign exchange, interest rate, equity or
commodities markets may be exposed to potentially large swings in market prices and
significant consequential losses. Potential losses may arise from general market price
movements and, in the case of interest rate and equity instruments, from price movements
specific to particular issuers.

An institution is required to divide its assets into either its banking book or its trading
book. A commercial bank must hold market risk capital against interest rate risks and
equity risks arising from positions held in its trading book. Also, market risk capital must
be held against credit derivatives in the bank's trading book. Market risk capital must be
held against all foreign exchange and commodity risks.

Market risk is split into two components: general market riskfor capital adequacy
purposes; changes in the overall market for interest rates, equities, foreign exchange and
commodities and specific market riskthe risk that the value of a security will change due
to issuer-specific factors. General market risk relates to changes in the overall market for
interest rates, equities, foreign exchange and commodities. Specific market risk is the risk
that the value of a security will change as a result of issuer-specific factors, such as a
change in the creditworthiness of the issuer. This is relevant only to interest rate and equity
positions.

p. 70

It is the responsibility of the board of directors to ensure that an institution has


documented a trading book policy statement. The institution must ensure that it has in place
adequate systems to identify, measure and manage market risk.

Institutions have a choice of two approaches to calculate their market risk capital
requirements: the internal model approach and the standardised approach. The internal
model approach is considered here.

In order to adopt the internal model approach to measure the market risk capital
requirement, a commercial bank must obtain approval from the prudential supervisor. The
bank must demonstrate the quality, integrity and robustness of its internal model.

An internal model is required to produce a measure of the value at risk (VaR)a


statistical probability model that measures financial risk exposures based on historic
observations from all market risks over a period of 10 trading days. To determine the
amount of capital required, the measure of VaR is multiplied by a factor set by the
regulator. The factor will range from 3 to 5 according to the regulator's view of the strength
and reliability of the internal VaR model. Added to this will be a plus factor of up to 1
depending on the expost performance of the model in back-testing.
Value-at-risk models (VaR)
VaR models endeavour to estimate maximum potential gains or losses that may be incurred
on a portfolio based on a specified probability over a fixed time period. APRA requires the
VaR model to include historical data observations for a minimum of one year. In times of
high market volatility APRA may also require the banks to calculate VaR over a shorter
time period to take account of the increased risk associated with the volatility. The model
data sets must be updated at least quarterly.

The regulator requires a model to apply a 99 per cent confidence level over a 10-day
holding period. This assumption implies that, on average, trading losses from market-
related contracts will exceed the VaR estimate only once in every 100 trading days.
However, VaR is calculated using historic observations and therefore is not necessarily an
accurate estimate of future losses, especially if an extreme event occurs that impacts upon
the financial markets.

The VaR model recognises the detailed structure of the balance-sheet and off-balance-
sheet items and, given specific assumptions on prices, values and volatility, determines a
VaR estimate. The sophistication of a VaR model used by an institution will vary
depending on the structure of its balance-sheet and off-balance-sheet items, the risk
management needs of the institution, the theoretical and technical skills of its risk managers
and the availability of computer hardware and software.

Simple VaR models:

estimate the sensitivity of portfolio components to small changes in prices, for example
a 1 basis pointinterest rates; 100 basis points equal 1 per cent change in interest rates
assume that market price movements follow a certain statistical distribution, usually a
normal or log-normal distribution
enable inferences to be drawn about potential losses with a given degree of statistical
confidence, for example a 99 per cent probability of a certain dollar amount loss.

More complex VaR models:

recognise correlations between different portfolio components (i.e. the model allows for
market price changes that move together or offset each other)
account for the effects of portfolio diversification

consider the liquidity of different portfolio instrumentsthat is, the ease or ability of an
institution to liquidate (sell) securities or close out an open risk position.
p. 71

VaR represents an important tool available to risk managers and boards of directors for
the estimation of potential exposures to market-rate-related risks. However, VaR models
are constrained by some theoretical and statistical limitations; they:

are based on a limited set of historical data which may not be a correct reflection of
future data
assume liquidity in all marketsthat is, the ability of an institution to trade all
components of its portfolio. This will not always be the case, particularly in times of
financial stress
assume that all instruments can be liquidated in one day. This is not possible.
Contractual constraints also mean that some items cannot be liquidated
do not include excessive intra-day price volatilitythat is, unusually large short-term
exchange rate or interest rate movements
assume a normal distribution, when data indicate that in some markets prices may be
volatile and a normal distribution is not always evident.
These limitations were on full display during the GFC. The historical data on which VaR
models were based simply did not include a housing market crisis of the proportions that
precipitated the GFC. A number of financial institutions significantly underestimated the
amount of potential losses that they could suffer and, in some cases, reported relatively low
levels of potential losses just days before being forced into bankruptcy. Because of these
limitations, and as part of good risk management practice, banks should back-test their VaR
model estimates against actual outcomes. The model should be applied to a range of
scenario analysis situations, and particularly must be stress tested for extreme market
conditions.

Following the GFC, stress testing of financial institutions and their models attracted much
attention. As part of its enhancements to the Basel II frameworkremember, Basel III
comes into effect in 2013APRA introduced a stressed Value at Risk requirement in
2011 that came into effect in January 2012. Among other things, the stressed VaR must
address illiquidity, price gapping, concentrated positions, one-way markets, non-linear
products, deep out-of-the-money positions and other risks that may not be captured by VaR,
including implied correlations and skew risk. For more information see APRA's APS 116,
especially Attachment C (www.apra.gov.au).

Pillar 2: Supervisory review of capital adequacy

As shown in Figure 2.1, the supervisory review process forms the second pillar of the Basel
II capital accord. The Basel Committee on Banking Supervision advises that the
supervisory review process is intended to:

1. ensure that banks have sufficient capital to support all the risk exposures in their
business
2. encourage banks to develop and use improved risk management policies and practices
in identifying, measuring and managing risk exposures.

Banks have a responsibility to ensure that they hold adequate capital to support the
overall risks of the organisation beyond the core minimum requirements determined in
Pillar 1. A bank's supervisors are expected to evaluate how well the bank is actually
assessing its capital needs relative to its level of risk.

The supervisory review process establishes a forum for dialogue between commercial
banks and their supervisors. Supervisors are expected to intervene when capital assessment
by a bank is seen as inadequate for its risk profile.

While capital adequacy is a key foundation in the support of sound risk management, it
should not be seen as the sole determinant. Pillar 2 encourages additional good risk
management practice, such as:

developing risk management policies and procedures, including education and training
(e.g. see Extended learning A)
applying internal responsibilities, delegations and exposure limits

p. 72

increasing provisions and reserves


strengthening internal control and reporting procedures.

Therefore, the Pillar 2 supervisory review process seeks to encourage banks to better
understand and account for:
risks that are not fully captured in Pillar 1, such as credit concentration risk, for
example lending large amounts to a single borrower, industry or within a limited
geographic region
those factors that are not taken into account by Pillar 1, for example interest rate risk in
the banking book, business risk and strategic risk
factors external to the bank, such as the effects of a changing business cycle.

An essential component of the Pillar 2 supervisory review process is the assessment, by


the supervisor, of compliance by the banks with the minimum standards and disclosure
requirements attached to the capital accord. Supervisors are responsible for ensuring that
these requirements are being met.

In order to establish an international benchmark for the application of Pillar 2, the Basel
Committee on Banking Supervision has identified four key principles of supervisory
review.

Principle 1 states: 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.
The five main features of a rigorous process are identified as:

1. board and senior management oversight


2. sound capital assessment
3. comprehensive assessment of risks
4. monitoring and reporting
5. internal control and review

Principle 2 states: 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.' To achieve these outcomes,
supervisors would be expected to be involved with, or require:

on-site examinations and inspections

off-site reviews

discussions with bank management

reviews of work done by external auditors

periodic reporting

Principle 3 states: 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. Reasons why commercial banks should be required to maintain a
capital buffer include:

Pillar 1 requirements represent only a minimum level of capital. Banks will require
additional capital in order to achieve business growth.
International banks will require a higher level of capital to enhance their credit ratings.

Fluctuations in capital requirements will occur as the dynamic business environment


changes.
Obtaining additional capital on short notice is generally more costly.
Failure of a bank to maintain the minimum capital requirement may trigger legislative
or supervisory corrective action.
Aexample
bank may be exposed to specific risks that are not taken into account in Pillar 1, for
a large exposure to a specific industry sector.
p. 73

Principle 4 states: 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. These actions may include:

intensifying the monitoring of the bank

restricting the payment of dividends

requiring the bank to prepare and implement a satisfactory capital adequacy restoration
plan
requiring the bank to raise additional capital immediately.

Pillar 3: Market discipline

Market disclosure forms the third pillar in the Basel II capital accord (Figure 2.1). The
purpose of Pillar 3 is to encourage market discipline by developing a set of disclosure
requirements that allow market participants to assess important information relating to the
capital adequacy of an institution.

The Basel Committee on Banking Supervision states that such disclosures have particular
relevance under the capital accord because banks are given greater discretion in assessing
their capital requirements through the use of internal methodologies and models.

The key word associated with Pillar 3 is transparency, whereby the objective is to make
banks' risk exposure, risk management and capital adequacy positions more transparent, or
apparent, such that market discipline can reinforce the regulatory process. For example,
market discipline may be reflected in a rise or fall in an institution's share price.

It is to be expected that institutions will provide the prudential supervisor with all material
relevant to risk exposures, risk management and capital adequacy. Each nation-state
supervisor will determine what information is released for public consumption. Clearly, the
general release of all information would raise concerns relating to the maintenance of
stability and confidence in the financial system, plus raise issues relating to proprietary and
confidential information.

Prudential supervisors will determine the minimum disclosure requirements for


institutions within their jurisdiction. They will also determine the frequency of various
reporting requirements.

The Basel Committee on Banking Supervision recommends that a range of qualitative


and quantitative disclosure reports be prepared that relate to the principal parts of Pillar 1
and Pillar 2. Within the context of the Basel II capital accord, these will include reports on:

the scope of the application of the capital accord within an organisation

the capital structure of the institution

the methodologies, approaches and assessment of capital adequacy by the institution

the determination of all aspects of credit risk exposures


the application of credit risk mitigation

the determination of equity risk within the banking book

the impact of securitisation of assets

the determination of market risk exposures

the measurement of operational risk

the assessment of interest rate risk within the banking book.

REFLECTION POINTS

Banks must maintain a minimum risk-based capital ratio of 8.00 per cent, of which at
least half must be Tier 1 capital; the remainder may be Upper or Lower Tier 2 capital.
The Basel II capital accord comprises three integrated pillars:

Pillar 1: the capital adequacy minimum requirements

Pillar 2: the supervisory review of capital adequacy

Pillar 3: the market discipline, incorporating disclosure and transparency


requirements
p. 74

Pillar 1 is divided into three components: credit risk, operational risk and market risk.
Either a standardised approach or a more advanced approach can be used to measure
risk.
The credit risk standardised approach requires a bank to assign each balance-sheet
asset and off-balance-sheet item a risk weight. The risk weight is either based on an
external credit rating or is a fixed weight specified by the bank supervisor. Off-
balance-sheet items are converted to balance-sheet equivalents before applying a credit
risk weight.
Operational risk is the risk of loss resulting from inadequate or failed internal
processes, people and systems or external events (e.g. the failure of the computer
system, employee fraud or a major fire). Basel II requires banks to hold additional
capital to support their exposure to operational risk.
The standardised approach to operational risk requires a bank to map its activities and
divide them into two areas: retail/commercial banking and all other activity.
Calculations are applied to these two areas to determine the operational risk capital
requirement.
A bank is required to hold market risk capital against its trading book. Market risk is
split into general market risk and specific market risk.
Commercial banks typically will use an internal value-at-risk (VaR) model to measure
their market risk requirement.
VaR models estimate potential gains or losses that may be incurred on a portfolio over
a 10-day holding period, based on a 99 per cent confidence level. Problems with VaR
were very clearly on display during the GFC and regulators have taken steps to ensure
that the VaR models are supplemented with additional stress testing.
Pillar 2 establishes dialogue between banks and their supervisors. It also encourages
good risk management practices for those risks not covered in Pillar 1.
Four key principles of supervisory review have been developed relating to the
monitoring of a bank's risk management processes and minimum capital levels.
Pillar 3 encourages market discipline establishing transparent disclosure requirements
which allow market participants to assess information relating to a bank's risk
exposure, risk management and capital adequacy positions.

2.8 Liquidity management and other


supervisory controls
Banks, in common with all organisations, must
manage their day-to-day liquidity needs, such as LEARNING
paying creditors and employees. Liquidityaccess to OBJECTIVE 2.7
cash and other sources of funds to meet day-to-day
expenses and commitments is access to funds that Examine liquidity
enable an institution to meet its business operating management and other
commitments. For example, if a bank approves a loan supervisory controls applied
to a customer, it needs to be able to provide those by APRA
funds at settlement date. Should a depositor wish to
withdraw funds from a demand account, the bank
must be able to make those funds available. The
nature of a bank's business means that banks have
special liquidity problems that they must manage.

The first problem relates to the mismatch in the terms to maturity of balance-sheet assets
and liabilities and the timing of associated cash flows. The majority of banks' sources of
funds are relatively short term. For example, the longest term to maturity of a bank deposit
product is typically five years. On the other hand, banks provide housing loans to their
customers with a term to maturity in excess of 30 years. Banks must manage the fact that
their sources of funds (liabilities) often need to be repaid sooner than their loan assets;
therefore, they have a liquidity risk exposure that has to be managed.

p. 75

The second liquidity problem relates to the role of banks in the payments system. This is
discussed in Chapter 12, but it should be noted that banks need to have funds available for
financial settlement of the millions of financial transactions carried out by their customers
each day. Value settlement of these transactions occurs through the payments system.

In order to obtain liquidity a bank must hold sufficient cash or have access to sources of
liquidity. Cash holdings do not provide a return on funds, therefore there is no incentive for
a bank to hold excess cash. A bank will invest surplus cash in securities that it will hold in
its securities portfoliofinancial securities held by an institution for investment and
trading purposes . The securities held in the portfolio will provide a return on investment,
but at the same time they can easily be sold into the secondary markets to convert into cash
as needed. For example, a bank may hold a portfolio of government securities. There is an
active secondary market in which these securities can be sold immediately, if required, to
access cash for liquidity purposes.

Liquid securities include cash, government securities, semi-government securities and


money-market securities. Another liquidity contingency arrangement would be the
provision of a stand-by credit facility by an international bank. In this situation, the
international bank must be able to provide immediate liquidity support, subject to the stand-
by credit facility terms and conditions.

It has already been noted that a modern, efficient financial system is essential to support
economic growth. Therefore, it is critical that banks have access to sufficient liquidity to
maintain stability within the financial system. Bank regulators have a particular
responsibility to ensure the soundness and stability of the financial system, and therefore
apply prudential standards in relation to the management of liquidity. Basel III is the first of
the Basel accords to include a global liquidity standard. At the time of writing, APRA had
not yet released its final prudential standards that will indicate how Basel III will apply in
Australia. It is clear, however, that stricter capital adequacy ratios will be its most important
feature.

Currently, the Australian supervisor, APRA, applies a liquidity prudential standard, APS
210. Under APS 210, the board of directors and management of a bank must implement and
maintain a liquidity management strategyan organisations objectives, policies and
procedures as they relate to cash flows and liquidity that will ensure that the institution
will be able to meet its operational liquidity demands as they fall due. The liquidity
management strategy must be reviewed at least annually, and a bank must immediately
inform the supervisor of any concerns about current or future liquidity. APRA will review
the adequacy and appropriateness of the 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 plana set of predetermined strategies to be implemented if a


designated event occurs for dealing with a potential liquidity crisis.

Prudential Standard APS 210, Liquidity, requires an institution's liquidity management


strategy to include regular scenario analysis of domestic and foreign currency liquidity
under a range of operating conditions. APRA stipulates two scenarios that must be
addressed:

1. The going concern. This refers to the normal behaviour of cash flows in the ordinary
course of business. A bank must be able to specify how its liquidity obligations and
commitments are to be met on a day-to-day basis over at least the next 30 days.
2. p. 76

The name crisis. This refers to the behaviour of cash flows in adverse operating
circumstances. A bank must be able to demonstrate that it is able to obtain access to
sufficient liquidity to keep operating during the crisis situation for at least five
business days.

A commercial bank that is exempted, or inadequately carries out scenario analysis, is


required to maintain a minimum holding of 9 per cent of its liabilities in highly liquid assets
such as cash and money-market securities approved by APRA.

The current liquidity standard places great emphasis on a bank's own internal
management practices for managing liquidity. Banks are now able to adopt a range of
strategies to manage liquidity, including:

setting limits on maturity mismatches between assets and liabilities

holding high-quality liquid assets that can easily be sold to relieve unexpected liquidity
pressures
diversifying liability sources to maintain a stable funding base

access to wholesale markets through the issue of money-market securities, or


establishing stand-by credit facilities
access to foreign currency markets for liquidity, particularly to meet foreign-currency-
denominated liquidity commitments
intra-group liquidity, whereby liquidity surpluses and shortfalls are identified, and any
regulatory or legal impediments are addressed
use of assets through sales, repurchase agreements and securitisation to provide
liquidity
industry liquidity support arrangements through the provision of stand-by liquidity
between banking institutions.

APRA will, if it has concerns about a particular bank's liquidity management strategy,
require the bank to hold a specified minimum level of liquid assets as deemed necessary.

2.8.1 OTHER REGULATORY AND SUPERVISORY


CONTROLS
Even though the operation of the financial system is often described as being deregulated,
this description is really only relative to previous periods. The capital adequacy and
liquidity management requirements of banks are supervised by the bank regulator, and there
is a range of other regulatory and supervisory controls with which banks must comply. The
following are some of the controls placed on Australian banks, many of which are similar
to those applied in other countries.

Risk management systems certification. A bank is required to provide APRA with an


annual attestation from the chief executive officer, endorsed by the board of directors
(or relevant senior officer outside Australia in the case of foreign bank branches), of
the efficacy of the bank's risk management systems. The chief executive officer and
the board will attest that risks have been identified, that systems have been designed to
manage those risks and that those systems are working effectively.
Business continuity management. The board and senior management of a bank must
ensure that appropriate policies and procedures are in place to identify, measure and
manage business continuity risk. In particular, a bank must develop, implement and
maintain a business continuity plan that documents procedures and information that
will enable the bank to respond to disruptions and recover critical business functions
(see also Extended learning A).
Audit (external auditors, on-site visits). APRA requires a commercial bank's external
auditor to inform it of the reliability of statistical data provided to APRA, and of
compliance with regulatory and prudential requirements. In addition, each year
external auditors are required to review a particular area of a bank's operation that is
specified by APRA. They are required to provide APRA with an analysis of the
strengths and weaknesses of the risk management systems employed by the bank.
APRA also conducts a program of on-site visits to banks, focusing on bank systems
used to measure and manage risk. The Reserve Bank may also participate in the on-
site visits.
p. 77

Disclosure and transparency. As discussed above in the context of Basel II, bank
supervisors now expect banks to improve the quality of publicly disclosed
information. This assists market participants to exercise their own disciplines on banks
as a complement to supervision. For example, banks are encouraged to upgrade
information on asset quality and off-balance-sheet business, particularly derivatives
activities.
Large exposures. Banks are required to report, for the consolidated group, exposures
of greater than 10 per cent of the group's capital base to an individual client or client
group. Further capital requirements may be imposed on banks with such large
exposures, due to the potentially increased counterparty credit risk.
Foreign currency exposures. APRA requires banks to report their overnight foreign
exchange positions, and may establish currency exposure limits for individual banks.
Subsidiaries. A further prudential requirement is the establishment of transparency
between banking group subsidiaries such as funds management and securitisation
entities. A bank must make a clear disclosure that such investments do not represent
deposit or other liabilities of the parent bank. Any commitment of a subsidiary that
creates recourse to the bank will require appropriate capital support.
Ownership and control. The Financial Sector (Shareholdings) Act 1998 provides that
an individual, entity or group is not permitted to have an aggregate interest of 15 per
cent or more of the nominal value of the voting shares of an institution. An exemption
may be sought from the Treasurer of the Commonwealth of Australia.

The ultimate responsibility for the sound and prudent operation of a commercial bank
rests with the board of directors. The board should comprise at least five directors who
should be fit and proper persons, capable of exercising independent judgment and widely
representative of shareholders. The chairperson and a majority of directors should be non-
executive board membersboard members who are not part of the management of a
corporation or its subsidiaries. The board also should have regard to its responsibilities to
depositors.

REFLECTION POINTS

Liquidity risk is a major risk exposure of commercial banks.

Banks need to have access to funds to meet day-to-day commitments, for example
repayment of deposits and loan settlements.
Banks hold liquid assets, such as money-market instruments, in their securities
portfolio for this purpose. These assets are easily sold in the secondary markets to raise
cash as needed.
Bank supervisors require banks to maintain a liquidity management strategy, including
access to contingency liquidity in an extreme situation.
The bank supervisor imposes a range of other prudential requirements on banks,
including risk management certification, business continuity management, external
audits, on-site visits, limits on large credit and foreign currency exposures, subsidiary
business operations and ownership and control restrictions.
In Australia, ADIs will be required to comply with the Basel III capital requirements
from the beginning of 2013. In 2012, APRA will finalise the operational details of
Basel III application in Australia.

Financial news case study


p. 78

In Chapter 2, the latest addition to the Basel accords, Basel III, was discussed. Although the
new Basel III capital adequacy requirements will be implemented very gradually, changes to
capital adequacy can have a significant impact on financial institutions. Australian banks
weathered the global financial crisis and have tended to maintain capital ratios in excess of
those required by Basel II. They should be well placed to make a smooth transition to Basel
III. Apply what you know about the ADIs that operate in Australia and your knowledge of
the Basel accords to comment critically on Eoin Blackwells article published in the Sydney
Morning Herald.

Sweeping regulatory reforms handed down by central bankers that require lenders to set
aside more capital to better withstand financial shocks have already been met by Australias
big four banks, analysts say. The proposed reforms agreed on Sunday in Switzerland, known
as Basel III, are also designed to prevent the need for government bailouts such as those that
occurred during the depths of the global financial crisis.

Basel III requires banks to hold a minimum of 7 per cent of tier one capital, namely
common stock and cash reservesup from the current 2 per cent. Tier 1 capital is also a core
measure of a banks financial strength. However, for some of the worlds banks, it means
they may have to raise billions of dollars of additional capital

Australias big fourCommonwealth Bank, National Australia Bank, Westpac and ANZ
Banking Groupwould largely be unaffected by the requirements because they had operated
with those restrictions for years, Southern Cross Equities banking analyst TS Lim said.
'There were no surprises for the Aussie banks,' Mr Lim said. Even with the 7 per cent core
tier one requirement, Aussie banks are already in excess of this number. Mr Lim said ANZ
already held 8 per cent in tier 1 capital, while Westpac, Commonwealth and NAB held the
required 7 per cent.

Global banks have a long lead time to implement the changes. The minimum common
equity requirement, currently 2 per cent, has to be 4.50 per cent by January 1 2015. A 2.50
per cent additional amount is required by January 1 2019, to help banks withstand periods of
financial stress and will bring the common equity component to its required 7 per cent.

'Overall, it's a good outcome for local banks,' Mr Lim said. 'Not to mention that the 7 per
cent includes that 2.50 per cent buffer in which the banks have until 2019 to implement.'

Commonwealth Bank group treasurer Lyn Cobley said it would take a little while for the
new regulations to be fully implemented in Australia. 'It's given us plenty of time to
comfortably meet the requirements without undue changes to what were doing,' she said.
'Keep in mind, these are just the Basel rules. The Australian Prudential Regulation Authority
(APRA) have to decide how to implement it. It's truly just work in progress at the moment.'

The Basel III committee comprises central bankers and government officials from the G20
group of top industrialised nations. Most of the Basel III proposals are expected to be agreed
upon before the G20 Leaders Meeting in South Korea in November.

SOURCE: Eoin Blackwell, 'Aussie Banks Already Meet Basel III', Sydney Morning Herald
AAP, 13 September 2010.

DISCUSSION POINTS

List some of the main features of the new Basel III accord and discuss how the new accord
differs from Basel II.
How adequately capitalised are Australian banks when judged against the new accord?

What are some of the reasons for the lengthy time delay in introducing the new capital
requirements? Do you think that the new capital requirements should be implemented
immediately?
Go to the website of the Australian Prudential Regulation Authority (www.apra.gov.au).
What is the latest development on the implementation of Basel III in Australia?

Summary
p. 79

LEARNING OBJECTIVE
Evaluate the functions and activities of commercial 2.1
banks within the financial system

Commercial banks are the largest group of financial institutions within a financial system
and therefore they are very important in facilitating the flow of funds between savers and
borrowers.
The core business of banks is often described as the gathering of savings (deposits) in
order to provide loans for investment.
The traditional image of banks as passive receivers of deposits through which they fund
their various loans and other investments has changed since deregulation. For example,
banks provide a wide range of off-balance-sheet transactions.

Identify the main sources of funds of commercial banks, LEARNING OBJECTIVE


including current deposits, demand deposits, term
deposits, negotiable certificates of deposit, bill
2.2
acceptance liabilities, debt liabilities, foreign currency
liabilities and loan capital

Banks now actively manage their sources of funds (liabilities).

They offer a diversity of products with different return, risk, liquidity and cash-flow
attributes to attract new and diversified funding sources.
Sources of funds include current deposits, call or demand deposits, term deposits,
negotiable certificates of deposit, bills acceptance liabilities, debt liabilities, foreign
currency liabilities, loan capital and shareholder equity.

LEARNING OBJECTIVE
Identify the main uses of funds by commercial banks,
including personal and housing lending, commercial
2.3
lending, lending to government, and other bank assets

Commercial banks now apply a liability management approach to funding growth in their
balance sheets.
Under this approach a bank will (1) encourage depositors to lodge savings with the bank,
and (2) borrow in the domestic and international money markets and capital markets to
obtain sufficient funds to meet forecast loan demand.
The use of funds is represented as assets on a bank's balance sheet.

Bank lending is categorised as personal and housing lending, commercial lending and
lending to government.
Personal finance is provided to individuals and includes housing loans, investment
property loans, fixed-term loans, personal overdrafts and credit card finance.
Banks invest in the business sector by granting commercial loans. Commercial loan assets
include overdraft facilities, commercial bills held, term loans and lease finance.
While banks may lend some funds directly to government, their main claim is through the
purchase of government securities such as Treasury notes and Treasury bonds.

Outline the nature and importance of banks' off LEARNING OBJECTIVE


balancesheet business, including direct credit 2.4
substitutes, trade and performancerelated items,
commitments and marketraterelated contracts

Viewing banks only in terms of their assets and liabilities greatly underestimates their
role in the financial system. Banks also conduct significant off-balance-sheet business.
The national value of off-balance-sheet business is over four times the value of the
accumulated assets of the banking sector.
Off-balance-sheet business is categorised as direct credit substitutes, trade- and
performance-related items, commitments, and foreign exchange, interest rate and other
market-rate-related contracts.
Over 94 per cent of banks' off-balance-sheet business is in market-rate-related contracts
such as foreign exchange and interest-rate-based futures, forwards, options and swap
contracts.

LEARNING OBJECTIVE
Consider the regulation and prudential supervision of 2.5
banks

One of the main influences of change in the banking sector has been the regulatory
environment within which banks operate.
p. 80

Commercial banks are now said to operate in a deregulated market. Relative to previous
regulatory periods this is a reasonable description; however, there still remains quite a
degree of regulation that affects participants in the financial markets, including the banks.
Each nation-state is responsible for the regulation and supervision of its own financial
system. In particular, central banks and prudential supervisors are responsible for the
maintenance of financial system stability and the soundness of the payments system.

LEARNING OBJECTIVE
Understand the background and application of the 2.6
capital adequacy standards

At the global level, the Bank for International Settlements takes an active interest in the
stability of the international financial system. To this end, the Basel Committee on
Banking Supervision has developed an international standard on capital adequacy for
banks.
The current capital adequacy standard is known as the Basel II capital accord, under
which banks are required to maintain a minimum risk-based capital ratio of 8.00 per cent.
This will increase with the introduction of Basel III.
Basel III was put into place after the GFC. However, APRA is yet to fully specify how
the new accord will operate in Australia.
Capital is categorised as either Tier 1 capital, Upper Tier 2 capital or Lower Tier 2
capital. At least half of a bank's capital requirement must be held in Tier 1 capital.
As part of the calculation process, risk weights are applied to balance-sheet assets using
specified risk weights. These weights may be based on the counterparty to an asset, or on
an external rating provided by an approved credit rating agency.
Off-balance-sheet items are converted to a balance-sheet equivalent using credit
conversion factors before applying the specified risk weights.
The Basel II capital accord comprises three pillars.

Pillar 1 relates to the calculation of the minimum capital requirement. Pillar 1 considers
three areas of risk: credit risk, operational risk and market risk. Within each of these risk
categories banks have a choice of applying a standardised approach or an internal
approach to measuring their capital requirement. Subject to approval from the bank
supervisor, an internal approach method allows a bank to use its own risk management
models.
Pillar 2 provides for a supervisory review process and includes four basic principles: (1)
the assessment of total capital requirements by a bank, (2) the review of capital levels and
the monitoring of banks' compliance by supervisors, (3) the ability of a supervisor to
increase the capital requirement of a bank, and (4) the intervention of a supervisor at an
early stage to maintain capital levels.
Pillar 3 seeks to achieve market discipline through a process of transparency and
disclosure. Banks are required to provide information and data on a periodic basis to the
supervisor. Some of these reports may be made public.

LEARNING OBJECTIVE
Examine liquidity management and other supervisory 2.7
controls applied by APRA

The bank regulator, APRA, applies a number of important prudential controls on


commercial banks. These include liquidity management policies, risk management
systems certification, business continuity management, audit (external auditors, on-site
visits), disclosure and transparency, large credit exposures, foreign currency exposures,
subsidiaries and ownership and control.

Extended learning A
The standardised approach to credit risk

The standardised approach to credit risk requires banks


to assign each balance-sheet asset and off-balance-sheet LEARNING
item a risk weight. The risk weights reflect the view of OBJECTIVE 2.8
regulators about credit risk on a portfolio basis. The
regulator emphasises that the risk weights should not be Understand the standardised
seen as a substitute for the credit risk assessment of approach to credit risk and
individual credit risk exposures. A bank has primary compute the capital
responsibility to ensure that adequate systems are requirements for particular
applied to measure credit risk, and that sufficient capital transactions
is allocated to cover that risk.

The risk-weighted amount of a balance-sheet asset is calculated by multiplying its current


book value by the relevant risk weight. The risk weight applied may derive from an external
rating grade or a risk weight specified by the regulator.
p. 81

An external credit assessment rating can only be obtained from regulator-approved external
credit assessment institutions. For example, in Australia APRA recognises the ratings of
Standard & Poor's Corporation, Moody's Investors Service and Fitch Ratings. Credit rating
agencies and the methodologies used are discussed in Chapter 11. A credit rating is the credit
rating agency's opinion of the creditworthiness of an issuer of debt or equity. Credit ratings
are represented by alpha or alpha-numeric codes; for example, the long-term ratings of
Standard & Poor's range from AAA (highest) to D (lowest). Basel II applies six external
rating grades to these published credit ratings (see Table 2.3).

TABLE 2.3 BASEL II STANDARDISED APPROACH: EXTERNAL


LONG-TERM RATING GRADES

The external rating grades (1 to 6) are given a risk weight. For example, APS 112 requires
that claims held in the banking book for corporate counterparties and commercial public
sector entities that have the following external rating grade (as determined in Table 2.3) will
need to use the relevant risk weight:

It should be noted that APS 112 applies different risk weights to the various external rating
grades depending on the category of counterparty to a claim.

Clearly, there is a direct relationship between the level of credit risk and the amount of
capital required. If a bank provides a $1 million loan to a company that has an AA credit
rating (external rating grade 1), the amount of capital required is the book value the risk
weight 8.00 per cent capital adequacy requirement. That is, $1 million 0.20 0.08 = $16
000. The remaining $984 000 can be funded from bank liabilities.

p. 82
Had the bank given a $1 million loan to a company that has a BB credit rating, the capital
requirement would have been $1 million 1.0 0.08 = $80 000. Therefore, there is a
significant difference in the amount of capital a bank must use between the AA-rated
company and the BB-rated company.

Risk weights specified by the regulator may range from zero to 400 per cent.

As mentioned earlier in the chapter, a large part of bank loan assets may be in the form of
residential housing loans (mortgage loans). With a standard mortgage loan, the risk weight is
determined relative to the loan-to-valuation ratio (LVR) and the level of mortgage insurance.
The loan-to-valuation ratio the percentage ratio of a loan to the bank's valuation of the
property being mortgaged is simply the amount borrowed to purchase a residential property
divided by the accredited valuation of the property. For example, with a house valued at $400
000 where the buyer borrows $350 000, the LVR is 87.50 per cent. Therefore, as indicated in
Table 2.4, the risk weight is 50 per cent with no mortgage insurance or 35 per cent with at
least 40 per cent of the mortgage insured.

TABLE 2.4 RISK WEIGHTS FOR STANDARD RESIDENTIAL


MORTGAGES

In the above example, assuming that the borrower has taken appropriate mortgage
insurance, the capital requirement will be $350 000 0.35 0.08 = $9 800.

Risk weights for balance-sheet assets are to be found on the website of a nation-state's bank
supervisor. For example, the Basel II risk weights applied by the Australian bank supervisor,
APRA, are listed in Prudential Standard APS 112, Capital Adequacy: Standardised Approach
to Credit Risk at www.apra.gov.au.

The Basel II capital accord also requires banks to hold capital to support their off-balance-
sheet transactions. The risk-weighted amount of an off-balance-sheet transaction that gives
rise to a credit exposure is generally calculated by means of a two-step process:
1. The notional amount of the off-balance-sheet transaction is converted into a balance-
sheet equivalent (the credit equivalent amount) by multiplying the amount by a specified
credit conversion factor.
2. The resulting credit equivalent amount is multiplied by the risk weight applicable to the
counterparty or type of asset.

Off-balance-sheet transactions are categorised as non-market-related transactions or


market-related transactions. Non-market-related off-balance-sheet transactions are those
items included in the first three types of bank off-balance-sheet business discussed earlier in
the chapter, namely direct credit substitutes, trade- and performance-related items and
commitments. Market-related off-balance-sheet transactions are those included in the fourth
type of off-balance-sheet business, that is, foreign exchange, interest rate and other market-
rate-related contracts. Again, the Basel II risk weights applied by the Australian bank
supervisor, APRA, are listed in Prudential Standard APS 112, Capital Adequacy:
Standardised Approach to Credit Risk.

Let us consider the example of a non-market-related off-balance-sheet transaction. A


company arranges for its bank to provide a $1 million documentary letter of credit to support
a trade transaction. The company has a single B credit rating issued by Standard & Poor's.
Reference to the website of the bank supervisor indicates that the credit conversion factor is
20 per cent and that the external rating grade 5 represents a risk weight of 150 per cent. The
capital required by the bank to support this off-balance-sheet transaction is $1 million 0.20
1.50 0.08 = $24 000.

Extended learning B
p. 83

Business continuity risk management

Business continuity risk management has an impact on


a bank's ability to maintain its day-to-day business LEARNING
operations. It relates to the risk of direct, indirect or OBJECTIVE 2.9
consequential operational and financial impacts as a
result of inadequate or failed internal or external Analyse business continuity
processes, people, systems or events. These may result, risk and construct an
for example, from a natural disaster such as an education and training
earthquake or a physical disaster such as a loss of framework for operational
computer or communication systems. risk management for
commercial banks

Business continuity risk management may be described as a dichotomy of:

1. a disaster recovery planning process, plus


2. a disaster recovery response process.

The two processes consist of a wide range of core components. Each component has
implications for, and must be incorporated in, business continuity risk management.

1. Disaster recovery planning process

The core components of the disaster recovery planning process are as follows:

The establishment of an organisational business continuity risk management structure


that is horizontally and vertically integrated throughout the bank using a top-down
approach. The management structure reports to the board of directors and includes a
global risk committee, a business continuity risk management group and divisional
contingency planning units. The global risk committee is made up of executive managers
and implements strategic policy initiatives to achieve the bank's business continuity risk
management objectives. The business continuity risk management group will develop,
implement, coordinate, monitor and maintain the bank's overall business resumption plan.
Divisional contingency planning units ensure the relevancy of business continuity risk
management within business units in each division of the bank. This includes planning
teams, emergency response teams and recovery teams.
Risk analysis and business impact analysis. These are processes of risk identification and
measurement using quantitative and qualitative methodologies. The risk analysis process
ensures that all risk exposures are identified and understood by the bank. This enables
existing procedures to be improved and thereby lessen the potential risk exposure. The
business impact analysis measures the operational and financial effects of a disruption to
a business function, particularly critical business functions.
Business function recovery prioritisation. When a large and diverse organisation such as a
bank experiences a major disruption to business operations, it is not possible to resume all
functions at the one time. This makes it necessary to establish a recovery prioritisation
schedule. The business impact analysis will be used to substantiate the prioritisation of
business function recovery at the divisional level, but within the constraints of the bank's
integrated business resumption plan.
Development of disaster recovery strategies. Bank personnel need to be aware of the
range of alternative strategies that may be put in place to maintain critical business
functions. For example, in order to ensure the resumption of computer operations, a bank
may build a dedicated backup computer centre; alternatively, the bank may outsource that
function to a specialist provider. To facilitate these arrangements, a bank will enter into
disaster recovery service agreements and support agreements.
Education and training. This is a core component of business continuity risk
management. Education and training will directly affect the preparedness and capability
of a bank and its people to plan for and respond to a disaster situation. A business
continuity risk management education and training framework is provided later in the
section.
Testing of disaster recovery strategies. A bank must be absolutely confident that its
disaster recovery strategies will be effective in the event of a disruption to critical
business functions. Therefore, the bank must establish a structured testing program that
progressively tests all components of the bank's disaster recovery strategies. Testing
should be integrated throughout the bank.
Plan maintenance. This includes the ongoing monitoring, review, reporting and auditing
of the bank's business continuity risk management processes. This component will ensure
that changes in a bank's systems, products and procedures are reflected in the disaster
recovery plan. Periodic auditing and review ensures that executive management and the
board of directors are appropriately informed.
p. 84

2. Disaster recovery response process

Ultimately, the effectiveness of the disaster recovery planning process is dependent on the
actions taken by bank personnel in response to a disaster situation. The core components of
the disaster recovery response process include:

Plan activation. The disaster recovery plan specifies when a disruption to normal
business operations is to be declared a disaster. The disaster alert trigger point will
activate notification procedures, emergency response teams and recovery strategies.
Impact assessment and evaluation. Divisional recovery teams will conduct an initial
analysis of the operational impact of a situation. They will report to management and
advise on which recovery strategies need to be implemented, including the initial
estimates of resources and time required in order to recover primary business operations.
Recovery control centre. This is the location from which the disaster recovery response is
managed. Key personnel will report to the centre and direct recovery operations within
the context of the bank's business resumption plan. The recovery control centre facilitates
the control, command and coordination management decision processes.
Communications and media liaison. The business continuity risk management group will
take control of a situation and communicate with executive management. Divisional
recovery planning teams must be able to communicate with their personnel.
Communications will be established with the providers of recovery facilities and service
and support agreements. Media liaison personnel will establish communications with
bank supervisors, government authorities, the press, customers and other market
participants.
Implementation of prioritised business recovery. Backup strategies, facilities, service
agreements and support agreements will be activated, but only within the constraints of
priorities established in the bank's overall business resumption plan.
Performance evaluation, reporting and plan review. During the course of an event, the
business continuity risk management group will monitor and evaluate recovery progress
and report to executive management. When recovery is complete, it is necessary to
analyse thoroughly, evaluate and review performance outcomes and, as appropriate,
revise the business continuity plan.

The purpose of business continuity risk management is to ensure that a bank and its
personnel are prepared to respond to an event that disrupts critical business functions and are
able to recover those functions effectively. Education and training is integral to achieving
these objectives.

An education and training framework for business continuity risk management

The education and training framework provided below is designed to support the business
continuity risk management objectives of commercial banks, and improve the capability and
preparedness of institutions and their personnel to plan for, and respond to, an occurrence that
may affect the continuity of critical business functions.

Three business continuity risk management education and training programs have been
developed:

1. Induction/awareness program
2. Contingency planning program
3. Executive program

All bank personnel and associated non-bank personnel should complete the
induction/awareness program. Participants in the contingency planning program will be
specialist business continuity risk management personnel, while the board of directors and
executive management, including global risk committee members and audit and compliance
committee members, will complete the executive program.

Each education and training program includes the rationale, participants, objectives,
curriculum framework, learning outcomes and performance indicators.

Program 1: Induction/awareness

The induction/awareness program should be completed by all bank personnel. A bank may
also provide the program to non-bank personnel from other organisations that provide critical
services to the bank.

This program recognises that the effectiveness of business continuity risk management is
dependent on the attitude and actions of personnel. All bank personnel must know and apply
the principles of risk management and want to participate in a corporate culture and practice
of active and positive disaster recovery planning and response.

p. 85

The induction/awareness program curriculum framework incorporates the following issues


and learning outcomes.
1. What is business continuity? Why is business continuity risk management important?
Participants will be able to describe examples of physical and natural disasters and
identify critical business functions that may be exposed to such situations.
2. Organisation of business continuity risk management objectives, policies and
procedures. Participants will be able to explain why a bank needs to maintain the
continuity of its critical business functions. Participants will know how they can
include business continuity risk management in their day-to-day operational practice.
3. The bank's business continuity risk management organisational structure. Participants
will be able to describe the bank's business continuity risk management organisational
structure, emphasising the roles and responsibilities of individuals within business
units.
4. Risk and the disaster recovery planning process. Participants will be able to give a
range of examples of risk and demonstrate the practical application of the risk
management process.
5. The disaster recovery response process. Participants will be able to explain through
examples why a bank implements a structured and prioritised disaster recovery
process.
6. How to respond in a disaster situation. Participants will know their responsibilities in
an emergency, including disaster identification and reporting procedures, personnel
safety, asset damage mitigation and building evacuation procedures.
7. Applying learning to practice. Participants will return to their workplace knowing they
have the fundamental knowledge and skills to apply effective business continuity risk
management practices in their day-to-day business operations.

Program 2: Contingency planning

Although all bank personnel must incorporate business continuity risk management into their
day-to-day practices, certain personnel will be responsible for core components of the
disaster recovery planning and response processes.

The contingency planning program will provide these personnel with the necessary
specialist knowledge and skills to complete those tasks effectively. Participants include
organisational business continuity risk management group members, divisional contingency
planning unit members and nominated global risk committee members.

The contingency planning program curriculum framework incorporates the following issues
and learning outcomes.

1. Construction of a contingency plan. Participants will appreciate the benefits that will
derive from contingency planning and develop a culture whereby contingency planning
is incorporated in normal business operations. Participants will be able to apply
effectively the bank's standard contingency planning software and format to their
business unit functions.
2. Risk analysis, business impact analysis and recovery prioritisation. Participants will be
able to identify risk exposures within their work environment and review procedures to
minimise such exposures. Participants will be able to apply quantitative methods and
qualitative measures to determine the operational and financial impact of a disruption
to business functions. Based on the risk analysis and business impact analysis,
participants will be able to document a recovery prioritisation schedule.
3. Disaster recovery strategies, service agreements and support agreements. Participants
will have acquired the knowledge and skills to identify, analyse, compare and evaluate
recovery strategy alternatives and be able to make recommendations to management
based on a costbenefit analysis. Participants will be able to construct basic service
agreements and support agreements.
4. Emergency response teams, divisional recovery teams and communications.
Participants will be able to perform the responsibilities of emergency response team
members in a disaster situationthat is, to ensure the safety of bank personnel, the
implementation of disaster notification procedures and the initial mitigation of damage
to assets. Participants will also be able to describe the roles and responsibilities of
divisional recovery teams in implementing disaster recovery procedures within the
context of the organisational business resumption plan and the divisional recovery
plan. Participants will be able to demonstrate the application of communication
procedures, including activating 24-hour contact arrangements and establishing
communications with the recovery control centre, backup facilities and service and
support providers.
5. p. 86

Disaster recovery plan testing. Participants will be able to develop and maintain a
structured and comprehensive recovery plan testing schedule. Participants will be able
to apply a range of testing methodologies, evaluate performance outcomes and report
results to management.
6. Plan maintenance, monitoring and review. Participants will be able to maintain the
currency of a disaster recovery plan, including the application of procedures to ensure
that new products and services and changes in operational procedures are reflected in
the disaster recovery planning and response processes. Participants will be able to
implement the bank's policies in relation to plan review and reporting requirements.

Program 3: Executive program

The essential role of the board of directors and executive management in driving business
continuity risk management is recognised in program 3. This program addresses issues that
will support the board of directors and executive management in determining appropriate
business continuity risk management objectives, policies, strategies and procedures. The
executive program curriculum framework incorporates the following issues and learning
outcomes.

1. Corporate governance and risk management. Participants will be able to critically


review corporate governance risk management policies and practices and shape new
strategies to improve the bank's business continuity risk management corporate culture.
2. Business continuity and disaster risk management. Participants will be able to apply a
structured risk management process to the disaster recovery planning and response
processes and identify issues that must be the focus of the strategic decision maker.
3. Regulation and prudential supervision. Participants will be able to evaluate different
prudential supervisor approaches to business continuity risk management. They will
also be able to investigate the implications of the Basel Committee on Banking
Supervision application of a capital charge for operational risk and the recording of
operational risk occurrences.
4. Objectives, policies, procedures, budget and infrastructure. Participants will be able to
review current business continuity risk management objectives, policies and
procedures and recognise any divergence between policy and practice. Participants will
also be able to identify the bank's critical business functions, and evaluate and review
disaster recovery strategies and infrastructure, budget allocations and testing programs.
5. Business continuity risk management organisational structure. Participants will be able
to identify and describe the scope, roles, responsibilities, authorities, reporting
structures and review procedures applicable to the business continuity risk
management organisational structure. Participants will also recognise the linkages
between divisional contingency planning units, the organisational business continuity
risk management group and the global risk committee.
6. Global best practice. Participants will be able to investigate and evaluate global best
practice in business continuity risk management, and analyse and compare the bank's
current practice. Participants will be able to develop and implement policies and
strategies that will enable the implementation of best practice.
7. Disaster response: recovery control centre, communications, media liaison.
Participants will be able to demonstrate leadership in responding to a disaster situation.
Participants will be able to activate recovery control centre procedures, particularly the
initiation of communications. They will be able to command, control and coordinate
the disaster recovery process. Participants will also know their roles and
responsibilities in relation to the bank's policies and procedures for media liaison.

Summary

The business continuity risk management education and training framework for banks
comprises three specific programs that are directed towards identifiable groups of bank
personnel:

an induction/awareness program for all bank personnel

a specialist contingency planning program

an executive program for strategic policy decision makers

The curriculum framework within each program is designed to achieve learning outcomes
that will result in measurable performance indicators that reflect the business continuity risk
management culture and practice that derives from the bank's related objectives, policies and
procedures.

Figure 2A.1 presents the three business continuity risk management education and training
programs and the curriculum framework relevant to each program.

p. 87
FIGURE 2A.1 AN EDUCATION AND TRAINING FRAMEWORK FOR
DISASTER RISK MANAGEMENT FOR BANKS
The overall success of the education and training programs will become evident through a
positive change in a bank's commitment to business continuity risk management and the
corporate culture. Some of the learning outcomes and performance indicators specified for
each program will be immediately measurable on completion of a program; others will be
sustained over time as bank personnel progressively apply their business continuity risk
management knowledge and skills to their day-to-day business practice.

The objective of business continuity risk management is to establish policies and


procedures that will ensure that a bank is able to maintain the continuity of its critical
business functions and resume normal operations within defined time parameters in the event
of a crisis. Education and training is essential in achieving this outcome.

Extended learning C
Corporate governance and ethics

It would be unusual today for someone to complete a


business or commerce degree without hearing the words LEARNING
corporate governance. The Australian Securities OBJECTIVE 2.10
Exchange (ASX) defines corporate governance as: The
framework of rules, relationships, systems and Discuss the importance of
processes within and by which authority is exercised corporate governance and
and controlled in corporations. It encompasses the ethics in the context of
mechanisms by which companies, and those in control, Australian financial
are held to account. Corporate governance influences institutions
how the objectives of the company are set and achieved,
how risk is monitored and assessed, and how
performance is optimised. The corporate scandals of
the late 1990s and early 2000s as well as the
tremendous volatility arising from the GFC have
gradually increased the prominence of corporate
governance within the business and regulatory
communities as the need to demonstrate good
governance to regulators, customers and investors has
grown.
p. 88

Each Australian company is responsible for developing its own appropriate governance
frameworks but the regulators have provided guidance in the form of principles and
minimum standards. For Australian listed companies, the ASX has developed its Corporate
Governance Principles and Recommendations to articulate the core principles of good and
effective corporate governance. It contains seven principles or recommendations:

1. Lay solid foundations for management and oversight.


2. Structure the board to add value.
3. Promote ethical and responsible decision-making.
4. Safeguard integrity in financial reporting.
5. Make timely and balanced disclosure.
6. Respect the rights of shareholders.
7. Recognise and manage risk.
8. Remunerate fairly and responsibly.

It is a requirement of the ASX's listing rules that each listed company discloses whether it is
following the guidelines and recommendations the ASX has set down. The approach is an if
not, why not approach that aims to gradually increase governance reporting and quality and
enhance transparency for shareholders.

For authorised deposit-taking institutions (ADIs), APRA oversees compliance with


Prudential Standard APS510 on Governance. This prudential standard sets down the
minimum standards for good governance of institutions regulated by APRA. All regulated
institutions must comply. The requirements include prescriptions on board size and
composition, the independence of the board and chair and the establishment of a Board Audit
Committee. These requirements are designed to ensure the prudent management of ADIs and
promote a culture of good governance within ADIs. The ultimate responsibility for the
prudent management of all companies, including ADIs, rests with the board of directors. A
strong governance framework will help to ensure that the board functions effectively and
good outcomes are obtained for all stakeholders, including shareholders.

Most Australian companies now have something to say on their websites about ethics and
corporate governance. For ADIs, it is usually possible to find an outline of the company's
corporate governance framework. For example, consider the Commonwealth Bank of
Australia (CBA). CBA has developed a corporate governance framework that is designed to
properly balance performance and conformance and thereby allow CBA to undertake, in an
effective manner, the prudent risk-taking activities which are the basis of its business. CBA
complies with the ASX principles and recommendations on corporate governance in setting
down a corporate governance framework designed to ensure the Board can effectively
undertake its roles and responsibilities. The framework encompasses board composition,
education, independence, remuneration and auditing.

As we can see, corporate governance involves frameworks for the management of the
company which, we hope, will be undertaken in an ethical manner. Companies place a good
deal of emphasis on ethics and ethical behaviour within their organisations and statements on
ethics can be found on many companies' websites. CBA has approached this issue by
developing a Statement of Professional Practice for its employees. Employees are expected to
comply with certain expectations regarding professionalism, honesty, common sense and
fairness. These encompass matters such as confidentiality, equal opportunity and conflicts of
interest. Together with good corporate governance frameworks, the ethical behaviour of all
employees is of the utmost importance to a financial institution. When there is crisis or
scandal the reputations of the individuals and the organisation can suffer markedly.
Reputation is a very valuable asset for a financial institution. Corporate governance and
ethics frameworks are important components in maintaining the value of this asset.

Key terms
p. 89
acceptancea bank puts its name on a bill issued by a 49
third party; bank accepts primary liability to repay the
face value of the bill at maturity
amortised loan instalmentsregular and equal loan 52
instalments that comprise the current interest payment
due, plus part repayment of the loan principal
outstanding
asset managementa bank restricts growth in its 46
lending to the level of funds available from its depositor
base
authorised deposit-taking institutionsfinancial 60
institutions authorised by APRA to accept retail
deposits in Australia
bank bills heldbills that have been accepted and 53
discounted by a bank and are held as a balance-sheet
asset
bank regulationconstraints on banking activities 60
through prescriptive legislation and prudential
supervision
Basel II capital accordthe standard that defines the 62
minimum capital adequacy requirement for a bank
Basel III capital accordthe standard that defines the 64
minimum capital adequacy requirement for a bank
basis pointsinterest rates; 100 basis points equal 1 per 70
cent
BBSWthe average mid-point of banks' bid and offer 53
rates in the bank bill secondary market
bill of exchangea short-term money-market discount 49
security; face value repayable at maturity
business continuity managementmaintenance of 69
strategies to ensure the continuance of critical business
functions
call depositsfunds held in a savings account that can be 48
withdrawn on demand
certificate of deposita short-term discount security 48
issued by a bank; face value repayable at maturity
collateralised floating chargesecurity attached to a 50
loan; if borrower defaults, the lender will take
possession of the borrowers assets
commercial billsa bill of exchange issued direct to 53
raise finance for a business; a discount security; may
be sold into the money market
commitmentsthe contractual financial obligations of a 57
bank that are yet to be completed or delivered
contingency plana set of predetermined strategies to 75
be implemented if a designated event occurs
credit carda card facility that provides access to funds 53
through electronic distribution systems: ATMs,
EFTPOS
credit riskthe risk that an obligor will not make future 63
interest payments or principal repayments when due
current account depositsliquid funds held in a cheque 47
account; cheques drawn to purchase goods and
services
current exposure methodoff-balance-sheet capital 67
calculation based on the current and potential credit
exposures mark-to-market
debenturea form of security attached to a corporate 49
bond; a fixed and/or floating charge over the assets of
the issuer
direct credit substitutesan undertaking provided by a 56
bank to support the financial obligations of a client
euromarketsdebt markets where instruments are 50
issued into another country, but not denominated in the
currency of that country
fixed-term loana loan provided for a predetermined 52
period; used to purchase specified goods or services
foreign currency liabilitiesdebt instruments issued into 50
the international capital markets that are denominated
in another currency
G-10Belgium, Canada, France, Germany, Italy, Japan, 62
the Netherlands, Sweden, the UK and the USA
general market riskfor capital adequacy purposes; 69
changes in the overall market for interest rates,
equities, foreign exchange and commodities
hedgingimplementing strategies to protect against an 57
identified risk exposure
housing financethe provision of long-term funds to 52
enable the purchase of residential property
internal ratings-based approach to credit riskfor 67
capital calculations a bank may use some or all of its
own risk measurement model factors; supervisor
approval required
investment property financefunding that enables a 52
borrower to purchase property to rent or lease to a
third party
leasean arrangement in which the owner of an asset, 54
the lessor, allows a lessee to use the asset in return for
periodic lease payments
liability managementwhere banks actively manage 46
their sources of funds (liabilities) in order to meet
future loan demand (assets)
liquidityaccess to cash and other sources of funds to 74,75
meet day-to-day expenses and commitments
liquidity management strategyan organisations 75
objectives, policies and procedures as they relate to
cash flows and liquidity
loan capitalsources of funds that have the 50
characteristics of both debt and equity
loan-to-valuation ratiothe percentage ratio of a loan 82
to the bank's valuation of the property being mortgaged
market riskthe exposure of a banks trading book to 63
changes in interest rates and exchange rates
market-rate-related contractsderivative products; 57
allow management of exposures to interest rate, foreign
exchange, equity and commodity price risks
mark-to-marketthe revaluation of a contract based on 67
its current quoted price on an exchange
mortgagea form of security whereby a lender registers 52
an interest over the title of a property
mortgage originatorsspecialist mortgage lenders that 52
typically refinance their lending through securitisation
negotiable securitya financial instrument that can 49
easily be sold into a deep and liquid secondary market
non-executive board membersboard members who 77
are not part of the management of a corporation or its
subsidiaries
off-balance-sheet businesstransactions that represent 46
a contingent liability and therefore are not recorded on
the balance sheet
operational risksexposures that may impact on the 67
normal day-to-day business functions of an
organisation
original exposure methodoff-balance-sheet capital 67
calculation based on the notional contract value
multiplied by a credit conversion factor
overdraftan arrangement with a bank that allows a 53
business to place its operating account into debit up to
an agreed limit
Pillar 1incorporates components of credit risk, 66
operational risk and market risk within the Basel II
capital accord
prudential supervisionthe imposition and monitoring 60
of standards designed to ensure the soundness and
stability of a financial system
reference interest ratea benchmark interest rate 53
published daily and used for pricing variable-rate loans
rollover facilityan arrangement whereby a bank agrees 53
to discount new bills over a specified period as existing
bills mature
securities portfoliofinancial securities held by an 75
institution for investment and trading purposes
securitisationnon-liquid assets are sold into a trust; the 52
trustee issues new securities; cash flows from the
original securities are used to repay the new securities
specific market riskthe risk that the value of a security 69
will change due to issuer-specific factors
standardised approach to credit riskprovides risk 67
weights to be applied to balance-sheet assets and off-
balance-sheet items to calculate minimum capital
requirement
term depositsfunds lodged in an account for a 48
predetermined period and at a specified fixed interest
rate
Tier 1 capitalhighest quality; core capital for capital 64
adequacy purposes
Tier 2 capital (lower)specified acceptable capital 65
adequacy instruments that are not permanent
Tier 2 capital (upper)specified acceptable capital 64
adequacy instruments, including hybrids, of a
permanent nature
trade- and performance-related keytermsan 56
undertaking provided by a bank to a third party
promising payment under the terms of a specified
commercial contract
Treasury bondmedium- to long-term securities issued 54
by the government; pay regular half-yearly interest,
principal repaid at maturity
Treasury notes (T-notes)short-term discount securities 54
issued by the government; face value payable at
maturity
unsecured notea corporate bond issued without any 49
form of underlying security attached
value at risk (VaR)a statistical probability model that 70
measures financial risk exposures based on historic
observations

True/False Questions

QUESTIONS

Answer TRUE or FALSE to the following statements. To assist in your review, you
might also write brief notes explaining your response.
1. Each nation-state is no longer responsible for the prudential supervision of
commercial banks as this is now the responsibility of the Bank for International
Settlements.
2. There is a direct correlation between the level of bank regulation and the
dominance of the commercial banks within a financial system.
3. Banks obtain funds from a number of different sources. These sources of funds
appear as assets on a bank's balance sheet.
4. Liability management is the strategic limitation of commercial bank lending to
match a bank's current deposit base.
5. Funds held in a cheque account are highly liquid and are called current deposits.
6. Call deposits are not a stable source of funds for banks because the deposits can be
withdrawn on demand.
p. A negotiable certificate of deposit is a discount security that may be issued into the
90 money markets.

7.
8. One of the attractions for a bank of funding a client through a bank bill facility is
that the security can be sold into the money markets.
9. A bank may seek to obtain funds by issuing unsecured notes with a collateralised
charge over the assets of the institution.
10. Bank regulators restrict the type and amount of securities that commercial banks
can issue into the international capital markets.
11. Mortgage originators often use the process of securitisation to finance their
housing lending activities.
12. A housing loan with an amortised loan requires the borrower to make periodic
interest-only instalments and repay the principal at the maturity date.
13. Small- to medium-sized businesses mainly borrow direct from the capital markets,
while large corporations with good credit ratings prefer to borrow from the banks.
14. A reference interest rate such as the BBSW may be used periodically to set the
interest rate on a variable-rate loan.
15. The deregulation of the banking sector means that it is no longer necessary for the
central bank to concern itself with the overall stability of the financial system.
16. Off-balance-sheet business is a transaction where a contingent liability exists and
therefore it cannot be recorded on the balance sheet.
17. Derivative products are primarily designed to facilitate hedging risks such as
changes in interest rates or exchange rates.
18. Under the Basel II capital accord, banks are required to maintain a maximum risk-
based capital ratio of 8.00 per cent at all times.
19. Pillar 3 of the Basel II capital accord requires commercial banks to report directly
changes in their capital structure to the Bank for International Settlements.
20. The standardised approach to the measurement of Pillar 1 credit risk allows a bank
to use external credit ratings.

Essay Questions

Write short essay-type responses to the following questions. Make sure that you are able to
explain in your own words the points you raise in relation to each question.

1. Banks have moved from a practice known as asset management to the practice of
liability management. Explain the differences in these two approaches and briefly
discuss the role of deregulation in facilitating this change in banking practice.(LO
2.1)
2. Banks have always been the dominant institutions within the financial system, but
their relative importance has fluctuated due, in part, to changes in the regulatory
environment in which they operate. Analyse and discuss this statement. (LO 2.1)
3. A customer has approached your commercial bank seeking to invest funds for a
period of six months. The customer is particularly worried about risk following the
GFC and the market volatility that continues to characterise world financial
markets. Explain the features of call deposits, term deposits and CDs to the
customer and provide advice on risk-reward trade-offs that might be associated
with each product. (LO 2.2)
4. Discuss the four main uses of funds by commercial banks and identify the role that
the purchase of government securities plays in commercial banks' management of
their asset portfolios. (LO 2.3)
5. Commercial banks are the principal providers of loan finance to the household
sector. Identify five different types of loan finance that a bank offers to individuals.
Briefly explain the structure and operation of each of these types of loans. (LO 2.3)
6. ABC Limited plans to purchase injection moulding equipment to manufacture its
new range of plastics products. The company approaches its bank to obtain a term
loan. Identify and discuss important issues that the company and the bank will
need to negotiate in relation to the term loan. (LO 2.3)
7. p. 91

The off-balance-sheet business of banks has expanded significantly and, in


notional dollar terms, now represents over four times the value of balance-sheet
assets. (LO 2.4)

(a) Define what is meant by the off-balance-sheet business of banks.

(b) Identify the four main categories of off-balance-sheet business and use an
example to explain each category.
8. Following the GFC, the off-balance-sheet activities of commercial banks attracted
a great deal of attention among commentators. With reference to the size and
composition of commercial banks' off-balance-sheet activities, outline some of the
possible reasons for this concern. (LO 2.4)
9. Nation-state bank regulators impose minimum capital adequacy standards on
commercial banks. (LO 2.5)

(a) Briefly explain the main functions of capital.

(b) What is the minimum capital requirement under the Basel II capital accord?

(c) Identify and define the different types of acceptable capital under the Basel II
capital accord. Provide an example of each type of capital.
10. Pillar 1 of the Basel II capital accord includes an operational risk component. (LO
2.6)

(a) Define operational risk.

(b) Using the standardised approach, explain how a commercial bank is required
to measure the operational risk component of its minimum capital adequacy
requirement.
11. The third Pillar 1 component of the Basel II capital accord relates to market risk.
(LO 2.6)

(a) Define market risk.

(b) A bank may use its own internal value-at-risk (VaR) model to measure
market risk. Briefly explain how a VaR model operates. In your answer
identify the basic VaR model requirements set by APRA.
12. Within the context of the Basel II capital accord, explain and discuss:

(a) Pillar 2: The supervisory review of capital adequacy.

(b) Pillar 3: Market discipline. (LO 2.6)

13. As part of the prudential supervision of banks the regulator requires banks to use
an internal model such as VaR to estimate potential gains and losses. Outline some
of the strengths and weaknesses of VaR models and briefly explain why regulators
have moved to implement a stressed VaR requirement for Australian banks. (LO
2.7)
EXTENDED LEARNING QUESTIONS
14. The Basel II capital accord comprises a framework of three pillars. Pillar 1
established the minimum capital required by a commercial bank and incorporates
three risk components: credit risk, operational risk and market risk. (LO 2.8)

(a) Define credit risk.

(b) What approaches may be used to measure the credit risk capital adequacy
component of Pillar 1?
(c) Using the standardised approach to credit risk, explain how a commercial bank
will use this method to calculate its minimum capital requirement.
15. Commercial banks are exposed to the very real risk that at some point their critical
business operations could fail. Business continuity risk management may be said to
incorporate a disaster recovery planning process and a disaster recovery response
process. (LO 2.9)

(a) Define business continuity risk management.

(b) Identify and briefly explain the core components of a disaster recovery
planning process.
(c) Identify and briefly explain the core components of a disaster recovery
response process.
16. An essential element of business continuity risk management is education and
training. (LO 2.9)

(a) Why is education and training important in the context of business continuity
risk management?
(b) Identify three discrete education and training programs that a bank should
provide.
(c) p. 92

Briefly discuss what issues should be incorporated in each of the three


education and training programs.
17. (a) Discuss the nature of corporate governance and its relationship with ethics.
(LO 2.10)
(b) Discuss the importance of corporate governance and ethics for Australian
ADIs both in terms of complying with regulations and effectively meeting the
expectations of stakeholders. (LO 2.10)
Chapter3: Non-bank financial institutions

Chapter Opener
p. 93

LEARNING OBJECTIVES

LO 3.1 Describe the roles of investment banks and merchant banks, with an emphasis
on the nature of their off-balance-sheet business, in particular mergers and
acquisitions.

LO 3.2 Explain the structure, roles and operation of managed funds and identify
factors that have influenced their rapid growth.

LO 3.3 Discuss the purpose and operation of cash management trusts and public unit
trusts.

LO 3.4 Describe the nature and roles of superannuation funds, including the primary
sources of superannuation funds and the different types of fund.

LO 3.5 Define life insurance offices and general insurance offices and explain the
main types of insurance policies offered by each type of insurer.

LO 3.6 Discuss hedge funds, including their structure, investors, investment strategies
and risk.

LO 3.7 Explain the principal functions of finance companies and general financiers
and the changes that have had an impact on finance company business.

LO 3.8 Outline the roles and relative importance of building societies and credit
unions and analyse the significant changes that have occurred in these sectors.

LO 3.9 Describe the unique role of export finance corporations.

EXTENDED LEARNING
LO 3.10 Understand project finance and structured finance and the related roles of
investment banks.

CHAPTER OUTLINE
3.1 Investment banks and merchant banks
3.2 Managed funds
3.3 Cash management trusts
3.4 Public unit trusts
3.5 Superannuation funds
3.6 Life insurance offices
3.7 General insurance offices
3.8 Hedge funds
3.9 Finance companies and general financiers
3.10 Building societies
3.11 Credit unions
3.12 Export finance corporations
Introduction
p. 94

In this chapter the focus moves away from the commercial banks to the wide range of other
financial institutions that operate in a modern financial system. For convenience, the market
refers to the collective group of financial institutions other than the commercial banks as
non-bank financial institutions. The institutions examined in this chapter are:

investment banks and merchant banks


managed funds
superannuation funds
cash management trusts
public unit trusts
life insurance and general insurance offices
hedge funds
finance companies and general financiers
building societies
credit unions
export finance corporations

Why do so many different financial institutions exist? In a deregulated and competitive


market it might be argued that the financial strength and enormous size and expertise of
commercial banks would create an environment in which other non-bank financial
institutions would struggle to compete. In part this may be true. For example, in Australia
there has been a significant reduction in the building society sector since the commercial
banks were largely deregulated in the 1980s. With increased competition between
commercial banks and building societies, the building societies responded by merging with
other institutions and many changed to become commercial banks.

However, other financial institutions have thrived by specialising within segments of the
financial markets. For example, investment banks have used their particular expertise to
expand their off-balance-sheet business, such as advising corporate clients on mergers and
acquisitions. As the insurance business of life insurance offices has declined, these
institutions have moved into, and taken a prominent position in, superannuation and
managed funds products. To meet the retirement savings needs of an ageing population,
there has been an enormous expansion in managed funds, in particular superannuation and
public unit trusts.

It is evident that the financial system as a whole is constantly evolving. Non-bank


financial institutions have developed in response to the different regulatory environments
that have existed from time to time; and to the changing preferences of market participants.

The chapter opens with an examination of the exciting world of investment and merchant
banking, in particular the investment and merchant banks' off-balance-sheet activities.

REFLECTION POINTS

A wide range of non-bank financial institutions is able to compete within a modern


financial system (e.g. investment and merchant banks, life insurance and general
insurance offices, superannuation funds, finance companies, building societies, credit
unions, cash management trusts and unit trusts).
p. 95

Non-bank financial institutions tend to specialise in areas of the financial markets in


which they have a particular strength or expertise; for example, investment banks
specialise in the provision

3.1 Investment banks and merchant banks


Investment banks and merchant banks have always
been regarded as financial innovators, at the leading LEARNING
edge of the financial system. Today, these institutions OBJECTIVE 3.1
continue to specialise in sophisticated areas of finance
that are both challenging and exciting. Describe the roles of
investment banks and
Merchant banking evolved over the centuries from merchant banks, with an
the need for countries such as the UK to finance their emphasis on the nature of
extensive global trade in goods. Early merchant their off-balance-sheet
bankers were simply traders who moved more and business, in particular
more into the provision of finance to support their mergers and acquisitions
own and others' trading activities.

Investment banks grew strongly in the USA, in particular as specialist facilitators of


financial transactions rather than providers of finance. Investment banks established a
reputation as financial innovators and were often responsible for the development of new
financial products and services that met the changing needs of market participants.
Investment banks are organised around risk taking, risk measurement and operational
controls. The activities that take place within an investment bank are normally described as
front officethe name given to those activities within an investment bank that involve
client relations, especially trading, investment banking, research and investment
management (including trading, investment banking, research and investment
management); middle officethe name given to those activities within an investment bank
that do not involve client relations but may complement or monitor front office activities.
Risk measurement and reporting are examples (including risk measurement, risk
management and reporting); and back officethe name given to those functions within an
investment bank that are most removed from client relations. Accounting and compliance
are examples (accounting, bookkeeping, audit and compliance). These features and other
aspects of investment banking are discussed in the context of the GFC by Mark Williams in
his book Uncontrolled Risk (2010). As Williams points out the relative power and prestige
of the activities, especially risk taking versus risk management, depends critically on
organisational culture. A culture of risk taking will place proportionally more power and
prestige in the hands of front office personnel and make it more difficult for the middle
office to ensure that risks are being managed appropriately. This may generate substantial
profits when markets are moving in the right direction but leave an investment bank
particularly vulnerable when market conditions change.

Today, the institutional differentiation between a merchant bank and an investment bank
is blurred, as they have each reduced their balance-sheet lending activities and strategically
become niche providers of off-balance-sheet financial services for their corporate and
government clients.

The relative size and importance of investment banks and merchant banksspecialist
providers of financial and advisory services to corporations, high-net-worth individuals
and government is significant, especially within the major financial centres of London and
New York. Outside these two financial centres, these banks often selectively focus on other
jurisdictions such as Asia, Australia, South America, Western Europe and Eastern Europe.

Historically, in Australia merchant banks were able to avoid the severe regulatory
restrictions that were placed on foreign bank access to the country prior to 1985. To operate
as a bank in Australia, an institution must have an authority issued by the bank supervisor
(APRA). Investment banks and merchant banks are not authorised banks; therefore in
Australia they are officially referred to as money-market corporationsofficial
classification of investment and merchant banks operating in Australia. Nevertheless,
within the financial markets these institutions continue to be referred to as investment
banks or merchant banks.

At times it may seem difficult to distinguish between a commercial bank and an


investment or merchant bank as they each provide a range of similar services. The major
distinction between commercial banks and investment or merchant banks is their role in the
retail markets. Commercial banks are authorised to accept deposits from individuals. In
many countries investment and merchant banks are not authorised to accept retail deposits.
In those countries where they are able to accept deposits, they do not choose to enter this
low-value, high-volume area of banking.

p. 96

Given that the roles of investment banks and merchant banks are essentially the same, for
ease of reading we will only use the term investment banks for the remainder of this
section.

3.1.1 SOURCES OF FUNDS AND USES OF FUNDS

Investment banks provide financial services to their corporate clients, high-net-worth


individuals and government clients. This is the world of high finance.

Unlike commercial banks, these institutions do not have a depositor base from which to
acquire assets. Their liabilities or sources of funds are usually raised through the issue of
securities into the international money markets and capital markets. Under normal market
conditions, the high-profile reputation of many of the investment banks affords them easy
access to the international capital markets.

Investment banks will provide some limited lending to clients, but usually on a short-term
basis. They tend to sell any loans into the secondary markets rather than hold them on their
balance sheet. They are primarily focused on advisory services, for example they will
advise their clients on all aspects of raising funds direct from the money and capital
markets. In fact, the relative size of financial assets held by investment banks has
diminished over time. For example, in Australia the financial assets held by investment
banks represent less than 2.00 per cent of the total assets of financial institutions. This
figure completely misrepresents the importance of the investment banks.

The decline in asset share does not indicate the demise of these institutions; rather it
shows the significant change that has occurred in their functions and operations. They now
mainly focus their activities on specialist off-balance-sheet advisory services.

3.1.2 OFF-BALANCE-SHEET BUSINESS


Investment banks have established a reputation as financial innovators. Much of that
financial innovation has been in the development of sophisticated off-balance-sheet
products and advisory services. Therefore, the principal income of these banks is fee
income associated with their off-balance-sheet activities. Examples of their off-balance-
sheet business include:

1 Operating as foreign exchange dealers. Within a global market, importers, exporters,


investors, borrowers, central banks, speculators and arbitrageurs conduct a range of
transactions that are written or denominated in a foreign currency. Investment banks
that operate as foreign exchange dealers quote both bid (buy) and offer (sell) prices on
all major currencies. As we will discuss in Chapter 15, the foreign exchange markets
are enormous, and at times quite volatile.
2 Advising clients on how, where and when to raise funds in the domestic and
international capital markets. Investment banks understand the global financial
markets and how to access funds in those markets. They provide advice and expertise
on the types and structures of securities that can be issued, interest rate risk and
exchange rate risk, and the preparation of documentation, including legal, accounting,
taxation and regulatory matters associated with a securities issue.
3 Acting as the underwriter of new share and debt issues. In order to ensure funds are
raised from an equity or debt issue, the issuing corporation may pay a fee and enter into
an underwriting agreement with an investment bank, whereby the underwriteran
institution that supports the issue of securities by a client and agrees to buy any
securities not bought by investors agrees, subject to the terms of the contract, to
purchase any securities that are not purchased by investors. By having an underwriting
agreement in place, the issuer is confident that they will raise the total funds they need
for their business operations.
4 p. 97

The placement of new issues with institutional investors. A corporate client may wish
to raise additional debt or equity by issuing new securities. One relatively simple way
to do this is to offer the securities to institutional investors. Investment banks have a
large corporate client list and also have access to institutional investors such as funds
managers. They are able to approach these investors and offer them the opportunity to
purchase large parcels of securities to be issued by clients. Placements are discussed in
Chapter 5.
5 Providing advice to corporate clients on balance-sheet restructuring. A balance sheet
is dynamic in that a corporation should always be considering the most effective
funding of its assets. This will change, for example, as the asset structure of the
business changes, as interest rates are forecast to move, as the economy or business
cycle is expected to shift, or as the exchange rate changes. An investment bank will
provide a client with advice on all these issues and assist the client to issue new
securities in order to restructure the balance sheet.
6 Evaluating and advising a corporate client on mergers and acquisitions. See the
section on mergers and acquisitions below.
7 Conducting feasibility studies and advising clients on project finance and structured
finance undertakings. Project finance is long-term finance for projects such as building
a tollway or a power station. The financing of the project is based on the future
expected cash flows that will be generated by the project once it has been built. As the
project will only generate cash flows once it is completed, and often has only limited
asset value before completion, this is a specialist area of high-risk lending (refer to the
extended learning section at the end of this chapter for a detailed discussion on project
finance and structured finance).
8 Identifying client risk exposures and advising on risk management strategies.
Corporations and governments are exposed to a wide range of financial and operational
risks. Risks that may affect the value of assets, liabilities or shareholder funds, or cash
flows generated by the business, include interest rate, foreign exchange, liquidity,
credit, investment, fraud and disaster risk exposures. Investment banks have the
expertise to provide sophisticated solutions that allow the identification, measurement
and management of risk exposures. Risk management strategies often involve the use
of complex financial products, such as derivatives.
9 Advising on, and partial provision of, venture capital. Venture capital, also known as
risk capital, is funding provided for new start-up businesses where there is a high level
of risk attached to the future success of the business but the potential for high returns.
The size of the funding requirement, plus the high level of associated risk, means that
funding is often provided by a group or syndicate of investors. An investment bank
may take on the role of lead manager of a syndicate and bring together a large group of
other investment and commercial banks who will all provide funding for the project.

This list of off-balance-sheet business carried out by investment banks demonstrates that
they operate in the more innovative and exciting areas of the financial markets. Many of the
types of off-balance-sheet business conducted by investment banks, including advisory
services, foreign exchange, underwriting, equity and debt issues, risk management and
derivatives, are discussed in various parts of this text.

At this stage one important function that is carried out by investment banks, mergers and
acquisitions, is considered.

Mergers and acquisitions

From time to time a corporation will consider the possibility of the strategic acquisition of
another business; alternatively, it may be the target of a takeover. Let us take the example
of a company, E-toys Limited. The company specialises in the production of electronic
games and has decided to purchase the business of a firm that manufactures a component
used by the company in its most popular game. How can E-toys proceed with this merger
and acquisition proposal? The managers of the company are experts in the production of
electronic games, not in the high-finance world of mergers and acquisitions. E-toys would
need to seek the advice of a mergers and acquisitions specialist such as an investment bank.

p. 98

Advising corporate clients on mergers and acquisitionstakeover company seeking to


gain control over a target companyin which one company gains control over another
is a significant feegenerating service provided by investment banks. There seems to be a
direct correlation between sustained economic growth in a nation-state and the level of
merger and acquisition activity. For example, an extended period of economic growth into
the 1990s in the USA corresponded with an increase in corporate merger and acquisition
activity. As the US economy slowed in the 2000s, so too did the number of mergers and
acquisitions. Fortunately for the investment banks, as market activity in the USA slowed it
was offset by increased activity within the European Union, and the opening up of Eastern
European markets to competition. As investment banks are global institutions, the location
of the merger and acquisition activity is of little importance.

Interestingly, investment banking deals in recent years have been dominated by spin-
offsa situation where a part of a company is separated from the whole and begins an
existence as an independent company, whereby a company breaks itself into pieces and
the pieces become separately listed public companies. In this process, previous mergers and
acquisitions are undone or divisions that have grown to a substantial size within the
company are spun off to begin an independent existence. Although the GFC saw a
substantial decline in spin-off activity, the annual values of such deals a few years after the
GFC looks set to exceed the 2007 record of US $234 billion (www.economist.com). When
companies cannot find buyers willing to pay a desirable price for the division that it wishes
to sell, the company spins off the division and becomes two separate companies: parent
and child. Often, the combined market value of the two new entities exceeds the market
value of the parent company before the spin off. This provides an incentive for companies
to investigate the possibility and for investment banks to initiate deals. Mergers,
acquisitions and spin-offs are important examples of the balance sheet restructuring
facilitated by investment banks.

The merger and acquisition plans of E-toys may be described as a vertical takeover.
Typically, merger and acquisition strategies are categorised as horizontal, vertical or
conglomerate takeovers.

A horizontal takeoverwhen two companies involved in a merger and acquisition are in


the same business occurs when the target company conducts the same type of business as
the takeover company (e.g. E-toys purchases another electronic toy manufacturer).

A vertical takeoverwhen the target company in a merger and acquisition operates in a


business related to that of the takeover company occurs when the takeover company
acquires a company that normally operates within a related business area (e.g. E-toys
purchases an electronic components supplier).

A conglomerate takeoverwhen the business of a merger and acquisition target


company is unrelated to the existing business of the takeover company is said to occur
when the takeover company diversifies its business activities by acquiring a company that
operates in a business area unrelated to the existing business of the takeover company (e.g.
E-toys purchases a travel company).

In the example of E-toys, the company will seek the services of an investment bank in its
efforts to take over the component manufacturer. On the other hand, the component
manufacturer may also seek the services of an investment bank to advise the company on
how best to resist what it might see as a hostile takeover by E-toys.

A hostile takeoverwhen the target company rejects the merger and acquisition
proposal of the takeover company is one in which the actions of the takeover company are
actively resisted by the board of directors of the target company.

Investment banks generate significant fee income from their mergers and acquisitions
business. They are not, therefore, passive players in the market; that is, they do not wait
until they are commissioned by a client on either side of a merger transaction. Rather,
investment banks actively seek out, analyse and evaluate potential takeover opportunities
for clients, then approach the client and try and sell them the takeover idea.

Theoretically, there should be value added in a merger. That is, the value of the merged
entity should be greater than the sum of the two original companies on a stand-alone basis.
This additional value could be gained from synergies that may be present in the merger.
Synergy benefits may be achievable from:

p. 99

Economies of scale. For example, a company might gain operating advantages from a
better use of productive capacity and a lowering of the overall cost of production.
Financial gains can also be made from reductions in overhead expenses associated with
administrative and management structures within the merged business.
Finance advantages. A merged corporation should be able to leverage its larger balance
sheet; that is, the merged company may have a greater capacity to extend its debt
funding. The enhanced reputation of the larger organisation may enable it to access new
debt markets, particularly the international capital markets, and at a lower average cost
of funds. The merged corporation will seek to maximise potential tax advantages that
may be available, for example through the possible offsetting of capital losses.
Competitive growth opportunities. A takeover company can achieve immediate growth
by acquiring the existing business operations of another company. The cost of
acquisition is typically more certain, and much quicker, than the cost of internally
generated growth. For example, it may be easier for a business to purchase a company
that has the production facilities it requires rather than building new facilities.
Business diversification. A corporation may extend its business operations into the
international markets through acquisition. Another firm may diversify its business
functions through a conglomerate takeover. In either situation the takeover company
will diversify its sources of revenue and will try to protect itself from a downturn in a
single economic market that might occur from time to time.

In advising a corporate client on a merger and acquisition opportunity, an investment


bank must consider the economic, legal, accounting and taxation implications of the
proposal, often across a number of jurisdictions. For example, anti-trust or competition
regulations can vary quite significantly between countries. Although most major countries
apply international accounting standards, variations do exist. This is noticeable in the
stringent regulatory reporting requirements of the Securities and Exchange Commission
(SEC) in the USA. Taxation regimes also vary between nation-states, particularly in
relation to the treatment of tax issues arising from merger and acquisition activity.

It is beyond the scope of this introduction to mergers and acquisitions to consider in detail
the valuation methods that may be applied, the legal requirements and constraints or the
accounting and taxation treatments of associated transactions. Instead a brief description is
given of a range of issues that an investment bank would bring to the attention of a
corporate client when considering a merger and acquisition proposition.

Analysis of the target company. Is the company a strategic fit? Issues to consider include
the company's size, geographic position, business mix, operational capacity, financial
strength and availability for takeover.
Valuation of the company. Quantitative models will be used that incorporate net asset
values (liquidation value), net present values of incremental cash flows and future
earning power. The value of the combined entity should be greater than its premerger
parts.
Establishment of contacts. Confidentiality is essential if a successful merger is to be
achieved at a reasonable price. If the market becomes aware of a potential merger, the
price of the target company will be pushed higher on expectation of a takeover
premium. Contacts need to be established with the investment bank and senior
representatives of the target company.
Transaction structures. Principally, this will include the development and evaluation of
acquisition and purchase methods. For example, should the deal involve a cash offer, a
share offer, an asset swap or a combination thereof? Other transaction issues include
legal, taxation and accounting structures, and future organisational and management
structures.
p. 100

Negotiation. Negotiation skills are essential when a dominant company is making a


takeover bid for a target company. If negotiations are conducted properly, there will be
no perceived winners or losers. Negotiators must resist taking positions, and should
separate people from the business issues; that is, the takeover should not be about
personalities and personal gain, but rather about benefiting the business.
Due diligence. This involves the detailed and careful analysis of the financial and
operational condition of the target company. Clearly, information gained in the due
diligence process will determine whether a proposal should proceed and at what offer
price.
Nature of the takeover. If an offer is made, will it be resisted by the board of directors of
the target company? If so, what are the strategic, financial and operational implications
of proceeding with a hostile takeover? If an unsolicited friendly merger is possible, what
concessions will need to be made?
Communication with the market. This includes regulatory communication requirements
to keep the market informed, plus strategic communication with the media and specific
market participants such as investment analysts.
Project management and integration. Development of a merger and acquisition
proposal will, at times, be influenced by issues of speed versus accuracy of information,
confidentiality versus transparency of information provided to stakeholders, and the
robustness versus the efficiency of the transaction structure.

The merger and acquisition advisory role of an investment bank provides enormous
opportunities for the institution to offer a range of further services to its corporate client.
Once it has advised on a merger proposal, the investment bank will seek to facilitate the
transaction on behalf of the client. Other additional services may include providing advice
and facilitating funding requirements for debt and equity, underwriting arrangements,
balance-sheet restructuring and risk management. All these functions are discussed in detail
in other parts of this textbook.

REFLECTION POINTS

Investment banks and merchant banks are providers of innovative financial products
and services to corporations, high-net-worth individuals and government.
These institutions do not have a depositor base; they raise funds in the international
financial markets.
Investment banks provide some lending products to clients, but are more likely to assist
a client to borrow directly from the money and capital markets.
The structure of investment banks is characterised by a division of activities among
front-office, middle-office and back-office employees. The front-office activities are
the most prominent activities within an investment bank and usually involve direct
relations with clients.
Investment banks specialise in the provision of off-balance-sheet products and advisory
services, such as:

operating as foreign exchange dealers, quoting bid and offer prices on a range of
currencies
advising clients on how to raise funds in the local and international capital
markets
acting as underwriters and assisting clients with the placement of new equity and
debt issues
advising clients on balance-sheet restructuring having regard to the forecast
business environment
p. 101

evaluating and advising on corporate mergers and acquisitions and spin-offs


conducting feasibility studies and advising clients on project finance and
structured finance
providing risk management advice, products and services
advising clients on accessing venture capital within the capital markets.
A merger and acquisition is a situation in which one company seeks to take over
another company. The merger may be friendly or hostile, and strategically may be a
horizontal takeover, a vertical takeover or a conglomerate takeover.
A spin off is a situation where an independent company is formed from a part of the
existing company. For example, a division that manufactures and sells one of the
company's products may be spun off to form an independent company.
The merger will seek to achieve synergy benefits such as economies of scale, finance
advantages, competitive growth opportunities and business diversification.
An investment bank would assist a client with analysis and valuation of the target
company, and will provide expertise in relation to contracts, transaction structures,
negotiation, due diligence, communication with the market, project management and
integration.

3.2 Managed funds


Over the past decade there has been an amazing
growth in the managed fundsinvestment vehicles LEARNING
through which the pooled savings of individuals are OBJECTIVE 3.2
invested industry on an international scale. For
example, growth in the amount of funds invested in Explain the structure, roles
mutual fundsmanaged funds that are established and operation of managed
under a corporate structure; investors purchase funds and identify factors
shares in the fund in the USA has had a significant that have influenced their
impact on the flow of funds into the US domestic rapid growth
capital market and other international capital markets.

In the USA a mutual fund is established under a corporate legal structure. That is, a fund
will be operated by an investment company. Investors purchase shares issued by the
investment company and funds managed by the mutual funds are invested using
professional funds managers.

An alternative structure, used in countries such as .the UK and Australia, is a trust


fundmanaged funds established under a trust deed; managed by a trustee or responsible
entity. In this situation managed funds are established under a trust deed. A trust
deeddocument detailing the sources, uses and disbursement of funds in a trust specifies
the parameters under which the trust will operate. The investor in the trust obtains a
beneficial right to the assets of the fund and an entitlement to share in the income and
capital gains (losses) derived from the fund.

Traditionally, managed funds have maintained a dual protective structure for investors by
separating the roles and responsibilities of the custodian or trustee and the fund manager.
For example, a mutual fund is required to use the services of a mutual fund custodian. A
mutual fund custodian is a commercial bank or trust company that provides safekeeping of
the fund's investment securities and controls cash flows to and from shareholders. With a
trust fund, the fund is controlled by a trustee, within the constraints of the trust deed. For
example, in Australia a trust must have a responsible entitythe trustee and manager of a
trust in Australia. The responsible entity is both the trustee and the manager of the trust
fund, and is responsible for all aspects of its operation, including the appointment of
professional fund managers and the administration and safe custody of the trust's assets.

Managed funds use the services and skills of professional investment managers or funds
managers. The funds managers seek to maximise the return they can achieve on investment
portfolios and therefore move very large volumes of investment funds around the globe, as
if they were playing a game of monopoly.

The driving forces behind the growth of managed funds have been:

deregulation of the flow of funds in the international capital markets


a more affluent population
p. 102

an ageing population where individuals are enthusiastically saving for their retirement
from the workforce
more highly educated investors with increased financial knowledge, which leads them
to seek more diverse and sophisticated investment opportunities.
3.2.1 STRUCTURE OF THE MANAGED FUNDS
SECTOR
Managed funds provide a range of investment structures and opportunities for an investor.
Managed funds gather the savings of individuals and then invest the accumulated amount
of funds in various asset classes in the domestic and international money markets and
capital markets. The main categories of managed funds are:

Cash management trusts (see Section 3.3)


Public unit trusts (see Section 3.4)
Superannuation funds (see Section 3.5)
Statutory funds of life offices (see Section 3.6)
Hedge funds (see Section 3.8)
Common funds. These are operated by trustee companies. They combine the funds of
beneficiaries into an investment pool and invest those funds in specified asset classes.
Common funds are different from unit trusts in that they do not issue units to investors.
Solicitor firms often offer mortgage trusts through a common fund.
Friendly societies. A mutual organisation that provides investment and other services,
such as insurance, sickness and unemployment benefits, to its members. Friendly
societies' investment products include the issue of bonds that invest in a range of asset
classes, such as cash, fixed-interest trusts, equity and property.
3.2.2 SOURCES AND USES OF FUNDS
A managed fund is not a financial intermediary, but rather provides direct access to a wide
range of investment opportunities, including the wholesale investment markets. Wholesale
markets were discussed in Chapter 1.

Managed funds derive their funding from the specific contractual commitments of
investors. These may be in the form of either periodic payments into the fund (e.g.
superannuation) or, alternatively, a single payment or premium (e.g. an insurance policy).

A large managed fund will typically allocate a portion of its total asset portfolio to several
professional fund managers. This is both a risk management and a performance
management strategy. Risk is diversified between a number of fund managers; therefore, if
one manager experiences a poor investment return for the fund, other managers should
offset that poor performance. Similarly, each fund manager will have a competitive
incentive to achieve higher returns; otherwise the services of the fund manager may be
dispensed with.

Each professional fund manager will:

invest in asset types authorised under the trust deed for the particular fund. For example,
a fund may be authorised to invest in commercial property
balance investments within their portion of the fund. For example, a fund manager will
usually maintain a diversified portfolio of assets (such as shares) within the asset class
authorised in the trust deed
reinvest income and any capital gains in the fund
p. 103

restructure the asset portfolio based on forecast changes in the financial markets and the
economy. For example, an expectation that interest rates might change may cause the
fund manager to sell assets that could adversely be affected by an interest rate change
provide financial advice to the fund trustee
periodically report to the fund trustee.

Table 3.1 demonstrates the remarkable growth that has occurred in managed funds in
Australia. Managed funds have increased from $345 billion in March 1995 to $1666 billion
at the end of 2010.

TABLE 3.1 MANAGED FUNDS, AUSTRALIA ($ MILLION, AS AT


DECEMBER 2010)

SOURCE: Reserve Bank of Australia, December 2010.

There are a number of different types of managed funds. These types of funds are defined
by the nature of the assets held in the fund:

capital guaranteed funds


capital stable funds
balanced growth funds
managed growth or capital growth funds

Managed funds offer members a choice of investment strategies to meet their particular
risk and liquidity preferences. For example, it might be reasonable for a person nearing
retirement to want to minimise risk exposure and adopt a conservative investment strategy
in order to protect their funds. On the other hand, a young person may wish to take a more
aggressive risk strategy to try and maximise the return over the longer term. Therefore,
managed funds may be categorised by the investment risk profile of the different types of
funds on offer.

3.2.3 CAPITAL GUARANTEED FUNDS


A capital guaranteed fundthe value of contributions to the fund are guaranteed, but
future earnings are not assures contributors that they will receive back at least the value of
their investment in the fund. Such funds are clearly designed to appeal to individuals who
place a high value on security. The funds are restricted to investment in instruments with a
very low risk of default, which are expected to return a steady, if unexceptional, income
stream. Such investments include government and semi-government securities, bank bills,
debentures and cash deposits. In order to improve the investment performance of these
funds, some providers adopt a broader range of assets, and establish the capital guarantee
by pledging their own accumulated reserves. However, there is the risk of reserves being
depleted, and capital guaranteed funds (which are guaranteed by internal reserves) have
virtually ceased being offered.

p. 104 CAPITAL STABLE FUNDS


3.2.4
A capital stable fundcontributions are mostly protected as the fund invests in low-risk
securities aims to at least secure the contributors' investment, but the fund does not provide
an explicit guarantee of that outcome. A capital stable fund focuses on its investment
income performance more than a capital guaranteed fund. The range of acceptable
investments is the same as for capital guaranteed funds, but capital stable funds may also
invest in a small proportion of riskier assets, including property.

3.2.5 BALANCED GROWTH FUNDS


A balanced growth fundinvestments target longer-term income streams supported by
limited capital growth aims at delivering a longer-term income stream and some capital
appreciation or growth. The investment strategies of this type of fund are more aggressive
than for a capital stable fund, with assets diversified across a greater risk spectrum. Their
portfolios include money-market instruments, some government securities, property and a
relatively high proportion of domestic and foreign equities. On average, the assets of the
balanced growth funds are subject to greater market fluctuations. An investor in this type of
fund typically has a longer-term investment horizon, or is willing to accept a higher level of
investment risk.

3.2.6 MANAGED GROWTH OR CAPITAL GROWTH


FUNDS
A managed growth fundinvests to obtain greater return through capital growth; lower
income streams is designed to maximise the return from capital growth; that is, funds
managers are looking for an appreciation in the value of assets held in an investment
portfolio. The proportion of equity in a managed growth fund portfolio is considerably
higher than it is in the balanced growth funds, and the equity segment also includes a
greater range of risk securities. While the risk of the portfolio is higher than for any of the
other types of funds, managed growth funds provide the opportunity of potentially higher
returns. Investors in managed growth funds will generally have a higher propensity to
accept risk and will usually have a longer-term investment horizon.

Now that we understand the purpose and function of managed funds, we will look at the
following:

Cash management trusts


Public unit trusts
Superannuation funds
Life insurance and general insurance offices

REFLECTION POINTS

Managed funds include cash management trusts, public unit trusts, superannuation
funds, statutory funds of life insurance offices, common funds and friendly societies.
Financial market deregulation, ageing populations, a more affluent population and
more highly educated investors have driven growth in this sector.
Managed funds accumulate savings (e.g. superannuation contributions or investors
buying units in a trust). The funds are invested using professional funds managers.
Funds managers invest funds in authorised assets, balance their portfolios, reinvest
income and capital gains, provide advice and periodically report to the fund.
Types of managed funds are categorised by their investment risk profile, being capital
guaranteed funds, capital stable funds, balanced growth funds, managed or capital
growth funds.

3.3 Cash management trusts


p. 105
LEARNING
A cash management trustinvests the accumulated OBJECTIVE 3.3
savings of individuals mainly in wholesale money-
market securities (CMT) is a mutual investment fund, Discuss the purpose and
often managed by a financial intermediary within the operation of cash
terms of a specific trust deed. The trust deed sets out management trusts and
the rules under which the CMT is to be managed, public unit trusts
including the manager's responsibility for the day-to-
day operation of the trust, and provides for a trustee to
be responsible for the supervision of the trust. The
deed also specifies the maximum management fees
that may be charged.

The CMT deed defines the types of assets in which the trust may invest. The assets are
generally restricted to short-term money-market instruments. Some funds specialise in
short-term-to-maturity government and semi-government securities, while others have a
broader portfolio, including bills of exchange, promissory notes and certificates of deposit
(these securities are discussed in Chapter 9). Table 3.2 shows the main types of investments
held by cash management trusts in Australia.

TABLE 3.2 CASH MANAGEMENT TRUSTS (AUSTRALIA):


ASSETS AS AT DECEMBER 2010
SOURCE: Reserve Bank of Australia, December 2010.

Cash management trusts provide a high degree of liquidity for the investor. Investments
are primarily in bank deposits and money-market securities. It is to be expected that the
weighted average maturity of investments held in a CMT will be measured in days.

The money markets provide a range of short-term investment opportunities; however, the
money markets are essentially a wholesale market, that is, most transactions are high value
and are carried out by institutional investors such as funds managers. The CMT provides an
opportunity for the smaller individual investor to obtain indirect access to money-market
investments. The CMT gathers the savings of investors and invests those accumulated
savings in money-market securities.

A significant growth area in the use of the CMT has been within the stockbroking
industry. With the introduction of electronic settlement arrangements for the sale and
purchase of securities traded on a stock exchange, the CMT has generally been adopted as
the account through which settlement occurs. Investors hold surplus funds in a CMT with
their stockbroker in anticipation of conducting future transactions on the stock exchange.
Also, when a shareholder sells shares the funds will be credited to the CMT held with the
stockbroker. Typical features attached to a CMT held with a stockbroker include:

no entry, exit or account-keeping fees


24-hour electronic access
personalised cheque book
free periodical payment service
direct crediting of dividends and unit trust distributions

p. 106

REFLECTION POINTS

A cash management trust (CMT) typically invests the majority of its funds in money-
market securities such as bills and commercial paper.
A CMT provides retail investors with access to the wholesale money markets.

Funds invested in a CMT are very liquid and normally can be withdrawn on 24 hours'
notice.
Stockbrokers quite often provide CMT accounts for their clients to enable the value
settlement of share trading transactions.

3.4 Public unit trusts


A public unit trustinvestors purchase units in a
trust; the pooled funds are invested in asset classes
LEARNING
specified in the trust deed is an investment fund OBJECTIVE 3.3
established under a trust deed whereby the trust sells
units in the trust to investors. The trustee, known as Discuss the purpose and
the responsible entity, is responsible for the operation of cash
management of the trust and the investment of the management trusts and
pooled funds of the unit holders in accordance with public unit trusts
the specified asset classes listed in the trust deed. The
trustee will normally appoint several funds managers
who will be authorised to invest funds on behalf of the
trust. The trust will also specify how unit holders may
sell their units in the trust.

The four main types of public unit trusts are defined by the assets accumulated in the
fund:

property trusts
equity trusts
mortgage trusts
fixed-interest trusts

Property trustsinvest in different types of property specified in the trust deed; includes
industrial, commercial and retail property invest in industrial, commercial, retail and
residential property. A particular trust may invest only in residential rental properties, while
another may invest in shopping centres, another in hotels and another in central business
district properties. The potential investment choices are quite wide, and the nature of the
unit trust, whereby investors purchase a limited number of units in the trust, means that the
investors gain access to investment opportunities that they may not be able to afford to
purchase direct from the market. For example, an individual person generally cannot afford
to buy a shopping centre complex; however, individuals are able to buy units in a trust
which invests in shopping centres.

Similarly, an equity trustinvests in different types of shares listed on stock exchanges


(e.g. industrial, resources, emerging markets) may invest in different equity markets,
including the local share market or any number of international share markets. The fund
may invest in particular industry sectors, such as stocks in the banking sector or the mining
sector. One fund may invest only in industrial stocks, while another may invest in resource
stocks. Funds will generally specify if they are income or growth funds. Income funds
invest in stocks that produce higher dividend returns, while growth funds seek to achieve
greater capital gains in the value of the portfolio. Equity trusts are particularly useful for
investors wishing to gain access to the international share markets. Generally, an individual
investor will not have the same level of knowledge about the international share markets as
they may have about their local share market. The trustee of an equity trust will appoint
funds managers who have an intimate knowledge of particular international markets.

Mortgage trustsinvests in mortgages registered as loan securities over land invest in


mortgages issued by borrowers. A mortgage is a registered security taken by a lender over
the land of a borrower. The majority of mortgages will be first mortgages, where the
mortgagee has first claim over the title to the land in the event that the mortgagor defaults
on the loan.

p. 107
Fixed-interest trustsinvests in a range of debt securities such as government and
corporate bonds invest in a range of bonds issued by governments or corporations. For
example, a fund may purchase Treasury bonds issued by the government or debentures
issued by listed corporations. These instruments are discussed in Chapters 12 and 10
respectively. The funds may also invest in securities issued in the domestic capital markets
and the international capital markets.

There has been an enormous growth in public unit trusts. Table 3.3 compares the situation
in Australia in 1995 and 2010. The amount invested in public unit trusts has increased from
less than $40 billion to more than $280 billion.

TABLE 3.3 PUBLIC UNIT TRUSTS (AUSTRALIA): ASSETS AS AT


DECEMBER ($ MILLION)

SOURCE: Reserve Bank of Australia, RBA Bulletin, various issues.

Table 3.3 categorises property and equity unit trusts as listed truststhe units of a trust
are listed and traded on a stock exchange and unlisted truststo sell units, a unit holder
must sell them back to the trustee after giving the required notice. With a listed trust, the
units of the trust are listed and traded on a stock exchange. A unit holder who wishes to sell
units held in a listed trust simply sells them through their stockbroker on the stock
exchange at the current market price. With an unlisted trust, a unit holder who wishes to
dispose of units held in a trust is required to sell them back to the trustee, after giving the
required notice of intention to sell under the terms of the trust deed. With the unlisted trust,
it is possible that the trustee may not be able to obtain enough liquidity to buy back the
units, particularly in a volatile falling market.

The distinction between listed and unlisted trusts is important. For example, this was
highlighted in Australia during the late 1980s when, in an environment of falling property
prices, the valuations of most property trusts were marked down. This caused a significant
demand for withdrawals by unit holders who wanted to exit the trusts before they
experienced further write-downs. The unlisted trusts were generally unable to meet the
demand for a large number of simultaneous withdrawal requests as, quite reasonably, the
trusts did not hold cash reserves to the extent of the withdrawal demand. Many trusts began
to impose a withdrawal notice period, which had the effect of stopping immediate
withdrawals. It also served to signal to investors what should have been obvious all the
time: that unlisted property trusts should not be seen as highly liquid investments but as
medium- to long-term investments.

As a result of that experience, a majority of property trusts are now listed on the stock
exchange. With a listed trust, the market determines the value of the units issued by a trust.
The listed unit trust is not involved with trading in existing units and therefore is not
exposed to the demand for liquidity that may be necessary for an unlisted trust.

It is interesting to compare the use of listed property trusts against the proportion of listed
equity trusts in Table 3.3. Listed property trusts predominate; the value of listed equity
trusts is relatively small. This reflects the liquidity characteristics of the underlying assets.
Because property typically is not a liquid asset it is desirable to list the units on a stock
exchange, thus creating a more liquid financial security. On the other hand, shares held by
equity trusts are generally highly liquid and therefore it is not as necessary to list the equity
trust itself.

p. 108

It should now be clear why there has been such a significant growth in public unit trusts.
Professionally managed public unit trusts represent an attractive investment option for an
ageing population, plus the growing number of more educated, affluent and sophisticated
investors.

REFLECTION POINTS

A public unit trust is formed under a trust deed.

The trustee, known as the responsible entity, manages the trust and ensures the pooled
funds are invested according to the terms of the trust deed.
The trust deed specifies the types of assets in which the trust will invest.

A property trust will invest in specified types of property, for example residential
property, hotels, shopping centres.
An equity trust will invest in specified shares listed on local or international stock
exchanges, for example industrial stocks or emerging market stocks.
A mortgage trust will invest in mortgages registered over land and the property
thereon.
A fixed-interest trust will invest in debt securities such as government bonds or
corporate bonds.
With a listed trust the units are listed on a stock exchange and may be sold by the unit
holder through the exchange at the current market price.
With an unlisted trust a unit holder must sell their units back to the trustee. The trust
needs sufficient liquidity to meet this demand.

3.5 Superannuation funds


In the international markets, financial institutions and
financial instruments are sometimes referred to by LEARNING
different names, even though they are very similar. OBJECTIVE 3.4
Superannuation funds, pension funds and provident
funds are terms used in different countries to describe Describe the nature and roles
essentially the same type of institution. For example, of superannuation funds,
the market convention in the USA is to use the term including the primary
pension fund, while in Singapore the market might sources of superannuation
refer to the Central Provident Fund. In Australia the funds and the different types
convention is to describe the institution as a of fund
superannuation fund.

Superannuationsavings accumulated by an individual to fund their retirement from


the workforce refers to specific savings accumulated by individuals in order to maintain
their lifestyle after retirement from work. When people leave the workforce they typically
no longer receive the regular income streams that have been a pattern of their working
lives. This is a significant and often traumatic change that should be planned for over an
extended period prior to retirement. Depending on the age at retirement, an individual may
reasonably expect to live more than 30 years in retirement.

In some countries individuals must fund their own retirement, while in other countries,
such as Australia, age pensiona limited regular income stream paid by a government to
older retired persons entitlements are available from the government. However, these
entitlements are restrictive and generally are not sufficient to allow an individual to live in
the manner to which they may have been accustomed. With many countries experiencing
an ageing population, it is probable that governments may provide less support for retirees
into the future. Therefore, superannuation savings will be essential for younger people
currently in the workforce.

For most individuals the secret to accumulating sufficient retirement funds is progressive
long-term savings. However, for young people entering the workforce retirement seems a
long way off and thus saving for retirement is not seen as a priority. Therefore, many
countries have introduced different compulsory superannuation savings schemes. While
compulsory-superannuation-type schemes are an excellent government policy decision,
most schemes will not provide sufficient retirement incomes to fund existing lifestyles.
Additional savings will be required.

p. 109

Superannuation funds gather long-term savings and are increasingly important in


providing a significant proportion of funds that are available within the financial system for
investment within an economy. Such long-term investment facilitates economic growth
which in turn leads to positive economic and social outcomes such as a higher standard of
living and higher levels of employment. Using Australia as an example, Table 3.4 shows
the contribution of superannuation savings. Superannuation assets in excess of $1300
billion represent a significant and growing level of savings within the context of a small,
open economy such as Australia.

TABLE 3.4 SUPERANNUATION ASSETS AND ENTITIES


(AUSTRALIA) AS AT DECEMBER 2010
SOURCE: APRA, Statistics Quarterly Superannuation Performance, December 2010.

In Table 3.4, APRA classifies superannuation funds as:

corporate superannuation funds: regulated superannuation entities with more than four
members established for the benefit of employees of a particular corporation or group of
related corporations, with joint member and employer control
industry superannuation funds: regulated superannuation entities with more than four
members that provide benefits for employees working in the same industry
public sector superannuation funds: superannuation entities with more than four
members that provide benefits for government employees, or schemes established by a
Commonwealth, state or territory law
retail superannuation funds: superannuation entities with more than four members that
offer superannuation products to the public on a commercial basis
small APRA superannuation funds: superannuation funds regulated by APRA that have
fewer than five members
self-managed superannuation funds: superannuation funds regulated by the Australian
Taxation Office that have fewer than five members, all of whom are trustees.

3.5.1 SOURCES OF FUNDS


Superannuation funds accept and manage contributions from their members. As
superannuation represents long-term savings for retirement, the majority of fund members
make regular periodic contributions to their superannuation fund over an extended working
life. The superannuation funds invest the accumulated contributions. Income derived from
investing those contributions is also added to the superannuation savings. Based on their
sources of funds, we consider the following groups of superannuation funds:

p. 110

corporate funds, industry funds and public sector funds


compulsory superannuation funds
private or personal superannuation funds
rollover funds

Corporate funds, industry funds and public sector superannuation funds

As discussed above, a corporate superannuation fundan employer contributes to a fund


established for the benefit of an employee; employee may also contribute to the fund
provides benefits to employees of a particular corporation, an industry superannuation
fundsimilar to a corporate fund, but the fund is established for all employees in a specific
industry provides benefits to employees working within a particular industry and a public
sector superannuation funda government-sponsored fund established for the benefit of
government employees provides benefits to government employees.

These superannuation funds may be contributory or non-contributory. With a contributory


fund, both the employer and the employee make specified contributions to the fund. With a
non-contributory fund only the employer makes payments into the fund on behalf of the
employees. Often government employers do not make direct contributions to public
servants' superannuation funds, but rather meet ongoing superannuation commitments from
future taxation receipts.

For example, universities in Australia offer contributory superannuation schemes


whereby the university (employer) contributes the equivalent of 17 per cent of an
academic's salary, and the academic contributes a further 7 per cent from their salary. On
the other hand, a corporation is more likely to offer a non-contributory scheme, with the
corporation only contributing the required 9 per cent compulsory contribution.

As shown in Table 3.4, the corporate, industry and public sector superannuation funds
represent nearly 40 per cent of total superannuation assets.

Compulsory superannuation funds

In many countries around the world the average age of the population is increasing. An
ageing population presents a twofold problem:

1. More people will be retiring from the workforce in the near future, and improved
living standards mean that they will live much longer than in the past. These people
will require access to funds in order to maintain a reasonable lifestyle.
2. Many governments have traditionally provided support for the aged from taxation
receipts. However, as the aged leave the workforce the proportion of the total
population still actively working and contributing to the tax base will fall. At the same
time there will be increased demand for aged support services such as hospitals and
nursing homes. At some time in the future governments may not be able to fund
directly all the necessary services.

A number of countries have implemented compulsory superannuationemployers must


contribute minimum specified amounts into retirement savings for employees (Australia)
schemes in an attempt to deal with this problem in the longer term. Compulsory
superannuation schemes differ considerably between countries; for example, in Singapore
the current scheme requires employers to contribute the equivalent of 20 per cent of an
employee's earnings and employees a further 16 per cent.

In Australia the current compulsory superannuation scheme is known as the


superannuation guarantee chargethe compulsory superannuation scheme operating in
Australia (SGC). The scheme was implemented on 1 July 1992 and phased in over a 10-
year period; it is designed to encourage an increase in the level of retirement savings and
gradually to reduce the burden of an ageing population on the social security system, by
ensuring that employers provide a required level of superannuation support to their
employees. Employers who pay the required level of superannuation into a complying
superannuation scheme do not need to pay the SGC to the Australian Taxation Office. The
SGC is therefore a penalty taxation charge made on employers who do not contribute to
their employees' superannuation.

p. 111

From 1 July 2002 employer contributions on behalf of employees were set at the
equivalent of 9 per cent of an employee's wages or salary. This has had an ongoing impact
on the flow of funds through the financial system and on the amount of funds available for
capital investment. As shown in Table 3.4, total superannuation funds are currently more
than $1 trillion. However, for a number of years there has been debate about the adequacy
of the 9 per cent SGC. In late 2011, the government introducted the Superannuation
Guarantee (Administration) Amendment Bill. The amendments to the legislation propose
the gradual increase in the SGC from 9 per cent to 12 per cent by 2019. The SGC will
increase by 0.25 per cent in July 2013 and again in 2014. This will be followed by annual
increases of 0.50 per cent until the SGC reaches 12 per cent in 2019.

Private (personal) superannuation funds


Retail superannuation funds, small APRA superannuation funds and self-managed
superannuation funds, defined above, represent another major source of retirement savings
for individuals. More than 30 per cent of total superannuation funds are held in these
superannuation funds.

Many of these funds use commercial superannuation products. One type of product, often
referred to as a superannuation savings planregular contributions made by an individual
into a private superannuation fund, involves an individual making regular pre-determined
payments into the plan for a specified number of years. Another type, a single-premium
schemea once-only contribution to a superannuation savings scheme, also referred to as a
superannuation bond, requires a single upfront contribution. Contributors may, at their
discretion, make further contributions to the scheme.

In Australia the government has introduced taxation incentives that make it attractive for
individuals to contribute additional funds into superannuation. For example, contributions
and earnings of a superannuation fund are taxed at a concessional 15 per cent taxation rate.
Withdrawals from superannuation funds after a member turns age 60 are free of tax
payments.

Perhaps the greatest incentive to the large numerical increase in private superannuation
funds is the concern that compulsory superannuation will not be sufficient to fund a
comfortable lifestyle in retirement; additional savings are required.

Rollover funds

An individual who changes jobs or retires early may need to retain accumulated
superannuation entitlements in a prescribed superannuation arrangement. Such prescribed
arrangements are set by the government to ensure that individuals retain their
superannuation savings until retirement age, and also to ensure the continuation of the
concessional taxation environment for superannuation funds. The vehicle through which
these benefits may be preserved is called a rollover fundholds existing eligible
termination payments within the regulated superannuation environment.

For example, in Australia an individual who moves from one job to another may roll over
their existing superannuation as an eligible termination paymentsuperannuation funds
due on termination of employment plus related redundancy payments (ETP). An ETP
includes a payout from a superannuation fund if a person withdraws from that fund, plus
other amounts directly related to a person's termination of employment, such as a financial
inducement paid for early retirement and retrenchment benefits.

3.5.2 DEFINED BENEFIT FUNDS AND


ACCUMULATION FUNDS
Superannuation funds offer members a choice of investment strategies to meet their
particular risk and liquidity preferences. For example, it might be reasonable for a person
nearing retirement to want to minimise risk exposure and adopt a conservative investment
strategy in order to protect their superannuation funds. On the other hand, a young person
may wish to take a more aggressive risk strategy to try and maximise the return over the
long term. The different types of managed funds were discussed in Section 3.2 and included
capital stable funds, balanced growth funds and managed growth funds.

p. 112

The net amount of funds paid to a fund member is also dependent upon the type of
superannuation fund. Superannuation funds are described as either defined benefit funds or
accumulation funds.

A defined benefit fundthe amount of superannuation paid to an employee on


retirement is based on a defined formula is a superannuation fund that may be offered by
an employer to employees. As the name implies, a defined benefit scheme is one in which
the amount of the benefit paid to a member on retirement is calculated based on a formula
stated at the time the member joins the fund. The final superannuation payout is normally
calculated on the basis of the specified factor times the employee's average salary over the
final year, or few years, of employment multiplied by the number of years of fund
membership.

Should the performance of the investments in the defined benefit fund not be sufficient to
meet the defined payout, the employer must make good the shortfall. With this type of fund
the investment risk falls directly on the employer. In recent years many employers have
transferred this risk exposure by encouraging employees to move to, or only offering,
accumulation funds.

An accumulation fundthe amount of superannuation funds available at retirement


consists of past contributions plus earnings, less taxes and expenses gathers in the
contributions of the employer and the employee and invests those funds on behalf of the
superannuation fund member. At retirement, the total amount of superannuation funds
available to the member is the accumulated sum of contributions plus investment earnings,
minus expenses and taxes. There is no defined payout; the amount received depends totally
on the investment performance of the fund. In other words, the investment risk remains
with the fund member. Accumulation schemes are the predominant type of superannuation
fund today.

3.5.3 REGULATION
The regulation and supervision of superannuation funds and pension funds varies between
nation-states. This text briefly considers the regulatory environment in Australia.

By the early 1990s the Commonwealth Government had developed a retirement incomes
policy to address a range of issues, including low levels of national savings, an ageing
population and declining labour participation rates. Legislative initiatives were
implemented to raise retirement savings and reduce future dependence on social security
age pensions. In 1992 the current compulsory superannuation arrangements were
implemented (these were discussed above).

The Superannuation Industry (Supervision) Act 1993 (Cwlth) (SIS) and the Income Tax
Assessment Act 1936 are the two principal pieces of legislation that directly affect the
operation of superannuation funds. The SIS is the governing legislation for the regulation of
complying superannuation funds that receive concessional taxation treatment. APRA has
responsibility for the prudential supervision of superannuation funds, while ASIC has an
associated responsibility for market integrity and consumer protection, which includes
superannuation products.

Superannuation funds are trusts established under a trust deed. The trustee is the
responsible entity and as such has a fiduciary duty of care to ensure that the fund is
managed for the benefit of its members.

The Superannuation Industry (Supervision) Act establishes an overarching test that must
be applied to superannuation investments: the sole purpose test. The sole purpose test
requires a superannuation fund to invest in a range of assets that seek to achieve the
member's established risk and liquidity preferences. The purpose is to provide the member
with funds for retirement.

The concessional taxation treatment of complying superannuation funds relates primarily


to a 15 per cent tax rate applied to fund contributions and earnings. There are, however,
limitations on the amount an individual can contribute to a superannuation fund annually.
Superannuation fund members can withdraw their superannuation funds as a pension, or in
a lump sum, tax free once they reach age 60.

p. 113

REFLECTION POINTS

Superannuation funds, provident funds or pension funds accumulate retirement savings


of individuals.
Superannuation funds may be classified as corporate funds, industry funds, public
sector funds, retail funds, small regulated funds and self-managed funds.
Superannuation savings come from a number of sources, including employer
contributions, employee contributions, compulsory superannuation contributions,
personal contributions and eligible rollover funds.
Many countries are experiencing a demographic shift to an ageing population. Some
have introduced compulsory superannuation schemes to ensure people fund at least
part of their own retirement.
In Australia, employers are required to pay the equivalent of 9 per cent of an
employee's wage or salary into a superannuation fund in the employee's name.
A fund may be a defined benefit fund or an accumulation fund. At retirement, a
defined benefit fund pays a lump sum or pension based on a predetermined formula,
whereas an accumulation fund pays the accumulated contributions and earnings of the
fund, less expenses and taxes.
Superannuation funds in Australia are supervised by APRA. A concessional taxation
rate of 15 per cent applies to contributions and earnings of a fund. Funds may be
withdrawn tax free after age 60.

3.6 Life insurance offices


Life insurance offices are contractual savings
institutions. The liabilities of insurance offices are LEARNING
defined by contracts in which, in return for the OBJECTIVE 3.5
payment of specified periodic cash flows, the
policyholder will be entitled to a determinable benefit Define life insurance offices
following the occurrence of a specified future event or and general insurance offices
condition. and explain the main types
of insurance policies offered
by each type of insurer

The main contract offered by a life insurance office is described as an insurance policy.
The cost of an insurance policy is the premium paid. The premiumthe amount paid by the
buyer of a contract, such as an option or an insurance policy is usually paid annually
until the policy matures or is terminated. Typically, in return for payment of the premium, a
policyholderthe person who takes out an insurance policy that covers a defined risk
event or a beneficiarythe party who is entitled to receive payment under the terms of an
insurance policy will receive a payment upon death or disablement, or at a nominated
maturity date, subject to the terms and conditions of the insurance policy.

From an economic point of view, insurance premiums represent a form of savings. The
accumulated savings derived from the premium payments received by a life office are
invested in a wide range of asset classes. The return received on those investments is used
to make payment to an insured policyholder or beneficiary if an event specified in the
insurance policy occurs. For example, a specified event may be the death of the insured.

Life insurance offices are also providers of superannuation or retirement savings


products, and therefore accumulate and invest the superannuation savings of individuals. In
Australia, superannuation represents over 87 per cent of the assets of life insurance offices'
statutory funds. Statutory funds are funds established within a life insurance office that
hold, and therefore separate, the assets backing policyholder liabilities from the other assets
of the life insurance office.

The inflow of funds to a life insurance office is typically regular, relatively predictable
and long term. This gives the life insurance offices, in aggregate, a very stable source of
funds. Their payment flows to policyholders and superannuation fund members can be
reasonably well predicted on an actuarial basis and generally are not subject to erratic,
seasonal fluctuations. Therefore, life insurance offices are able to invest a large proportion
of their funds in long-term securities. For example, as indicated in Table 3.5, life insurance
offices in Australia are large investors in equities, unit trusts, long-term securities and
property, in both the domestic and international markets, with over $232 billion in total
funds invested.

p. 114 LIFE INSURANCE OFFICES (AUSTRALIA):


STATUTORY FUNDS AS AT DECEMBER 2010
TABLE 3.5

SOURCE: Reserve Bank of Australia, December 2010.

Each country has its own legislative and regulatory supervision requirements for life
insurance offices. In Australia, the prudential supervisor of life insurance offices is the
Australian Prudential Regulation Authority (APRA). As the prudential supervisor of
insurance offices, APRA regulates them in the same manner as it does the commercial
banks, particularly with regard to capital adequacy requirements and liquidity management
(discussed in Chapter 2). The principal legislation is the Life Insurance Act 1995 (Cwlth).
This legislation covers the licensing and control of life insurance offices.

3.6.1 LIFE INSURANCE POLICIES


As the name implies, a life insurance policy provides a named beneficiary with a financial
payment in the event of the death of the policyholder. Alternatively, the policyholder may
receive payment if some other defined event occurs, such as a permanent disability. As
discussed below, some life insurance policies also make a payment if the policyholder
survives to a nominated age, such as 65 years.

In a competitive market each life insurance office offers a range of different policies that
will incorporate a selection of terms and conditions. The basic insurance policy products
offered by a life insurance office include:

whole-of-life policy
term-life policy
total and permanent disablement policy
trauma policy
income protection policy
business overheads insurance policy

Whole-of-life policy

The whole-of-life policya life insurance policy that incorporates a risk component and an
investment component, thus accumulating bonuses and a surrender value is a long-term
life insurance policy. The policy will pay the sum insured, plus bonuses, on the death of the
policyholder.

p. 115

The whole-of-life policy incorporates a special featurean investment


componentallows periodic bonuses to accumulate on a whole-of-life insurance policy
that affects the amount paid on the death of the policyholder. The life office invests the
periodic premiums paid by the policyholder. The returns on investment will, typically, be
higher than the risk componentthe cost of the actual life insurance cover as determined
by an actuary of the policy and therefore a surplus is accumulated in the life office
statutory fund. The surplus is returned to the policyholder in the form of bonuses that are
attached to the policy.

Therefore, the policy will pay both the sum insured and the total bonuses attached to the
policy. Should the policyholder get into financial difficulty and not be able to pay the
premiums on the policy, the accumulated bonuses may be used to offset the outstanding
premium payments due.

A whole-of-life policy, over time, acquires a surrender valuethat is, an amount that will
be paid if the policy is cancelled by the policyholder.

Term-life policy

The term-life policylife insurance cover for a fixed amount and a predetermined period
pays a specified benefit to a nominated beneficiary on the death of the insured, if that death
occurs during the term of the policy. The term-life policy is for a predetermined period and
does not include an investment component.

The term-life policy is often more attractive than the whole-of-life policy. It allows the
policyholder to obtain financial protection for the nominated beneficiary over that period in
the policyholder's life when personal debt commitments are high. For example, a married
couple with children may have outstanding debts on their house and car and are planning to
send their children to private schools. If the main income earner died during this period, the
surviving family members may experience severe financial hardship. The amount of
insurance cover taken with a term-life policy should be at least sufficient to cover these and
any other forecast debt exposures.

Premium payments are made by the policyholder to the life office during the term of the
policy. The policy may require regular, periodic fixed premium payments for the term of
the policy. Alternatively, the premiums may be stepped over time, whereby the premium
increases progressively during the term of the policy. This form of premium reflects more
closely the increasing level of risk of death over time.

A feature that is available with a term-life policy is the indexation of the sum insured.
Generally, the policyholder is given the option to increase the amount of life cover each
year during the term of the policy.

A prospective policyholder should clearly understand exclusions that are incorporated in


a term-life policy. For example, cover will not be extended to the insured in the event of
suicide occurring within a specified period from the commencement of the policy. Also, a
policyholder is required to advise the insurer of any pre-existing health and physical
conditions. The insurer may not cover those conditions. Similarly, if the policyholder dies
as a result of an undeclared pre-existing condition, coverage may be excluded. If a
policyholder is injured or dies as a result of a riot, a terrorist act or war, the cover may be
limited or unavailable.

Total and permanent disablement insurance

total and permanent disablement policyinsurance policy covering loss of limbs or total
inability to resume an occupation is often taken as an extension to a life insurance policy.
It would seem prudent and logical to cover the situation in which death does not occur but
serious injury results. This is quite often the case, for example, in a car accident. The injury
suffered may be such that the policyholder is no longer able to work.

A total and permanent disablement policy will pay a specified amount, either as a lump
sum or as an annuitya series of cash flows of equal amount, equally spaced over time, if
an injury causes total and permanent disablement to the policyholder. Therefore, the
definition of a total and permanent disablement is critical in determining whether an
insurance claim will be paid or not. The definition is, at best, very restrictive. Before taking
this type of insurance, one should be aware of the limitations associated with disablement
insurance. The restrictiveness of a policy will vary between insurers. It is necessary to read
a policy proposal very carefully.

p. 116

In general terms, a total and permanent disablement will be determined within the
constraints of either:

the total and permanent loss of the use of a combination of two of the following: hands,
feet and/or eyes; or
total and permanent disablement resulting from an injury, accident or illness whereby
the insured is unable to carry out the normal functions of their usual occupation. This
measure will usually be subject to a range of conditions.

Trauma insurance

Another type of insurance policy that can be attached to a life policy is trauma insurancea
lump-sum payment made if a specified trauma event, such as a stroke, occurs. With
trauma insurance, the life office will make a lump-sum payment to the insured in the event
of a specified trauma occurring. Examples of trauma events include cancer, heart attack,
HIV, major body parts failure and terminal disease or illness. Again, as with all insurance,
the extent of coverage of a policy, definitions of events and terms and conditions need to be
examined with great care. For example, at what point is a heart attack a trauma event under
a policy?

Income protection insurance

Serious injury or illness may result in an individual being unable to work for an extended
period of time. income protection insurancepayment of a limited income stream if the
insured is unable to work in the event of illness or accident offers a periodic payment of
an amount up to 75 per cent of average pre-tax income, for a predetermined period. The
amount paid will be offset by any other related payments received, such as workers'
compensation, and will be confined to the length of time specified in the policy. Again, this
type of policy will vary between insurers. Given the nature of this type of policy, a
policyholder must ensure that a policy includes a guarantee of policy renewal by the life
insurance office.

Business overheads insurance

An extension of an income protection policy may be necessary where an individual runs


their own business. business overheads insurancecoverage of specified day-to-day
operating expenses in the event of business disruption provides coverage for strictly
defined, normal day-to-day operating expenses such as telephones, electricity, insurance
premiums, bank interest and fees, office cleaning and administrative personnel.

REFLECTION POINTS

Life insurance offices are contractual savings institutions; that is, their liabilities are
defined by insurance contracts that provide a determinable payout if a specified event
occurs. The cost of the policy is the periodic premium paid.
Life insurance offices are large investors in the financial markets, particularly in
longer-term debt and equity securities.
A whole-of-life policy is a long-term life insurance policy that pays a beneficiary the
sum insured, plus bonuses derived from an investment component, on the death of the
policyholder. The policy may accrue a surrender value.
A term-life policy also pays the sum insured but does not incorporate an investment
component. This is a fixed-term policy that is used to cover that period of a person's
life when they have high personal debt commitments.
Life insurance offices provide a range of other insurance policies, including total and
permanent disablement, trauma, income protection and business overheads insurances.
Policyholders need to understand the policy exclusions and limitations.

3.7 General insurance offices


p. 117
LEARNING
General insurance policies cover specified risks and OBJECTIVE 3.5
provide a promise to pay the insured a predetermined
amount in the event that the peril that is insured Define life insurance offices
against occurs. These funds include medical and general insurance offices
insurance, motor vehicle insurance, travel insurance, and explain the main types
public liability insurance and house and contents of insurance policies offered
insurance. by each type of insurer

Since insurance premiums are paid in advance, general insurers have substantial amounts
of funds to invest. However, because the uncertain nature of the risks that are underwritten
in general insurance policies, claims are less predictable than those of life offices. Thus,
general insurers tend to invest a larger proportion of their assets in shorter-term, highly
marketable securities. They will typically invest significant amounts in money-market
assets such as bills of exchange, commercial paper and certificates of deposit. These are
very liquid assets that can easily be sold should the insurance company need to raise cash to
meet claims against insurance policies.

3.7.1 GENERAL INSURANCE POLICIES


General insurance offices provide a wide range of risk insurance products. Policies offer
protection to individuals in the retail market and to businesses in the commercial market.
This section considers two of the principal insurance policy types:

house and contents insurance


motor vehicle insurance

House and contents insurance

House insurance provides financial protection to the insured in the event of loss or damage
to a residential property. Typically, a policy will provide insurance cover up to a specified
amount.

The insured must ensure that the amount of the cover is sufficient to replace or rebuild the
property covered in the policy. Under-insurance is a significant issue. Policies generally
incorporate a co-insurance if an asset is under-insured the policy will cover only the
proportional value insured, which means that the general insurance office will pay on a
claim only up to the proportional insurance coverage.

For example, if a house is insured for $400 000 but the replacement cost is determined to
be $500 000, then under a co-insurance clause the house is covered for only 80 per cent of
any loss. If an event occurs that is covered under the policy that causes, say, $100 000
damage to the property, the general insurance office will pay only $80 000. The
policyholder is said to have self-insured for the remaining 20 per cent of the damage.
Under-insurance can therefore be very expensive.

The range of events covered under a policy varies between insurers. The following is a
list of perils that an insurer may include in house and contents insurance policies:

fire or explosion
natural disasters such as lightning strike, flood and earthquake
malicious acts, riots, civil commotion
theft by persons other than residents
external impact
storm and water damage

Contents insurance policies usually provide new-for-old replacement value. Specified


items and items over a certain value may need to be listed in a schedule attached to the
policy. For example, valuable paintings or antiques may need to be catalogued and listed on
the schedule. Expert written valuations of the items will usually be required.

p. 118

House insurance policies typically incorporate public liability insurance covers injury
or death of a third party due to negligence of a property owner or occupier coverage up to
a specified amount. Public liability insurance covers injury or death to a third party visiting
the named property that may result from negligence on the part of the property owner or
occupier. For example, if, in the dark, a visitor to a house falls down steps leading from the
house, and if it can be shown that the lighting was defective, the visitor may have a claim
against the property owner.

Motor vehicle insurance

Accidents do happen, particularly when it comes to road transport. The owner or driver of a
vehicle has the choice of a number of motor vehicle insurance policies, each providing a
different level of cover.

The highest level of cover is provided by a comprehensive insurance policy covers


damage to the insured vehicle, plus third-party vehicle or property damage policy. A
comprehensive motor vehicle policy covers damage to the named vehicle, plus damage to
any third-party vehicles and property. Motor vehicles are generally covered for market
value, although it is possible to negotiate a higher cover if necessary.

A lesser level of cover is available with a third-party, fire and theft policy policy covers
only fire or theft of the insured vehicle, plus third-party vehicle or property damage. With
this type of policy the named vehicle is covered only for damage or loss associated with fire
or theft of the vehicle. Damage to any third-party vehicles and property is covered.

A third-party policy policy covers only third-party vehicle or property damage only
covers damage or loss to a third-party vehicle or property, but does not cover the vehicle of
the insured.

The cost, or premium, for the above motor vehicle insurance policies reduces as the level
of coverage or protection reduces. Also, the more expensive the vehicle owned, the more
prudent it is to take higher insurance cover.

Finally, within the Australian market there is compulsory third-party insurance covers
legal liability for bodily injury resulting from a motor vehicle accident. All vehicle owners
must pay for this insurance cover when they pay their annual vehicle registration. The
policy covers any legal liability for bodily injury caused by a motor vehicle accident. The
cover varies between states; some require proof of driver negligence, while others are on a
no-fault basis.

REFLECTION POINTS
General insurance provides financial protection against an insured event (e.g. travel or
medical insurance).
House and contents insurance protects against loss or damage to a residential property,
up to a specified amount, caused by a range of perils specified in the policy, such as
fire, flood or theft. The policy will include a co-insurance clause. The policy should
also include public liability insurance which covers negligent injury to third parties.
Motor vehicle insurance includes (1) comprehensive insurance, which covers damage
to the named vehicle, plus damage to third-party vehicles or property, (2) third-party
fire and theft, which covers damage to the named vehicle from fire or theft, plus
damage to third-party vehicles or property, and (3) third-party policy, which does not
cover the named vehicle, but covers damage to third-party vehicles and property.

3.8 Hedge funds


p. 119
LEARNING
A hedge funds invest in exotic financial products OBJECTIVE 3.6
mainly for high-net-worth individuals and
institutional investors typically uses so-called Discuss hedge funds,
sophisticated investment strategies and exotic including their structure,
investment products to try and achieve higher returns investors, investment
on investments. Therefore, a hedge fund investment is strategies and risk
generally regarded as a higher risk asset in an
investment portfolio. Hedge funds will tend to
specialise in different types of financial instruments.
These include equity, foreign exchange, bonds,
commodities and derivatives. The hedge fund sector is
generally divided into (1) single-manager hedge funds
and (2) fund of funds. The main difference is that the
fund of funds invest in a number of single-manager
funds; that is, the fund of funds attempts to diversify
their hedge fund investments across a number of
funds.

Hedge funds may be offered and managed by individual managers or financial


institutions, particularly investment banks. Individual managers usually have a very high
profile and an established reputation in the financial markets. Similarly, investment banks
employ individuals with specialist skills, but offer the extra protection of operational
transparency. That is, they keep investors informed. Hedge funds use their reputation to
attract funds in that investors perceive the manager (individual or investment bank) to have
superior skills, particularly in relation to sophisticated investment strategies and the use of
exotic investment products.

Hedge funds obtain their funds from institutional investors, high-net-worth individuals
and retail investors. In particular, superannuation funds and life offices are a major source
of institutional funds. Institutional investors seek to manage the risk and return structure of
their investment portfolios by adding hedge fund investments to a portfolio. Retail investors
may invest in hedge funds in some countries, such as Australia, but are excluded from this
type of investment in the USA. If a hedge fund makes an offer to retail investors in
Australia, the fund must meet the same regulatory requirements that are applicable to any
other type of retail fund, such as an equity unit trust.

A hedge fund may choose to list on a stock exchange. This will provide a secondary
market that will allow a hedge fund investor to buy and sell units in the fund. As such, a
listed fund may be much more liquid in that the price of the units in the hedge fund will
move with current market valuations.

An expectation of investors is that hedge funds will achieve positive returns in both an
upward- and a downward-moving market. This is in contrast to the traditional funds
management outcome where a portfolio, on average, increases with an upward-moving
market, but decreases with a downward-moving market. While this expectation is possible,
clearly it will be dependent on the skills of the hedge fund manager.

A hedge fund may seek to leverage investment opportunities by borrowing large amounts
of debt, over and above the funds lodged by the hedge fund investors. Also, a typical hedge
fund will leverage a position by using derivative products. Derivative products such as
options, forward and futures contracts may be bought or sold to take either a short or a long
position in the equity market or the foreign exchange market. For example, a hedge fund
that takes a short position will either sell forward shares, or use a derivative such as an
option or futures contract, that they forecast will fall in price. Alternatively, the fund may
buy shares they forecast will rise in price by using either borrowed funds or derivative
products. Note that with a derivative product, the fund may only need to pay a premium for
an option contract, or a deposit margin for a futures contract; that is, the full value of the
shares does not need to be paid during the term of the contract. If the share price moves up
or down as forecast, the fund will take a profit and not have to pay the full amount at all.
(The operation of derivative contracts is discussed in detail in Part 6.)

In the above examples, the profit potential to the hedge fund is multiplied by the high
level of leverage taken. Of course, the level of risk is also much higher.

p. 120

REFLECTION POINTS

A hedge fund seeks to achieve above-average returns using sophisticated investment


strategies and exotic investment products.
Funds are often highly leveraged by using borrowed funds or derivative products, and
invest in equities, foreign exchange, bonds, commodities and derivatives.
Single-manager funds or fund of funds may be managed by a high-profile individual or
a financial institution such as an investment bank.
Hedge fund investors may be institutional investors, high-net-worth individuals or
retail investors.
Hedge funds should be regarded as a higher-risk investment.

3.9 Finance companies and general


financiers
finance companies and general financiers borrow
funds direct from markets to provide loans and lease
LEARNING
finance to customers borrow funds in the domestic OBJECTIVE 3.7
and international financial markets in order to provide
loans to their customers. They do not accept deposits Explain the principal
from the general public. functions of finance
companies and general
financiers and the changes
that have had an impact on
finance company business

Finance companies emerged largely in response to regulatory constraints that existed in


the previously highly regulated banking sector, where interest rate ceilings and lending
directives were often imposed on commercial banks by regulators. Constraints placed on
banks created an opportunity for the development of institutions that could conduct
business outside the regulated banking sector.

In order to circumvent regulatory ceilings placed on bank deposit and lending interest
rates, and constraints on their ability to lend to higher-risk borrowers, the banks took a
major role in the ownership and funding of finance companies.

3.9.1 SOURCES OF FUNDS AND USES OF FUNDS


There is a direct correlation between the rise and fall in the relative importance of finance
companies and general financiers and the process of deregulation of the banking sector. For
example, in Australia in 1955 these institutions represented only 3 per cent of the total
assets of financial institutions, but by 1980 their market share had risen to 13 per cent.
However, with the deregulation of the interest rate and portfolio restrictions on commercial
banks, the finance companies' share of total assets declined continuously, and in 2010 stood
at less than 3 per cent.

The main sources of funds of these institutions are from borrowings from related
corporations, loans from banks and borrowing direct from the domestic and international
money markets and capital markets. The high level of funding obtained from related
corporations derives from the fact that a number of finance companies are subsidiaries of a
parent company. For example, as mentioned above, many finance companies are
subsidiaries of a commercial bank. Other finance companies have parent companies that are
manufacturers, such as motor vehicle manufacturers. In both instances, the parent company
may provide a large amount of the funds required by the finance company from its own
balance sheet. Another significant source of funds has been the increased use of offshore
funding following deregulation of capital flows in the international markets and the floating
of the exchange rates of major currencies.

p. 121

On the asset side of the balance sheet the main categories of business of the finance
companies and general financiers are:

loans to individuals
instalment credit to finance retail sales by retail stores
lease financing
loans to business, including bills finance, term loans, wholesale financing or floor plan
financing, factoring and accounts receivable financing.

These lending products are discussed in detail in Chapters 9 and 10.

3.9.2 SECTOR STRUCTURE


Clearly, the finance company and general financier sectors of the market have experienced
considerable change. There has been an enormous contraction in finance companies in
particular. Participants in the market can be classified into one of three broad categories:
1 diversified finance companies that provide a wide range of lending products
2 manufacturer-affiliated companies whose business is almost exclusively involved with
the financing of the sale of the parent manufacturer's products, for example motor
vehicles
3 niche specialists, which tend to be relatively small independent companies that have
developed an expertise in one aspect of lending, such as lease financing (see Chapter
10).

Examples of finance companies that operate in Australia include:

ESANDA: owned by the Australia and New Zealand Banking Group; a leading provider
of vehicle and equipment finance solutions and fixed-interest investments.
Ford Credit Australia Limited: owned by Ford Motor Company; mainly provides
financing for products of the parent company.
RACV Finance Limited: a vehicle roadside service organisation that has diversified into
the provision of financial products.

A full list of registered financial corporations operating in Australia may be found at


www.apra.gov.au.

REFLECTION POINTS

These institutions borrow funds in the local and international money and capital
markets and use those funds to provide loans and lease financing mainly to individuals
and small and medium-sized businesses.
The finance company sector has contracted as commercial banks have become more
competitive in the deregulated environment.
A number of finance companies specialise in niche areas of the market, such as motor
vehicle financing and lease financing.

3.10 Building societies


p. 122
LEARNING
Building societies are an example of a niche financial OBJECTIVE 3.8
institution that evolved to meet a specific market need
during the period of heavy regulation of commercial Outline the roles and relative
banks. This type of institution is not found in all importance of building
countries; rather it is found in certain countries where societies and credit unions
there is a large demand for finance to buy residential and analyse the significant
property and the demand is not able to be fully met by changes that have occurred
the banking sector. in these sectors

The main activities of building societies authorised deposit-taking institutions that


primarily give loans to customers to buy residential property are to accept deposits from
individuals and to provide mortgage finance primarily for owner-occupied housing. That is,
building societies gather in savings from their depositors and provide loans to their
customers to purchase residential property.

In Australia as at December 2010, the building society sector held $24.7 billion in
balance-sheet assets, which represented 0.50 per cent of the total assets of the financial
system. Ninety per cent of liabilities required to fund the balance sheet came from deposits
from customers. Residential lending represented 68 per cent of total assets.

It is interesting to consider the changes that have occurred in the building society sector in
Australia, as it demonstrates the direct impact of changing regulation on the structure of the
financial system.

Originally, the growth of building societies resulted from portfolio and interest rate
restrictions imposed by the Reserve Bank on the activities of savings (commercial) banks,
which were the major providers of residential mortgage finance. Building societies were not
regulated by the Reserve Bank and were able to offerand chargemore-market-related
interest rates than could the savings banks. The market rates paid on deposits by the
building societies increased their liability base, thus providing more available funds for
mortgage lending. With the progressive deregulation of product and interest rate controls
over the banks, building societies came under greater competitive pressure and lost
substantial market share. Their responses to the increased competition from the banks
include the following:

Smaller building societies merged with a view to rationalising administrative and other
costs.
Improved technology was adopted with the aim of reducing costs and improving
services to customers.
Diversifying the products and services offered to members, for example an increase in
lending to small business, credit card facilities and personal term loans.
The most important response of many building societies was to seek regulatory approval
and become a commercial bank. This final response has had a significant impact on the
building society sector and is largely responsible for the overall decline in total assets of
the sector. The largest building societies progressively converted to banks, and now
form a large proportion of the regional bank sector in Australia. A number of other
building societies that converted to banks have subsequently been taken over by larger
commercial banks.

Building societies are authorised deposit-taking institutions financial institutions


authorised by APRA to accept retail deposits in Australia and as such are regulated and
supervised by APRA. Essentially, APRA applies the same prudential and reporting
standards to the building societies as to the commercial banks. These requirements were
discussed in Chapter 2in particular, the capital adequacy and liquidity management
requirements.

REFLECTION POINTS

Building societies accept deposits from customers and provide personal finance to
individual borrowers, particularly housing finance, but also term loans and credit card
finance.
p. 123

In Australia, the building society sector contracted significantly as the banking sector
was deregulated. Many building societies merged and eventually converted into
commercial banks.
Building societies are authorised deposit-taking institutions that are regulated by
APRA.
3.11 Credit unions
credit unionsauthorised deposit-taking institutions
that accept retail deposits and provide loans to
LEARNING
members provide deposit and loan products for their OBJECTIVE 3.8
members. The strength of credit unions derives
mainly from a common bond of associationmembers Outline the roles and relative
are drawn together from a common background of importance of building
work, industry or community of its members. The societies and credit unions
common bond of association may be based in and analyse the significant
employment, industry or the community. For changes that have occurred
example, the Shell Employees' Credit Union is an in these sectors
employer-based credit union; the Maroondah Credit
Union is a community-based credit union; and the
Industries Mutual Credit Union is an industry-based
institution.

Credit unions obtain the majority of their funds from deposits lodged by their members.
To a limited extent they supplement their deposit base by borrowing from other credit
unions, or issuing promissory notes and other securities into the financial markets. Many
credit unions are able to attract deposits inexpensively through automatic customer payroll
deductions. This is an arrangement whereby an employee authorises an employer to
forward part of their salary each pay day to an account held with a nominated credit union.

On the asset side of their balance sheets, credit unions provide loans to members for
residential housing, personal term loans, credit card facilities and limited commercial
lending to small business. Another attraction offered to members is an automatic bill
payment facility against the member's credit balance.

The credit union sector in Australia has more than $50.2 billion in assets (December
2010), which represents 1 per cent of the total assets in the financial system. Although the
asset base is relatively small, in December 2010 there were 104 credit unions.

Credit cooperatives are authorised deposit-taking institutions and as such are regulated
and supervised by APRA. The regulator applies the same prudential and reporting standards
to credit unions as to banks and building societies. These requirements were discussed in
Chapter 2in particular, the capital adequacy and liquidity management requirements.

REFLECTION POINTS

Credit unions accept deposits from their members and provide loans to those members,
including housing loans, term loans and credit card finance.
Members of a credit union tend to have a common bond of association. This may be
based on the members' employer, the industry in which they work or the community in
which they live.
In Australia, credit unions are authorised deposit-taking institutions and are regulated
by APRA.

3.12 Export finance corporations


p. 124
LEARNING
Nation-states generally support economic growth by OBJECTIVE 3.9
encouraging increased exports of goods and services.
Many countries have therefore established export Describe the unique role of
finance corporationsgovernment authorities that export finance corporations
provide finance and insurance support and services
to exporters. These organisations are government
authorities that provide financial support and services
to exporting corporations in a nation-state.

In Australia the official export credit agency is the Export Finance and Insurance
Corporation (EFIC). The role of EFIC is to facilitate and encourage Australian export trade
through the provision of trade insurance and other trade-related financial services and
products. EFIC is constituted under the Export Finance and Insurance Corporation Act
1991 (Cwlth). Through its charter, EFIC encourages Australian international trade by:

insuring Australian suppliers of goods and services against non-payment


guaranteeing trade finance for the purchase of Australian goods and services
insuring Australian firms that invest in enterprises overseas against the political risks
associated with such investments
lending directly to overseas borrowers in support of particular classes of capital goods
and services transactions
indemnifying financial transactions of insurers that provide bonds or guarantees to
overseas buyers, and providing performance bonds in support of Australian export
contracts
insuring Australian suppliers of goods and services against the unfair calling of such
bonds or guarantees.

There is a continual demand for export credit. This is particularly true for the export of
capital and semi-capital goods, where the terms of payment and financing facilities can be
just as important as price. To be successful in international markets, exporters need access
to payments insurance, guarantees and bonding and loan facilities that compete with those
available to overseas competitors.

Exporters wishing to compete successfully in overseas markets sometimes need to offer


deferred payment terms; however, this increases the risk exposure to non-payment. EFIC
provides protection against this risk. Where applicable, EFIC makes loans for export sales
of capital equipment and services at concessional rates of interest. An EFIC loan is usually
made to the buyer or to its financier in the buyer's country. For government and public
sector buyers in countries that are recipients of Australian aid, mixed credits may be made
availablethat is, EFIC finance combined with aid funds.

REFLECTION POINTS

Export finance corporations typically encourage export trade through the provision of
trade insurance and financial services and products to corporations.
Export finance corporations are often able to provide exporters with innovative trade
finance solutions that may not be available through other financial institutions.
In Australia the official export credit agency is the Export Finance and Insurance
Corporation (EFIC).
Financial news case study
p. 125

In Chapter 3, we spent a lot of time discussing the roles and operations of fund managers. We
imagine that each fund manager independently researches and analyses potential investments
and allocates funds based on the conclusions of the analysis. But what if fund managers have
a tendency to move in the same direction as most of the other fund managers? You should be
able to apply your knowledge of funds management to a critical discussion of this possibility
and the implications of fund manager herding for markets and clients. The basis for your
discussion is John Beveridge's article published by the Herald Sun.

A fund manager survey by HSBC released yesterday is a perfect example of the herding
instincts of fund managers.

It showed 100 per cent of global fund managers surveyed were overweight towards US
shares for the first quarter of 2011up from 25 per cent in the previous quarter. With the
benefit of hindsight, we now know all of them were right through January and February.

But by the time the ides of March had arrived this week, 100 per cent of them were 100 per
cent wrong, courtesy of a fast-correcting market with the added impetus of the unpredictable
Japanese earthquake and tsunami. You can now predict with almost 100 per cent certainty
that for the next quarter, the fund managers' overweight call on the US market will be more
muted, even though the reasons given of an improving economy, merger and acquisition
opportunities and encouraging company reports remain valid.

One reason animals travel in herds is to protect the weakest members from predators and
fund managers tend to do it for the same reason. If they can point out that their colleagues
made the same mistake they did, it's an effective counter to the angry investor. That's not to
criticise fund managersthey do a tough job in markets which trade as much on human
psychology as fundamentals. But this survey suggests that when 100 per cent of fund
managers are doing anything, it's time for the brave contrarian to make money by doing the
polar opposite.

SOURCE: John Beveridge, Fund Managers Travel in Packs, Herald Sun, 18 March 2011.

DISCUSSION POINTS

What are some of the implications for market prices if fund managers, with large amounts
of funds under management, travel in herds?
What are the implications of this type of behaviour for the flow of funds in the financial
system?
Is herding in and out of markets desirable for those investors who have very long time
horizons (for example, superannuation fund investors saving for retirement)?
Is the conclusion of the article sound? Is it wise for investors to do the opposite of what the
fund managers are doing or would a sounder investment strategy be to attempt to guess
what the average fund manager will do and attempt to profit from the behaviour of the
herd?

Summary
LEARNING OBJECTIVE
Describe the roles of investment banks and merchant
banks, with an emphasis on the nature of their off - 3.1
balance-sheet business, in particular mergers and
acquisitions

A wide range of non-bank financial institutions has evolved within the financial system in
response to changing market regulation and to meet particular needs of market
participants.
Investment banks and merchant banks play an extremely important role in the provision
of innovative products and advisory services to their corporations, high-net-worth
individuals and government.
The structure of investment banks is characterised by a division of activities between
front office (trading, investment banking, investment management, research), middle
office (risk measurement, risk management) and back office (accounting, audit,
compliance).
p. 126

Investment and merchant banks raise funds in the capital markets, but are less inclined to
provide intermediated finance for their clients; rather they advise their clients and assist
them in obtaining funds direct from the domestic and international money markets and
capital markets.
Investment banks specialise in the provision of off-balance-sheet products and advisory
services, including operating as foreign exchange dealers, advising clients on how to raise
funds in the capital markets, acting as underwriters and assisting clients with the
placement of new equity and debt issues, advising clients on balance-sheet restructuring,
evaluating and advising on corporate mergers and acquisitions, identifying and advising
on potential spin-offs, advising clients on project finance and structured finance,
providing risk management services and advising clients on venture capital.
An investment or merchant bank may advise a corporation on all aspects of a merger and
acquisition proposal. This is a situation in which one company seeks to take over another
company. The merger may be friendly or hostile, and strategically may be a horizontal
takeover, a vertical takeover or a conglomerate takeover. The merger will seek to achieve
synergy benefits such as economies of scale, finance advantages, competitive growth
opportunities and business diversification.

LEARNING OBJECTIVE
Explain the structure, roles and operation of managed 3.2
funds and identify factors that have influenced their
rapid growth

Managed funds are a significant and growing sector of the financial markets due, in part,
to deregulation, ageing populations, a more affluent population and more highly educated
investors.
The main types of managed funds are cash management trusts, public unit trusts,
superannuation funds, statutory funds of life offices, common funds and friendly
societies.
Managed funds may be categorised by their investment risk profile, being capital
guaranteed funds, capital stable funds, balanced growth funds or managed or capital
growth funds.
LEARNING OBJECTIVE
Discuss the purpose and operation of cash management 3.3
trusts and public unit trusts

Cash management trusts are highly liquid funds that allow individual retail investors to
access the wholesale money markets.
Public unit trusts allow investors to purchase units in a trust that is controlled by a trustee
under the terms of a trust deed. The trustee (responsible entity) arranges for the pooled
funds of the trust to be invested by selected funds managers in specified asset classes.
Public unit trusts include property trusts, equity trusts, mortgage trusts and fixed-interest
trusts.
Unit trusts may be listed on the stock exchange or they may be unlisted.

LEARNING OBJECTIVE
Describe the nature and roles of superannuation funds, 3.4
including the primary sources of superannuation funds
and the different types of fund

Superannuation funds facilitate savings by individuals for their future retirement.

Types of superannuation funds include corporate funds, industry funds, public sector
funds, retail funds, small regulated funds and self-managed funds.
Sources of superannuation savings include employer contributions, employee
contributions, compulsory superannuation contributions, personal contributions and
eligible rollover funds.
Many countries are experiencing a demographic shift to an ageing population.

Some countries have introduced compulsory superannuation schemes to ensure people


fund at least part of their own retirement.
In Australia, employers must contribute the equivalent of 9 per cent of an employee's
wage into a superannuation account in the name of the employee. The superannuation
funds receive concessional taxation treatment.
A defined benefit scheme pays a superannuation amount on retirement based on a defined
formula, while an accumulation fund pays the total of contributions plus fund earnings
after tax and expenses.
APRA is the prudential supervisor of most superannuation funds.

LEARNING OBJECTIVE
Define life insurance offices and general insurance 3.5
offices and explain the main types of insurance policies
off ered by each type of insurer

Life insurance offices are contractual savings institutions. They generate funds primarily
from the receipt of premiums paid for insurance policies written.
Life insurance offices are also major providers of superannuation savings products.

p. 127

Whole-of-life insurance policies include an insurance risk component and an investment


component. The policy will accumulate a surrender value over time.
A term-life policy provides life insurance cover for a specified period. If the policyholder
dies during that period, an amount is paid to the named beneficiary.
Related insurance policies include total and permanent disablement insurance, trauma
insurance, income protection insurance and business overheads insurance.
The regulator of life insurance offices is APRA.

General insurance offices also generate funds from premiums paid on insurance policies.

General insurance policies include house and contents insurance.

Policyholders need to be aware of the co-insurance clause and the amount of public
liability cover.
Motor vehicle insurance includes comprehensive, third-party fire and theft, third party
only and compulsory third-party insurance.

LEARNING OBJECTIVE
Discuss hedge funds, including their structure, investors, 3.6
investment strategies and risk

A hedge fund seeks to achieve above-average returns using sophisticated investment


strategies and exotic investment products; as such, they are higher-risk investments.
Funds are often highly leveraged by using borrowed funds or derivative products; they
invest in equities, foreign exchange, bonds, commodities and derivatives.
Single-manager funds, or fund of funds, may be managed by a high-profile individual or
a financial institution such as an investment bank.
Hedge fund investors may be institutional investors, high-net-worth individuals or retail
investors.

LEARNING OBJECTIVE
Explain the principal functions of finance companies 3.7
and general financiers and the changes that have had an
impact on finance company business

Finance companies derive the largest proportion of their funding from the sale of
debentures.
They provide loans to individuals and businesses, including lease finance, floor plan
financing and factoring.
Deregulation of commercial banks has resulted in a significant decline in finance
companies.
Many finance companies are now operated by manufacturers, such as car companies, to
finance sales of their product.

LEARNING OBJECTIVE
Outline the roles and relative importance of building 3.8
societies and credit unions and analyse the significant
changes that have occurred in these sectors

The majority of building society funds are deposits from customers. Residential housing
is the main form of lending.
Credit unions funds are sourced primarily from deposits of members. Housing loans,
personal loans and credit card finance is available to their members.
A defining characteristic of a credit union is the common bond of association of its
members, usually based on employment, industry or community.

LEARNING OBJECTIVE
3.9
Describe the unique role of export finance corporations

Government agencies play an important role in providing financial services to the


corporate sector to support the export of goods and services.
The official Australian agency is the Export Finance and Insurance Corporation (EFIC),
which provides trade insurance and trade-related financial services and products.

Extended learning
Project finance and structured finance LEARNING
Project finance
OBJECTIVE 3.10

Project finance is an interesting and complex area of Understand project finance


finance. project financefinancing large projects and structured finance and
where loan repayments are based on the future cash the related roles of
flows of the completed project supports economic investment banks
growth within a country in that it enables important
development and infrastructure projects to proceed.
Such projects include the building of power stations,
toll roads and tunnels, the extraction of minerals,
heavy industry and processing plants, tourist resorts
and casinos.

Investment banks have developed expertise in the provision of advisory services for their
corporate and government clients on the structuring and financing of major projects. The
possible finance and ownership structures and the range of risks associated with project
finance are quite extensive. This extended learning section will give you an understanding
of the main features of project finance and structured finance.

Distinguishing features

p. 128

The key difference between project finance and most other forms of lending is that, with
project finance, the lenders determine their participation primarily on the basis of the
expected future cash flows and assets of the project. There is only a secondary reliance on
the balance sheets and financial positions of the project sponsors. Figure 3A.1 provides a
simplified conceptual framework that diagrammatically represents a basic project finance
structure.

FIGURE 3A.1 CONCEPTUAL PROJECT FINANCE STRUCTURE


As indicated in Figure 3A.1, a corporation or syndicate of corporations that implements a
project is known as the project sponsor. project sponsors the originators and equity
providers of a project, as the project originators, take an equity position in the project. For
example, the sponsors may form a project company to build, own and operate the project.
The sponsors will inject equity into the project company by buying shares in the company.
The remainder of the funding for the project will come from loans provided by a syndicate
of lenders. The debt will eventually be repaid from the future cash flows that the completed
project will generate.

Within the context of the simple structure in Figure 3A.1, a number of acronyms have
evolved which describe different structures that may be used in project finance. These
include build, own, operate and transfer (BOOT) structures, build, own and operate
(BOO) structures and build, operate, lease and transfer (BOLT) structures.

A BOOT structure may be a project such as a toll road; a project company builds the road
and operates the toll road for a specified number of years, at which date the road is
transferred back to the government. A BOO structure may be used for a project such as a
power station; the project company builds the station and continues to operate the station
for the productive life of the facility. A BOLT structure will include capital leasing
arrangements.

A number of projects are completed in partnerships between the public sector and the
private sector. These are referred to as public, private partnership structures.

Characteristics that distinguish project financing from more traditional methods include
the following:

The project company is established as a separate legal entity, and it relies very heavily on
debt financing. Project financing generally provides up to 75 per cent of the total capital
requirements. The remainder of the funding consists of equity and subordinated debt
contributed by the project sponsors.
The debt of the project company is separate from the project sponsors' other business
obligations.
The lenders' security is usually limited to the assets of the project company, and does not
include the assets of the project sponsors. However, sponsors generally provide various
completion and performance guarantees.
Commitments from related third parties are sought as credit support for the project.
Support may be in the form of specific performance guarantees. Third parties may
include suppliers, intending purchasers of the project's output and government
authorities.
p. 129

Project finance loans are generally for a considerably longer term than is usually
available through finance provided by banks and other intermediaries.
Debt is on a limited recourse or non-recourse basis.

The recourse provisions are important, because they specify the rights of the lenders from
project commencement up to the time when the project is built and begins to generate
positive cash flows. Under non-recourse lending the lender is totally reliant on future
project cash flows for loan repayments, lenders are totally dependent on the project's future
cash flows for interest payments and the eventual repayment of the debt. During the total
life of the loan the lenders have no recourse to other repayment sources, including the
project's sponsors. Non-recourse lending is most unlikely to be provided by banks. In so far
as it is available, it has been from major corporate investors.

Where bank finance is involved, it is almost always limited recourse lending lenders
have certain claims on the assets of the project sponsors if project cash flows fail to
achieve specified levels. While the particular recourse arrangements vary widely, lenders
typically have very tightly defined and restricted access to the sponsors for loan repayments
prior to project completion point at which a project is built and is generating a
prescribed level of cash flows. Once the project is complete, the lenders have recourse only
to the project's cash flows and assets.

Completion is said to occur when construction is finished, the project is operational and
specified cash-flow levels are achieved. For example, with a toll road, completion is said to
occur when the road has been built, is open for public use and is generating a required level
of revenue from vehicle tolls.

Participants

Projects are typically very large and extend over many years before completion. Often they
require hundreds of millions of dollars in finance. Given their size, most project
undertakings are jointly owned and controlled. Some of the advantages of joint ownership
include:

The project development risk is shared between the joint owners. This is particularly
important where the sponsors have provided completion guarantees to the project
lenders.
Joint ventures between parties bring different sets of skills to the project. These include
both specialist operational skills and specialist financial skills.
The project size may well require a greater financial and managerial capability than can
be provided by a single sponsor. Greater sponsor expertise and commitment will
encourage project lenders.

In addition to the project sponsors, the investment banks are essential in that they will
facilitate syndicated loan the provision of loan funds by a group of financiers for a single
project, partly through bill acceptance facilities, term loans and overdraft facilities. More
importantly, the investment banks will assist the project company with the issue of debt
securities direct to the capital markets.

The size of a project will normally require a syndicate of lenders, whereby several
financial institutions form a syndicate to share the risk of providing project finance. The
syndicate of banks will use the standing of the banks in the financial markets to access
funds in the domestic and international capital markets. Syndicates are also able to raise
loans in currencies that match the currencies that will be earned once the project cash flows
are positive. This minimises the foreign exchange (FX) risk exposure of the project's
earnings. (Chapter 17 discusses FX risk exposure and its management.)

Where the development and operation of a project involves the leasing the borrowing of
an asset in return for lease payments, rather than borrowing the funds to purchase the
asset of assets, lessor partnerships form another party to the project. The key suppliers of
equipment to the project may also be important providers of funds. Indeed, the availability
and terms of funding associated with a lease may determine the ultimate choice of
equipment used for the project.

Project finance is a highly specialised task. Both financial and technical expertise is
required by the lending syndicate to assess the potential productive capacity of the project
and the length of the development period before a positive cash flow can be expected, and
to establish appropriate guarantees from other participating parties. In order to achieve this,
the syndicate of investment banks will bring together the specialist engineers,
environmentalists, marketing consultants, financial consultants, auditors, accountants,
taxation experts and legal counsel necessary when drafting the project ownership
agreements and loan documentation.

Structured finance

structured finance funding provided for major infrastructure projects is the term applied
by the market to complex infrastructure funding arrangements; essentially it is a specialist
area of project finance. However, there are a number of characteristics of structured finance
that tend to differentiate it from other forms of project finance. These include:

Infrastructure provides the essential major connectors for economic capital and activity
such as power, water and roads.
Infrastructure supports economic growth and activity within an economy; for example,
railway networks efficiently carry goods from suppliers to markets.
p. 130

Facilities such as hospitals are maintained for the public good.


Infrastructure projects tend to represent natural monopolies (e.g. the reticulation of
water).
The projects are capital intensive (e.g. the construction of a water storage dam or an
electricity generating plant).

In the past, governments have primarily been responsible for infrastructure development
and finance. However, in recent years a change in political ideology has seen an enormous
increase in private sector infrastructure developments. Factors that have influenced private
sector infrastructure finance include:

the current preference of governments to maintain budget surpluses, resulting in fiscal


constraints being imposed on the ability of governments to fund large infrastructure
projects
the granting of tax concessions to qualified infrastructure projects in order to encourage
private sector investment
policy initiatives to create market competition within economic sectors that were
previously monopolised by government
the privatisation of existing government authorities and enterprises.

The above initiatives have encouraged new infrastructure projects, often referred to as
greenfield projects. Infrastructure projects often retain a monopoly position within the
market, and also retain very stable and predictable cash flows. For example, retail
electricity users will continue to buy similar quantities of electricity regardless of the
supplier.

Infrastructure projects may well incorporate embedded options specific performance


guarantees included in a project contract. That is, government may legislate or contract to
provide various guarantees such as revenue streams, anti-competition advantages and
periods of monopolistic advantage. However, government may also restrict commodity
price rises for a specified period of time; for instance, product price rises may be limited to
movements in the consumer price index a measure of changes in the price of a basket of
goods and services.

Project and structured financing incorporate equity and debt funding techniques. These
were introduced in Chapter 1 and will be discussed in greater detail in later chapters. Equity
includes ordinary shares and hybrids such as preference shares and convertible notes. Debt
ranges from bank overdrafts to commercial paper facilities, medium-term note issues and
longer-term bond issues. Debt contains different priority rankings, from senior debt to
subordinated junior debt claims of these security holders are subordinated after all
other creditors, and incorporates different interest rate structures, such as fixed and variable
rates, and repayment structures. Debt may also be denominated in a number of major
currencies. The role of the investment bank is to advise on funding structures and
participate in syndicated lending and underwriting agreements.

Risks associated with project finance

For providers of debt finance, particular importance is attached to the project reaching the
completion stage. It is at that point that the limited recourse provisions expire, and both
limited recourse and non-recourse lenders become dependent on the project's future income
stream for repayment of their loans. As a result, lenders must carefully assess the risks
associated with achieving project completion, and the subsequent risk that may adversely
impact upon the project's income streams, such that they may not be sufficient to provide
for the repayment of debt.

There are a host of risks that can be identified. Most of them are also relevant to the
assessment of the risk of a borrower seeking any loan. However, the risks are more critical
in the case of project finance because the project (the borrower) often has no other assets
that can be secured by the lenders. As a result, it is likely that, when quantifying the risks,
the lenders will be more conservative in their calculations than they would be if they were
assessing the risk for the purposes of making a secured loan.

For example, in the case of a resource development project, one of the risks that must be
taken into account is the amount of recoverable resources. Will they be sufficient to cover
commitments to the debt providers, particularly if resource prices fall? To cover themselves
against this risk, debt providers typically seek an assurance that the proven reserves that are
accessible under current technologies are well in excess of those necessary to meet the debt-
servicing requirements. A 2:1 ratio of accessible reserves to necessary sales is not
uncommon. In projects where the object is the development of infrastructure, such as the
development of electricity-generating facilities, usage and revenue guarantees may be
sought from the relevant government authorities.

Given the significance of completion, lenders will typically seek non-completion


covenants specific loan conditions enforceable against project sponsors if a project is not
completed from the project sponsors. The forms of the covenants are varied and may
include some of the following.

p. 131

Guarantees from the sponsors that they will repurchase the debt, or convert it on
specified terms into obligations of the sponsoring corporations, if the completion
conditions are not achieved.
Guarantees from the sponsors that they will provide the appropriate management
expertise and additional funding (including equity funding) to ensure that the completion
conditions will be met.
Guarantees from the sponsors that they will meet any working capital finance required
by a firm to fund its day-to-day operations shortfall during the development phase.

The definition of completion is also of significance. From the lenders' point of view, the
preferred definition of completion would include a benchmark for performance criteria. The
performance criteria may include the performance of the project at design specification
standards for a specified period following the physical completion of the project, or the
attainment of a predetermined cash flow or a minimum level of sales.

In addition to these risks, the debt providers must also calculate the risks associated with
the management of the project beyond completion, the impact of future changes in the
regulatory environment and financial risks such as the impact of changes in interest rates
and exchange rates.

The complexity and sophistication of project financing should now be evident. Managers
of corporations typically are not experienced in these aspects of finance and therefore seek
the expertise and advice of investment banks. Fees earned on a project by an investment
bank may run into millions of dollars.

Key terms
accumulation fundthe amount of 112
superannuation funds available at retirement
consists of past contributions plus earnings,
less taxes and expenses
age pensiona limited regular income stream 108, 109
paid by a government to older retired persons
annuitya series of cash flows of equal 115
amount, equally spaced over time
authorised deposit-taking 122
institutionsfinancial institutions authorised
by APRA to accept retail deposits in Australia
back officethe name given to those functions 95
within an investment bank that are most
removed from client relations. Accounting and
compliance are examples
balanced growth fundinvestments target 104
longer-term income streams supported by
limited capital growth
beneficiarythe party who is entitled to receive 113, 114
payment under the terms of an insurance
policy
building societies authorised deposit-taking 122
institutions that primarily give loans to
customers to buy residential property
business overheads insurancecoverage of 116
specified day-to-day operating expenses in the
event of business disruption
capital guaranteed fundthe value of 103
contributions to the fund are guaranteed, but
future earnings are not
capital stable fundscontributions are mostly 104
protected as the fund invests in low-risk
securities
cash management trustinvests the 105
accumulated savings of individuals mainly in
wholesale money-market securities
co-insurance if an asset is under-insured the 117
policy will cover only the proportional value
insured
common bond of associationmembers are 123
drawn together from a common background of
work, industry or community
comprehensive insurance policy covers 118
damage to the insured vehicle, plus third-
party vehicle or property damage
compulsory superannuationemployers must 110
contribute minimum specified amounts into
retirement savings for employees (Australia)
compulsory third-party insurance covers 118
legal liability for bodily injury resulting from
a motor vehicle accident
conglomerate takeoverwhen the business of a 98
merger and acquisition target company is
unrelated to the existing business of the
takeover company
consumer price indexa measure of changes 130
in the price of a basket of goods and services
corporate superannuation fundan employer 110
contributes to a fund established for the
benefit of an employee; employee may also
contribute to the fund
credit unionsauthorised deposit-taking 123
institutions that accept retail deposits and
provide loans to members
defined benefit fundthe amount of 112
superannuation paid to an employee on
retirement is based on a defined formula
eligible termination 111
paymentssuperannuation funds due on
termination of employment plus related
redundancy payments
embedded optionsspecific performance 130
guarantees included in a project contract
equity trustinvests in different types of shares 106
listed on stock exchanges (e.g. industrial,
resources, emerging markets)
export finance corporationsgovernment 124
authorities that provide finance and insurance
support and services to exporters
finance companies and general financiers 120
borrow funds direct from markets to provide
loans and lease finance to customers
fixed-interest trustinvests in a range of debt 107
securities such as government and corporate
bonds
front officethe name given to those activities 95
within an investment bank that involve client
relations, especially trading, investment
banking, research and investment
management
hedge funds invest in exotic financial 119
products mainly for high-net-worth
individuals and institutional investors
horizontal takeoverwhen two companies 98
involved in a merger and acquisition are in
the same business
hostile takeoverwhen the target company 98
rejects the merger and acquisition proposal of
the takeover company
income protection insurancepayment of a 116
limited income stream if the insured is unable
to work in the event of illness or accident
industry superannuation fundsimilar to a 110
corporate fund, but the fund is established for
all employees in a specific industry
investment banks and merchant 95, 96
banksspecialist providers of financial and
advisory services to corporations, high-net-
worth individuals and government
investment componentallows periodic 115
bonuses to accumulate on a whole-of-life
insurance policy
leasing the borrowing of an asset in return for 129
lease payments, rather than borrowing the
funds to purchase the asset
limited recourse lending lenders have certain 129
claims on the assets of the project sponsors if
project cash flows fail to achieve specified
levels
listed trustthe units of a trust are listed and 107
traded on a stock exchange
managed fundsinvestment vehicles through 101
which the pooled savings of individuals are
invested
managed growth fundinvests to obtain 104
greater return through capital growth; lower
income streams
merger and acquisitiontakeover company 98
seeking to gain control over a target company
middle officethe name given to those 95
activities within an investment bank that do
not involve client relations but may
complement or monitor front office activities.
Risk measurement and reporting are examples
money-market corporationsofficial 95, 96
classification of investment and merchant
banks operating in Australia
mortgage trustinvests in mortgages 106
registered as loan securities over land
mutual fundsmanaged funds that are 101
established under a corporate structure;
investors purchase shares in the fund
non-completion covenants specific loan 130
conditions enforceable against project
sponsors if a project is not completed
non-recourse lending the lender is totally 129
reliant on future project cash flows for loan
repayments
policyholderthe person who takes out an 113
insurance policy that covers a defined risk
event
premiumthe amount paid by the buyer of a 113
contract, such as an option or an insurance
policy
project completion point at which a project is 129
built and is generating a prescribed level of
cash flows
project financefinancing large projects where 127, 128
loan repayments are based on the future cash
flows of the completed project
project sponsors the originators and equity 128
providers of a project
property trustsinvest in different types of 106
property specified in the trust deed; includes
industrial, commercial and retail property
public liability insurance covers injury or 118
death of a third party due to negligence of a
property owner or occupier
public sector superannuation funda 110
government-sponsored fund established for
the benefit of government employees
public unit trustinvestors purchase units in a 106
trust; the pooled funds are invested in asset
classes specified in the trust deed
responsible entitythe trustee and manager of 101, 102
a trust in Australia
risk componentthe cost of the actual life 115
insurance cover as determined by an actuary
rollover fundholds existing eligible 111
termination payments within the regulated
superannuation environment
single-premium superannuation schemea 111
once-only contribution to a superannuation
savings scheme
spin-offa situation where a part of a company 98
is separated from the whole and begins an
existence as an independent company
structured finance funding provided for 129
major infrastructure projects
subordinated junior debt claims of these 130
security holders are subordinated after all
other creditors
superannuationsavings accumulated by an 108
individual to fund their retirement from the
workforce
superannuation guarantee chargethe 110
compulsory superannuation scheme operating
in Australia
superannuation savings planregular 111
contributions made by an individual into a
private superannuation fund
syndicated loan the provision of loan funds 129
by a group of financiers for a single project
term-life policylife insurance cover for a 115
fixed amount and a predetermined period
third-party policy policy covers only third- 118
party vehicle or property damage
third-party, fire and theft policy policy 118
covers only fire or theft of the insured vehicle,
plus third-party vehicle or property damage
total and permanent disablement 115
policyinsurance policy covering loss of limbs
or total inability to resume an occupation
trauma insurancea lump-sum payment made 116
if a specified trauma event, such as a stroke,
occurs
trust deeddocument detailing the sources, 101, 102
uses and disbursement of funds in a trust
trust fundmanaged funds established under a 101
trust deed; managed by a trustee or
responsible entity
underwriteran institution that supports the 96
issue of securities by a client and agrees to
buy any securities not bought by investors
unlisted trustto sell units, a unit holder must 107
sell them back to the trustee after giving the
required notice
vertical takeoverwhen the target company in 98
a merger and acquisition operates in a
business related to that of the takeover
company
whole-of-life policya life insurance policy 114
that incorporates a risk component and an
investment component, thus accumulating
bonuses and a surrender value
working capitalfinance required by a firm to 131
fund its day-to-day operations

True/False Questions
QUESTIONS

p. 132

Answer TRUE or FALSE to the following statements. To assist in your review, you
might also write brief notes explaining your response.

1. Investment bank business focuses mainly on innovative financial products, while


merchant bank business is mainly directed towards providing debt securities for
corporate clients.
2. Investment banks often act as foreign exchange dealers whereby they quote both bid
and offer rates on foreign currencies.
3. Off-balance-sheet services provided by investment banks include the provision of
advice to corporate clients on balance-sheet restructuring and risk management
using derivative products.
4. The difference between a horizontal takeover and a vertical takeover is whether the
target company perceives the proposed merger to be a hostile offer or not.
5. When an issue of debt securities is underwritten by a syndicate of banks, the
syndicate is providing a guarantee to investors that the debt will be repaid at
maturity.
6. A managed fund that offers a balanced growth fund invests mainly in securities that
have the potential for large capital growth over time.
7. Cash management trusts provide retail savers with an investment opportunity that
returns a yield that is derived mainly from yields in the wholesale money markets.
8. From the point of view of the unit holder, units in a listed property trust tend to be
more liquid than units in an unlisted property trust.
9. Because superannuation savings do not provide savers with a very liquid asset, it is
probable that they will become less important in the flow of funds into the capital
markets in the future.
10. With a defined benefit scheme, the amount of superannuation funds paid to a
member on retirement consists of all contributions paid plus income earned by the
fund.
11. A whole-of-life insurance policy includes a risk component and an investment
component, thus accumulating bonuses and a surrender value.
12. Term-life insurance policies only cover a policyholder for a limited period and
therefore are not attractive as a form of life insurance.
13. The prudential supervisor of life insurance offices in Australia is the Australian
Prudential Regulation Authority (APRA).
14. General insurance offices are contractual savings institutions that provide a promise
to pay the insured up to a predetermined amount in the event that the peril that is
insured against occurs.
15. A motor vehicle third-party policy only covers damage to the vehicle or property of
the policyholder.
16. Hedge fund investments are lower risk because they use leverage rather than equity
to achieve above-market returns.
17. In Australia, building societies and credit unions are authorised deposit-taking
institutions and generally provide personal finance to their members.
18. Export finance corporations assist corporations to import foreign goods from the
international markets at a favourable exchange rate.
EXTENDED LEARNING QUESTIONS

19. Project sponsors are the originators of a project; they establish a project company
into which they inject large amounts of debt, supported by collateral security.
20. Limited recourse lending provides lenders with claims against project sponsors if
project cash flows do not achieve a specified level.

Essay Questions
p. 133

Write short essay-type responses to the following questions. Make sure that you are
able to explain in your own words the points that you raise in relation to each
question.
1. Investment banks were at the very centre of the GFC. With reference to the
activities of investment banks, outline the ways in which investment banks'
involvement in pioneering financial innovations may have contributed to their
prominence during the GFC. (LO 3.1)
2. A number of the advisory services investment banks provide for their corporate
clients are defined as off-balance-sheet business. One service is providing advice to
clients on balance-sheet restructuring. Explain the concept of balance-sheet
restructuring and provide some examples of the areas of advice that an investment
bank might provide in this situation. (LO 3.1)
3. Hostile takeovers rose to prominence during the 1980s and remain a part of the
mergers and acquisitions landscape. Explain the rationale for a hostile takeover and
discuss the roles that investment banks may play in both offence and defence.
(LO 3.1)
4. Typically, an investment bank will act on behalf of a company involved in a merger
and acquisition. What are the main areas to which the investment bank will draw
the client's attention? (LO 3.1)
5. Managed funds are often categorised by the type of investments purchased by the
fund. These include capital guaranteed funds, capital stable funds, balanced growth
funds and managed capital growth funds. For each of these funds, discuss the types
of investments the fund might accumulate and explain the purpose of the investment
strategies. (LO 3.2)
6. Since 1995, there has been significant growth in public unit trusts. With reference to
the structure and operation of public unit trusts, explain some of the reasons why
investors may have been willing to invest a growing amount in these vehicles. (LO
3.3)
7. Identify and discuss three classes of assets in which public unit trusts may invest
funds. Extend your discussion by distinguishing between listed and unlisted trusts.
(LO 3.3)
8. Superannuation savings for retirement is a growth area and represents a significant
proportion of the assets accumulated in the financial system. (LO 3.4)

(a) Why has there been such growth in superannuation savings?


(b) Industry funds are a popular choice among investors. Compare the amount of
assets under management in industry funds with that of competing types of
funds and explore some of the factors that may explain this distribution.
9. One of the functions of a life insurance office is the writing of life insurance
policies for individuals. (LO 3.5)

(a) How does the life office derive income from this function?
(b) Describe the basic characteristics of the two main types of life insurance
policies.
(c) Briefly describe one other type of related insurance policy that an individual
may purchase.
10. The summer of 2010 has been called the summer of natural disasters. Many
households suffered damage to their property as a result of floods and storms and
many households found, to their dismay, that their policies did not cover them for
some types of damage. The clauses that are embedded within insurance policies are
of obvious importance. Outline the consequences that may result from a
combination of under-insuring property while over-looking the presence of a co-
insurance clause. (LO 3.5)
11. You have purchased a motor vehicle and been advised that you should consider
insuring the vehicle. You contact an insurance office and receive advice on three
forms of cover that are available. (LO 3.5)
(a) Explain the three different levels of motor vehicle cover that you can choose
from.
(b) If the vehicle that you purchased is valued at $45 000, which level of
insurance might you decide to take? Why?
12. A friend has suggested that you should consider investing in an equity hedge fund
because the fund may achieve returns higher than the share market. (LO 3.6)

(a) Describe how a hedge fund is structured, including the manager, investors
and types of investment
p. Explain how a hedge fund may use leverage strategies to achieve higher
134 returns. Give an example.

(b)
13. Along with investment banks, hedge funds have figured prominently in the
commentary that has been written on the GFC. With reference to the types of
strategies that hedge funds may use, outline some of the reasons why hedge funds
may have attracted criticism during and after the crisis. (LO 3.7)
14. Credit unions typically have a common bond of association. (LO 3.8)

(a) Define the nature and role of a credit union.


(b) Explain the concept of a common bond of association and provide two
examples of this form of association.

EXTENDED LEARNING QUESTIONS

15. Project finance is largely based on forecast future cash flows:

(a) Draw a diagram showing the flow of funds that occurs in a basic project
finance structure. Referring to your diagram, explain the nature of project
financing, why this type of funding structure is established, the major
participants and the guarantees that the lenders will request from the project
sponsors to support their loans.
(b) A form of project finance is described as structured finance. Identify some of
the factors that have influenced the growth in structured finance. What are the
characteristics of structured finance that tend to differentiate it from other
forms of project finance? (LO 3.10)