About the subject

Welcome to Commercial Bank Management

In this subject you will need to read the text book, read lecture slides
Introduction to Commercial and complete tutorial homework questions prior to attending tutorials.
The case studies and the final exam will be drawn from:
Bank Management Lectures, text book and tutorials
Assessment format: 2 case studies (50%), final exam (50%)
The subject draws on knowledge you have learnt in prerequisite
subjects in Finance and Accounting

Commercial Bank Management LECTURE 1 LECTURE 1

Assumed knowledge What do Banks do?

TFS: Banks, the Payments System, Regulation, Borrow money from individuals and firms
At a low rate for short periods of time
plus Options, Futures, Swaps, Foreign exchange
TFS and FBF: Bond valuation, Time Value of Money, Lend money to individuals and firms
At a high rate for long periods of time
Share valuation, dividend models, NPV and IRR
Accounting: Balance Sheets, Assets and Liabilities, P&L , Revenue
and Expenditure The definition of a bank is varied but the main one is that it accepts
deposits from the public and facilitates lending activities
Due to the importance of banks in the economy they are heavily
regulated
LECTURE 1 Commercial Bank Management LECTURE 1
To learn about the major operations of banks
we need to look at their balance sheet Banks
Assets Liabilities Banks tend to be the largest and oldest financial organisations in an
Cash Balance due to banks
economy
Balance due to Central Bank
Due from banks
Customer deposits Many banks have expanded vigorously
Balance held with Central bank
Certificates of deposit
Government Investments Long term debt/ Bonds
Main function of a bank is taking deposits and lending money
Loans and Advances Derivative instruments In making credit available, banks are rendering a great social service
Derivative instruments Other borrowings Key issues about banking is that it is a public trust
Investments Equity
Share capital
Fixed Assets
Reserves
Other assets Retained earnings

Commercial Bank Management LECTURE 1 Commercial Bank Management LECTURE 1

Why is TRUST so important? Why are banks regulated?

A friend asks you to lend them some money for a period of time
Control the money supply and growth of the economy
This is risky
They may not pay you back Promote public confidence in the financial system
Facilitate the orderly payment for goods and services
But borrowing money from individuals is what banks do every day Provide government with tax revenues and other services
So why do we lend banks our money?

TRUST

Commercial Bank Management LECTURE 1 Commercial Bank Management LECTURE 1

Who regulates banks? Changes reshaping banking
The Council of Financial Regulators (CFR) is the coordinating body for Since the Global Financial Crisis (GFC) many changes have occurred
Australia's main financial regulatory agencies. It is a non-statutory body
whose role is to contribute to the efficiency and effectiveness of financial Governments concerned with risks banks have taken
regulation and to promote stability of the Australian financial system.
Regulators trying to reduce bank risk taking
CFR members include:
Reserve Bank of Australia (RBA) Impact of globalisation
Australian Prudential Regulation Authority (APRA) Banks are the major source of loans to:
Australian Securities and Investments Commission (ASIC) Individuals and companies
Australian Treasury Governments
Australian banks are also subject to regulation relating to competition,
privacy and some international regulations

Commercial Bank Management LECTURE 1 Commercial Bank Management LECTURE 1

The Global Financial Crisis 2007-09 Global Financial Crisis

Started in the middle of 2007 Major issue of the GFC is some financial products had become so
World stock markets fallen, complex and twisted,
Large financial institutions collapsed difficult to unravel
Governments implemented rescue packages to bail out their financial Trust in the whole system began to fail
systems (US and UK)
Collapse of US sub-prime mortgage market
End of the housing boom had a ripple effect around the world
Other weaknesses in global financial system surfaced

Commercial Bank Management LECTURE 1 Commercial Bank Management LECTURE 1

 What happens if a bank fails?
to survive in a global market?
What do banks need to understand today
Banks must-
Manage their assets and liabilities
Need to plan and forecast
Have adequate controls and procedures
The key areas
Money, securities, and capital markets
Regulations current and proposed
International events

Commercial Bank Management LECTURE 1 Commercial Bank Management LECTURE 1

Major risks in banking Credit risk

There are many risks in banking the major one are: Borrower may not repay on a timely basis or amount borrowed
Credit and Default Results in variation to profit and market value
Interest rate
Liquidity Changes in economic conditions and employment affect borrowers
Market risk ability to repay
Foreign exchange Difficult to predict but banks use credit analysis to determine borrower's capacity
Operating (Fraud & Fiduciary Risk) to repay
Capital Having a portfolio of loans helps but does not remove all problems
Off-Balance Sheet risk
Country risk

Commercial Bank Management LECTURE 1 Commercial Bank Management LECTURE 1

Interest rate risk Liquidity risk
Risk of the maturities (or interest reset dates) of assets and liabilities Risk that a sudden or unexpected surge in withdrawal of depositors
are mismatched funds may require a bank to sell assets in a short space of time at less
Difference between lending and borrowing rates than a fair value
Sensitivity of interest income to changes in asset yields plus interest Change in net income and market value caused by difficulty in
costs of liabilities obtaining cash at reasonable cost
How much will net interest income vary with movements in rates Liquidity can be obtained by:
Sale of assets or new borrowings
Increased sensitivity to changes in rates
Lower net interest income Greatest risk is when bank cannot anticipate new loan demand or
withdrawal of deposits

Commercial Bank Management LECTURE 1 Commercial Bank Management LECTURE 1

Foreign exchange risk Operational risk

Risk that the exchange rate changes can effect the value of the banks Risk that existing procedures, may break down or malfunction
assets and liabilities in foreign currencies Leads to earnings variability,
Examples: losses due to employee or customer theft
Extent the bank has mismatched the financing of foreign currency
loans Operating expenses -increase significantly
Changes in the returns on foreign investments Fraud & Fiduciary Risk
Changes in foreign exchange rates will affect return on loans or investments
denominated in other currencies Number of divisions or subsidiaries
Convertibility of foreign currency Number of employees
Use of technology

Commercial Bank Management LECTURE 1 Commercial Bank Management LECTURE 1

Capital or solvency risk
Risk that the bank may not have enough capital (Equity) to offset a
sudden decline in the value of its assets (loss)
Worse case -market value of equity is negative
High credit risk bank has significant loan losses
High interest rate risk due to mismatched reset dates of assets and
liabilities
High operating risk banks costs are out of control
High risk banks are expected to have greater capital than low risk
Off-balance sheet risk
Risk of banks activities in providing guarantees or other services that
This activity has expanded rapidly for international active banks
By definition off-balance sheet, the risk does not appear on a banks
balance sheet
This activity generates fee income without the bank having to finance
assets
Trade letters of credit are one example

Commercial Bank Management LECTURE 1 Commercial Bank Management LECTURE 1

Off-balance sheet activities Country risk

Country risk is the possibility that future returns from international
of the contract activities may be impaired by economic or political events surrounding a
foreign country
ie pay Potential loss on international loans due to a borrower refusing to
money on behalf of client make payments
Many examples; Greece is just one example
Standby letters of credit
Varies from country to country and can change rapidly
obligation
Bank accepted bills

Commercial Bank Management LECTURE 1 Commercial Bank Management LECTURE 1

Operational risk in banking includes which Which of the following is NOT one of the
of the following? objectives of bank regulation?
a) Failure of bank's computer system a) Maintain confidence in and the viability of the financial system
b) Closure of a bank for three months due to fire from a electrical fault b) Produce monetary and economic stability in the economy
c) Embezzlement of funds of a bank by a teller of that bank c) Create an efficient and competitive financial system for the benefit of the
d) Closure of a bank for two weeks due to a wall collapsing from a lightning strike economy
e) All of the above are examples of operational risk d) Protect the public from bank management taking excessive risks/abuses
e) Maximise bank profitability
The answer is? e)
The answer is? e)

Commercial Bank Management LECTURE 1 Commercial Bank Management LECTURE 1

Assumed Knowledge - Valuation of a Bill

Practice Question of Exchange
Why does a bank take security for a loan? What amount of funds will the drawer of a bill receive today if the bill is
To sell the security and repay the loan if the borrower defaults for 180 days and a $100,000 face value. The market rate is 8% pa.
What is the normal form of security for a home loan to a individual? Solution
Normally it is the home or unit that loan has been granted for i.e. a mortgage
PV = FV / (1 + rt)
Why take security?
The security taken is of a higher value than loan amount to ensure the bank will PV = 100,000 / (1 + 0.08 * 180/365)
get its money back
= $96,204.53
What happens to the value and risk of a bank if there is a great fall in Price of security increases as term to maturity shortens
the property market?
Bank value may fall if the risk exposure of the bank increases

Commercial Bank Management LECTURE 1 Commercial Bank Management LECTURE 1

Assumed Knowledge - Bond Valuation Bond Valuation Solution
What is the price of a bond that was issued two years ago and has Number of payments per year = 2
eight years to maturity? Coupon PMT = 200,000 * 5% / 2 = 5,000
Coupons are paid half-yearly and a coupon payment was made today. Years to maturity = 8
The coupon rate is 5% pa and the current market yield is 6% pa. number of compounding periods = 8 x 2 = 16

The face value is $200,000 Market yield? = 6%/2 = 3%

1 (1 i) n FV= 200000; PMT= 5000; i=3; n=16

n
PV PMT FV (1 i) 16
i 1 (1 0.03) 16
PV 5000 200000(1 0.03)
0.03
187,438.90
Commercial Bank Management LECTURE 1 Commercial Bank Management LECTURE 1