Chapter 2 Commercial Banks

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Chapter 2- Commercial Banks
Main activities of a Commercial Bank Commercial bank products and services include balance sheet items and non -balance sheet items (contingent liabilities- depending on the context). Asset management: It is practised in a highly regulated environment. The banks restricted their loan activity (assets) to match the available amount of deposits they received from customers. Liability management: It is practised in a less regulated environment. Banks manage their liabilities (sources of funds) and raise funds in the capital market to make sure they have sufficient funds to meet future loan demands Sources of Funds This refers to where banks get their funds from. There are current, call, term, negotiable certificates of deposit (CDs), bills acceptance, debt, foreign currency liabilities and loan capital/SE. Current Account/call deposits (short-term and liquid sources) Liquid funds that are held in a cheque account facility and can be used directly in the payment of goods and services. This is a stable source of funds as individuals and businesses are continually conducting transactions for goods and services and are not likely to switch to other banks.Call deposits- funds are available in demand and this is usually known as the saving accounts. Term deposits Funds lodged in an account with a bank for a specified period of time, with a fixed interest rate (higher than current account) to compensate the loss of liquidity. Negotiable certificates of deposits (liquid) It is a short term discount security issued by a bank to an investor and the bank will repay the face value of the security at maturity. It is a negotiable security as the original purchaser of a CD may sell it in the secondary market to other party, at anytime up to the maturity date. Bill acceptable liabilities The bank may act as acceptor to the bill or discount the bill. A bill s a discount security; sold at a price that is less than the face value. o The issuer of the bill may ask a bank to put its name on the bill (as guarantee) to increase the creditworthiness of the bill in exchange for a fee. It is recorded as liabilities as the bank has the responsibility to pay the $$ to the third party if the issuer of the bill couldn t pay. Alternatively, the bank can buy the bill and sell it to the market to earn revenue from interest differences.
Bank put name

Company A

Sell to Market

Banks buy the bill to earn interest differences

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

loans approved but not yet drawn and credit card limit approvals that have not been used by card holders. interest rate contract and other market rate related contracts They involve the use of derivative products (e.g. underwriting facilities. The bank does not provide the finance from its own balance sheet but only effectively ensures that the client is able to raise funds direct from the market by giving the third party its guarantee. This includes outright forward purchase agreements. Loan losses are write off against capital and not liabilities. facilitates the matching of foreign exchange denominated assets Loan capital It is also known as hybrid capital. o The bank will have to make payment if the bank s client fails to meet its financial obligation to the party. Capital is important as it is the source of equity and enables growth in a business and is a source of future profits Basel I capital accord It applied the standardise approach and was successful in increasing the amount of capital held by banks and created a strong foundation to support the stability of the global financial system. market risk. Examples include guarantees. Off-balance-sheet business Direct credit substitutes It is provided to support a client s financial obligation. (focused more on credit risk) Basel II capital accord. indemnities and letters of comfort issued by a bank that have the effect of guaranteeing the financial obligations of a client. documentary letters of credit: the bank authorise payment to a third party against delivery and payments are made between the banks. options. o Performance guarantee: the bank agrees to provide financial compensation to a third party if a client does not complete the terms and conditions of a contract Commitments It refers to the contractual financial obligations of a bank that are yet to be completed or delivered. For example.3 Pillars It extends Basel I further in which the new capital accord is much more sensitive to different level of assets and OBS business risks that may exist such as credit risk. Instruments are subordinated which means that the holder of the security will only be paid interest payments or have the principal repaid after the entitlements of all other creditors have been paid. It also allows diversification of funding resources. repurchase agreements. swaps and forward contracts) which are designed to facilitate hedging against risk Background to capital adequacy standards The main assets accumulated by banks are its loans to customers and there is a possibility that borrowers default in their loan payments. Trade and performance related items This is also guarantees made by a bank on behalf of its clients but they are made to support a client s non-financial contractual obligations. operational risk and the .Chapter 2 Commercial Banks 2 Foreign currency liabilities Large international markets are an important source of foreign currency liabilities as banks find it easier to raise substantial amounts of debt in international capital markets at a lower price. futures. Foreign exchange contract.

It is also defined as a risk of loss from an inadequate or failed internal processes. " !     ¥     ¤¢¡££ ¢¡   3 §¤      ¢  . Pill 3 Market Dis ipline o Aim to develop a set of disclose requirements that allow market participants to assess important information relating to the capital adequacy of an institutions. damaged to physical assets.Ch pt 2 Co i lB n s form/quality of capital held. The bank must maintain a minimum risk-based capital ratio of 8%. Market risk can be divided into general market risk (changes in overall market for interest rates etc and specific market risk. delegations and e posure limits. o Market risk refers to risk of losses resulting from movements in market prices. The other objective is to make parent in order banks risk e posure. business disruption and system failures. Basel II also applies a range of risk weightings that is based on an e ternal rating published by an agent or prudential supervisor o Operational risk arises from day-to-day business activities such as internal/e ternal fraud. o It encourages additional good risk management practice such as applying internal responsibilities. 4% must be Tier 1 Capital (core and the other 4% is Tier 2 (supplementary upper and lower Tier 2. measuring and managing risk e posures. risk management and capital adequacy positions more trans to reinforce the regulatory process. increasing provision/reserves and strengthening internal control and reporting procedures. people and systems. A measurement for market risk is VAR (value at risk model)     ¨ © ¡ Pill 2 Sup iso Review o It ensures that banks have sufficient capital to support all the risk e posures and encourage banks to develop and use improved risk management policies/practices in indentifying. ¦ ¦ Pill 1 C pit l Ad qu o Credit risk refers to the risk that borrower will not meet their commitments on loan repayments when due.

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