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FINC71-604 Capital Markets

Reading & Assignment 2-1

School of Business TOPIC 2 - TYPES AND FUNCTIONS OF FINANCIAL INTERMEDIARIES Prescribed Reading: Mishkin, F. and S. Eakins, (2009) Financial Markets and Institutions, 6th Edition, Addison Wesley, Reading Massachusetts. Chapter 15, Why do financial institutions exist Viney, Chapters 2 and 3 Assignment: Give fairly brief answers to the questions. No answer should exceed one page. Wellplanned answers are highly desirable, they are evidence of your understanding of a topic and are excellent quick references for revision at a later date. Question 1 What are asymmetric information, moral hazard and adverse selection? Do you think financial intermediaries would exist without these problems? Asymmetric information: one party having insufficient information about the other party involved in a transaction to make accurate decisions.

Adverse selection is an asymmetric information problem that occurs before the transaction occurs. Potential bad borrowers are those who most actively seek out a loan. Thus the borrowers most likely to default on a loan are those most likely to borrow. This increases the probability that a loan will go bad and so deters potential lenders from making loans. Moral Hazard is an asymmetric information problem that occurs after a loan has been made. Such behaviour includes: risk switching, cash in and run, and claim dilution Without these problems the purchase and sale of negotiable debt and equity would be simplified. It would be relatively easy to identify the potential defaulters and not lend to them. In the presence of these problems, financial intermediaries offer mechanisms to overcome the unwillingness of individuals to make loans. By using private information the free rider problem is circumvented. By specialising in the collection and collation of information the asymmetric information problem is reduced, but not removed.

FINC71-604 Capital Markets Question 2

Reading & Assignment 2-2

Describe two ways in which financial intermediaries lower transactions costs. 1) Economies of scale: The transactions cost of individual transactions do not increase markedly as the size of the transaction increases. (This indicates a relatively high proportion of fixed costs.) By investing in large scale technology such as computer delivery systems, large volumes of transactions can be processed at relatively low cost per transaction but at high fixed costs. 2) Expertise: Financial intermediaries provide expertise in managing delivery systems, loan assessments and manage liquidity. These skills are expensive to obtain at an individual level, but the costs of acquisition can be spread across a large number of transactions by a financial intermediary. 3) Lower search costs: by being specialists in financial transactions it is simpler and easier to go to one place to conduct financial transactions. Question 3 What is the market for lemons? How does this relate to the market for loans? The lemons problems is so called because it is based upon the problems confronted when buying a used car. The seller of a used car will know if the car is a lemon, but will not reveal this information in the interests of obtaining the highest possible price for the car. The market price will reflect the average quality of the cars on the market. This will be too low for a peach (good car) and too high for a lemon. The owners of the lemon will be happy to receive the average price, as they know it is too much money for the cars real value. The owners of a peach will not be happy to receive the average price as they know it is too low. Thus peach owners will not sell and the average car quality declines to the point where no-one will buy a used car.

With loans a similar problem occurs in the adverse selection framework. The market interest rate will reflect the average level of defaults. For a someone not willing to repay a loan, they will agree to pay this interest rate because they know that they will not actually repay, they only say that they will repay. For a good credit risk the rate is too high, but they cannot persuade the lenders that they are actually a good risk. As a result the good borrowers are not willing to borrow because they feel they are paying too high an interest rate. The end effect will be a decline in the average quality of potential borrowers to the point where potential lenders cannot make a profit and so do not lend.

FINC71-604 Capital Markets

Reading & Assignment 2-3

Question 4 What is the free rider problem? How do financial intermediaries overcome this problem? In the financial markets, free riders are investors who do not pay for information but are able to observe the investment patterns of those who do have information. The free riders are able to replicate the investment patterns of those who have paid for information and so profit from their information. The increased demand for the investments identified by the purchased information results in an increased price for these securities. If you have purchased information, you do so in the expectation of being able to profit from that information in terms of higher profits. The actions of the free riders reduce those profits to the point where the information is too expensive. Thus investors are not willing to buy information and the lemons problem persists. Financial intermediaries overcome this problem by investing in private information and investing in a manner which makes in hard for individuals to replicate their investment patterns. As a result the information retains its value and the intermediaries can continue to profit from their investment in information. Some recent studies have argued that intermediation is about information flows and important part of a banks value is the franchise value contained in its ownership of information about its clients.

Question 5 Which firms are more likely to use direct finance rather than intermediated finance? Why? Firms which are more likely to use direct finance are those for whom the adverse selection, moral hazard and information asymmetry problems are the smallest. These are typically larger better-known firms. With such firms the scope for correct evaluation of credit risk is greater as there is more publicly available information. This reduces adverse selection. As such large firms are closely monitored, any change in company policy becomes quickly and widely known. This reduces moral hazard. Note: Enron and HIH show that even large firms can still have moral hazard.

FINC71-604 Capital Markets

Reading & Assignment 2-4

Question 6 Viney Chapter 2, Question 1, pg 96 1. You are travelling to work by train when a student seated next to you notices that you work for a bank. She asks you what a bank is, why we have banks and what they do. In your own words, respond to her questions. commercial banks are the dominant group of institutions within the financial system they are financial intermediariesattract savings and investment from surplus entities in the economy, and substitute their credit, and provide funds to deficit entities, this definition together with the addition that banks have access to the payment system used to be enough o distinguish banks from other financial services providers they are also financial services groupsprovide a range of other products and services, for example, financial planning, risk management, off-balance-sheet transactions obtain funds through active liability management use funds by providing loans to customers (individuals, business and government) and investing in securities are an important conduit for economic growth within a country regulated and supervised, for example, APRA in Australia TODAY with the impact of the effects of convergence, banks are mainly distinguished by the fact that they have a banking licence, all other aspects of hteir activities (including access to the payment system) is also a characteristic of non bank financial services providers including credit unions and building societies. Some commercial firms eg Coles also have access to the payments system. The payments system is the place where payments by cheques ATM, EFTPOS, credit card payments and similar are cleared and the appropriate accounts are debited and credited.

Viney Chapter 2, Question 2, pg 196. 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. until early 1980s commercial banks operated in a protected but highly regulated market in order to avoid regulation other non-bank financial institutions emerged and grew strongly, attracting an increasing market share during this period the size of the banking sector diminished government, through the central bank, found their influence on economic activity also diminished as their control of the overall financial system lessened two choicesregulate all financial institutions, or deregulate the banks most developed countries, including Australia, have deregulated the commercial bank sector for example in Australia in the 1980s, controls on interest rates and bank products were removed. The exchange rate was floated. Foreign banks were granted banking authorities

FINC71-604 Capital Markets

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in the new competitive environment the banking sector has grown strongly commercial banks must still meet certain regulatory requirements, such as minimum capital and liquidity requirements, set by the bank supervisor to ensure an efficient, strong and stable financial system

Viney Chapter 2, Question 3, pg 96. 3. Within the context of a commercial bank funding its balance sheet, explain asset management and liability management. Provide an example of how a bank uses liability management when determining the structure of its balance sheet. Traditionally banks receive deposits and make loans on the basis of those deposits. Though these two functions constitute a large proportion of their activities, banks are neither as passive in obtaining funds, nor are they as limited in their activities, as this view suggests. Banks have adapted to manage the structure of their balance sheets, and the extent of their off-balance sheet business, in response to the significant changes that have occurred in the regulation, structure and operation of the financial system. Since deregulation banks now aggressively compete for the funds necessary to support their loan programs and other commitments. Banks have progressively moved from asset management to liability management. Asset management is where banks used to tailor their assets (loan portfolio) to match the available deposit base. Liability management is where the banks manage their liabilities (sources of funds) in order to fund the growth (or decline) in lending commitments arranged for their borrowers and others who have a financial commitment from the bank. Using a liability management approach, banks actively seek new lending business (as witnessed currently in the competition in the housing loan market), but are not constrained by growth in their deposit base. Rather they will enter the money markets and capital markets to purchase liabilities; for example, with the issue of negotiable certificates of deposit in the money market, or the issue of notes into the international capital markets. Providing the bank maintains a high credit rating, generally it will experience no problem in raising purchased funds in both the domestic and international markets. The main constraining factor on balance sheet growth through liability management is the capital adequacy requirements, whereby banks must support risk weighted asset growth with a minimum level of capital. The other issue bought out by the recent sub-prime mortgage crisis is the need for the marketplace to have sufficient liquidity so that as banks need to issue new securities they will be able to do so. Another significant development in the activity of banking which affected the need to generate liabilities to support asset growth was the development of instruments that allowed banks to, in effect, meet some of the funding and other financial requirements of their customers without having to rely on a deposit base. The primary example of this development was the banks very active participation in the bank bill market.

FINC71-604 Capital Markets

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Question 7. Viney, Chapter 2, Question 9. 9. The off-balance-sheet business of banks has expanded significantly and, in notional dollar terms, now represents around six times the value of balancesheet assets. (a) Define what is meant by the off-balance-sheet business of banks. A transaction that is conducted by a bank that is not recorded on the balance sheet. A contingent liability that will only be recorded on the balance sheet if some specified condition or event occurs.

(b) Identify the four main categories of off-balance-sheet business and use an example to explain each of them. Direct credit substitutessupport a clients financial obligations, such as a standby letter of credit or a financial guarantee. Trade- and performance-related itemssupport a clients non-financial obligations, such as a performance guarantee or a documentary letter of credit. Commitmentsa financial commitment of the bank to advance funds or underwrite a debt or equity issue. For example, the unused credit limit on a credit card, or a housing-loan approval where the funds have not yet been used. Foreign exchange, interest rate and other market-rate-related contracts principally derivative products such as futures, forwards, options and swaps used to manage foreign exchange and interest rate risk exposures.

Question 8. Viney Chapter 3, Question 1, pg 140. 1. It is said that the distinction between merchant banks and investment banks has become blurred. Briefly discuss the origins of merchant banking and investment banking. Explain why these two types of institutions have become very similar in their business activities. merchant banks evolved principally from the United Kingdom. Wealthy merchants saw an opportunity to finance the trade of others rather than just being traders themselves investment banks principally originated in the USA and focused mainly on the provision of specialist financial services and products to large corporate and government clients

FINC71-604 Capital Markets

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in a modern competitive environment, these institutions have each moved more into the specialist advice niches of the markets rather than trying to compete directly with the larger commercial banks that provided standard banking products

Question 9. Viney Chapter 3, Question 8 pg 141. 8. Superannuation savings for retirement is a growth area and represents a significant proportion of the assets accumulated in the financial system. (a) Why has there been such growth in superannuation savings? superannuation funds are savings accumulated by an individual to fund retirement many countries are moving into a demographic period of an ageing population individuals are seriously saving in anticipation of nearing retirement from the work force further, some countries have introduced compulsory superannuation regimes, or provide taxation incentives to save for retirement (b) There are four main sources of superannuation savings. Identify and briefly explain the nature of each source. employer-sponsored and industry fundsprovided by an employer, often within an industry group, where the employer contributes a specified amount, usually a percentage of salary, into a superannuation account for each employee. The employee may also contribute a percentage of their salary into the fund. The fund may pay a defined benefit upon retirement or may be an accumulation fund where the employee receives the net balance of contributions plus investment returns, less tax and expenses compulsory superannuation fundsa number of countries have introduced a regime where employers must pay the equivalent of a percentage of an employees salary into a superannuation account on behalf of the employee. The intent is to force individuals to save towards their retirement. Percentage varies significantly between countries private or personal superannuation fundswhere an individual contributes funds into a fund voluntarily in order to accumulate retirement savings rollover fundsenable existing superannuation funds and eligible termination payments invested through one employer fund to be shifted to another fund by the beneficiary and still retain the funds within the superannuation environment

FINC71-604 Capital Markets Viney Chapter 3, Question 9 pg 141.

Reading & Assignment 2-8

9. One of the functions of a life insurance office is the writing of life insurance policies for individuals. (a) How does the life office derive income from this function? a life insurance office derives income from the premiums it charges a policyholder for the insurance policy further, the insurance office invests the premiums received and derives income from those investments

(b) Describe the basic characteristics of the two main types of life insurance policies. a whole-of-life policy is a long-term life insurance policy that incorporates a death benefit and an investment component. The policy will pay the sum insured plus bonuses derived from the investment component. The policy may acquire a surrender value that will be paid if the policy is cancelled a term-life policy pays a specified benefit to a nominated beneficiary upon the death of the insured, if the death occurs during the term of the policy. The policy will be for a nominated period and does not include any surrender value or investment component. The premium on a term-life policy will be less than an equivalent whole-of-life policy

(c) Briefly describe one other type of related insurance policy that an individual may purchase. total and permanent disablement insurancecovers loss of limbs or total inability to resume an occupation trauma insurancepays a lump sum if a specified trauma event occurs, such as an individual having a stroke income protection insurancein the event of an illness or accident where an individual is unable to work, a limited income stream is paid business overheads insuranceif a businesss normal operations are disrupted by an event such as a fire, then certain day-to-day operating expense are paid Viney Chapter 3, Question 14 pg 141. 14. Credit unions typically have a common bond of association. (a) Define the nature and role of a credit union. a credit union is an authorised deposit taking institution (in Australia) accepts deposits from members often through payroll deduction arrangements. May issue securities into the money and capital markets to expand their liability base provides loans to individual members and some small business lending

FINC71-604 Capital Markets

Reading & Assignment 2-9

(b) Explain the concept of a common bond of association and provide two examples of this form of association. common bond of association relates to the fact that members of the society are drawn from a common background or group examples include a work related credit union, a community credit union or a geographic credit union

New Question FINC13-304 Topic 2. What is the difference between a deposit guarantee and deposit insurance? Which one does Australia have? (Since when?) What are the moral hazard concerns with deposit insurance and deposit guarantees? Deposit insurance is where a bank pays a fee (usually expressed as a percent of insured deposits) to a government body or private insurer so that if the bank can no longer honour its obligations the insurer will pay up to an agreed amount to the depositors. A deposit guarantee is where the government announces that it will repay up to an agreed amount to depositors of banks in the event of bank failure. Up until the 28th November 2008 (formal commencement date; announced 12 October 2008), Australia operated on a system of depositor preference. Under depositor preference the depositors have priority in claim over ALL OTHER claimants in the event of bank liquidation. Australia and New Zealand were the only two OECD member nations to not have some form of deposit insurance. The Wallis Report (1997) argued that the small size and highly concentrated nature of Australia banking system meant that the costs and risks of deposit insurance outweighed the benefits in terms of systemic protection. The Davis report (2004) into financial system guarantees tended to support the current state of play as well. A major concern was moral hazard (below). From 28th November Australia adopted system of deposit guarantees for all retail deposits up to a value of $1 million in all banks, subsidiaries of foreign banks, credit unions and building societies, for an initial period of 3 years. There is no fee paid for this guarantee. This arrangement will be reviewed in October 2011 Large wholesale borrowing (over $A 1 million) were subject to deposit insurance, according to the schedule below, irrespective of maturity up to 60 months: Credit Rating AA A BBB and Unrated Debt Issues Up to 60 Months 70bp 100bp 150bp

FINC71-604 Capital Markets

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The wholesale funding guarantee was withdrawn with effect from the 31st March 2010 for all new fund raisings (thus no new debt raisings by Australian banks in the wholesale markets will have government insurance). Existing debts covered by the guarantee will continue to be covered until maturity. Moral Hazard: The main reason for deposit insurance is to reduce the risk of systemic run (simultaneous withdrawal) on the banking system, by instilling confidence that there is a third party with sufficient cash to solve any problem. The main concern with deposit insurance is that is removes any incentive for the depositors to monitor the banks. This means there is no incentive for depositors to ensure that the rate of return reflects the risk of their deposit or that that the banks have adequate liquidity or a prudently managed. Further, it creates a second moral hazard in that the boards of banks know that in extremis the insurer / government will protect the depositor and so increasingly act as if they have an unlimited put option on the value of the banks assets. The outcome in the past has been for the bank board to encourage writing riskier assets by lending officers, to increase returns to shareholders; knowing that depositors will be protected. This effect has been increased in some cases by certain types of management remuneration packages. Another problem that Australia faces is that the Big Four banks can consider themselves Too Big To Fail and as such see no need to be insured (almost certainly true), and the small asset value of regional banks, credit unions and building societies in Australia means that any deposit insurance scheme is poorly diversified, but any scheme including the Big Four will mean subsidy in risk from the Big Four to the smaller players. It is difficult, if not impossible, to create a risk-adjusted deposit insurance pricing scheme that removes both the moral hazard and free rider problems due to information asymmetries.

Extra Questions if time allows: Viney, Chapter 3, Question 2, page 140. 2. A number of the advisory services investment banks provide to 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. the structure of a balance sheet of a corporation is not fixed, but changes over time a corporation must consider the most effective funding of its assets this will change as the asset structure of the business changes; interest rates are forecast to move; the economy or business cycle is expected shift; or the exchange rate changes an investment bank can provide a client of how best this might be achieved for example, a company may be expanding its operations into the USA and expects to generate income in USD. The investment bank may advise the client to obtain funding (loans) in USD in order to match the currencies on both sides of the balance sheet in another example, the investment bank may advise the client on how to raise short-term funds in the money markets as an alternative to using a bank overdraft

FINC71-604 Capital Markets Viney Chapter 3, Question 5, pg 140-141.

Reading & Assignment 2-11

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. capital guaranteed fundsthe amount invested into the fund is guaranteed, that is, the investor will receive at least the amount of the principal placed in the fund, but the expectation is to receive a return as well. Return will be lower because of the secure guarantee provided on the principal amount. Fund will invest in secure assets such as government securities, debentures and bank accepted bills capital stable fundsthe initial principal invested is secured, but not explicitly guaranteed. Investments include government securities, debentures, bank accepted bills and a limited portfolio of property balanced growth fundsseek to deliver longer-term income streams and some capital growth in the value of the assets held. The investment strategies are more aggressive than for a capital stable fund, but generally will hold a very diversified investment portfolio of fixed interest securities, property and equities managed or capital growth fundsstructured to maximise the return from capital growth, that is, an appreciation in the value of the assets held. Less emphasis on income receipts. Higher risk profiles within an investment portfolio, therefore will usually hold a higher percentage of funds in equity investments and a much smaller portfolio of fixed interest investments Viney Chapter 3, Question 12, pg 141 12. A friend has suggested you should consider investing in an equity hedge fund because the fund may achieve returns higher than the share market. (a) Describe how a hedge fund is structured, including the manager, investors and types of investment 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. the hedge fund sector is generally divided into single-manager hedge funds, and fund of funds fund of funds diversify their investments across a number of single-manager funds hedge funds will tend to specialise in equity, foreign exchange, bonds, commodities and derivatives 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

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a hedge fund typically uses so-called sophisticated investment strategies and exotic investment products to try and achieve higher returns on investments and is therefore generally regarded as a higher risk investment a hedge fund may choose to list on a stock exchange, thus providing a secondary market that will allow investors to buy and sell units in the fund an expectation of investors is that hedge funds will achieve positive returns in both an upward and a downward moving market.

(b) Explain how a hedge fund may use leverage strategies to achieve higher returns. Give an example. hedge funds leverage investment opportunities by borrowing large amounts of debt further, a hedge fund may leverage a position by using derivative products such as options, forwards and futures contracts derivatives 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 may buy shares they forecast will rise in price by either using borrowed funds or derivative products the profit potential to the hedge fund is multiplied by the high level of leverage taken, but the level of risk is also much higher

FINC71-604 Capital Markets

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Chapter 2 Commercial banks

Learning objective 1: evaluate the functions and activities of commercial 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.

Learning objective 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 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 3: identify the main uses of funds by commercial banks, including personal and housing lending, commercial 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.

FINC71-604 Capital Markets

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Learning objective 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 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 notional 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 5: examine the principal risk exposures of commercial banks and consider related issues of regulation and prudential supervision One of the main influences of change in the banking sector has been the regulatory environment within which banks operate. 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. 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. Banks are required to maintain a minimum risk-based capital ratio of 8.00 per cent. Capital is categorised as either Tier 1 capital, Upper Tier 2 capital or Lower Tier 2 capital. At least half of a banks 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. o 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

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to use its own risk management models. o 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. o Pillar 3 seeks to achieve a market discipline impact 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. The bank regulator also applies a number of other 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.

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Chapter 3 Non-bank financial institutions

Learning objective 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 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. 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, 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 2: explain the structure, roles and operation of managed 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, managed or capital growth funds.

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Learning objective 3: discuss the purpose and operation of cash management 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 4: describe the nature and roles of superannuation funds, 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 employees 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 5: define life insurance offices and general insurance offices and explain the main types of insurance policies offered 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. 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.

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Reading & Assignment 2-18

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 6: discuss hedge funds, including their structure, investors, 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; 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 7: explain the principal functions of finance companies 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 8: outline the roles and relative importance of building 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 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.