ch02

Chapter 2
The Banking Sector
Websites:
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http://www.asic.gov.au
http://www.accc.gov.au
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2003 McGraw-Hill Australia Pty Ltd
Slides prepared by Anthony Stanger
Learning Objectives
Evaluate the functions and activities
of commercial banks
Identify the main sources and uses of
funds and reasons for changes

Analyse the importance of changes in
the role of banks on the financial

system
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Learning Objectives (cont.)

Examine the market structure of the
banking sector
Outline the nature and importance of
banks off-balance-sheet (OBS)

business
Consider the regulation and prudential
supervision of banks
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Chapter Organisation
2.1
2.2
2.3
2.4
2.5
2.6
Introduction
Functions of Banks
Sources of Funds
Uses of Funds
Off-balance-sheet Business
Regulation and Prudential
Supervision
2.7 Summary
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2.1 Introduction
Banking Act 1959 (Cwlth)
Authorises a financial institution to
operate as a bank
Three categories of banks
Incorporated banks: domestic and foreign
Unincorporated foreign bank branches
Foreign bank representative offices
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2.1 Introduction (cont.)

Importance of banks
Largest share of assets of all institutions
Share declined 1950s to mid-1980s due to

regulation which
constrained development of banks

supported evolution and growth in NBFIs
Role in international financial markets

Increase in managed funds activities and
OBS business
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2.1 Introduction (cont.)
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2.1
2.2
2.3
2.4
2.5
2.6
Introduction
Functions of Banks
Sources of Funds
Uses of Funds
Supervision
2.7 Summary
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2.2 Functions of Banks

Asset management (1980s)
Loans portfolio is tailored to match the
available deposit base
Liability management (1980s)
Deposit base and other funding sources

are managed to fund loan demand
Commercial bill market

Provision of other financial services
OBS
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2.1
2.2
2.3
2.4
2.5
2.6
Introduction
Functions of Banks
Sources of Funds
Uses of Funds
Off-balance sheet Business
Supervision
2.7 Summary
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2.3 Sources of Funds

Sources of funds appear in the
balance sheet as either liabilities or

shareholders funds
Banks offer a range of deposit and
investment products with different

mixes of liquidity, return, maturity and
cash flow structure to attract the
savings of surplus entities
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2.3 Sources of Funds (cont.)

Current deposits
Funds held in a cheque account
Highly liquid
May be interest or non-interest bearing
Call or demand deposits
Funds held in savings accounts that can
be withdrawn on demand
e.g. passbook account, electronic
statement account with ATM and EFTPOS
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Term deposits
Funds lodged in an account for a
predetermined period at a specified
interest rate
Term: one month to five years

Loss of liquidity due to fixed maturity
Higher interest rate than current or call
accounts
Generally fixed interest rate
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Negotiable certificates of deposit
(CDs)
Paper issued by a bank in its own name

Issued at a discount to face value
Specifies repayment of the face value of
the CD at maturity
Highly negotiable security
Short term (30 to 180 days)
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Bill acceptance liabilities
Bill of exchange
A security issued into the money market at a

discount to the face value. The face value is
repaid to the holder at maturity
Acceptance
Issuer of bill agrees to pay bank face value of

bill, plus a fee, at maturity date
Acceptance by bank guarantees flow of funds
to its customers without using its own funds
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Debt liabilities
Medium- to longer-term debt instruments
issued by a bank
Debenture
A bond supported by a form of security, being a

charge over the assets of the issuer (e.g.
collateralised floating charge)
Unsecured note
A bond issued with no supporting security
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Foreign currency liabilities
The issue of debt instruments into the
international capital markets that are
denominated in a foreign currency
allows diversification of funding sources into

international markets
facilitates matching of foreign exchange
denominated assets
meet demand of corporate customers for
foreign exchange products
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Loan capital
Sources of funds that have the
characteristic of both debt and equity
(e.g. subordinated debentures and
subordinated notes)
Subordinated means the holder of the security

has a claim on interest payments or the assets
of the issuer, after all other creditors have been
paid (excluding ordinary shareholders)
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2.1
2.2
2.3
2.4
2.5
2.6
Introduction
Functions of Banks
Sources of Funds
Uses of Funds
Supervision
2.7 Summary
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2.4 Uses of Funds

Uses of funds appear in the balance
sheet as assets
The majority of bank assets are loans
which give rise to an entitlement to
future cash flows, i.e. interest and
repayment of principal
Lending to government
Commercial lending
Personal finance
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2.4 Uses of Funds (cont.)

Lending to government
Treasury notes
Treasury bonds
Short-term discount securities issued by the

Commonwealth Government
Medium- to longer-term securities issued by the
commonwealth government that pay a
specified interest coupon stream
State government debt securities

Low risk and low return
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Commercial lending (business sector
and other financial intermediaries)
Fixed-term loan
A loan with negotiated terms and conditions
Period of the loan

Interest rates
Fixed or variable rates set to a specified
reference rate (e.g. BBSW)
Timing of interest payment
Repayment of principal
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Overdraft
Bank bills held
A facility allowing a businesss operating

account into debit up to an agreed limit
Bills of exchange (see slide 15) accepted and
discounted by a bank and held as assets
A rollover facility is where a bank agrees to
discount new bills over a specified period as
existing bills mature
Leasing
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Personal finance
Housing finance
Mortgage
Amortised loan
Investment property
Fixed-term loan
Credit card
Other bank assets (e.g. infrastructure,
shares in controlled entities)

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2.1
2.2
2.3
2.4
2.5
2.6
Introduction
Functions of Banks
Sources of Funds
Uses of Funds
Supervision
2.7 Summary
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2.5 Off-balance-sheet
Business
OBS transactions are a significant part
of a banks business
OBS transactions include
Direct credit substitutes
Trade and performance-related items
Commitments
Market rate-related transactions
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Business (cont.)
Direct credit substitutes
An undertaking by a bank to support the
financial obligations of a client (e.g.
stand-by letter of credit)
The bank acts as guarantor on behalf of a client

for a fee
Client has a financial obligation to a third party
Bank is only required to make a payment if the
client defaults on a payment to a third party
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Business (cont.)
Trade and performance-related items
A form of guarantee provided by a bank to
a third party, promising financial
compensation for non-performance of
commercial contract by a bank client
Examples
Documentary letters of credit

Performance guarantees
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Business (cont.)
Commitments
The contractual financial obligations of a

bank that are yet to be completed or
delivered
Bank undertakes to advance funds or make a

purchase of assets at some time in the future
Examples
Forward purchases
Underwriting
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Business (cont.)
Market rate-related transactions
The use of derivative products to manage
exposures to foreign exchange risk,
interest rate risk, equity price risk and
commodity risk, i.e. hedging
Examples
Futures, options, foreign exchange contracts,

currency swaps, forward rate agreements
(FRAs)
Also used for speculating
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Business (cont.)
Volume of OBS business
At June 2001, the face value of OBS
business undertaken by banks in Australia
was over six times the level of total assets
Over 92% of OBS business is based on
market rate-related transactions
Nature and size of contracts combined with the

volatility and speed of contract repricing has
resulted in extraordinary losses
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2.1
2.2
2.3
2.4
2.5
2.6
Introduction
Functions of Banks
Sources of Funds
Uses of Funds
Supervision
2.7 Summary
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2.6 Regulation and Prudential

Supervision
Objectives of regulation and
prudential supervision
Wallis Report
Capital adequacy requirements
Liquidity management
Other regulatory and supervisory
controls
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Objectives of regulation and

prudential supervision
Reasons for regulation of banks
Importance of the banking sector for
health of the economy
Prudential supervision
Control of the money supply

The imposition and monitoring of
standards designed to ensure the
soundness and stability of the banking
sector
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Wallis Report
Inquiry into the Australian Financial
System with a focus on
the effect of compulsory superannuation and

changing savings patterns on customer needs
technology facilitating easy access to a
greater range of financial products
the need for a change in regulatory
framework motivated by financial market
globalisation and the Campbell Report
findings
the changing financial landscape due to the
evolution of business needs, financial markets
and products
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Wallis Report (cont.)
Post-inquiry Regulatory Structure

Australian Securities and Investments
Commission (ASIC)
Australian Prudential Regulation Authority

(APRA)
New prudent regulator of deposit-taking

institutions (previously RBA)
Australian Competition and Consumer

Commission (ACCC)
Market integrity and consumer protection
Competition policy
RBA
System stability and monetary policy

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(cont.)
Capital Standards
Bank for International Settlements (BIS)
developed international capital adequacy
requirements (1988)
Adopted in all major industrial countries
(including Australia)
Banks required to hold minimum 8%
capital to risk-weighted assets and OBS
items
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Capital adequacy
requirements (cont.)
Capital measured in two tiers
Tier 1: core capital
e.g. ordinary shares, general reserves, retained

earnings
tier 1 capital required to be at least 50% of
banks required capital base
Tier 2: supplementary capital
upper tier 2: e.g. asset revaluation reserves

perpetual subordinated debt
lower tier 2: e.g. term subordinated debt
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(cont.)
Risk Weighting of Balance Sheet
Assets
Asset risk weightings are based on the

counterparty to the transaction
0%
notes and coins, claims against central

governments and central banks
20%
claims against local governments,
domestic banks and
international banks
50%
loans secured by residential mortgages
100%
all other assets and claims against
counterparties
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(cont.)
Application of Asset Risk Weightings
Asset type
Asset value
($billion)
Cash and cwth govt

securities
2 000
Loans to local govt
Housing loans 24 000
Loans to corporations
TOTAL
20 000
47 000
Risk weight
(%)
0
1 000
50
20
12 000
100
Risk-weighted asset
value ($billion)
200
20 000
32 200
Total capital requirement:

8% x $32 200 billion = $2576 billion
Tier 1 capital requirement:
$32 200 x 4% = $1288 billion
To fund these assets, the bank requires $2576 in capital. The remaining $44 424
billion could be raised as liabilities
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(cont.)
OBS Credit Conversion
STEP 1: Convert face value of OBS transactions to on-balance
sheet equivalents
100% Direct credit substitutes, sales and repurchase
agreements
50%
Performance-related contingencies, note issuance
facilities,
underwriting
20%
Trade-related contingencies, including documentary
letters of credit, acceptance of trade bills
0%
Commitments with residual maturity less than
one year
STEP 2: Apply risk-weightings based on counterparty
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(cont.)
OBS Credit Conversion
OBS items
Face value
Credit conversion
of contract ($m)
factor (%)
Credit
equivalent ($m)
Financial guarantees issued

on behalf of corporations
Performance bonds for
state governments
Housing loan approvals
Documentary letters of credit
issued for corporations
700
100
700
500
50
250
100
20
2000
50
2000
250
TOTAL
3450
3000
The asset risk-weightings are then applied to the credit equivalent column (as per the onbalance-sheet items)
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Liquidity management
Liquidity
Access to sufficient funds for a bank to
meet its business operating commitments
APS210-Liquidity
Replaced PAR and LGS

Emphasis on banks own internal liquidity
management practices
APRA reserves the right to specify
minimum level of liquid assets
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Other regulatory and

supervisory controls
Risk management systems
certification
Audit
Disclosure and transparency
Large exposure
Foreign currency exposures
Ownership and control
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2.1
2.2
2.3
2.4
2.5
2.6
Introduction
Functions of Banks
Sources of Funds
Uses of Funds
Supervision
2.7 Summary
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2.7 Summary
Banks are the dominant institution and
have moved to liability management

Sources of funds include deposits
(current, call and term deposits) and
non-deposit sources (bill acceptances,
debt and foreign currency liabilities,
OBS business and other services)
Uses of funds include government,
commercial and personal lending
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2.7 Summary (cont.)

OBS transactions are a major part of a
banks business and include
direct credit substitutes

trade and performance-related items
commitments
market rate-related transactions
APRAs bank prudential supervision
requirements include capital adequacy,

liquidity management and other
controls
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Chapter 2

The Banking Sector

Slides prepared by Anthony Stanger

funds and reasons for changes

the role of banks on the financial

Slides prepared by Anthony Stanger

Learning Objectives (cont.)

banks off-balance-sheet (OBS)

Slides prepared by Anthony Stanger

Slides prepared by Anthony Stanger

Slides prepared by Anthony Stanger

2.1 Introduction (cont.)

Share declined 1950s to mid-1980s due to

constrained development of banks

Role in international financial markets

Slides prepared by Anthony Stanger

2.1 Introduction (cont.)

Slides prepared by Anthony Stanger

Slides prepared by Anthony Stanger

2.2 Functions of Banks

Deposit base and other funding sources

Commercial bill market

Slides prepared by Anthony Stanger

Slides prepared by Anthony Stanger

2.3 Sources of Funds

balance sheet as either liabilities or

investment products with different

Slides prepared by Anthony Stanger

2.3 Sources of Funds (cont.)

Slides prepared by Anthony Stanger

2.3 Sources of Funds (cont.)

Term: one month to five years

Slides prepared by Anthony Stanger

2.3 Sources of Funds (cont.)

Paper issued by a bank in its own name

Slides prepared by Anthony Stanger

2.3 Sources of Funds (cont.)

A security issued into the money market at a

Issuer of bill agrees to pay bank face value of

Slides prepared by Anthony Stanger

2.3 Sources of Funds (cont.)

A bond supported by a form of security, being a

A bond issued with no supporting security

Slides prepared by Anthony Stanger

2.3 Sources of Funds (cont.)

allows diversification of funding sources into

Slides prepared by Anthony Stanger

2.3 Sources of Funds (cont.)

Subordinated means the holder of the security

Slides prepared by Anthony Stanger

Slides prepared by Anthony Stanger

2.4 Uses of Funds

Slides prepared by Anthony Stanger

2.4 Uses of Funds (cont.)

Short-term discount securities issued by the

State government debt securities

Slides prepared by Anthony Stanger

2.4 Uses of Funds (cont.)

and other financial intermediaries)

A loan with negotiated terms and conditions

Period of the loan

Slides prepared by Anthony Stanger