FINS1612

CAPITAL MARKETS AND

INSTITUTIONS

Lecture 2
Commercial Banks
REVISION
Learning Objectives

 Evaluate the functions and activities of commercial banks

 Identify the main sources and uses of funds for commercial
banks
 Outline the nature and importance of banks’ off-balance-sheet
business
 Examine the main risk exposures and consider related issues of
regulation and prudential supervision of banks
Chapter Organisation

2.1 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
2.6 Background to Capital Adequacy Standards
2.7 Basel II Capital Accord
2.8 Liquidity Management and Other Supervisory Controls
2.9 Summary

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Authorised Deposit-taking Institutions (ADIs)

 In Australia, financial institutions that are approved to carry out

financial intermediation are authorised by the Australian
Prudential Regulation Authority (APRA), and labelled authorised
depository institutions (ADIs)

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2.1 Main Activities of Commercial Banking

 Importance of banks
– High level of regulation prior to the mid-1980s constrained their
development and led to growth of non-bank financial institutions
– Largest share of assets of all institutions, but understated without
considering off-balance-sheet transactions, managed funds,
superannuation and subsidiary finance, insurance and companies

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2.1 Main Activities of Commercial Banking (cont.)

 Asset management (−1980s)

– Loan portfolio is tailored to match the available deposit base
– Highly regulated environment
 Liability management (1980s−)
– Less regulated environment
– Deposit base and other funding sources are managed to fund
loan demand
• Borrow directly from domestic and international capital market
• Provision of other financial services
• Off-balance-sheet (OBS) business

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Chapter Organisation

2.1 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
2.6 Background to Capital Adequacy Standards
2.7 Basel II Capital Accord
2.8 Liquidity Management and Other Supervisory
Controls
2.9 Summary

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2.2 Sources of Funds

 Sources of funds appear in the balance sheet as either liability

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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2.2 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
 Stable funding

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2.2 Sources of Funds (cont.)

 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
 History shows us that in times of volatility in the financial marekts,
especially the stock markets, investors tend to revert to the safe
haven of the bank term deposit

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2.2 Sources of Funds (cont.)

 Negotiable certificates of deposit (CDs)

 Short term discount security
– 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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2.2 Sources of Funds (cont.)

 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
 The business that issues the bill will sell the bill to an investor
with bank’s guarantee to increase the creditworthiness of the bill.
The bank charges a fee for this service – acceptor

 The bank may agree to buy the bill from the drawer. The bank is
most likely to immediately sell the bill into the money market. The
bank has also been able to arrange finance for its business
customer without having to use its own funds - discounter

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2.2 Sources of Funds (cont.)

 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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2.2 Sources of Funds (cont.)

 Foreign currency liabilities

– Debt instruments issued 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
• Meets demand of corporate customers for foreign exchange products
 Euromarkets : debt markets where instruments are issued into
another country but not denominated in the currency of that
country.

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2.2 Sources of Funds (cont.)

 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)
 Shareholder’s Equity
– Ordinary shares
– Retained funds – additional shareholders’ funds

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Chapter Organisation

2.1 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
2.6 Background to Capital Adequacy Standards
2.7 Basel II Capital Accord
2.8 Liquidity Management and Other Supervisory
Controls
2.9 Summary

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2.3 Uses of Funds

 Uses of funds appear in the balance sheet as asset

 The majority of bank assets are loans that give rise to an
entitlement to future cash flows, i.e. interest and repayment of
principal
– Personal and housing finance
– Commercial lending
– Lending to government

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2.3 Uses of Funds (cont.)

 Personal and housing finance

– Housing finance
• Mortgage
• Amortised loan (Principal + Interest payment)
– Investment property
– Fixed-term loan
– Credit card

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2.3 Uses of Funds (cont.)

 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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2.3 Uses of Funds (cont.)

 Commercial lending (business sector and other financial

intermediaries) (cont.)
– Overdraft
• A facility allowing a business to take its operating account into debit up
to an agreed limit
– Bank bills held
• Bills of exchange 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
• Lease payments

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2.3 Uses of Funds (cont.)

 Lending to government
– Treasury notes
• Short-term discount securities issued by the Commonwealth
Government
– Treasury bonds
• 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
 Other bank assets (e.g. electronic network infrastructure and
shares in controlled entities)

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Chapter Organisation

2.1 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
2.6 Background to Capital Adequacy Standards
2.7 Basel II Capital Accord
2.8 Liquidity Management and Other Supervisory Controls
2.9 Summary

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2.4 Off-balance-sheet Business

 OBS transactions are a significant part of a bank’s business

 OBS transactions include

– Direct credit substitutes
– Trade and performance-related items
– Commitments
– Foreign exchange, interest rate- and other market rate-related
contracts

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2.4 Off-balance-sheet 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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2.4 Off-balance-sheet 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 contractual
obligations.
• Documentary letters of credit
• Performance guarantees

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2.4 Off-balance-sheet 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, e.g.
– Forward purchases
– Underwriting
– Loans
– creditcard

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2.4 Off-balance-sheet Business (cont.)

 Foreign exchange, interest rate- and other market rate-related

contracts
– The use of derivative products to manage exposures to foreign
exchange risk, interest rate risk, equity price risk and commodity
risk (i.e. hedging), e.g.
• Futures, options, foreign exchange contracts, currency swaps, forward
rate agreements (FRAs)
– Also used for speculating

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2.4 Off-balance-sheet Business (cont.)

 To the extent that these OBS activities involve risk-taking and

positions in derivative securities, OBS activities raise some
concerns about bank regulation
 The notional value of such activities is more than 5 times the total
value of assets held by the banks
 A significant OBS business is based on market rate-related
transactions

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Chapter Organisation

2.1 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
2.6 Background to Capital Adequacy Standards
2.7 Basel II Capital Accord
2.8 Liquidity Management and Other Supervisory Controls
2.9 Summary

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Regulation and Prudential supervision

 The GFC has focussed attention on the regulation of the financial

system
 A number of financial institutions collapsed during the crisis
 The five largest U.S. investment banks, with combined liabilities
or debts of $4 trillion, either went bankrupt (Lehman Brothers),
were taken over by other companies (Bear Stearns and Merrill
Lynch), or were bailed-out by the U.S. government (Goldman
Sachs and Morgan Stanley) during 2008
 The amount of leverage on the balance sheets of these
institutions was a primary factor contributing to their weakness
 Debate concerning bank regulation and prudential supervision
has concentrated on how regulators can maintain a stable
financial system
2.5 Regulation and Prudential Supervision

 Reasons for regulation of banks

– Importance of the banking sector for health of the economy

 Prudential supervision
– The imposition and monitoring of standards designed to ensure
the soundness and stability of a financial system

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 2.5 Regulation and Prudential Supervision (cont.)

 Australian regulatory structure

– Reserve Bank of Australia (RBA)
• System stability and payment system
– Australian Prudential Regulation Authority (APRA)
• Prudential regulation and supervision of depository institutions,
insurance offices and superannuation funds
– Australian Securities and Investments Commission (ASIC)
• Market integrity and Investor protection
– Australian Competition and Consumer Commission (ACCC)
• Competition policy

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Chapter Organisation

2.1 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
2.6 Background to Capital Adequacy Standards
2.7 Basel II Capital Accord
2.8 Liquidity Management and Other Supervisory Controls
2.9 Summary

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Background to Capital Adequacy Standards

 The business activities of financial institutions will inevitably

involve the need to write-off of abnormal business losses
 The capital held by financial institutions serves as the ‘buffer’
against such losses
 If capital is inadequate, a financial institution may face
insolvency. This has significant implications for the stability of the
financial system
 The capital adequacy standards set down in Basel II and III
define the minimum capital adequacy for a bank
 The standards are designed to promote stability within the
financial system
2.6 Background to Capital Adequacy Standards

 Functions of capital
– The source of equity funds for a corporation
– Provides equity funding for growth
– Demonstrates shareholder’s commitment to the organisation
– Write-off periodic loan losses of defaulting borrowers that exceed
profits
 The evolution of the international financial system led to
development of international capital adequacy standards
– 1988 Basel I capital accord and Basel II (2008) capital adequacy
guidelines
– Basel III (2010)

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Basel 1

 Globalisation of banking system i.e. Bank Capital adequacy

needed?
 The committee (G10) worked on the adequacy of banks’ capital
and on the development of a common minimum standard of
capital adequacy that international bank should maintain – “The
international Convergence of Capital measurement and Capital
Standards”
 Basel 1 capital accord applied a standardised approach to the
measurement of the capital adequacy of banks
Tier 1 capital

 Tier 1 capital or core capital, consists of the highest quality

capital elements which fully satisfy all the essential capital
characteristics:
– Provide a permanent and unrestricted commitment of funds
– Freely available to absorb losses
– Do not impose any unavoidable servicing charge against earnings
– 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
Tier 2

 Tier 2 or supplementary, capital includes other elements which,

to varying degrees, fall short of the quality of Tier 1 capital. Tier 2
capital is divided into two parts
 Upper Tier 2 capital, which consists of elements that are
essentially permanent in nature, including some hybrid capital
instruments
 Lower Tier 2 capital, which consists of instruments that are non
permanent –that is, dated or limited-life instruments
Definition of capital

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Chapter Organisation

2.1 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
2.6 Background to Capital Adequacy Standards
2.7 Basel II Capital Accord
2.8 Liquidity Management and Other Supervisory Controls
2.9 Summary

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Basel II structural framework

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2.7 Basel II Capital Accord
 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
 Basel II extends Basel I to increase sensitivity to different levels
of asset and OBS business risk
 Main elements of Basel II
– Credit risk of bank’s assets and OBS business
– Market risks of bank’s trading activities
– Operational risks of bank’s business operations
– Form and quality of capital held to support these exposures
– Risk identification, measurement and management processes
adopted
– Transparency through accumulation and reporting of information
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Capital adequacy standard

 Minimum capital adequacy requirement applies to commercial

banks and other institutions specified by prudential regulator
 Capital adequacy standard
– Minimum risk-based capital ratio of 8%
• Minimum 4% held as Tier 1 capital
– Highest quality core capital
• Remainder can be held as Tier 2 (supplementary) capital
– Upper – specified permanent hybrid instruments
– Lower – specified non-permanent instruments

– Regulator can require an institution to hold a capital ratio above

8%

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Basel II structural framework (cont.)
 Pillar 1—Capital adequacy

– Credit risk—risk that borrower will not meet commitments when

due. Three measures:
• Standardised approach

i. Risk weights applied to balance-sheet and OBS items to calculate

minimum capital requirement

ii. Risk weights derived from external rating grade or supervisor (see
www.apra.gov.au APS112)

iii. For residential housing loans, risk weight relates to loan-to-valuation ratio
(LTVR) and level of mortgage insurance

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Basel II structural framework (cont.)
 Pillar 1—Capital adequacy (cont.)

– Credit risk (cont.)

– OBS items converted to balance-sheet equivalents by determining
the credit conversion factor and multiplying by the applicable risk
weighting

• Non-market-related OBS transactions, e.g. documentary letter of credit

• Market-related OBS transactions—credit conversion factor can be

determined by:
 current exposure method—current and potential credit exposures mark-to-
market (contract revalued by its current quoted price)
 original exposure method—notional contract value multiplied by a credit
conversion factor

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Capital adequacy requirements (cont.)
 Standardised approach -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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Capital adequacy requirements (cont.)

 Application of Asset Risk Weightings

Asset type Asset value Risk weight Risk-weighted asset
($billion) (%) value ($billion)

Cash and cwth govt

securities 2 000 0 0
Loans to local govt 1 000 20 200
Housing loans 24 000 50 12 000
Loans to corporations 20 000 100 20 000
TOTAL 47 000 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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 Capital adequacy requirements (cont.)
 OBS Credit Conversion
OBS items Face value Credit conversion Credit
of contract ($m) factor (%) Equivalent ($m)

Financial guarantees issued 700 100 700

on behalf of corporations
Performance bonds for 500 50 250
state governments
Housing loan approvals 2000 100 2000
Documentary letters of credit 250 20 50
issued for corporations
TOTAL 3450 3000

The asset risk-weightings are then applied to the credit equivalent column (as per the on-
balance-sheet items)

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Operational risk

 Operational risk is defined as risk of loss from inadequate or

failed internal processes, people and systems or from external
events
– Internal and external fraud
– Employment practices and workplace safety
– Damage to physical assets
– Business disruption and system failure
– etc
Market Risk

 Market risk is split into two components

– General market risk
• Changes in the overall market for interest rates, equities, foreign
exchange and commodities
– Specific market risk
• The risk that the value of a security will change due to issuer specific
factors e.g. creditworthiness of the issuer
 A measurement for market risk – value at risk models
– VaR – a statistical probability model that measures financial risk
exposures.
Basel II structural framework (cont.)
 Pillar 2—Supervisory review of capital adequacy

– Intended to ensure banks have sufficient capital to support all

risks and encourage improved risk-management policies and
practices in identifying, measuring and managing risk exposures
such as:

• risks incompletely/not captured in Pillar 1 and factors external to the

bank, like a changing business cycle

• additional risk management practices such as education/ training;

internal responsibilities, delegation and exposure limits; increased
provisions and reserves; and improved internal controls and reporting
practices

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Basel II structural framework (cont.)
 Four key principles of supervisory review
 Principle 1 : 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
 Principle 2: 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
 Principle 3: 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
 Principle 4: 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.
Basel II structural framework (cont.)
 Pillar 3—Market discipline

– Aim is to develop discloure requirements that allow the market to

assess information on the capital adequacy of an institution, i.e.
increase the transparency of an institution’s risk exposure, risk
management and capital adequacy

• Prudential supervisors to determine minimum disclosure requirements

and frequency

• Basel II recommends a range of qualitative and quantitative

information disclosure relating to principal parts of Pillars I and II

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Basel 3

 Basel III was developed in 2010.

 aims to enhance the risk coverage of the Basel II framework by
enhancing capital adequacy requirements
Basel II structural framework

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Chapter Organisation

2.1 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
2.6 Background to Capital Adequacy Standards
2.7 Basel II Capital Accord
2.8 Liquidity Management and Other Supervisory Controls
2.9 Summary

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 2.8 Liquidity Management and Other Supervisory
Controls
 Liquidity risk— unable to access funds to meet day-to-day
expenses and commitments
– Banks have special liquidity problems due to:
• Mismatch in maturity structure of balance sheet assets and liabilities
and associated cash flows
• Role of banks in the payments system
– Liquidity prudential standard APS210
• The board of directors and management must implement a liquidity
management strategy, which is reviewed annually
• Must immediately advise APRA of any liquidity concerns
• Strategy must include a contingency plan
• Emphasis on bank’s internal liquidity management practices
• APRA reserves right to specify minimum level of liquid assets

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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 plan for dealing with a potential liquidity
crisis
 2.9 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
 OBS transactions are a major part of a bank’s business and include
– direct credit substitutes
– trade and performance-related items
– commitments
– market rate-related transactions
 APRA’s bank prudential supervision requirements include capital
adequacy, liquidity management and other controls
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