Banks

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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

• Understand the background and application of the capital adequacy

standards

• Examine liquidity management and other controls applied by APRA

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Simply

• What do banks do and how do they do it?

• Regulators: why do we need them? And how do they regulate banks?

• What is capital adequacy and why is it matters? Basel 1, 2, & 3

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Commercial banks

Overview:

• Commercial banks provide a full range of financial services

Pre 1980’s - Asset management

• Loans portfolio is tailored to match the available deposit base

Post 1980’s - Liability management

• Deposit base and other funding sources are managed to meet
loan demand
• Borrow directly from domestic and international capital
markets

• Provision of other financial services

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• Off-balance-sheet (OBS) business
Commercial banks

Importance of banks

• A major “financial intermediation” which provides the following

benefits to the financial system:

• Asset transformation

• Maturity transformation

• Credit risk diversification & transformation

• Liquidity transformation

• Economies of scale

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Banks – Balance Sheet
ASSET
Personal and housing finance
Commercial lending
Lending to Government
Other bank assets
LIABILITIES
Current account deposit
Call deposit
Term Deposit
Certificates of deposit
Bill acceptance liabilities
Debt liabilities
Foreign currency liabilities
EQUITIES
Loan capital (hybrid securities) and
shareholders’ equity
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Commercial banks – 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

• Current account 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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Commercial banks – Sources of funds

• 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 owing to fixed maturity
• Higher interest rate than current or call accounts
• Generally fixed interest rate
• 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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Commercial banks – Sources of funds

• 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
• Bank accepts primary liability to repay face value of bill to
holder
• 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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Commercial banks – Sources of funds

• 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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Commercial banks – Sources of funds

• 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

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Commercial banks – Sources of funds

• Loan capital and shareholders’ equity

• Sources of funds that have characteristics 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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Banks – Balance Sheet
ASSET
Personal and housing finance
Commercial lending
Lending to Government
Other bank assets
LIABILITIES
Current account deposit
Call deposit
Term Deposit
Certificates of deposit
Bill acceptance liabilities
Debt liabilities
Foreign currency liabilities
EQUITIES
Loan capital (hybrid securities) and
shareholders’ equity
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Commercial banks – Uses of funds

• Uses of funds appear in the balance sheet as assets

• 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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Commercial banks – Uses of funds

• Personal and housing finance

• Housing finance
• Mortgage
• Amortised loan
• Investment property
• Fixed-term loan
• Credit card

• Commercial lending
• Involves bank assets invested in the business sector and lending
to other financial institutions

• 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 payments
• Repayment of principal 15
Commercial banks – Uses of funds
• Commercial lending (cont.)
• Overdraft
• A facility allowing a business to take its operating account
into debit up to an agreed limit
• Bills of exchange
• Bank bills held
• Bills of exchange accepted and discounted by a bank
and held as assets
• Commercial bills
• Bills of exchange issued directly by business to raise
finance
• Rollover facility
• Bank agrees to discount new bills over a specified
period as existing bills mature
• Leasing
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Commercial banks – Uses of funds
• 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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Banks – Balance Sheet

ASSET LIABILITIES
Personal and housing finance Current account deposit

Commercial lending Call deposit

Lending to Government
Other bank assets
Term Deposit
Certificates of deposit
Bill acceptance liabilities
Debt liabilities
Foreign currency liabilities
EQUITIES
Loan capital (hybrid securities) and
shareholders’ equity

https://www.commbank.com.au/content/dam/commbank/about-us/share
holders/pdfs/annual-reports/annual_report_2017_14_aug_2017.pdf
(p.90, note 12, 17, 23) 18
Off-balance sheet

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

• OBS transactions include:

• direct credit substitutes - SBLC
• trade- and performance-related items – Doc LC
• Commitments – Underwriting, Repos
• foreign exchange, interest-rate- and other market-rate-related
contracts

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Off-balance sheet

• 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, e.g.:
• documentary letters of credit
• performance guarantees
• 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

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Off-balance sheet

• 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
• To the extent that these OBS activities involve risk-taking and
positions in derivative securities, OBS activities raise some
concerns about bank regulation
• This is a particularly important concern when the size of off
balance sheet activities is considered
• The notional value of such activities is more than 5 times the
total value of assets held by the banks

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Australian regulatory structure

• Australian regulatory structure

• Reserve Bank of Australia (RBA)
• System stability and payments system

• Australian Prudential Regulation Authority (APRA)

• Prudential regulation and supervision of deposit-taking
institutions

• Australian Securities and Investments Commission (ASIC)

• Market integrity and consumer protection

• Australian Competition and Consumer Commission (ACCC)

• Competition policy
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Regulations 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 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
• Reasons for regulation of banks
• Importance of the banking sector for health of the economy
• Prudential supervision
• Imposition and monitoring of standards designed to ensure the
soundness and stability of a financial system

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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

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Background to Capital Adequacy standards

• Functions of capital

• Source of equity funds

• Demonstrates shareholder commitment

• Provides funding for growth and source of future profits

• Write-off periodic abnormal business losses

• 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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Capital Adequacy standards
• Minimum capital adequacy requirement applies to commercial banks
and other institutions specified by prudential regulator

• Capital adequacy standard – Basel 2

• 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 Tier 2 – specified permanent hybrid instruments

• Lower Tier 2 – specified non-permanent instruments

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

8% 26
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

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Tier 2 Capital

• 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

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Basel I to Basel II

Basel II increased sensitivity to different levels of asset and OBS

business risk

Main elements of Basel II

• Credit risk of banks’ assets and OBS business
• Market risks of banks’ trading activities
• Operational risks of banks’ 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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Basel II structural framework
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
Basel II structural framework (cont.)
• Pillar 1—Capital adequacy (cont.)

– Credit risk (cont.)

• Standardised approach (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
Basel II structural framework (cont.)
• Pillar 1—Capital adequacy (cont.)

– Credit risk (cont.)

• Internal ratings-based approach involves banks using some
or all of their own risk measurement model factors, subject
to supervisor approval. Two approaches available:

i. Foundation internal ratings-based approach (FIRB)

» Bank determines probability of default and effective
maturity but relies on supervisor estimates for other
credit risk components

ii. Advanced internal ratings-based approach (AIRB)

» Bank provides estimates of all credit risk
components
Basel II structural framework (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
Basel II structural framework (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
 Basel II structural framework (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)
Basel II structural framework (cont.)
• Pillar 1—Capital adequacy (cont.)

– Operational risk—risk of loss from inadequate or failed internal

processes, people and systems, or external events
• E.g. internal/external fraud, workplace safety, business
practices, damage to physical assets, systems failure

• Main operational risk management objectives:

– Operational objectives—impact of loss of business
function integrity and capability
– Financial objectives—losses owing to operational risk
exposure, cost of recovering operations and ongoing
financial losses
– Regulatory objectives—prudential standards of bank
supervisors
Basel II structural framework (cont.)
• Pillar 1—Capital adequacy (cont.)

– Market risk—risk of losses resulting from changes in market

rates in FOREX, interest rates, equities and commodities

• General market risk—changes in the overall market for

interest rates, equities, FOREX and commodities

• Specific market risk—changes in the value of a security

owing to issuer-specific factors. Affects only interest rate
and equity positions of institutions

• Two approaches to market risk capital requirements

i. Internal model—requires a statistical probability model
that measures financial risk exposures, i.e. value at risk
(VaR)
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
Basel II structural framework (cont.)
• Pillar 3—Market discipline

– Aim is to develop disclosure 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
Basel III

Basel III was developed in 2010.

• aims to enhance the risk coverage of the Basel II framework by
enhancing capital adequacy requirements
• It is generally accepted that Australian ADIs are well-placed to
meet the requirements of the Basel III

Three principal aims:

1. Boost the banking sector’s ability to absorb shocks arising from

financial and economic stress,

2. Improve risk management and governance, and

3. Strengthen banks’ transparency and disclosure.

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Basel III – broad framework

(1) Strengthen capital base:

• Increase minimum Tier 1 capital to 6% (4% in Basel II) of risk-

weighted assets (RWA) by 2015.

• Increase minimum Common Equity Tier 1 capital to 4.5% (2% in

Basel II) of RWA by 2015.

• Improve the quality of capital (e.g. tighter definition of Common

Equity Tier 1 capital to include only common stocks, retained
earnings, and other comprehensive income).

• Create capital conservation buffer (new) for use during a financial

crisis and economic distress. (Starting from 0.625% of RWA in 2016
and increasing to 2.5% of RWA by 2019.)

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Basel III – broad framework

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Basel III – broad framework

(2) Liquidity Requirements

• Minimum liquidity coverage ratio (LCR) to ensure banks have

sufficient high-quality liquid assets (HQLA) for expected net cash
outflows over a 30-day period stress scenario.

• Minimum net stable fund ratio (NSFR) to ensure that assets at

greater risk of suffering a one-year stress event are matched with
longer term sources of financing.

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RBA Charts on bank indicators

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Basel III – broad framework

(3) Governance & Systemic Risk Mitigation

• Create firm-wide governance and risk management.

• Require sound compensation practices.

• Widen coverage of risks (e.g. higher capital requirements for

securitization exposure, counterparty credit risk, OTC activities, etc.).

• Create countercyclical capital buffer (new) to mitigate systemic risk

during a financial crisis and economic distress.

• Set maximum leverage ratios to prevent excess leverage in good times

and reduce the deleveraging dynamic in periods of stress.

• Identify global systemically important banks (G-SIBs) for special

treatment (e.g., greater loss absorbency, more intense supervisory
oversight, stronger resolution, reducing their systemic importance over
time, etc.).
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Liquidity management

• Liquidity—access to sources of funds to meet day-to-day expenses and

commitments
• Banks have special liquidity problems owing 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 (APRA)
• The board of directors and management must implement a liquidity
management strategy, which is reviewed annually
• Measure, assess and report liquidity
• Manage liquidity related to balance-sheet and OBS activities
• Emphasis on banks’ internal liquidity management practices
• Strategy must include a contingency plan
• APRA reserves right to specify minimum level of liquid assets
• Going concern and crisis scenario liquidity management strategy 47
Supervisory control

• APRA’s liquidity standard APS210 aims to ensure that banks to not face
a situation where they have insufficient funds to meet their obligations

• Basel III introduces a number of reforms to liquidity standards. The first

of these (the LCR) become effective in 2015

• The most important of these reforms are the Liquidity Coverage Ratio
(LCR) and the Net Stable Funding Ratio (NSFR)

• The requirement will be for these ratios to exceed 100 percent. In the
case of the LCR, this means that banks will have to allow for a 30 day
‘survival horizon’

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Supervisory control

• This requirement will be several times stricter than the existing APRA
liquidity standards. APRA’s current standards allow for a 5 day survival
horizon (i.e. Enough liquidity to survive a 5 day period of acute stress)
• Other regulatory and supervisory controls:
• Risk management systems certification
• Business continuity management
• Audit
• Disclosure and transparency
• Large exposures
• Foreign currency exposures
• Ownership and control
• Example
• https://www.commbank.com.au/content/dam/commbank/about-us/shareh
olders/pdfs/results/1h18/31-december-2017-pillar-3.pdf 49
Summary

• Banks are the dominant financial 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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