AFC2000 Financial Institutions and Markets

Tutorial Solution: Week 5

12.1 Why are bank failures considered to have a greater effect on the economy than other types of business failures? Do you agree with this conclusion?

Individual bank failures can hurt a community by shrinking the money supply and disrupting credit. Thus, commerce in the community suffers if other institutions cannot or do not move quickly to fill the void of money and credit left by a bank failure. If a banking panic occurs, the economy will slow down because bank reserves and the money supply will shrink abruptly unless the central bank quickly takes action to provide liquidity and restore confidence in the financial system. 12.3 Bank regulation is considered to be in the public interest. Therefore, the more regulation, the better. Explain why you agree or disagree with this statement.

All regulation purports to be in the public interest. To assert categorically that more regulation is necessarily better, one must assume that (1) the public interest has been conclusively defined and (2) all regulations are conceived with equal deliberation and regard for likely consequences. Too much regulation stifles innovation and competition; too little regulation may leave the public inadequately protected. Regulators are responsible for finding the balance between bank safety and economic stability on the one hand, and an efficient banking system on the other. This is a difficult task. 12.5 What are the main pieces of regulation that influence the financial sector? Outline the role of each.

The five key pieces of legislation that govern financial institutions include: 1. The Reserve Bank Act 1959, which created the RBA and defines its constitution, powers and responsibilities. 2. The Banking Act 1959 and its various amendments that provide regulatory control over who has authority to conduct a banking business. 3. The Financial Sector (Shareholdings) Act 1998, which regulates ownership of financial institutions. 4. Financial Sector (Collection of Data) Act 2001 which empowers APRA to collect information from financial institutions. 5. The Financial Services Reform Act 2001 (FSRA), which implements several of the recommendations made by the Financial System Inquiry including to impose a single licensing regime for financial sales, advice and dealings in relation to financial products. 12.6 Outline APRAs PAIRS and SOARS. What is the purpose of the systems?

APRA has developed two risk assessment and supervisory response tools for this purpose: the Probability and Impact Rating System (PAIRS) and the Supervisory Oversight and Response System (SOARS). APRA uses these systems to: assess risk determine the focus of supervisory effort determine the level of supervisory response for each regulated institution define reporting obligations for each regulated institution

illustrate to regulated institutions how the level of supervision they receive from APRA is determined.

PAIRS is APRAs system to assess the probability that a regulated institution will fail and the effect such a failure would have on the financial system. Supervisory Oversight and Response System. SOARS is then used to determine the response APRA should make to the outcomes of PAIRS ratings. 12.8 Outline the process of calculating the CAR as defined by the current prudential statements.

APRA imposes an 8 per cent capital adequacy ratio (CAR) for all ARPA-regulated ADIs. The CAR is calculated as: CAR = capital/risk-adjusted assets = at least 8 per cent The calculation of the CAR requires four main steps. These are:

1.

estimate the capital base using the regulatory capital definitions (Tier 1 and Tier 2 capital) set out in APS111 2. calculate total credit risk-weighted assets using the four risk-weighting categories for both on- and off-balance-sheet items 3. calculate total market risk-weighted assets 4. calculate the CAR by dividing the capital base by total risk-weighted assets (the total credit risk-weighted assets from step 2 plus market risk-weighted assets from step 3).
12.11 What is Basel II? Briefly explain the main differences between it and the current capital adequacy requirements. Since the release of the Basel I in 1988, the Basel Committee has been working on refinements to the capital adequacy framework to deal with concerns such as: the exclusion of risks other than credit and market risk, such as operational risk the credit risk categories being too broad a lack of consideration of the degree of sophistication of institutions risk management systems. These issues, together with the increasing innovation and sophistication within the finance sector, have led to the development of Basel II. The substantially revised capital adequacy framework is based on three pillars that deal with capital requirements for credit, traded market and operational risks; supervisory review; and market discipline respectively.

Following the GFC the central banks and goverments of the world closely scrutinised the capital adequacy requirements of financial institutions. It was generally agreed that these requirements, in light of the GFC, may not be strict enough and at the time of writing there was discussion of significant amendments to Basel II. It was foreshadowed that this may lead to a Basel III with stricter measures of risk (particularly operational risk) and generally higher requirements on all measures. Only time will tell whether this eventuates.

13.1

What is the primary goal of a commercial bank? Why may this goal be translated into maximising the firms stock share price?

The primary goal of a bank is profit maximisation. Stock prices provide continuous monitoring of how well management is doing on behalf of stockholders, and reflect shareholders expectations about the firms future performance. For firms not widely traded, this type of continuous review is not available. 13.2 Why are demand deposits a more important source of funds for small banks than for large banks? Why are demand deposits considered to be a more stable source of funds for small banks than for large banks?

Small banks are usually retail oriented and have a greater proportion of consumer checking accounts. Large banks have proportionally more business checking balances, which fluctuate more. 13.4 Describe the impact that the GFC had on the balance sheets of financial institutions in Australia.

The GFC had a significant impact on the balance sheets of financial institutions around the globe. The impact in Australia was comparatively less, however key issues include the increased reliance on deposit sources of funds with international sources dry up, increased provisions (and actual) bad debts from loan defaults as unemployment, asset value depreciation and economic slow down increases the percentage of non-performing loans.
13.6 Define bank capital. What is the economic importance of capital to a firm?

Bank capital comprises capital stock, undivided profits, and special reserve accounts (not to be confused with reserve balances at the Fed). Capital is the cushion against which losses particularly loan losses--are written off. Capital is also the residual claim of owners against the firm. For regulatory purposes, capital notes (debt) may count as part of a bank's capital if they are subordinated. 13.9 What do we mean by off-balance-sheet activities? If these things are not on the balance sheet, are they important? What are some off-balance-sheet activities?

Off-balance-sheet activities are financial services which earn revenue but do not directly or immediately put assets or liabilities on the balance sheet. Examples include loan commitments, letters of credit, loan brokerage, securitisation, and derivatives. These activities are important: They are a growing component of the revenue of the worlds largest banks, they materially affect a banks overall risk profile and profitability, and yet they are not readily apparent in cursory examination of financial statements. Assessment of their full effect requires in-depth analysis of notes to financial statements. 13.12 Explain the profitability versus solvency and liquidity dilemma facing bank management. Because of banks' large proportion of short-term liabilities and low equity capitalisation, banks are more subject to failure than other businesses. Too many liquid assets mean high safety but low profitability. Too many risky loans or investments may mean higher profit because of higher

expected yield; but higher than expected losses can cause bank failure because of low equity capitalisation. 13.13 What are the two ways a bank can fail? Explain how these two conditions cause failure. Give examples of times when we have had the two different types of failures. Commercial banks can fail in two ways. A bank can become insolvent by suffering losses on its loans or investments (credit risk or interest rate risk), depleting its capital. A bank can be profitable but become illiquidunable to meet the cash demands of depositors or borrowers (liquidity risk). Many bank failures of the early 1930s were liquidity-based: Depositors lost confidence in the banking system and appeared in large numbers to withdraw funds. Most of the bank failures of the 1980s were insolvency-based: loan losses quickly absorbed banks thin equity capital. 13.15 Discuss the debt instruments used in liability management. What are the common characteristics of these debt instruments and what type of bank is most likely to issue them? The debt instruments commonly used in liability management are: (a) negotiable CDS, (b) Federal Funds, (c) repurchase agreements, and (d) Eurodollar deposits. These instruments are all short-term, large-denomination money market instruments with highly rate-sensitive investor constituencies. Accordingly, a large bank is more likely to use them. 13.16 How do banks decide on the proper amount of primary and secondary reserves to hold? The decision is a function of (a) deposit variability, (b) availability and cost other sources of liquidity (e.g., Federal Funds), (c) bank regulations, and (d) risk posture of the bank's management. Liquidity management is essentially a constraint-optimisation exercise in which the bank seeks the minimum liquidity consistent with operational stability and regulatory compliance. 13.20 Explain how financial futures are used to reduce bank interest rate risk. How does the value of a futures contract change when interest rates change? If financial futures are used for interest rate hedging, the type of financial futures contract, the number of contracts, and the buy or sell decision must be made. The selection of the specific contract is related to how closely changes in interest rates would affect the bank versus the futures contract. The amount is a function of the size of the GAP one wishes to hedge or retain. The buy/sell decision is related to the GAP position of the bank. The manager must position (buy/sell) the futures contracts so that interest rate movements unfavorable to the balance sheet would be offset by favorable changes in the value of the futures contracts. For example, a positive maturity GAP bank would be hurt if interest rates decreased. Purchasing financial futures would hedge the bank. If interest rates declined, the value of the financial futures would be rising, providing a gain to offset the business loss.