FINANCIAL MARKETS AND INSTITUTIONS

Banks

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

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

Commercial banks
Overview:
Commercial banks provide a full range of financial services
Pre 1980s - Asset management
Loans portfolio is tailored to match the available deposit base

Post 1980s - 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
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

Banks Balance Sheet

ASSET

LIABILITIES

Personal and housing finance

Current account deposit

Commercial lending

Call deposit

Lending to Government

Term Deposit

Other bank assets

Certificates of deposit
Bill acceptance liabilities
Debt liabilities
Foreign currency liabilities
EQUITIES
Loan capital (hybrid securities) and
shareholders equity

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Funds held in savings accounts that can be withdrawn on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
7

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)

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

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

10

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

11

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)

12

Banks Balance Sheet

ASSET

LIABILITIES

Personal and housing finance

Current account deposit

Commercial lending

Call deposit

Lending to Government

Term Deposit

Other bank assets

Certificates of deposit
Bill acceptance liabilities
Debt liabilities
Foreign currency liabilities
EQUITIES
Loan capital (hybrid securities) and
shareholders equity

13

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

14

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

16

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
17

Banks Balance Sheet

ASSET

LIABILITIES

Personal and housing finance

Current account deposit

Commercial lending

Call deposit

Lending to Government

Term Deposit

Other bank assets

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/aboutus/shareholders/pdfs/annualreports/2013_CBA_Annual_Report_19_August_2013.pdf (p.75, note

13, 19, 23)

18

Off-balance sheet
OBS transactions are a significant part of a banks 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

19

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
20

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
21

RBA Charts on bank indicators

22

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

23

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

24

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

25

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)
26

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

27

Background to 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%

28

Definition of capital

Definition of capital

Basel II structural framework

Basel II structural framework (cont.)

Pillar 1Capital adequacy

Credit riskrisk 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 loanto-valuation ratio (LTVR) and level of mortgage
insurance

Basel II structural framework (cont.)

Pillar 1Capital 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 transactionscredit conversion
factor can be determined by:
current exposure methodcurrent and potential
credit exposures mark-to-market (contract revalued
by its current quoted price)
original exposure methodnotional contract value
multiplied by a credit conversion factor

Basel II structural framework (cont.)

Pillar 1Capital 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.)

Pillar 1Capital adequacy (cont.)

Operational riskrisk 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 objectivesimpact of loss of business
function integrity and capability
Financial objectiveslosses owing to operational risk
exposure, cost of recovering operations and ongoing
financial losses
Regulatory objectivesprudential standards of bank
supervisors
Business continuity management and additional capital

Basel II structural framework (cont.)

Pillar 1Capital adequacy (cont.)

Market riskrisk of losses resulting from changes in market
rates in FOREX, interest rates, equities and commodities

General market riskchanges in the overall market for

interest rates, equities, FOREX and commodities

Specific market riskchanges 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 modelrequires a statistical probability model
that measures financial risk exposures, i.e. value at risk
(VaR)
ii. Standardised approach

Basel II structural framework (cont.)

Pillar 2Supervisory 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
Four key principles of supervisory review

Basel II structural framework (cont.)

Pillar 3Market 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 institutions 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 sectors ability to absorb shocks arising from
financial and economic stress,
2. Improve risk management and governance, and
3. Strengthen banks transparency and disclosure.
39

Basel III broad framework

(1) Strengthen capital base:
Increase minimum Tier 1 capital to 6% (4% in Basel II) of riskweighted 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.)

40

In addition to the Minimum Capital Ratios, Basel III implemented certain capital buffers (see
Table A1) that would all require additional Common Equity Tier 1. So while total minimum capital ratios
appear to remain constant at 8%, the capital buffers serve to substantially increase Common Equity Tier 1
requirements.

Basel III broad framework

Table A1. Capital requirements Basel II and Basel III.

MinimumCapitalRatiosas%ofRiskWeightedAssets
CommonEquityTier1
AdditionalTier1
TotalTier1Capital
Tier2Capital
TotalCapital(Tier1+Tier2)
AdditionalCapitalBuffersas%ofRiskWeightedAssets
CapitalConservationBuffer
CountercyclicalBuffer
SurchargeforSystemicallyImportantFinancialInstitutions
MinimumCapitalRatios+CapitalBuffers
CommonEquityTier1
Add:CapitalBuffers
TotalCommonEquityTier1
AdditionalTier1
TotalTier1Capital
Tier2Capital
TotalCapital(Tier1+Tier2+Buffers)

BaselII

BaselIII

2.0%
2.0%
4.0%
4.0%
8.0%

4.5%
1.5%
6.0%
2.0%
8.0%

N/A
N/A
N/A

2.5%
0.0%2.5%
1.0%2.5%
0.095

2.0%
4.5%
0.0%
3.5%7.5%
2.0% 8.0%12.0%
2.0%
1.5%
4.0% 9.5%13.5%
4.0%
2.0%
8.0% 11.5%15.5%

Data source: Basel III: A Global Regulatory Framework for More Resilient Banks
and Banking Systems.

41

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.

42

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.).

43

Liquidity management

Liquidityaccess 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

44

Supervisory control
APRAs 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) will 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

45

Supervisory control
This requirement will be several times stricter than the existing APRA
liquidity standards. APRAs 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/aboutus/shareholders/pdfs/2016-asx/31-march-2016-basel-3-pillar-3-2016-0546
02.pdf

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 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
47