Tài chính doanh nghiệp - Chapter 2: Commercial banks

Chapter 2Commercial BanksWebsites:www.apra.gov.auwww.asic.gov.auwww.accc.gov.auwww.rbnz.govt.nzwww.anz.com.auwww.commbank.com.auwww.nab.com.auwww.westpac.com.auLearning objectivesEvaluate the functions and activities of commercial banksIdentify the main sources and uses of funds for commercial banksOutline the nature and importance of banks’ off-balance-sheet businessExamine the main risk exposures and consider related issues of regulation and prudential supervision of banks(cont.)Learning objectives (cont.)Understand the background and application of the capital adequacy standardsExamine liquidity management and other controls applied by APRAUnderstanding the standardised approach to credit riskAnalyse business continuity riskDiscuss the importance of corporate governance and ethics in the context of Australian financial institutionsChapter organisation2.1 Main activities of commercial banking2.2 Sources of funds2.3 Uses of funds2.4 Off-balance-sheet business2.5 Regulation and prudential supervision2.6 Background to capital adequacy standards2.7 Basel II capital accord2.8 Liquidity management and other supervisory controls2.9 Summary2.1 Main activities of commercial bankingOverview:Commercial banks provide a full range of financial servicesIn the modern financial system, the activities of commercial banks are far less regulated than they have been historicallyIn a less regulated environment, commercial banks practice ‘liability management’ whereby shortfalls in loan demand are borrowed on the capital marketsThe regulation of the banking sector attracted renewed attention following the GFC(cont.)2.1 Main activities of commercial banking (cont.)Importance of banksHigh level of regulation prior to the mid-1980s constrained their development and led to growth of non-bank financial institutionsLargest share of assets of all institutions, but understated without considering off-balance-sheet transactions, managed funds, superannuation and subsidiary finance, insurance and companies(cont.)2.1 Main activities of commercial banking (cont.)Asset management (−1980s)Loans portfolio is tailored to match the available deposit baseLiability management (1980s−)Deposit base and other funding sources are managed to meet loan demandBorrow directly from domestic and international capital marketsProvision of other financial servicesOff-balance-sheet (OBS) businessChapter organisation2.1 Main activities of commercial banking2.2 Sources of funds2.3 Uses of funds2.4 Off-balance-sheet business2.5 Regulation and prudential supervision2.6 Background to capital adequacy standards2.7 Basel II capital accord2.8 Liquidity management and other supervisory controls2.9 Summary2.2 Sources of fundsSources of funds appear in the balance sheet as either liabilities or shareholders’ fundsBanks 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(cont.)2.2 Sources of funds (cont.)Current account depositsFunds held in a cheque accountHighly liquidMay be interest or non-interest bearingCall or demand depositsFunds held in savings accounts that can be withdrawn on demandE.g. passbook account, electronic statement account with ATM and EFTPOS(cont.)2.2 Sources of funds (cont.)Term depositsFunds lodged in an account for a predetermined period at a specified interest rateTerm: one month to five yearsLoss of liquidity owing to fixed maturityHigher interest rate than current or call accountsGenerally fixed interest rate(cont.)2.2 Sources of funds (cont.)Negotiable certificates of deposit (CDs)Paper issued by a bank in its own name Issued at a discount to face valueSpecifies repayment of the face value of the CD at maturityHighly negotiable securityShort term (30 to 180 days)(cont.)2.2 Sources of funds (cont.)Bill acceptance liabilitiesBill of exchangeA security issued into the money market at a discount to the face value. The face value is repaid to the holder at maturityAcceptanceBank 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 dateAcceptance by bank guarantees flow of funds to its customers without using its own funds(cont.)2.2 Sources of funds (cont.)Debt liabilitiesMedium- to longer term debt instruments issued by a bankDebentureA bond supported by a form of security, being a charge over the assets of the issuer (e.g. collateralised floating charge)Unsecured noteA bond issued with no supporting security(cont.)2.2 Sources of funds (cont.)Foreign currency liabilitiesDebt instruments issued into the international capital markets that are denominated in a foreign currencyAllows diversification of funding sources into international marketsFacilitates matching of foreign exchange denominated assetsMeets demand of corporate customers for foreign exchange products(cont.)2.2 Sources of funds (cont.)Loan capital and shareholders’ equitySources 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)Chapter organisation2.1 Main activities of commercial banking2.2 Sources of funds2.3 Uses of funds2.4 Off-balance-sheet business2.5 regulation and prudential supervision2.6 background to capital adequacy standards2.7 Basel II capital accord2.8 Liquidity management and other supervisory controls2.9 Summary2.3 Uses of fundsUses of funds appear in the balance sheet as assetsThe 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 financeCommercial lendingLending to government(cont.)2.3 Uses of funds (cont.)Personal and housing financeHousing financeMortgageAmortised loanInvestment propertyFixed-term loanCredit card(cont.)2.3 Uses of funds (cont.)Commercial lendingInvolves bank assets invested in the business sector and lending to other financial institutionsFixed-term loanA loan with negotiated terms and conditionsPeriod of the loanInterest ratesFixed or variable rates set to a specified reference rate (e.g. BBSW)Timing of interest paymentsRepayment of principal(cont.)2.3 Uses of funds (cont.)Commercial lending (cont.)OverdraftA facility allowing a business to take its operating account into debit up to an agreed limitBills of exchangeBank bills heldBills of exchange accepted and discounted by a bank and held as assetsCommercial billsBills of exchange issued directly by business to raise financeRollover facilityBank agrees to discount new bills over a specified period as existing bills matureLeasing(cont.)2.3 Uses of funds (cont.)Lending to governmentTreasury notesShort-term discount securities issued by the Commonwealth governmentTreasury bondsMedium- to longer-term securities issued by the Commonwealth government that pay a specified interest coupon streamState government debt securitiesLow risk and low returnOther bank assetsE.g. electronic network infrastructure and shares in controlled entitiesChapter organisation2.1 Main activities of commercial banking2.2 Sources of funds2.3 Uses of funds2.4 Off-balance-sheet business2.5 Regulation and prudential supervision2.6 Background to capital adequacy standards2.7 Basel II capital accord2.8 Liquidity management and other supervisory controls2.9 Summary2.4 Off-balance-sheet businessOBS transactions are a significant part of a bank’s businessOBS transactions include:direct credit substitutestrade- and performance-related itemscommitmentsforeign exchange, interest-rate- and other market-rate-related contracts(cont.)2.4 Off-balance-sheet business (cont.)Direct credit substitutesAn 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 feeClient has a financial obligation to a third partyBank is required to make a payment only if the client defaults on a payment to a third party(cont.)2.4 Off-balance-sheet business (cont.)Trade- and performance-related itemsA 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 creditperformance guarantees(cont.)2.4 Off-balance-sheet business (cont.)CommitmentsThe contractual financial obligations of a bank that are yet to be completed or deliveredBank undertakes to advance funds or make a purchase of assets at some time in the future, e.g.:forward purchasesunderwriting(cont.)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(cont.)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 regulationThis is a particularly important concern when the size of off balance sheet activities is consideredThe notional value of such activities is more than 5 times the total value of assets held by the banksChapter organisation2.1 Main activities of commercial banking2.2 Sources of funds2.3 Uses of funds2.4 Off-balance-sheet business2.5 Regulation and prudential supervision2.6 Background to capital adequacy standards2.7 Basel II capital accord2.8 Liquidity management and other supervisory controls2.9 Summary2.5 Regulation and prudential supervisionThe GFC has focussed attention on the regulation of the financial systemA number of financial institutions collapsed during the crisisThe amount of leverage on the balance sheets of these institutions was a primary factor contributing to their weaknessDebate concerning bank regulation and prudential supervision has concentrated on how regulators can maintain a stable financial system(cont.)2.5 Regulation and prudential supervision (cont.)Reasons for regulation of banksImportance of the banking sector for health of the economyPrudential supervisionImposition and monitoring of standards designed to ensure the soundness and stability of a financial system(cont.)2.5 Regulation and prudential supervision (cont.)Australian regulatory structureReserve Bank of Australia (RBA)System stability and payments systemAustralian Prudential Regulation Authority (APRA)Prudential regulation and supervision of deposit-taking institutionsAustralian Securities and Investments Commission (ASIC)Market integrity and consumer protectionAustralian Competition and Consumer Commission (ACCC)Competition policyChapter organisation2.1 Main activities of commercial banking2.2 Sources of funds2.3 Uses of funds2.4 Off-balance-sheet business2.5 Regulation and prudential supervision2.6 Background to capital adequacy standards2.7 Basel II capital accord2.8 Liquidity management and other supervisory controls2.9 Summary2.6 Background to capital adequacy standardsThe business activities of financial institutions will inevitably involve the need to write-off of abnormal business lossesThe capital held by financial institutions serves as the ‘buffer’ against such lossesIf capital is inadequate, a financial institution may face insolvency. This has significant implications for the stability of the financial systemThe capital adequacy standards set down in Basel II and III define the minimum capital adequacy for a bankThe standards are designed to promote stability within the financial system(cont.)2.6 Background to capital adequacy standards (cont.)Functions of capitalSource of equity fundsDemonstrates shareholder commitmentProvides funding for growth and source of future profitsWrite-off periodic abnormal business lossesThe evolution of the international financial system led to development of international capital adequacy standards1988 Basel I capital accord and Basel II (2008) capital capital adequacy guidelinesBasel III (2010)Chapter organisation2.1 Main activities of commercial banking2.2 Sources of funds2.3 Uses of funds2.4 Off-balance-sheet business2.5 Regulation and prudential supervision2.6 Background to capital adequacy standards2.7 Basel II capital accord2.8 Liquidity management and other supervisory controls2.9 Summary2.7 Basel II capital accordBasel II extends Basel I to increase sensitivity to different levels of asset and OBS business riskMain elements of Basel IICredit risk of banks’ assets and OBS businessMarket risks of banks’ trading activitiesOperational risks of banks’ business operationsForm and quality of capital held to support these exposuresRisk identification, measurement and management processes adoptedTransparency through accumulation and reporting of informationCapital adequacy standardMinimum capital adequacy requirement applies to commercial banks and other institutions specified by prudential regulatorCapital adequacy standardMinimum risk-based capital ratio of 8%Minimum 4% held as Tier 1 capitalHighest quality core capitalRemainder can be held as Tier 2 (supplementary) capitalUpper Tier 2 – specified permanent hybrid instrumentsLower Tier 2 – specified non-permanent instrumentsRegulator can require an institution to hold a capital ratio above 8%Definition of capital(cont.)Definition of capitalBasel II structural framework(cont.)Basel II structural framework (cont.)Pillar 1—Capital adequacyCredit risk—risk that borrower will not meet commitments when due. Three measures:Standardised approachRisk weights applied to balance-sheet and OBS items to calculate minimum capital requirementRisk weights derived from external rating grade or supervisor (see www.apra.gov.au APS112)For residential housing loans, risk weight relates to loan-to-valuation ratio (LTVR) and level of mortgage insurance(cont.)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 creditMarket-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(cont.)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:Foundation internal ratings-based approach (FIRB)Bank determines probability of default and effective maturity but relies on supervisor estimates for other credit risk componentsAdvanced internal ratings-based approach (AIRB)Bank provides estimates of all credit risk components(cont.)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 failureMain operational risk management objectives:Operational objectives—impact of loss of business function integrity and capabilityFinancial objectives—losses owing to operational risk exposure, cost of recovering operations and ongoing financial lossesRegulatory objectives—prudential standards of bank supervisorsBusiness continuity management and additional capital(cont.)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 commoditiesGeneral market risk—changes in the overall market for interest rates, equities, FOREX and commoditiesSpecific market risk—changes in the value of a security owing to issuer-specific factors. Affects only interest rate and equity positions of institutionsTwo approaches to market risk capital requirementsInternal model—requires a statistical probability model that measures financial risk exposures, i.e. value at risk (VaR)Standardised approach(cont.)Basel II structural framework (cont.)Pillar 2—Supervisory review of capital adequacyIntended 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 cycleadditional risk management practices such as education/ training; internal responsibilities, delegation and exposure limits; increased provisions and reserves; and improved internal controls and reporting practicesFour key principles of supervisory review(cont.)Basel II structural framework (cont.)Pillar 3—Market disciplineAim 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 adequacyPrudential supervisors to determine minimum disclosure requirements and frequencyBasel II recommends a range of qualitative and quantitative information disclosure relating to principal parts of Pillars I and IIBasel IIIBasel III was developed in 2010. aims to enhance the risk coverage of the Basel II framework by enhancing capital adequacy requirementsBanks will face their first tests under Basel III in 2013It is generally accepted that Australian ADIs are well-placed to meet the requirements of the Basel IIIThe exact nature of APRA’s treatment of Basel III is still being worked out. Discussion papers and details are available on the APRA websiteChapter organisation2.1 Main Activities of commercial banking2.2 Sources of funds2.3 Uses of funds2.4 Off-balance-sheet business2.5 Regulation and prudential supervision2.6 Background to capital adequacy standards2.7 Basel II capital accord2.8 Liquidity management and other supervisory controls2.9 Summary2.8 Liquidity management and other supervisory controls (cont.)Liquidity—access to sources of funds to meet day-to-day expenses and commitmentsBanks have special liquidity problems owing to:mismatch in maturity structure of balance sheet assets and liabilities and associated cash flowsrole of banks in the payments systemLiquidity prudential standard APS210 (APRA)The board of directors and management must implement a liquidity management strategy, which is reviewed annuallyMeasure, assess and report liquidityManage liquidity related to balance-sheet and OBS activitiesEmphasis on banks’ internal liquidity management practicesStrategy must include a contingency planAPRA reserves right to specify minimum level of liquid assetsGoing concern and crisis scenario liquidity management strategy2.8 Liquidity management and other supervisory controls (cont.)APRA’s liquidity standard APS210 aims to ensure that banks to not face a situation where they have insufficient funds to meet their obligationsBasel III introduces a number of reforms to liquidity standards. The first of these (the LCR) will become effective in 2015The 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’2.8 Liquidity management and other supervisory controls (cont.)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 certificationBusiness continuity managementAuditDisclosure and transparencyLarge exposuresForeign currency exposuresOwnership and controlChapter organisation2.1 Main activities of commercial banking2.2 Sources of funds2.3 Uses of funds2.4 Off-balance-sheet business2.5 Regulation and prudential supervision2.6 Background to capital adequacy standards2.7 Basel II capital accord2.8 Liquidity management and other supervisory controls2.9 Summary2.9 SummaryBanks are the dominant financial institution and have moved to liability managementSources 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(cont.)2.9 Summary (cont.)OBS transactions are a major part of a bank’s business and include:direct credit substitutestrade- and performance-related itemscommitmentsmarket-rate-related transactionsAPRA’s bank prudential supervision requirements include capital adequacy, liquidity management and other controls