Chapter 2

Commercial Banks

Websites:
www.apra.gov.au
www.asic.gov.au
www.accc.gov.au

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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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 2.1 Main Activities of Commercial
Banking
• Three categories of banks
– Incorporated banks—domestic and foreign
– Unincorporated foreign bank branches
– Foreign bank representative offices
• 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)
– Loans portfolio is tailored to match the available deposit
base
• Liability management (1980s−)
– Deposit base and other funding sources are managed to
fund loan demand
 Commercial bill market
 Provision of other financial services
 Off-balance-sheet (OBS) business

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 2.2 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

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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– Funds held in savings accounts that can be withdrawn on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

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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

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 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 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
– 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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 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

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 2.2 Sources of Funds (cont.)
• Loan capital and shareholders’ equity
– 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)

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 2.3 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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 2.3 Uses of Funds (cont.)
• Personal and housing finance
– Housing finance
 Mortgage
 Amortised loan
– 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 (see slide 11) 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

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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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 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 of
commercial contract by a bank client, e.g.
 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

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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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 2.5 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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 2.6 Background to Capital Adequacy
Standards
• Functions of capital
– The source of equity funds for a corporation
– Provides equity funding for growth
– A source of profits
– Write-off periodic loan losses of defaulting borrowers that
exceed profits
• Latter function and the evolution of the
international financial system lead to development
of international capital adequacy standards
– 1988 Basel I capital accord and Basel II (2008) capital
capital adequacy guidelines

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 2.7 Basel II Capital Accord
• 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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 Definition of capital

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 Basel II structural framework

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 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

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 2.9 Summary (cont.)
• 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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