lecture-2-commercial-banks-and-non-bank-financial-institutions.pdf

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Lecture 2 - Commercial Banks and Non-Bank Financial
Institutions
Financial Markets & Institutions (University of Wollongong)
StuDocu is not sponsored or endorsed by any college or university
Lecture 2 - Commercial Banks and Non-Bank Financial
Institutions
Financial Markets & Institutions (University of Wollongong)
Downloaded by Ashenafi Techane (ashenafitechane205@gmail.com)
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Lecture 2 – Commercial Banks and Non-Bank Financial Institutions
Commercial Banks – Chapter 2
Learning Objectives:
o Evaluate the functions and activities of commercial banks.
o Identify the main sources and uses of funds for commercial banks.
o Identify the main uses of funds by commercial banks.
o Outline the nature and importance of banks’ off-balance-sheet business.
o Consider the regulation and prudential supervision of banks.
o Understand the background and application of Basel III.
o Examine liquidity management and supervisory controls applied by APRA in Basel III context.
Chapter Outline:
o Main activities of commercial banking
o Source of funds
o Uses of funds
o Off-balance-sheet business
o Regulation and prudential supervision
o Background to capital adequacy standards
o Evolution from Basel I to Basel III
o Liquidity management and other supervisory controls
Main Activities of Commercial Banking
Asset management (before 1980s):
Loans portfolio is tailored to match the available deposit base.
There was very heavy regulation in Australia and other places in the world. This regulation meant
that banks could not loan out more money to consumers than what they held in deposits that savers
put in their bank accounts i.e. they could not loan out more money than what they physically had.
This meant there were not sufficient funds for the economy to grow.
Banks could only participate in banking activities (not super or insurance) and they could not choose
interest rates.
Liability management (1980s onwards):
Deposit base and other funding sources are managed to meet loan demand.
o Borrow directly from domestic and international capital markets.
o Provision of other financial services.
o Off-balance-sheet (OBS) business.
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Regulations were eased to allow banks to become more competitive by allowing them to borrow
money and to be involved in other services. Prior to deregulation, commercial banks were focused
on asset management. The assets of a bank are the loans they offer, therefore they had to focus on
loaning out as much money as possible in order to make money. After deregulation, banks could
borrow money from international and domestic markets, and they were allowed to provide other
services such as insurance, superannuation, investment banking activities, and issuing securities such
as derivatives. This meant that banks were now focused on liability management as they provided
more loans. Liabilities for banks include deposits.
Sources of Funds
Current account deposits:
o Funds held in a cheque account
o Highly liquid
o May be interest or non-interest bearing (typically low interest)
This is when you have a debit card connected to an account. You can take money out or put money in
easily. You can easily spend this money.
Call or demand deposits:
These are funds held in savings accounts that can be withdrawn on demand and include a passbook
account, and electronic statement account with ATM and EFTPOS.
This is like a savings account that isn’t linked to a card. You can easily still transfer money from this
account and into a current account with a card.
Term deposits:
These are funds lodged in an account for a predetermined period at a specified interest rate.
o Term: one month to five years
o Loss of liquidity owning to fixed maturity
o Higher interest rate than current or call accounts
o Generally fixed interest rate
These are longer term and lock your money in for a period of time. As you cannot withdraw this
money, higher interest rates are offered and they are locked in for the duration of the term. If you
withdraw prior to maturity, you will be penalised to cover the interest they have paid you.
Negotiable certificates of deposit (CDs):
o Paper issued by a bank in its own name
o Issued at a discount to face value
o Specified repayment of the face value of the CD at maturity
o Highly negotiable security
o Short term (30 to 180 days)
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These are short-term money market instruments issued by banks. It is a safe IOU, it is a wholesale
instrument, meaning it has extremely high face value such as $1 million. If a bank needs money for
180 days, they issue a negotiable certificate of deposit in the money market and any participant in
the market (such as a banks or large institutional investors) can purchase the CD and negotiate the
terms (usually negotiating the yield). The purchaser is essentially buying the CD at a price that is
below the face value, and at maturity the bank must pay whoever holds the CD the face value.
e.g. if the CD has a face value of $1 million, the bank must sell it for below that such as $96,500 in
the money market. The purchaser can then resell this CD to someone else if they need their money
and don’t want to wait 180 days. Then, once the 180 days is up, whoever holds the CD can take it to
the bank who issued it and receive the face value. The return is therefore the difference between the
price the buyer pays and what the face value is.
Bill acceptance liabilities:
o 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.
This is a way for banks to raise funds in the money markets. It is (like a CD) a discount instrument
which means it is issued and sold at a price below it’s face value and the bank pays the face value to
whoever holds it at maturity. A commercial bill is a type of bill of exchange.
o Acceptance – the bank accepts primary liability to repay the face value of the bill to the
holder. The issuer of the bill agrees to pay the bank face value of the bill, plus a fee, at the
maturity date. Acceptance by the bank guarantees flow of funds to its customers without
using its own funds.
Debt liabilities:
These are medium to longer term debt instruments issued by a bank:
o Debenture – a bond supported by a form of security, being a charge over the assets of the
issuer (e.g. collateralised floating charge)
o Unsecure note – a bond issued with no supporting security.
This is when banks borrow money. They can issue a debenture (secured with assets) or unsecured
notes (no security) which are debt and liabilities.
Foreign currency liabilities:
These are debt instruments issued into the international capital markets that are denominated in a
foreign currency.
o Allows diversification of funding sources into international markets
o Facilitates matching of foreign exchange denominated assets
o Meets demand of corporate customers for foreign exchange products
This is when banks raise funds through international markets. This is a vital source of funds as there
may not always be enough funding within Australia (domestically).
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Loan capital and shareholders’ equity:
Sources of funds that have characteristics of both debt and equity (e.g. subordinated debentures and
subordinated notes).
o 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).
The bank can issue hybrid securities such as subordinated debts (loan capital). By law it is classified
as equity even though it is hybrid and they have debt characteristics such as the money having to be
paid back + interest.
Uses of Funds
Personal and housing finance:
Banks use these funds to issue loans over various categories.
o Personal and housing finance
- Mortgage
- Amortised loan
o Investment property
o Fixed-term loan
o Credit card
Commercial lending:
This involved bank assets invested in the business sector and lending to other financial institutions.
Banks can lend to small businesses in the form of overdraft and to large businesses to support
projects by providing finance. They can also lend to other banks to manage liquidity i.e., they can
finance businesses or other institutions.
Fixed-term loan – a loan with negotiated terms and conditions.
o Period of the loan
o Interest rates – fixed or variable rates set to a specified reference rate (e.g. BBSW)
o Timing of interest payments
o Repayment of principle
Overdraf – a facility allowing a business to take it’s operating account into debit up to an agreed
limit. This is an account which allows a business to overdraw their account when they haven’t got as
much income. The bank overdraft allows the business to withdraw up to an agreed maximum
amount whenever they need it. This is sometimes also available personally.
Bill of exchange
o Bank bills held – bills of exchange accepted and discounted by a bank and held as assets.
These are used in trades.
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o Commercial bills – bills of exchange issued directly by a business to raise finance. They are a
type of IOUS and are short-term money market instruments used for borrowing and lending
that can be invested in. a bank with savings can purchase a commercial bill from the money
market and receive the face value at maturity.
o Rollover facility – bank agrees to discount new bills over a specified period as existing bills
mature.
Leasing – through finance arms they can lease assets to other companies by charging a fee.
Lending to government:
o Treasury notes – short-term discount securities issued by the Commonwealth Government
o Treasury bonds – medium to longer-term securities issued by the Commonwealth
Government that pay a specified interest coupon stream.
o State government debt securities
o Low risk and low return
Banks can also loan to the government by purchasing government debt securities (both short-term
treasury notes and long-term treasury bonds). These are issued by the Commonwealth Government
or State Government. Government bonds have little to no risk with treasury notes return is used as
risk-free rate. These instruments are therefore useful to banks as they allow safe savings and liquid
assets. It is also good to balance the bank’s risk portfolio. This is good for diversification.
Other bank assets:
This includes electronic network infrastructure and shares in controlled entities.
Off-Balance-Sheet Business
OBS transactions are a significant part of a bank’s business. OBS transactions include:
o Direct credit substitutes
o Trade-and-performance-related items
o Commitments
o Foreign exchange, interest-rate and other market-rate-related contracts (derivatives)
These are activities that do not fall under the definition of an asset or a liability based on their
accounting standard. The reason they do not fit the definition is because of the level of certainty
associated with he return or liability being insufficient.
Direct credit substitutes:
An undertaking by a bank to support the financial obligations of a client (e.g. ‘stand-by letter of
credit’).
o The bank acts as a guarantor on behalf of a client for a fee.
o The client has a financial obligation to a third party.
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o The bank is required to make a payment only if the client defaults on a payment to a third
party.
This is a promise by the bank to pay a third party for any financial obligation that a client has. For
example, if an individual has to make a payment to a third party and they want a guarantee, you can
go to the bank and ask for a letter of credit which allows the third party to trust the issuer and the
bank only has to pay the third party if the client fails to do so i.e., the bank will pay the third party if
the individual does not.
Trade and performance related items:
A form of guarantee provided by a bank toa third party, promising financial compensation for a non-
performance of commercial contract by a bank client, for example: documentary letters of credit or
performance guarantees.
These are similar to letters of credit and direct credit substitutes and used for different purpose. They
are promises by the bank that a payment will be made if a client doesn’t pay, and they are used for
exports and imports and for performance guarantees i.e. if a bank guarantees that a client will
perform something that the third party has asked for, if that does not happy and the third party is
not happy, the bank will make the payment.
Commitments:
The contractual financial obligations of a bank that are yet to be completed or delivered. The bank
undertakes to advance funds or make a purchase of assets at some time in the future, for example:
forward purchases (forward contracts), or underwriting (the bank promises to purchase whatever
securities are not sold when they help a client to issue them, this is part of investment banking
activities of a commercial bank).
This is a loan the bank has committed to but not yet issued. An example is a pre-approval from the
bank to someone looking at buying a house. It is a commitment to a future loan.
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), for example: futures, options, foreign exchange
contracts, currency swaps, forward rate agreements (FRAs). It is also used for speculating.
Derivatives are like a bet as there are two sides: one party promises to make a payment to the other
party if a certain condition is met. There is always one party that wins (receives funds) and one party
that loses (loses funds). Due to this uncertain nature, it is off-balance-sheet.
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Non-Bank Financial Institutions – Chapter 3
Learning objectives:
o Describe the roles of investment banks.
o Explain the structure, roles and operation of managed funds and identify factors for their
rapid growth.
o Discuss the purpose and operation of cash management and public unit trusts.
o Describe nature and roles of superannuation funds
o Define life insurance and general insurance offices and explain main types of insurance
policies.
o Discuss hedge funds.
o Explain the principal functions of finance companies and general financiers, and changes that
have impacted finance company business.
o Describe the unique role of export finance corporations.
Chapter outline:
o Investment banks
o Managed funds
o Cash management trusts
o Public unit trusts
o Superannuation funds
o Life insurance offices
o General insurance offices
o Hedge funds
o Finance companies and general financiers
o Building societies
o Credit unions
o Export finance corporations
Investment Banks
Investment banks are innovators at the cutting edge of developments in the financial system, often
using the latest theoretical work produced by finance scholars.
The organisation of an investment bank is interesting: front office, middle office, and back office.
In Australia, investment banks or money market corporations do not control a large share of the total
assets of financial institutions, however, they remain important as innovators and deal-makers.
Investment banks are not authorised to take deposits, and so they do not give loans like a
commercial bank. Instead, they invest for their own profit. Investment banks mostly borrow money,
and raise funds through said borrowing as well as through the fees they charge for their services.
They provide services to companies, not individuals (unless a high net-worth individual such as
Warren Buffet).
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Investment banks employ dealers who are professionals that buy and sell assets for them (i.e. shares,
bonds, foreign exchange, derivatives, anything that can create profit). Examples are Macquarie Bank
or Morgan Stanley which are investment banks. They are involved in services that companies and
institutional investors use, and they charge fees for this. One of these services is underwriting –
when a company wants to issue shares, they will ask an investment bank to act as an underwriter,
which means they will help the company to issue the shares, and if the shares are not sold, the
remainder are sold to the investment bank where they can resell them on the secondary market
(plus they will charge fees for their services).
Sources of funds:
Their sources of funds are mainly securities into international money markets and capital markets.
This is done by borrowing internationally and domestically, and using those funds to service their
commercial clients.
Uses of funds:
o Limited lending to clients, usually on a short-term basis.
o These loans tend to be sold into the secondary market.
o Primarily focused on off-balance-sheet advisory services.
Off-Balance-Sheet Business:
Innovative products and services in provision of advice, management and funding services,
generating their main income from fees. For example:
o FOREX dealers, advice on raising funds, underwriting equity/debt issues, shares placements,
balance-sheet restructuring, venture capital.
o Mergers and acquisitions – takeover company seeks to gain control over a target company.
Managed Funds
Managed funds are investment vehicles for investing the pooled savings of individuals in various
asset classes in domestic and international money and capital markets funded by managers.
They are specialist investment companies that help their clients by investing on their behalf. A
managed fund can have different types of funds. They are based on the creation of trust as the
company will create a trust account where they invite people to invest into this account where they
will produce a product disclosure statement (PDS) and they invest they funds on behalf of the clients.
Mutual fund (United States)
o Managed funds established under a corporate structure.
o Investors purchase shares in the fund.
Trust fund (Australia and United Kingdom)
o Managed funds established under a trust deed, managed by a trustee or responsible entity.
o Investors in the fund obtain a right to the assets of the fund and a share of the income and
capital gains (loss) derived.
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Main categories of managed funds:
o Cash management trusts (section 3.3) – only invests in money market instruments and is
therefore very liquid to keep your portfolio diverse and liquid
o Public unit trusts (section 3.4) – issues units to investors
o Superannuation funds (section 3.5) – managed funds where they take your contributions
and invest on your behalf
o Statutory funds of life offices (section 3.6) – life insurance companies, they invite people to
invest
o Hedge funds (section 3.8) – a kind of managed funds that invest through specific strategy
through heavy diversification and derivatives in order to hedge/manage risk to ensure
positive returns even when markets are going down
o Common funds
- These are operated by trustee companies, they pool funds of beneficiaries and invest in
specified asset classes.
- Differ from unit trusts in that units are not issued.
- Include solicitors offering mortgage trusts.
o Friendly societies
- Mutual organisations that provide members with investment and other services
(insurance, sickness, and unemployment benefits).
- Investment products include the issue of bonds that invest in asset classes like cash,
fixed-interest, equities, and property.
- They have limited members and invest money and their behalf to provide for the needs
of their members. It is used by members only.
Categorisation of managed funds by investment risk profile:
Balanced growth funds – investments in longer term income streams supported by limited capital
growth. Investments include domestic and foreign equities. This is more diversified in terms of assets
that grow in value rather than provide income (not ideal for the retired).
Managed growth (or capital growth) funds – invest for greater return through capital growth and
less through income streams. Investments include a greater proportion of domestic and foreign
equities. This has income but not much.
Cash Management Trusts
A mutual investment fund, often managed by a financial intermediary, established under a trust
deed, specifying the trust’s investments.
o Generally invest in short-term money-market instruments.
o Provide high liquidity for the investor.
o Share total financial institutions assets grew from 0.6% in 1990 to 1.1% in 2010. Despite
substantial declines during and after the Global Financial Crisis (GFC), cash management
trusts controlled 4.57% of total assets of financial institutions at the end of 2017.
o Provide retail investors with access to the wholesale market. Cash and deposits 75%, other
assets are 25%.
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Public Unit Trusts
o Investment fund established under trust deed.
o Investors purchase a share in the trust called a ‘unit’.
o The trustee invests the pooled funds received from investors.
o Unit holders receive a return in the form of income and/capital gain.
o Types of unit trusts and share of public unit trusts assets include property trusts, equity
trusts, mortgage trusts, fixed-interest trusts.
Listed trusts – units quotes and sold on the ASX (more liquid) – mainly property trusts. Listed means
it is on the ASX.
Unlisted trusts – units sold back to trustee after giving the required notice (less liquid) – mainly
equity trusts. Unlisted means it is not on the ASX.
Superannuation Funds
The largest part of the managed funds industry is the superannuation sector. Indeed, superannuation
funds account for almost one-fifth of the assets held by financial institutions in Australia. Most
surprisingly, self-managed-super-funds (SMSFs) hold the largest amount of assets within the
superannuation sector. There are more than 500,000 SMSFs holding a total of more than $700 billion
in assets.
Savings accumulated are to fund an individual’s retirement. Superannuation assets exceeds $2600
billion by 2018. More than $700 billion of this is held in SMSFs.
APRA classifies superannuation funds as:
o Entities with more than four members
o Pooled superannuation trusts (PSTs)
o Small APRA funds
o Balance of life office and statutory funds
o Self-managed funds
SMSFs are managed privately by trustees (maximum four people). For example, a family of four can
set up an SMSF trust fund created by a solicitor and managed by an accountant and you can ask a
financial advisor to help with the investors or do it yourself. Research has shown that not all trustees
with SMSF manage as well as superfunds. They often simply keep the money in cash in the accounts
with little returns and without investing, or they simply invest in other managed funds which could
be done through a superfund. It can be expensive to open an SMSF so you have to really want to run
it and manage it yourself and ensure you invest properly. Another advantage is that you can have
direct property by purchasing a unit through the fund.
Life Insurance Offices
Life Insurance Offices:
These sell insurance and superannuation policies.
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Their sources of funds include:
o Premiums paid and policy holders or beneficiaries receive payment upon death/disablement
or at a nominated maturity date, subject to policy terms.
o Superannuation/retirement contributions. This is when the inflow of funds is regular,
predictable, and long-term.
o Life insurance office policies. These are whole-life, term-life, total and permanent
disablement, trauma, income protection, business overheads.
Uses of funds:
The outflow of funds are quite predictable and stable and therefore are invested mainly in long-term
securities. Statutory funds invest in:
o Equities and unit trusts
o Long-term securities
o Cash and short-term securities
o Overseas
Life insurance policies use the funds that they raise to pay claims and to invest in equities and long-
term securities. Usually, insurance companies make most of their money this way, not through
premiums. APRA regulates life insurance.
Regulation:
o Supervised by APRA, which applies the same capital and liquidity management requirements
as for banks.
o Life Insurance Act (Cth) – licensing and control.
General Insurance Offices
Insurer pays the insured a predetermined amount if some prespecified event occurs.
Sources of funds:
Contractual premiums paid in advance for:
o House and contents – co-insurance, public liability insurance
o Motor vehicle insurance – comprehensive, third party, fire and theft, compulsory third party
o Other risk insurance policies to individuals in the retail market and businesses in the
commercial market.
Inflow of funds not as stable as life offices.
Uses of funds:
Generally shorter term, highly marketable securities, owing to the less predictable nature of the risks
underwritten. Examples include: money market securities, such as bills of exchange, commercial
paper, and certificates of deposit.
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Share of total assets declined from 4.4% in 1990 to 3% in 2018.
Hedge Funds
These use sophisticated investment strategies and products mainly for high-net-worth individuals
and institutions to achieve higher returns.
o They tend to specialise in different financial instruments such as equity, FOREX, bonds,
commodities, and derivatives.
o Hedge fund sector generally divided into single-manager hedge funds and fund of funds.
o Sources of funds mainly from superannuation and life offices and high-net-worth individuals.
o May leverage investments through debt financing and/or use derivative products.
Finance Companies and General Financiers
Borrow in domestic and international financial markets and make loans to small business and
individuals.
They emerged largely owing to previously highly regulated banking sector to circumvent on interest
rates and lending.
The sector can be classified into:
o Diversified finance companies
o Manufacturer-affiliated companies (e.g. Ford Credit)
o Niche specialists (e.g. motor vehicle and lease financing)
The sector share of total assets has declined from 7.5% in 1990 to less than 2% in 2018 as
commercial banks are more competitive in deregulated environment.
They have high-risk loans. For example, if you go to purchase a car and the dealership provides
financing, it is through a finance company.
Sources of funds:
o Issue of debentures and unsecured notes
o Borrowings from related corporations and banks
o Borrowing direct from domestic and international money and capital markets
Their funds may be borrowed from their parent company, or if they do not have a parent company
they issue debt securities such as debentures, or long-term bonds to raise their money.
Uses of funds:
o loans to individuals, possibly higher risk
o lease financing
o loans to small- to medium-sized businesses (e.g. bills finance, term loans, floor plan
financing, factoring and accounts receivable financing).
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They give riskier loans to individuals and to businesses e.g., factoring. They also lease, where they
purchase assets and receive regular payment over time. If the asset loses value after time, that is a
loss to them, hence it is risky.
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Building Societies
Authorised deposit-taking institutions mainly lending for residential property. During period of
regulation, building societies gained market share at the expense of savings banks. Since
deregulation, the sector share of total assets declined from 3.1$ in 1990 to less than 1% in 2018. In
response some building societies have:
o merged to rationalise costs
o become banks (e.g. Challenge Bank, Advance Bank and Heritage Bank)
o improved technology for service and cost reasons
o diversified activities and products offered to savers and borrowers.
Sources of funds:
Their main source of funds are deposits from customers.
Uses of funds:
Funds are mainly used as personal finance to individual borrowers. This is mainly in the form of
housing finance, and term loans and credit card finance.
Regulation:
As they are ADIs (i.e. authorised by APRA to accept retail deposits), regulation is by APRA with the
same prudential and reporting standards as banks.
Credit Unions
Common bond of association often exists between members owing to employment industry to
community (e.g. Shell Employees’ Credit Union).
Share of total financial institutions assets remained relatively stable, only declining from 1.2% in
1990 to less than 1% in 2018.
Sources of funds:
Their main source of funds are from deposits from members (payroll deductions). Other credit
unions and the issue of promissory notes and other securities are also sources of funds.
Uses of funds:
Funds are primarily personal finance to members:
o residential housing loans
o personal loans and credit card facilities
o limited commercial lending
Regulation:
As ADIs (authorised deposit taking institutions), they are regulated by APRA, which applies the same
prudential and reporting standards as for banks and PBSs.
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Export Finance Corporations
Export finance companies support the export activities of domestic firms. In Australia, the official
export credit agency is the government authority, Export Finance and Insurance Corporation. The
purpose of the EFIC is to overcome financial barriers for exporters by providing financial solutions,
risk management options and professional advice, when the private market lacks capacity or
willingness, we create opportunities for Australian exporters and offshore investors to grow their
international business’ (efic.gov.au).
EFIC facilitates export trade by providing trade insurance and financial services and products that
may not be available from other financial institutions.
o Insures Australian exporters against non-payment.
o Guarantees trade finance for the purchase of Australian goods and services.
o Insures Australian firms against political risk of overseas investments.
o Indemnities financial transactions of insurers that provide bonds/guarantees to overseas
buyers and provide performance bonds in support of Australian export contracts.
These are companies that have been established to assist Australian exporters as exporting is an
essential part of our economy.
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