Notes inclass 19/02

TEST module 1-2

Week 4 important worth 40%
Look at the questions for revision
Look at other chapter resources for financial institutions
Intro
-An authorized deposit-taking institution (ADI) is an entity approved by the APRA
Australian preduential regulation authority to collect deposits
-A bank is an adi approved by apra to use the term bank in its trading name
Banks make up significant component of ADIs
The business of banking
-heart of banking = accepting deposits and making loans. Also todays banks run
the payments system and trade securities.
-seek to provide a full range of financial services one-stop shop
-retail banking: small transactions, household sector
-wholesale banking: large transactions, comporate sector
Payments system
Banks playu a dominant role by facilitating:
-currency issuance
-cheque deposits and clearing
-credit and debit cards
-electronic payments
-international payments
Balance sheet management
-liquidity transformation: banks offer variety of deposits products (more towards
liquid deposits) but provide long-term loans- comfortable
-This exposes them to a balance-sheet liquidity mismatch in their sources and
uses of funds
-in normal circumstances this is not a problem because net deposit withdrawals
(at any one time) are relatively small (retail in nature)
Asset- Liability management
-asset-liability management (ALM) by a bank involves changing the structure of
its balance sheet to sustain its business
-purposes include: to ensure sufficient liquidity is on hand, to offload unwanted
assets, to protect against interest rate exposure

-deregulation has improved alm flexibility via introduction of new financial

products and financial engineering (securitisation) (superannuation fundsregular income stream low risk) (higher credit ranking less risk) decreasing the
yield the pv will be higher
Lending
-a core business function of banks.
-mortgages (home/investment) are a major part of their portfolio, and since
deregulation banks have introduced wider (e.g. fixed rate mortgages, home
equity loans).
-loans to business include overdrafts, bill lines, leasing, trade finance or term
loans may be secured or unsecured. (reflect the relevant risk exposure)
Interes rate margins (IRM)
Defined as the gap between the average rate received on a banks assets and the
average rate paid on its liabilities
IRM= IR/TA) IP
IR= interest received
IP= Interest paid
TA= Total assets
Fisher effect- inflation,
Real rate of return
IRM
-What determines the size of the IRM?
- capital adequacy and reserve requirements- regulatory/internal risk
management systems
-the marginal cost of the product- administration; establish/set-up monitor/
discharge
-elasticity of demand- sensitivity to interest rates, margins decrease with
increased competition (how much can u rip of customer)
-One approach to setting the IRM is user pays pricing is set so that each
consumer pays the full cost of their particular product.
-another approach is cross subsidy pricing where some consumer are undercharged and the bank recovers the subsidy by over-charging others
Off-Balance- Sheet activities (OBS)
-definition: activities that earn income (and involve risk) but do not create an
explicit asset or liability on balance sheet
-also known as contingent or implicit liabilities

-Banks can create contingent claims on themselves as well as others (overdraft

facilities, standby letters of credit) contingent- may or may not occur ( car
insurance)
-three categories of OBS activity:
1. fee-based services: corporate advice, underwriting, securitisation, managing
loan syndications
2. Financial services: funds management, stockbroking, travel
3. market trading: taking a poist CFD
Bank business stradegies
-one strategyZ: Citicorp involves a one stop shop financial supermarket . they
seek to profit from economies of scale (falling unit costs as size increases) and
scope (cost efficiencies arising from joint-production)
-another strategy: the BT approach is to specialize in specific niche areas such as
funds management (bt) or retail banking (st George)
Australian Banks
-the four pillars policy says it is desirable to retain four major banks to enhance
competition. This means maergers amongst the four majors are not allowed.
Other financial conglomerates remain possible, subject to ACCC approval: for
example, a major bank and an insurance giant, a takeover by a foreign bank, or a
major bank buying a smaller local bank.
Offshore activities of banks
-following deregulation, Australian banks pushed into offshore markets. This was
mainly done by:
-following an existing client base into global markets;
-competing in foreign markets at the retail level by acquiring existing branch
networks or setting up new ones; or providing speciaklized
Bank regulation
-the general regulatiuon of banks is based around both liquidity and capital
adequacy requirement s: liquidity requirements recognize the importance of
these insitiutions and maintain sufficient liquidity
Banking regulation
-capital adequacy requirements recognize the business of banking to transform
and multiply financial products and their wider impact on the general confidence
Liquidty requirements
- Apra via the preduential standard
Basel accord 1 11 111
Purpose to maintain sufficient liquidity to protect depositors in wind-up and
maintain market confidence in the banking system

Teir 1- tier 2 casnnot exceed

Basel 11 accord
-minimum capital requirement (to make capital more sensitive to risk)
-supervisory review process to ensure sound internal management processes are
in place), and
-market discipline (through increased disclosure)
Credit risk capita
-loss from borrower default
-capital requirements assessed on a risk weighted basis
-often risk assessed via internal/external credit rating
Operational risk capital
-risk of loss from inadequate/failed;- internal processes, people, systems or
external events
-capital requirements generally based on some fraction of banks gross income
Value at Riswk (VaR)/ market risk capital
-assess magnitude of losses from movements in market for value of exposure
(interest rates, exchange rates, commodity prices)
-may be adjusted by weighting for credit risk component