Chapter 2

Commercial Banks

Websites:
www.apra.gov.au
www.asic.gov.au
www.accc.gov.au
www.rbnz.govt.nz
www.anz.com.au
www.commbank.com.au
www.nab.com.au
www.westpac.com.au

Copyright 2012 McGraw-Hill Australia Pty Ltd

PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips 2-1
Slides prepared by Peter Phillips
 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

(cont.)

Copyright 2012 McGraw-Hill Australia Pty Ltd

PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips 2-2
Slides prepared by Peter Phillips
 Learning objectives (cont.)
• Understand the background and application of the
capital adequacy standards
• Examine liquidity management and other controls
applied by APRA
• Understanding the standardised approach to credit risk
• Analyse business continuity risk
• Discuss the importance of corporate governance and
ethics in the context of Australian financial institutions

Copyright 2012 McGraw-Hill Australia Pty Ltd

PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips 2-3
Slides prepared by Peter Phillips
 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

Copyright 2012 McGraw-Hill Australia Pty Ltd

PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips 2-4
Slides prepared by Peter Phillips
 2.1 Main activities of commercial
banking
• Overview:
– Commercial banks provide a full range of financial services
– In the modern financial system, the activities of commercial
banks are far less regulated than they have been historically
– In a less regulated environment, commercial banks practice
‘liability management’ whereby shortfalls in loan demand are
borrowed on the capital markets
– The regulation of the banking sector attracted renewed
attention following the GFC

(cont.)

Copyright 2012 McGraw-Hill Australia Pty Ltd

PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips 2-5
Slides prepared by Peter Phillips
 2.1 Main activities of commercial
banking (cont.)

• 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

(cont.)

Copyright 2012 McGraw-Hill Australia Pty Ltd

PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips 2-6
Slides prepared by Peter Phillips
 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
meet loan demand
 Borrow directly from domestic and international capital markets
 Provision of other financial services
 Off-balance-sheet (OBS) business

Copyright 2012 McGraw-Hill Australia Pty Ltd

PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips 2-7
Slides prepared by Peter Phillips
 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

Copyright 2012 McGraw-Hill Australia Pty Ltd

PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips 2-8
Slides prepared by Peter Phillips
 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

(cont.)

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PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips 2-9
Slides prepared by Peter Phillips
 2.2 Sources of funds (cont.)

• 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

(cont.)

Copyright 2012 McGraw-Hill Australia Pty Ltd

PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips 2-10
Slides prepared by Peter Phillips
 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 owing to fixed maturity
 Higher interest rate than current or call accounts
 Generally fixed interest rate

(cont.)

Copyright 2012 McGraw-Hill Australia Pty Ltd

PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips 2-11
Slides prepared by Peter Phillips
 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)

(cont.)

Copyright 2012 McGraw-Hill Australia Pty Ltd

PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips 2-12
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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

(cont.)

Copyright 2012 McGraw-Hill Australia Pty Ltd

PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips 2-13
Slides prepared by Peter Phillips
 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

(cont.)

Copyright 2012 McGraw-Hill Australia Pty Ltd

PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips 2-14
Slides prepared by Peter Phillips
 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

(cont.)

Copyright 2012 McGraw-Hill Australia Pty Ltd

PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips 2-15
Slides prepared by Peter Phillips
 2.2 Sources of funds (cont.)
• 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)

Copyright 2012 McGraw-Hill Australia Pty Ltd

PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips 2-16
Slides prepared by Peter Phillips
 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

Copyright 2012 McGraw-Hill Australia Pty Ltd

PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips 2-17
Slides prepared by Peter Phillips
 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

(cont.)

Copyright 2012 McGraw-Hill Australia Pty Ltd

PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips 2-18
Slides prepared by Peter Phillips
 2.3 Uses of funds (cont.)

• Personal and housing finance

– Housing finance
 Mortgage
 Amortised loan

– Investment property
– Fixed-term loan
– Credit card

(cont.)

Copyright 2012 McGraw-Hill Australia Pty Ltd

PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips 2-19
Slides prepared by Peter Phillips
 2.3 Uses of funds (cont.)

• 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

(cont.)

Copyright 2012 McGraw-Hill Australia Pty Ltd

PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips 2-20
Slides prepared by Peter Phillips