Topic 2 - Commercial Banks

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This article is a topic within the subject Capital Markets and Institutions.


Required Reading

Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 46-97.

Commercial Banking

[1] In Australia, financial institutions that are approved to carry out financial intermediation are authorised by APRA & are authorised depository institutions. Commercial banks are extremely important as they make up a significant of the financial system (~50% of assets not including OBS transactions) since being deregulated due to the rise of non-bank financial institutions in the 80’s (Govt. Had to choose between total regulations or deregulating the commercial banks).

Main Activities:

  • Asset Management (Pre 1980’s) - Loan portfolio tailored to available deposit base. Restricted loans
    • Highly regulated environment
  • Liability Management (1980s –) - Deposit base & other funding sources tailored to loan demand
    • Less regulated environment. The banks borrow direct from capital markets to meet forecast loan demand.

Sources Of Funds


  • Deposits - Current (Cheque/Operating Accounts) or Call/Demand Deposits (Savings Accounts – can withdraw on demand)
    • Highly liquid for surplus units, stable – accounts are maintained for future expenses or firm operating expenses
  • Term Deposits - 1 month to 5 years
    • Fixed maturitysacrificing liquidity for return, investors tend to come here in times of market turmoil
  • Negotiable Certificates of Deposit - Short term deposit security(30-180 Days), Bank may issue into money market
    • Paper issued by the bank at a discount to face value specifying that face value will be repaid at maturity (date)
    • Negotiable security – deep/liquid secondary market, Banks can adjust yield on new CDs to adapt to funding requirements.
  • Bill Acceptance Liabilities - Bill of exchange
    • Acceptor Role – bank commits to repay the face value of the bill to the holder at maturity for a fee (to boost creditworthiness) & has a separate arrangement with the issuer to recover the funds at maturity.
    • Discounter Role – Bank buys bill from drawer and resells in the money market. Arranges finance for a customer without using its own funds
  • Debt Liabilities - Medium to Longer term debt instruments issued by a bank
    • Debenture - Bonds supported by a form of security, a collateralised floating charge over the assets of issuer
    • Unsecured Note - A bond issued with no supporting security
    • Transferable Certificate of Deposit - Long term (3-5) fixed rate instruments issued with face value of 100,000+
  • Foreign Currency Liabilities - Debt instrument issued in international capital mkts. – denominated in foreign currency
    • Diversification of funding, matches foreign assets with liabilities, corporate demand for FOREX products
    • Euromarkets – instruments issued into debt markets or foreign country but not in the currency of that country
  • Loan Capital - Characteristics of both debt & equity – hybrid securities (e.g. subordinated debentures)
  • Shareholders’ Equity - Ordinary shares issued or retained earnings

Uses Of Funds


Personal And Housing Finance

  • Housing Finance – Mortgages (security interest of lender in the property) & amortised Loans for residential property
    • Securitisation – selling off existing loans into a trust to fund new loans. Trustee funds this buy issue securities to investors (e.g. bonds secured by housing loans)
  • Investment Properties – Bank takes registered mortgage over the property as security
  • Fixed Term Loans – Typically matures before 5 years, a guarantee may be needed
  • Credit Cards – Used for electronic transactions using ATM’s or EDTPOS, user draws against a predetermined limit
  • Personal Overdrafts – allows for the mismatch of cash flow timing for individuals

Commercial Lending

Commercial lending is needed since most businesses cannot access capital markets (direct finance).

  • Fixed Term Loans – negotiated terms (maturity, interest rates (fixed/variable – specified to a reference rate e.g. bank bill swap rate), repayment timing, principal repayment, security, yes/no amortised loan instalments)
  • Overdraft – Allowing a firm to takes its operating account into debit by an agreed amount
  • Bank Bills Held – Bills of exchange bought by the bank at less than face value & held as asset (not sold into MM)
    • Rollover facility – Bank agrees to discount new bills over a specified period as existing bills mature
  • Leasing – owner of the assets allows lessee to use assets in return of periodic lease payments


Lenders/Investors often place surplus funds in low risk government issued securities.

  • Treasury Notes – short term discount securities issued by the government
  • Treasury Bonds – medium to longer term securities issued by the government, pay a specified interest coupon stream
    • Low risk, low return, high liquidity
  • Term Loans & Overdrafts – To various government agencies

Off Balance Sheet Business


OBS transactions are a major part of banking operations (14,000,000 million in 2010). They include:

  • Direct Credit SubstitutesContingent liability, bank makes a payment if the client defaults.
    • The bank supports the financial obligations of a client, acts as a guarantor for a fee e.g. stand by letter of credit
    • Allows clients to borrow directly from the markets, reduces risk as either borrower and bank must repay
  • Trade & Performance Related Items
    • A form of a guarantee provided by a bank to a 3rd party, promising financial compensation for non financial contractual obligations. E.g. performance guarantees (failure to complete terms of contract) or documentary letters of credit (bank on behalf of client, authorises payment for the delivery of G&S at arrival (importing))
  • CommitmentsContractual financial obligations of a bank that are yet to be completed/delivered
    • Bank undertakes to advance funds or purchase assets in the future credit cards, loans, underwriting, forwards
    • Outright forward purchase agreements – contracts to buy a specific asset at an agreed price at a specified date
    • Underwriting Agreements – Bank guarantees client that it will cover shortfall in funds received from a primary market issue
    • Loan & Credit Card Limit Approvals – Provide loans/credit in the future
  • FOREX, Interest Rate & Other Market Related Contracts + Speculating (Majority of OBS – 94.5%)
    • Use of derivatives to manage exposures to FOREX, interest rate, equity price, commodity risk.
    • Forward exchange Contracts – Buy/Sell specified amount of foreign currency at a future date at an exchange rate that is set today
    • Currency Swap – Bank exchanges a principal amount & ongoing interest payments that are denominated in foreign currency
    • Forward Rate Agreements – Compensation agreement between a bank & client based on a notional principal amount. One party compensates the other if interest rates move above or below an agreed interest rate.
    • Interest Rate Futures Contracts – Exchange traded agreements to buy/sell a security at a specific price at a predetermined future date
    • Interest Rate Option Contracts – Right but not obligation to buy/sell a specified financial instrument at a specific price at a predetermined future date
    • Equity Contracts – Futures/Option contracts based on specific stocks or indices, locks in equity prices today that will apply at a future date

Regulation And Prudential Supervision: Ensuring Stability And Soundness of Financial System


  • Important for economy’s health. Regulation is constraints on banking activities (imposition & monitoring of standards)
  • RBA – system stability & payment System  can provide emergency liquidity funds, Govt. Can also guarantee deposits.
  • APRA – prudential regulation & supervision of depository institutions, insurance offices & superannuation funds
  • ASIC – Market integrity & investor protection (Corporations law)
  • ACCC – Competition Policy

Capital Adequacy Standards: Basel


Capital is a source of equity funds that can provide growth &/or a cushion against excessive losses (periodic abnormal business losses).

Capital Adequacy requirements have been designed to ensure that banks have sufficient capital to meet obligations if loan losses exceed the level of profits (i.e. go above revenue)

Tier 1 or Core Capital consists of the highest quality capital elements which satisfy all the essential capital characteristics. It generally refers to paid up ordinary shares, retained earnings or general reserves. It must be 50% of minimum required capital

  • Permanent & unrestricted commitment of funds
  • Freely available to absorb losses
  • Don’t impose any unavoidable servicing charge against earnings
  • Rank behind the claims of depositors & other creditors

Tier 2 or Supplementary Capital includes other elements which fall short of quality tier 1 capital. Upper Tier 2 Capital consists of essentially permanent capital in nature, including hybrid capital instruments (preference shares, convertibles), whilst Lower Tier 2 Capital consists of instruments that are not permanent – dated/limited life instruments (subordinated debt)

BASEL 1 Capital Accord 1988

  • Created & applied a standardised approach to the measurement of the capital adequacy of international banks
  • Successful in increasing the amount of capital held by banks

BASEL 2 Capital Accord 2008

Basel 2 is an extension of BASEL 1 to increase sensitivity to different levels of asset risk (principally credit risk) & OBS business risk.

BASEL 2 Pillar 1 - Capital Adequacy

  • Credit Risk of banking assets & OBS business - Risk that a borrower/counterparty will default on their commitments
    • Risk weights applied to balance sheet & OBS items to calculate minimum capital requirement
    • Standardised Approach – Assign risk weights to B/S assets & OBS items (after being converted to B/S equivalents based on specified credit conversion factors) based on external ratings & multiply the risk weight by the book value of each specific asset/item. For residential housing loans risk weights can be determined by Loan to value ratios.
  • Operational Risk of bank’s business operations - risk of loss from inadequate or failed internal processes, people & systems or from external events. E.g. fraud, damage to physical assets, system failure. Banks must maintain a comprehensive operational risk management framework.
    • Standardised Approach – map & divide activities into retail/commercial banking & other activity, the risk capital requirement is a % of total gross outstanding loans, advancements & the book value of securities, whilst for other activities it is a % of net income
  • Market Risk of Banks’ trading activities - risk of loss from movements in market prices, use VaR models
    • General Market Risk, Changes in the overall market in interest rates, equities, FOREX, commodities
    • Specific Market Risk, The risk that the value of a security will change due to instrument specific factors
  • Form/quality of capital held to support the above exposures
    • Risk identification, measurement & management process adopted
    • Transparency – through accumulation & reporting of information

The minimum capital adequacy requirement applies to commercial banks & other institutions specified by a prudential supervisor (who can increase it depending on the institution). Currently the minimum risk based capital ratio is 8%, with a minimum of half of that being tier 1 capital.


This example from the lecture notes given [7] illustrates the calculations needed for this section of the course


Basel 2 Pillar 2 - Supervisory Review of Capital Adequacy

  • Is intended to ensure banks have sufficient capital to support all risk exposures
  • Encourage improved risk management policies (identifying, measuring & managing risk exposures).
  • Establishes dialogue between banks & their supervisors

Banks have the responsibility to ensure they hold adequate capital beyond the minimum core requirements (credit concentration risk i.e. large amounts to one borrower, industry or region), while regulators are expected to evaluate how well the bank is assessing its capital needs relative to its level of risk & may intervene.

The 4 key principles include:

  1. Banks should have a process for assessing capital adequacy & a strategy for maintaining it in relation to risk
  2. Supervisors should review bank’s internal capital adequacy assessment & strategies & ensure compliance
  3. Supervisors should expect banks to operate above the minimum regulatory capital ratios + ability to increase it.
  4. Supervisors should intervene at an early stage to prevent capital from falling below minimum levels

Basel 2 Pillar 3 - Market Discipline

  • Aim is to develop disclosure requirements to allow the market to assess information on the capital adequacy of an institution, i.e. increase transparency of the institutions risk exposures, risk management & capital adequacy. Especially with banks who do internal risk estimates to determine required capital.
  • Risk exposure, risk managemen & capital adequacy must be transparent
  • Both quantitative & qualitative information disclosure relating to Pillar 1 & 2

Liquidity Management And Other Supervisory Controls


Liquidity Risk is the risk of being unable to access funds to meet day to day expenses & commitments. Banks have special liquidity problems due to mismatch of maturity structures of assets & liabilities & associated cash flows. Instead of holding excess cash, banks tend to hold a portfolio of government securities to earn a return.

APRA requires that a liquidity management strategy be reviewed annually, approved by the board of directors & must include:

  • A system of measuring, assessing & reporting liquidity
  • Procedures for measuring liquidity relevant to BS & OBS activities on a group basis
  • Clearly defined managerial responsibilities & controls
  • Formal contingency plan for dealing with a potential liquidity crisis

This strategy must include scenario analysis - The going concern, how a business will meet liquidity needs over the next 30 days & in the name crisis situation, how a bank will meet liquidity requirements in an adverse situation over 5 days (adverse cash flow behaviour). Exemption or inadequate scenario analysis means that the bank must hold 9% of liabilities in highly liquid assets

Other Supervisory Controls – Risk management systems certification (identify, manage & control risk report to APRA), business continuity management (responding to disruptions or crises), Audit (check risk management systems), Disclosure & tranparency, large exposures (>10% must report), Forex exposures (report overnight FOREX positions), Subsidiaries, Ownership & control (must be less than 15%).



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Textbook refers to Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill.

  1. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 46-48
  2. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 49-53
  3. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 53-57
  4. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 58-62
  5. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 62-63
  6. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 64-80
  7. Natalie Oh, Lecture Notes, ASB, UNSW
  8. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 80-83
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