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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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6 hree categories of banks
± Incorporated banks²domestic and foreign
± Unincorporated foreign bank branches
± Foreign bank representative offices
6 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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6 Asset management (í1980s)
± Loans portfolio is tailored to match the available deposit
base
6 Liability management (1980sí)
± 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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6 Sources of funds appear in the balance sheet as
either liabilities or shareholders¶ funds

6 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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6 Current deposits
± Funds held in a cheque account
± Highly liquid
± May be interest or non-interest bearing
6 Call or demand deposits
± Funds held in savings accounts that can be withdrawn on
demand
± e.g. passbook account, electronic statement account with
A M and EF POS

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6 erm deposits
± Funds lodged in an account for a predetermined period at
a specified interest rate
 erm: 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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6 egotiable 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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6 Bill acceptance liabilities
± Bill of exchange
 A security issued into the money market at a discount to the
face value. he 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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6 Debt liabilities
± Medium- to-longer-term debt instruments issued by a
bank
 Debenture
6 A bond supported by a form of security, being a charge over
the assets of the issuer (e.g. collateralised floating charge)
 Unsecured note
6 A bond issued with no supporting security

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6 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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6 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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6 Uses of funds appear in the balance sheet as
assets
6 he 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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6 Personal and housing finance
± Housing finance
 Mortgage
 Amortised loan
± Investment property
± Fixed-term loan
± Credit card

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6 Commercial lending (business sector and other
financial intermediaries)
± Fixed-term loan
 A loan with negotiated terms and conditions
6 Period of the loan
6 Interest rates
± Fixed or variable rates set to a specified reference rate (e.g.
BBSW)
6 iming of interest payment
6 Repayment of principal

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6 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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6 Lending to government
± reasury notes
 Short-term discount securities issued by the Commonwealth
Government
± reasury 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
6 Other bank assets (e.g. electronic network
infrastructure and shares in controlled entities)

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6 OBS transactions are a significant part of a bank¶s
business

6 OBS transactions include


± Direct credit substitutes
± rade and performance-related items
± Commitments
± Foreign exchange, interest rate- and other market rate-
related contracts

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6 Direct credit substitutes
± An undertaking by a bank to support the financial
obligations of a client (e.g. µstand-by letter of credit¶)
 he 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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6 rade 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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6 Commitments
± he 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.
6 Forward purchases
6 Underwriting

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6 Foreign exchange, interest rate- and other market
rate-related contracts
± he 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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6 Reasons for regulation of banks


± Importance of the banking sector for health of the
economy

6 Prudential supervision
± he imposition and monitoring of standards designed to
ensure the soundness and stability of a financial system

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6 Functions of capital
± he 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
6 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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6 Basel II extends Basel I to increase sensitivity to
different levels of asset and OBS business risk
6 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
± ransparency through accumulation and reporting of
information

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6 Minimum capital adequacy requirement applies to
commercial banks and other institutions specified
by prudential regulator
6 Capital adequacy standard
± Minimum risk-based capital ratio of 8%
 Minimum 4% held as ier 1 capital
6 Highest quality core capital
 Remainder can be held as ier 2 (supplementary) capital
6 Upper ± specified permanent hybrid instruments
6 Lower ± specified non-permanent instruments
± Regulator can require an institution to hold a capital ratio
above 8%

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6 Banks are the dominant institution and have
moved to liability management
6 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)
6 Uses of funds include government, commercial
and personal lending

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6 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
6 APRA¶s bank prudential supervision requirements
include capital adequacy, liquidity management
and other controls

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