Tutorial 2 Banks

Question 1
Deregulation has changed banking practices in Australia.
Discuss this statement with reference to banks asset and liability
management.

In asset management, a bank restricts growth in its lending to the level of

funds available from its depositor base.

In liability management, a bank manages its sources of funds (liabilities)

in order to meet future loan demand (assets). If loan demand is forecast to
increase, banks enter the capital markets and borrow the necessary funds
required to meet their forecast loan demand.

Deregulation involved the removal of restrictive regulations, allowing

banks to apply liability management.

Question 3
A customer has approached your commercial bank seeking to
invest funds for a period of six months. The customer is
particularly worried about risk following the GFC and the market
volatility that continues to characterise world financial markets.
Explain the features of call deposits, term deposits and CDs to
the customer and provide advice on risk-reward trade-offs that
might be associated with each product.

Call deposits are funds held in a savings account that can be withdrawn
on demand. Call deposit account holders usually receive interest
payments, but the return on funds invested is low, which represents the
highly liquid nature and low risk attached to this type of account.

Term deposits are funds lodged in an account for a predetermined period

and at a specified fixed interest rate. Term deposits offer savers a higher
rate of return than is available on current accounts or call deposits, which
compensates the save for the loss of liquidity with this type of deposit,
that is, the term deposit is fixed for the nominated period. The term
deposit is a safe and stable investment that is particularly attractive to a
conservative investor.

Certificate of deposits (CDs) are a short-term deposit issued by a bank.

The face value is repayable at maturity. CDs have a high liquidity.

Question 4
Discuss the four main uses of funds by commercial banks and
identify the role that the purchase of government securities plays
in commercial banks management of their asset portfolios.

The four main uses of funds by commercial banks include:

 Personal and housing finance
Commercial lending
Lending to government
Other bank assets

Securities issued by the government are usually regarded as having a

very low level of risk and therefore yield a low rate of return. The purchase
of government securities provide banks with the flexibility to actively
manage its overall asset portfolio, while at the same time lowering the
overall levels of risk in its asset portfolio. Government securities:

Are an investment alternative for surplus funds that a bank is

holding
Are a source of liquidity as they can be easily sold in the secondary
markets when funds are needed for further lending
Provide income streams and potential capital gains, whereas holding
cash does not
May be used as collateral to support the banks own borrowings in
the direct finance markets
May be used for a repurchase agreement with the central bank in
order to raise cleared funds for payments system settlements
Improve the quality of the balance sheet by holding a group of
assets with lower-risk attributes
Enable a bank to manage the maturity structure of its balance sheet
by purchasing securities with a range of maturities and cash flows
Allow a bank to manage its interest rate risk by buying or selling
securities with different interest rate structures

Question 6
ABC Limited plans to purchase injection moulding equipment to
manufacture its new range of plastic products. The company
approaches its bank to obtain a term loan. Identify and discuss
important issues that the company and the bank will need to
negotiate in relation to the term loan.

In relation to the term loan, the company and the bank will need to
negotiate the:

Period of the loan

Interest rate
Security
Timing of repayments

Question 7
The off-balance-sheet business of banks has expanded
significantly and, in notional dollar terms, now represents over
seven times the value of balance-sheet assets.
 a) Define what is meant by the off-balance-sheet business of
banks.

The off-balance-sheet business are transactions that represent a

contingent liability and therefore are not recorded on the balance sheet.

b) Identify the four main categories of off-balance sheet

business and use an example to explain each category.
The four main categories of off-balance sheet business are:
Direct credit substitutes an undertaking provided by a bank to
support the financial obligations of a client, such as a stand-by letter
of credit
Trade- and performance- related items an undertaking provided by
a bank to a third party promising payment under the terms of a
specified commercial contract, such as documentary letters of credit
(DLCs) and performance guarantees
Commitments the contractual financial obligations of a bank that
are yet to be completed or delivered, such as outright forward
purchase agreements
Foreign exchange contracts, interest rate contracts and other
market-rate-related contracts derivate products, such as forward
exchange contracts

Question 9
Bank regulators impose minimum capital adequacy standards on
commercial banks.

a) Briefly explain the main functions of capital.

The main functions of capital include:

It is the source of equity funds for a corporation.

It demonstrates shareholders commitment to the organisation.
It enables growth in a business and is a source of future profits.
It is necessary in order to write off periodic abnormal business
losses.
b) What is the minimum capital requirement under the Basel III
capital accord?

The minimum capital requirement under the Basel III capital accord is a
risk-based capital ratio of 8% of total-risk-weighted assets at all times. At
least half of the risk-based capital ratio must take the form of Tier 1
capital, that is, at least 4%. The remainder of the capital requirement
could be held as Upper Tier 2 and Lower Tier 2 capital.

c) Identify and define the different types of acceptable capital

under the Basel II and Basel III capital accords. Remember
that Basel II continues to function, with Basel III acting to
strengthen its main pillars.
The different types of acceptable capital under the Basel II and Basel III
capital accords are:

Tier 1 capital, which consists of the highest quality capital elements

that fully satisfy all the essential capital characteristics:
o They provide a permanent and unrestricted commitment of
funds.
o They are freely available to absorb losses.
o They do not impose any unavoidable servicing charge against
earnings.
o They rank behind the claims of depositors and other creditors
in the event of winding-up.
Upper Tier 2 capital, which consists of elements that are essentially
permanent in nature, including some hybrid capital instruments.
Lower Tier 2 capital, which consists of instruments that are not
permanent, that is, dated or limited0-life instruments.

Question 10
Pilar I of Basel II capital accord includes an operational risk
component.

a) Define operational risk.

Operational risks are exposures that may impact on the normal day-to-day
business functions of an organisation.

b) Using the standardised approach, explain how a commercial

bank is required to measure the operational risk component
of its minimum capital adequacy requirement.

The operational risk capital requirement for the retail/commercial banking

area of business is calculated by:

Taking the last six half-yearly observations of total gross outstanding

loans and advancements,
Multiplying a proportion (3.5% of total gross outstanding loans and
advances at each observation point) by a factor of 15%, to produce
a result in respect of each observation
Determining an average result for the six observations

The operational risk capital requirement for the all other activity area of
business is calculated by:

Taking the last six half-yearly observations of net income earned

over a six-month period
Multiplying net income at each observation point by a factor of 18%
to produce a result in respect of each observation
Determining an average result for the six observations
Question 11
Provide an overview and rationale for the two new liquidity
standards introduced by Basel III.

The two new liquidity standards introduced by Basel III are:

A Liquidity Coverage Ratio (LCR) that aims to ensure that financial

institutions hold high quality liquid assets in sufficient volume to
sustain them for a period of one moth during a period of acute
stress.
A Net Stable Funding Ratio (NSFR) that aims to foster longer-term
stability by requiring financial institutions to fund their activities
with stable sources of funding.