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Chapter 2 Commercial banks 1.

You are travelling to work by train when a student seated next to you notices that you work for a bank. She asks you what a bank is, why we have banks and what they do? In your own words, respond to her questions. A bank is essentially a financial institution that acts as a payment agent for customers by providing a wide range of financial services including the acquisition and provision of funds. They are the largest group of financial institutions within a financial system and hence central to facilitating the flow of funds between savers and borrowers. Because of the wide range of services that they provide, most businesses, individuals and governments consider them indispensable. 2. Banks have always been the dominant institutions within the financial system, but their relative importance has fluctuated due, in part, to changes in the regulatory environment in which they operate. Analyse and discuss this statement. Commercial banks are the main financial institutions operating in all major international financial systems, accounting for the largest share of the assets of all financial institutions. However, their dominance has a direct correlation with the level of financial system regulation that is evident within a nation-state. For example, prior to the mid-1980s there was a high level of bank regulation in most major economies that constrained the development of commercial banks. This high level of regulation led to a wide range of new financial institutions evolving in competition with the commercial banks, hence diminishing the dominance of the banks. These days, however, due to the deregulation of the commercial banks, the banking sector has grown so much that the nominal value of their off-balance-sheet transactions exceeds their balance-sheet assets. 3. Within the context of a commercial bank funding its balance sheet, explain asset management and liability management. Provide an example of how a bank uses liability management when determining the structure of its balance sheet. Which form of management is predominantly used by banks today? Asset management is basically where a bank restricts the growth in its lending to match the available deposit base, this often resulted in a bank running out of funds for lending towards the end of the month expecting customers would try to obtain a loan again. Liability management is instead of controlling the amount of funds available for lending, the bank seeks out other avenues/funding sources (liabilities) in order to ensure that they have sufficient funds available to meet loan demand and other commitments. If loan demand increases, banks simply enter the capital markets and borrow the necessary funds. Banks like other firms look to expand their financial services activities and hence aggressively compete for the funds necessary to support their loan programs. This has resulted, following the deregulation of financial markets in the movement from asset management to liability management as the predominant form of management.

4. A customer has approached a commercial bank seeking to invest funds for a period of six months. The customer is considering lodging the funds in a term deposit or, alternatively, purchasing a negotiable certificate of deposit. (a) Explain each of these investment products to the customer. Term Deposits are funds lodged in an account for a predetermined period and at a specified fixed interest rate. A Certificate of Deposit is a short-term discount security issued by a bank; face value repayable at maturity. (b) Why might the CD be a more appropriate investment choice? A CD would be the more appropriate investment choice, as the customer is only looking to invest his/her money for six months. Though the bank may offer a term deposit to suit him/her, CDs are much more flexible. If the CD has a maturity of longer than six months, it can be reissued into the deeply liquid secondary money markets whenever the customer chooses. 5. The ANZ Banking Group announced today that it has raised USD500 million through the issue of debt instruments into the international capital markets. Why might the bank borrow such a large amount of foreign currency liabilities? The deregulation of the financial system opened up enormous opportunities for banks to expand their activities and fund their loan demands through international money-market and capital-market sources. The fact that it is easier to raise larger amounts of debt in the international capital markets and often at lower net costs, meant the removal of constraints on the activities in the foreign exchange market, the floating of the exchange rate and the removal of most restrictions on capital flows in the international markets, made it extremely attractive as it allowed banks to diversify their funding base and raise foreign currency liabilities. Many of the banks major corporate clients have become more internationalised and have increased their demand for financial services denominated in currencies of their commercial hence deriving the banks demand for foreign currency liabilities. 6. Commercial banks are the principal providers of loan finance to the household sector. Identify five different types of loan finance that a bank offers to individuals. Briefly explain the nature and purpose of each of these types of loans. Housing Finance - the provision of long-term funds to enable the purchase of residential property. The bank registers a mortgage over the property as security for the loan, such that it will tank possession of the house and sell it should the borrowers fail to meet their housing loan commitments. Investment Property Finance - funding that enables a borrower to purchase property to rent or lease to a third party. Again, the bank will take a registered mortgage over the property as security for the loan. Fixed-term Loan - a loan provided for a predetermined period; use to purchase specified goods or services. The bank will require some form of security to support the loan. Credit Card - a card facility that provides access to funds through electronic distribution

systems. They typically have high interest rates on used credit, and a range of transaction and other fees might also apply. Personal Overdraft Facility - allows an individual to put a nominated account into debt from time to time up to an agreed limit. The bank expects that the overdraft will be brought back into credit when the individual receives income. 7. ABC Limited plans to purchase injection moulding equipment to manufacture its new range of plastics 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. Term loans are provided for a predetermined period; usually for a known purpose. The issues which the bank and the company will need to negotiate include the interest rate whether it will be a fixed interest rate or a variable rate. Generally, a fixed-rate loan will be renegotiated or reset after a specified period. The repayment schedule, ie, the frequency of loan repayments and the form of repayment need to be discussed as well. The bank will also require some form of security attached to the loan so if the borrower defaults on loan repayments, the lender will exercise the security and take possession of the pledged assets in order to recover the amount owing on the loan. 8. Banks invest in financial securities that they hold in their securities portfolio. A proportion of these securities may be government securities. Government securities are regarded as essentially risk-free and therefore pay a low rate of return. Why then do banks invest in this type of security? Banks invest in government securities because government securities: are an investment vehicle for surplus funds that a bank is holding in anticipation of future lending are a primary source of liquidity for a bank in that these securities can be easily sold in the secondary markets and converted into cash as needed augment bank earnings by providing income streams and potential capital gains whereas holding cash does not produce income represent collateral that can be used as security to support the bank's own borrowings may be used with 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 creating a group of assets with lower risk attributes enable a bank to manage the maturity structure of its balance sheet in that the bank can purchase securities with a range of maturities and associated cash flows allow a bank to manage its interest rate sensitivity by quickly restructuring its securities portfolio, by purchasing or selling securities with fixed or variable interest rate payments

9. The off-balance-sheet business of banks has expanded significantly and, in

notional dollar terms, now represents around six times the value of balance-sheet assets. (a) Define what is meant by the off-balance-sheet business of banks. Off-balance-sheet business of banks is the business undertaken that by nature is not recorded as assets or liabilities on the banks balance sheets. These off-balance-sheet transactions represent an major source of income for banks and are imperative in the financial life of businesses and governments. (b) Identify the four main categories of off-balance-sheet business and use an example to explain each of them. Direct credit substitutes are a guarantee to support a clients financial obligations. This could be a stand-by letter of credit, which is an undertaking by the bank to make payment to a specified third party if the banks client fails to meet its financial commitment to that party. Trade- and performance-related items are similar to direct credit substitutes in which the bank acts as a guarantor to support a clients non-financial contractual obligations. This can include trade-related undertakings or agreements to provide goods or services. For example a documentary letter of credit, is where the bank substitutes its credit rating for that of its client, and on behalf of its client the bank authorises payment to a named party against delivery by that party of a shipment of goods. Commitments involve the bank in an undertaking to advance funds to a client, to underwrite debt and equity issues or to purchase assets at some future date. Repurchase agreements are an example of a commitment in which the bank sells assets such as government securities on the understanding that they will repurchase them again at a specified date. Foreign exchange contracts, interest rate contracts and other market-rate-related contracts involve the use of derivative products (futures, options, swaps, forward contracts.) to facilitate hedging against the effects of movements in exchange rates, interest rates, equity prices and commodity prices. Forward exchange contracts are where the bank contracts to buy or sell at a future date a specified amount of foreign currency at an exchange rate that is set today, ie reducing the level of risk in case of exchange rate fluctuations that may occur in the future. 10. Nation-state bank regulators impose minimum capital adequacy standards on commercial banks. (a) Briefly explain the main functions of capital. Capital has a number of important functions, including: It is the source of equity funds for a corporation It provides the equity funding base that enables growth in a business It is a source of profits It is necessary in order to write-off periodic abnormal business losses (b) What is the minimum capital requirement under the Basel II capital accord?

Under the Basel II capital accord, the prudential standard requires an institution, at a minimum, to maintain a risk-based capital ratio of 8.00 per cent at all times. At least half of the risk-based capital ratio must take the form of Tier 1 capital. The remainder of the capital requirement may be held as Tier 2 (upper and lower) capital. Where considered appropriate, a regulator may require an institution to maintain a minimum capital ration above 8.00 per cent. (c) Identify and define the different types of acceptable capital under the Basel II capital accord. Provide an example of each type of capital. Tier 1 (core capital) consists of the highest quality capital elements which fully satisfy all the essential capital characteristics [e.g. paid-up ordinary shares] i. They provide a permanent and unrestricted commitment of funds ii. They are freely available to absorb losses iii. They do not impose any unavoidable servicing charge against earnings iv. They rank behind the claims of depositors and other creditors in the event of windingup Upper Tier 2 capital consists of elements that are essentially permanent in nature, including some hybrid capital instruments which have the characteristics of both equity and debt. [e.g. perpetual subordinated debt approved by the regulator] Lower Tier 2 capital consists of instruments that are not permanent that is, dated or limited life instruments. [e.g. term subordinated debt approved by the regulator]