Financial Institutio
Financial Institutions,
ns, Instruments and Markets
Instruments and Markets
8th Edition
8th Edition
Instructor's Resource Manual
Instructor's Resource Manual
Christopher Viney and Peter Phillips
Christopher Viney and Peter Phillips
Chapter 2
Chapter 2
Commercial banks
Commercial banks
Learning obje
Learning objective 2.1: Evaluate the ctive 2.1: Evaluate the functions and acfunctions and activities of commerciativities of commercial banks within thel banks within the financial system
financial system
•
• Commercial banks are the largest group of financial institutions within a financial system andCommercial banks are the largest group of financial institutions within a financial system and
therefore they are very important in facilitating the flow of funds between savers and borrowers. therefore they are very important in facilitating the flow of funds between savers and borrowers.
•
• The core business of banks is often described as the gathering of savings (deposits) in order toThe core business of banks is often described as the gathering of savings (deposits) in order to
provide loans for
provide loans for investment.investment.
•
• The traditional image of banks as passive receivers of deposits through which they fund theirThe traditional image of banks as passive receivers of deposits through which they fund their
various loans and other investments has changed since deregulation. For example, banks provide various loans and other investments has changed since deregulation. For example, banks provide a wide range of offbalancesheet transactions.
a wide range of offbalancesheet transactions.
Learning obje
Learning objective 2.2: Idenctive 2.2: Identify the maitify the main sourcn sources of funes of funds of cods of commercial mmercial banks, banks, including including currencurrent t deosits, demand deosits, term deosits, negotiable certificates of deosit, bill accetance
deosits, demand deosits, term deosits, negotiable certificates of deosit, bill accetance liabilities, debt liabilities, foreign currency liabilities and loan caital
liabilities, debt liabilities, foreign currency liabilities and loan caital
•
• !anks now actively manage their sources of funds (liabilities).!anks now actively manage their sources of funds (liabilities). •
• They offer a diversity of products with different return, risk, li"uidity and cashflow attributes toThey offer a diversity of products with different return, risk, li"uidity and cashflow attributes to
attract new and diversified funding sources. attract new and diversified funding sources.
•
• #ources of funds include current deposits, call or demand deposits, term deposits, negotiable#ources of funds include current deposits, call or demand deposits, term deposits, negotiable
certificates of deposit, bills acceptance liabilities, debt liabilities, foreign currency liabilities, loan certificates of deposit, bills acceptance liabilities, debt liabilities, foreign currency liabilities, loan capital and shareholder e"uity.
capital and shareholder e"uity.
Learning obje
and housing lending, commercial lending, lending to government, and other bank assets and housing lending, commercial lending, lending to government, and other bank assets
•
• Commercial banks now apply a liability management approach to funding growth in theirCommercial banks now apply a liability management approach to funding growth in their
balance sheets. balance sheets.
•
• $nder this approach a bank will (%) encourage depositors to lodge savings with the bank, and (&)$nder this approach a bank will (%) encourage depositors to lodge savings with the bank, and (&)
borrow in the domestic an
borrow in the domestic and international money markd international money markets and capital markets ets and capital markets to obtain sufficientto obtain sufficient funds to meet forecast loan demand.
funds to meet forecast loan demand.
•
• The use of funds is represented as assets on a bank's balance sheet.The use of funds is represented as assets on a bank's balance sheet. •
• !ank lending is categorised as personal and housing lending, commercial lending and lending to!ank lending is categorised as personal and housing lending, commercial lending and lending to
government. government.
•
• ersonal finance is provided to individuals and includes housing loans, investment propertyersonal finance is provided to individuals and includes housing loans, investment property
loans, fixedterm loans, personal overdrafts and credit card finance. loans, fixedterm loans, personal overdrafts and credit card finance.
•
• !anks invest in the business sector by granting commercial loans. Commercial loan assets!anks invest in the business sector by granting commercial loans. Commercial loan assets
include overdraft facilities, commercial bills held, term loans and lease finance. include overdraft facilities, commercial bills held, term loans and lease finance.
•
• hile banks may lend some funds directly to government, their main claim is through thehile banks may lend some funds directly to government, their main claim is through the
purchase of gov
purchase of government securities sucernment securities such as Treasury notes and Treasury bonds.h as Treasury notes and Treasury bonds.
Learning obje
Learning objective 2.": #utline the naturctive 2.": #utline the nature and imortance and imortance of banks$ e of banks$ off%balance%sheoff%balance%sheet business,et business, including direct credit substitutes,
including direct credit substitutes, trade% and erformance%related items, commitments andtrade% and erformance%related items, commitments and market%rate%relate
market%rate%related d contractscontracts
•
• *iewing banks only in terms of their assets and liabilities greatly underestimates their role in the*iewing banks only in terms of their assets and liabilities greatly underestimates their role in the
financial system. !anks also conduct significant offbalancesheet business. financial system. !anks also conduct significant offbalancesheet business.
•
• The national value of offbalancesheet business is over four times the value of the accumulatedThe national value of offbalancesheet business is over four times the value of the accumulated
assets of the banking sector. assets of the banking sector.
•
• +ffbalancesheet business is categorised as direct credit substitutes, trade and performance+ffbalancesheet business is categorised as direct credit substitutes, trade and performance
related items, commitments, and foreign exchange, interest rate and other marketraterelated related items, commitments, and foreign exchange, interest rate and other marketraterelated contracts.
contracts.
•
• +ver - per cent of banks offbalancesheet business is in marketraterelated contracts such as+ver - per cent of banks offbalancesheet business is in marketraterelated contracts such as
foreign exchange and interestratebased futures, forwards, options and swap contracts. foreign exchange and interestratebased futures, forwards, options and swap contracts.
Learning obje
Learning objective 2.&: 'onsider thctive 2.&: 'onsider the regulation and e regulation and rudential suervisrudential suervision of banksion of banks
•
• +ne of the main influences of change in the banking sector has been the regulatory environment+ne of the main influences of change in the banking sector has been the regulatory environment
within which banks operate. within which banks operate.
• Commercial banks are now said to operate in a deregulated market. /elative to previous
regulatory periods this is a reasonable description0 however, there still remains "uite a degree of regulation that affects participants in the financial markets, including the banks.
• 1ach nationstate is responsible for the regulation and supervision of its own financial system. 2n
particular, central banks and prudential supervisors are responsible for the maintenance of financial system stability and the soundness of the payments system.
Learning objective 2.(: )nderstand the background and alication of *asel II and *asel III
• At the global level, the Bank for International Settlements takes an active interest in the stability
of the international financial system. To this end, the Basel Committee on Banking Supervision has developed an international standard on capital adequacy for banks.
• $nder !asel 22 banks were re"uired to maintain a minimum riskbased capital ratio of
3.44 per cent. !asel 222 increased the amount of Tier % capital that must be included in a banks capital ratio.
!asel 222 enhances the capital re"uirements of !asel 22 and introduces additional li"uidity
re"uirements. 2n particular, banks will be re"uired to maintain a ratio of 5igh 6uality 7i"uid 8ssets (5678) to net cash outflows per month of at least %44 per cent. This is called the 7i"uidity Coverage /atio (7C/).
Capital is categorised as either Tier % capital, $pper Tier & capital or 7ower Tier & capital.
$nder !asel 222, at least 9.44 per cent of a banks 3.44 per cent riskbased capital re"uirement must be held in Tier % capital. This has been increased from -.44 per cent under !asel 22.
8s part of the calculation process, risk weights are applied to balancesheet assets using
specified risk weights. These weights may be based on the counterparty to an asset, or on an external rating provided by an approved credit rating agency.
+ffbalancesheet items are converted to a balancesheet e"uivalent using credit
conversion factors before applying the specified risk weights.
The !asel 22 capital accord comprises three pillars, which are enhanced under !asel 222.
illar % relates to the calculation of the minimum capital re"uirement. illar % considers
three areas of risk: credit risk, operational risk and market risk. ithin each of these risk categories banks have a choice of applying a standardised approach or an internal approach to measuring their capital re"uirement. #ub;ect to approval from the bank
supervisor, an internal approach method allows a bank to use its own risk management models.
illar & provides for a supervisory review process and includes four basic principles: (%)
the assessment of total capital re"uirements by a bank, (&) the review of capital levels and the monitoring of banks compliance by supervisors, (<) the ability of a supervisor to increase the capital re"uirement of a bank, and (-) the intervention of a supervisor at an early stage to maintain capital levels.
illar < seeks to achieve market discipline through a process of transparency and
disclosure. !anks are re"uired to provide information and data on a periodic basis to the supervisor. #ome of these reports may be made public.
Learning objective 2.+: Eamine li-uidity management and other suervisory controls alied by /0 in the contet of *asel III
• The bank regulator , APRA, applies a number of important prudential controls on commercial
banks. These include liquidity management policies, risk management systems certification, business continuity management, audit (external auditors, on-site visits), disclosure and
transparency, large credit exposures, foreign currency exposures, subsidiaries and ownership and control.
Essay uestions
The following suggested answers incorporate the main points that should be recognised by a student. An instructor should advise students of the depth of analysis and discussion that is required for a particular question. For example, an undergraduate student may only be required to briefly introduce points, explain in their own words and provide an example. On the other hand, a post-graduate student may be required to provide much greater depth of analysis and discussion.
!" #$ere%ulation has chan%ed bankin% practices in &ustralia"' $iscuss this statement ith re(erence to banks) asset and liability mana%ement" *+
2"!-• Asset management relates to the practice of a bank only giving loans (assets) when it had
sufficient deposits—that is, asset growth is managed, and often constrained by, the bank’s deposit base.
• Liability management relates to the practice of raising funds (liabilities) in the capital markets
sufficient to meet expected forecast loan demand—that is, lending is not constrained by the liability side of the balance sheet.
• Modern banking practice is the application of liability management. The removal of regulation
has facilitated this change. Banks are no longer constrained by the size of their deposits in determining how much to lend.
• After deregulation, banks operate by estimating their total loan demand in the next period and
accessing different capital markets to obtain the necessary funds. Before deregulation, the deposits held by a bank would determine how much it could lend. Once this amount was depleted in a given period, no more loans would be issued. This is one way in which deregulation has changed banking practices.
2" #$ecades a(ter the commencement o( dere%ulation in the (inancial markets, the international capital markets remain a relati.ely unimportant source o( (unds (or commercial banks"' &nalyse and discuss this statement" *+
2"!-• !anks source their funds from a variety of sources, including deposits, bills acceptances, debt
liabilities and shareholder e"uity.
• Foreign currency liabilities are also an important source of funds. These funds are sourced on the
international capital markets.
• =eregulation of the financial system in 8ustralia and around the world, including the floating of
exchange rates, opened up these international capital markets as never before.
• 2t is now routine for 8ustralian commercial banks to issue liabilities into the international capital
markets in order to raise large amounts of capital. The international capital markets have become an important source of funds for commercial banks and deregulation of the global financial system played a significant role in opening up these opportunities.
/" & customer has approached your commercial bank seekin% to in.est (unds (or a period o( si0 months" 1he customer is particularly orried about risk (olloin% the FC and the market .olatility that continues to characterise orld (inancial markets" E0plain the (eatures o( call deposits, term deposits and C$s to the customer and pro.ide ad.ice on risk3reard trade3o((s that mi%ht be associated ith each product" *+
• pays a fixed interest rate for the nominated fixed investment period • rate of interest will be bank’s carded rate for that term and amount • interest may be payable periodically (e.g. monthly) or at maturity • principal is repaid at maturity.
Certificate of deposit:
• discount security issued by a bank
• an investor will purchase the CD at less than the face value • the investor will receive the full face value back at maturity • price is the face value discounted by the yield
• yield/price relationship will vary with changes in market rates.
/iskreward tradeoffs:
• a call deposit will pay a very low rate of interest but will be essentially risk free
• a CD is a highly liquid form of investment that will pay a higher rate than the call deposit
• a CD can easily be sold into the money market to obtain funds, whereas with a term deposit there
is a loss of liquidity as the funds are locked-up for the fixed period
• however, a term deposit may pay a higher rate of return.
4" $iscuss the (our main uses o( (unds by commercial banks and identi(y the role that the purchase o( %o.ernment securities plays in commercial banks) mana%ement o( their asset port(olios" *+
2"/-• Personal and housing finance • Commercial lending
• Lending to government • Other bank assets
• For banks, government securities are a primary source of liquidity: o government securities easily converted into cash
o invest short-term surplus funds—securities provide a return, cash does not o augment investment earnings—another source of income
o use for repurchase agreements to raise exchange settlement account funds—sell securities
back to central bank and receive cleared funds
o improve the quality of the overall balance sheet—lower risk government securities offset
higher risk loans to customers
o manage the maturity structure of the overall balance sheet—average maturity structure of
government security portfolio will be less than the loan portfolio
o manage the interest rate sensitivity of the overall balance sheet—purchase government
securities with interest rate structures that offset interest rate risk within the overall loan portfolio.
5" Commercial banks are the principal pro.iders o( loan (inance to the household sector" Identi(y (i.e di((erent types o( loan (inance that a bank o((ers to indi.iduals" 6rie(ly e0plain the structure and operation o( each o( these types o( loans" *+
2"/-• +wneroccupied housing finance>loans to purchase residential property such as a house or unit.
#ecurity is a mortgage taken over the land and property thereon. ?ortgage registered on title of land. 7oan may have a fixed or variable interest rate. 7oan instalments paid periodically (monthly) and typically amortised (interest and principal components).
• 2nvestment property finance>very similar to above, except property is usually leased to a third
party. 2nterest rate generally higher reflecting higher risk of lease agreement.
• Fixedterm loans>used to finance nonproperty transactions such as buying a car. !ank will
seek security such as a guarantee from the borrower or a third party. 5igher interest rate reflects higher credit risk associated with borrower and lower "uality security.
• ersonal overdrafts>allows an individual to place their account into debit up to an agreed limit.
$sed for managing cash flow mismatches over time. #hould be fully fluctuating. ay interest on the debit amount0 also unused limit fee.
• Credit card finance>plastic card issued with an available credit limit, that is, the cardholder can
make purchases or obtain cash advances up to the amount of the credit limit. 5igh interest rate charged on used credit.
7" &6C +imited plans to purchase inection mouldin% euipment to manu(acture its ne ran%e o( plastics products" 1he company approaches its bank to obtain a term loan" Identi(y and discuss important issues that the company and the bank ill need to ne%otiate in relation to the term loan" *+
2"/-• The bank and the borrow will structure the loan and negotiate the terms and conditions of the
loan
• eriod of the loan>consider matching principal0 what are the funds being used for
• 2nterest rate>fixed versus variable interest rate0 if variable, what is the reference interest rate
(e.g. !!#) and the margin above the reference rate
• #ecurity>will the lender be able to take a mortgage over property or a charge over the other
assets of the borrower
• Timing of repayments>how fre"uently will loan instalments occur0 will the loan be amortised
(interest and principal components), or an interest only loan with principal repaid at maturity.
9" 1he o((3balance3sheet business o( banks has e0panded si%ni(icantly and, in notional dollar terms, no represents o.er se.en times the .alue o( balance3sheet assets" *+
2"4-*a- $e(ine hat is meant by the o((3balance3sheet business o( banks"
• a transaction that is conducted by a bank that is not recorded on the balance sheet
• a contingent liability that will only be recorded on the balance sheet if some specified condition
or event occurs.
*b- Identi(y the (our main cate%ories o( o((3balance3sheet business and use an e0ample to e0plain each cate%ory"
• Direct credit substitutes—support a client’s financial obligations, such as a stand-by letter of
credit or a financial guarantee
• Trade and performance related items—support a client’s non-financial obligations, such as a
performance guarantee or a documentary letter of credit
• Commitments—a financial commitment of the bank to advance funds or underwrite a debt or
equity issue. For example, the unused credit limit on a credit card, or a housing loan approval where the funds have not yet been used
• Foreign exchange, interest rate and other market rate related contracts—principally derivative
products such as futures, forwards, options and swaps used to manage f/x and interest rate risk exposures.
8" Folloin% the FC, the o((3balance3sheet acti.ities o( commercial banks attracted a %reat deal o( attention amon% commentators" :ith re(erence to the si;e and composition o(
commercial banks) o((3balance3sheet acti.ities, outline some o( the possible reasons (or this concern" *+
2"4-• The notional value of the offbalance sheet activities of banks is five times the total value of the
assets held by the banks.
• !ecause this offbalance sheet activity is less transparent, it is difficult for regulators to assess
the financial health of financial institutions.
• 8lso of concern is the type of securities that constitute offbalance sheet activities. These may
include the types of derivative securities that played such an important role in the @FC.
<" 6ank re%ulators impose minimum capital adeuacy standards on commercial banks" *+
2"5-*a- 6rie(ly e0plain the main (unctions o( capital"
• equity and quasi-equity capital is a source of long-term funds for an institution • it provides the equity funding base that enables on-going growth in a business • it is a source of profits
• it may be necessary to use capital to write-off periodic abnormal business losses.
*b- :hat is the minimum capital reuirement under the 6asel III 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 three-quarters or 6.00 per cent 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 ratio above 8.00 per cent.
*c- Identi(y and de(ine the di((erent types o( acceptable capital under the 6asel II and 6asel III capital accords" Remember that 6asel II continues to (unction, ith 6asel III actin% to stren%then its main pillars"
• Capital, within the context of the !asel 22 capital accord, is measured in two tiers • Tier % capital, or core capital, comprise the highest "uality capital elements:
o provide a permanent and unrestricted commitment of funds o are freely available to absorb losses
o do not impose any unavoidable servicing charge against earnings
o rank behind the claims of depositors and other creditors in the event of windingup.
• Tier % capital must constitute at least three"uarters of a banks minimum re"uired capital base • Tier &, or supplementary, capital includes other elements which also contribute to the overall
strength of an institution as a going concern
• Tier & capital is divided into two parts:
o upper tier & capital>comprising elements that are essentially permanent in nature, including
some hybrid capital instruments which have the characteristics of both e"uity and debt
o lower tier & capital>comprising instruments which are not permanent0 that is, dated or
limited life instruments.
• 1xamples:
o tier % capital: ordinary shares0 retained earnings
o tier & capital (upper): mandatory convertible notes0 perpetual subordinated debt o tier & capital (lower): term subordinated debt approved by the regulator.
!>" Pillar ! o( the 6asel II capital accord includes an operational risk component" *+ 2"7-*a- $e(ine operational risk"
The !ank for 2nternational #ettlements categorises operational risk as:
• internal and external fraud
• employment practices and workplace safety • clients, products and business practices • damage to physical assets
• business disruption and system failures
• execution, delivery and process management.
*b- ?sin% the standardised approach, e0plain ho a commercial bank is reuired to measure the operational risk component o( its minimum capital adeuacy reuirement"
• !asel 22 re"uires banks to hold additional capital to support their exposure to operational risk • ith the standardiAed approach to operational risk an institution is re"uired to map and divide its
activities into two areas of business:
o retailBcommercial banking o all other activity.
• 8n institution must document its mapping process, detailing the policy and procedures used to
map the full range of business activities. This process must be sub;ect to independent review.
• The retailBcommercial banking area capital re"uirement is determined using a proportion of an
institutions total gross outstanding loans and advances as an indicator of that areas operational risk exposure. This also includes the book value of securities held in the banking book.
• The operational risk capital re"uirement for the all other activity area of business is determined
using a proportion of an institutions net income as an indicator of that areas operational risk exposure. et income is defined as profit from ordinary activities before goodwill, amortiAation and income tax.
• +perational risk capital for retailBcommercial banking is calculated by taking the last six
consecutive halfyearly observations of total gross outstanding loans and advances, then multiplying a proportion, being <.D per cent, of total gross outstanding loans and advances at each observation point, by a factor of %D per cent, to produce a result in respect of each observation, then determining an average result for the six observations.
• The operational risk capital for all other activity is calculated by taking the last six consecutive
halfyearly observations of net income earned over a six month period, multiplying each observation point by a factor of %3 per cent to produce a result in respect of each observation, then determining an average result for the six observations.
• The total operational risk capital re"uirement under the standardised approach to operational risk
is the sum of the two average results determined above.
!!" Pro.ide an o.er.ie and rationale (or the to ne liuidity standards introduced by 6asel III"
• The two new li"uidity standards are: (%) a li"uidity coverage ratio or 7C/0 and (&) a net stable
funding ratio or #F/.
• The 7C/ is supposed to ensure that banks have a Ebuffer that will help them to withstand a
period of acute financial stress for a period of one month. The 7C/ is the ratio between a financial institutions 5igh 6uality 7i"uid 8ssets (5678) and net cash outflows over a <4day (one month) period.
• The #F/, which will take longer to implement, aims to foster longerterm stability by re"uiring
• The rationale for these two new li"uidity standards is to ensure banks do not face capital
shortages and li"uidity problems during times of extreme market volatility. The new standards directly address some of the problems that emerged during the @FC.
!2" :ith re(erence to liuidity mana%ement, outline the implications o( 6asel III and the associated chan%es to &PR&)s &P@ 2!> (or the boards o( directors o( &ustralia)s (inancial institutions"
• 2n addition to the "uantitative re"uirements of !asel 222, 8/8 will introduce several "ualitative
prudential re"uirements.
• The most important of these relates to the responsibilities of the board of directors of a financial
institution.
• 7i"uidity risk management is identified as the responsibility of the board of a financial
institution. The board is responsible for setting the institutions risk tolerance levels and clearly articulating it.
• The board must also approve a formal funding strategy.
• These measures are designed to improve board oversight of li"uidity risk management. 8/8s
8# &%4 prudential standards incorporate these !asel 222 enhancements of good practice and governance.
!/" &s part o( the prudential super.ision o( banks the re%ulator reuires banks to use an internal model such as VaR to estimate potential %ains and losses" utline some o( the stren%ths and eaknesses o( VaR models and brie(ly e0plain hy re%ulators ha.e mo.ed to implement a #stressed VaR) reuirement (or &ustralian banks" *+
2"9-#trengths:
• enable inferences to be drawn about potential losses with a given degree of statistical
confidence, for example a 99 per cent probability of a certain dollar amount loss.
• recognise correlations between different portfolio components (i.e. the model allows
for market price changes that move together or offset each other)
• account for the effects of portfolio diversification
• consider the liquidity of different portfolio instruments—that is, the ease or ability of
Weaknesses:
• are based on a limited set of historical data which may not be a correct reflection of future
data
• assume liquidity in all markets—that is, the ability of an institution to trade all
components of its portfolio. This will not always be the case, particularly in times of financial stress
• assume that all instruments can be liquidated in one day. This is not possible. Contractual
constraints also mean that some items cannot be liquidated
• do not include excessive intra-day price volatility—that is, unusually large short-term
exchange rate or interest rate movements
• assume a normal distribution, when data indicate that in some markets prices may be
volatile and a normal distribution is not always evident.
The Estressed *a/ aims to ensure that banks are prepared for events that would normally have a very low probability, especially when the models are based on historical data and normal distributions.
E0tended learnin% uestions
!4" 1he 6asel II capital accord comprises a (rameork o( three pillars" Pillar ! established the minimum capital reuired by a commercial bank and incorporates three risk componentsA credit risk, operational risk and market risk" *+
2"8-*a- $e(ine credit risk"
• credit risk is the risk that counterparties to a transaction will default on their commitments
• for example, the risk that a borrower may default on the payment of interest andBor repayment of
loan principal.
*b- :hat approaches may be used to measure the credit risk capital adeuacy component o( Pillar !=
• !asel 22 provides three alternative ways for a bank to measure credit risk:
%. the standardised approach
or
<. the advanced internal ratingsbased approach.
*c- ?sin% the standardised approach to credit risk, e0plain ho a commercial bank ill use this method to calculate its minimum capital reuirement"
• The standardised approach to credit risk re"uires banks to assign each balance sheet asset and
offbalance sheet item a risk weight.
• The risk weight must be based on an external rating published by an approved credit rating
agency (such as #tandard and oors), or a fixed weight specified by the prudential supervisor.
• The risk weighted amount of a balance sheet asset is calculated by multiplying its current book
value by the relevant risk weight.
• !alance sheet example: a bank gives a D44 444 loan to a company that has an 8 credit rating
(external rating grade & G risk weight D4H). The capital re"uired is the book value x the risk weight x 3.44H capital ade"uacy re"uirement. That is, D44 444 x 4.D4 x 4.43 G &4 444. The remaining -34 444 can be funded from bank liabilities.
• +ffbalance sheet exposures that give rise to credit risk are first converted into socalled balance
sheet e"uivalents according to specified credit conversion factors prior to allocating the relevant risk weight.
• +ffbalance sheet example: a bank provides a company with a ! credit rating a &D 444
documentary letter of credit. This has a credit conversion factor is &4 per cent and an external rating grade D representing a risk weight of %D4 per cent. The capital re"uired by the bank to support this offbalance sheet transaction is &D 444 x 4.&4 x %.D4 x 4.43 G 944.
!5" Commercial banks are e0posed to the .ery real risk that at some point their critical business operations could (ail" 6usiness continuity risk mana%ement may be said to incorporate a disaster reco.ery plannin% process and a disaster reco.ery response process" *+
2"<-*a- $e(ine business continuity risk mana%ement"
• The purpose of business continuity risk management is to ensure a bank and its personnel are
prepared to respond to an event that disrupts critical business functions and are able to effectively recover those functions.
• The risk of adverse operational and financial outcomes resulting from inade"uate or failed
internal or external processes, people, systems or events.
o For example, losses incurred from fraud by personnel, or failure of computer or
communication systems, or loss of premises due to a fire or earth"uake.
*b- Identi(y and brie(ly e0plain the core components o( a disaster reco.ery plannin% process" %. The establishment of an organisational business continuity risk management structure that is
horiAontally and vertically integrated throughout the bank, including a global risk committee, a business continuity risk management group and divisional contingency planning units. This
includes planning teams, emergency response teams and recovery teams
&. /isk analysis and business impact analysis>risk analysis ensures all risk exposures are identified. The business impact analysis measures the operational and financial effects of a disruption to a business function.
<. !usiness function recovery prioritisation to ensure available resources are used to effectively recover critical business functions.
-. =evelopment of disaster recovery strategies that will maintain critical business functions if a business disruption occurs0 includes disaster recovery service agreements and support
agreements.
D. 1ducation and training maintain the preparedness and capability of a bank and its people to respond to a disaster situation.
9. 2ntegrated testing of disaster recovery strategies ensures they will be effective in the event of a disruption to critical business functions.
I. lan maintenance that incorporates ongoing monitoring, review, reporting and auditing of the banks business continuity risk management processes.
*c- Identi(y and brie(ly e0plain the core components o( a disaster reco.ery response process" %. lan activation, including disaster alert trigger points, notification procedures for emergency
response teams, and activation of recovery strategies.
&. 2mpact assessment and evaluation by divisional recovery teams, including estimates of resources and time re"uired to recover functions and advice on which recovery strategies need to be implemented.
<. /ecovery control centre where key personnel will direct recovery operations. The centre facilitates the control, command and coordination of the management decision processes.
-. Communications and media liaison. Communications to be established with divisional recovery teams, and providers of recovery facilities, service and support agreements. ?edia liaison to be established with bank supervisors, government authorities, the press, customers and other market participants.
D. 2mplementation of prioritised business recovery using backup strategies, facilities, service agreements and support agreements established in the banks overall business resumption plan 9. erformance evaluation, reporting and plan review.
!7" &n essential element o( business continuity risk mana%ement is education and trainin%" *+
2"<-*a- :hy is education and trainin% important in the conte0t o( business continuity risk mana%ement=
• 1ducation and training is integral to achieving an institutions business continuity risk
management ob;ectives.
• 1ducation and training will improve the capability and preparedness of institutions and their
personnel to plan for, and respond to, an occurrence that may affect the continuity of critical business functions.
• 1ffective responses by personnel will minimise risk to personnel, limit the operational impact of
a business disruption, and lessen the financial cost of a disruption.
• The ob;ective of business continuity risk management is to establish policies and procedures that
will ensure the capacity of a bank to maintain the continuity of its critical business functions and resume normal operations within defined time parameters. 1ducation and training is an essential in achieving this outcome.
*b- Identi(y three discrete education and trainin% pro%rams that a bank should pro.ide"
%. 2nductionBawareness program.>To be completed by all bank personnel, plus nonbank personnel from organisations that provide critical services to the bank. 2t introduces the basic operational risk management knowledge and awareness re"uired of all personnel.
&. Contingency planning program for personnel responsible for core components of the disaster recovery planning and response processes that need specialist knowledge and skills to effectively complete those tasks. articipants include organisational business continuity risk management group members, divisional contingency planning unit members and nominated global risk committee members.
<. 1xecutive program for the board of directors and executive management to assist in determining appropriate business continuity risk management ob;ectives, policies, strategies and procedures.
*c- 6rie(ly discuss hat issues should be incorporated in each o( the three education and trainin% pro%rams"
!9" *a- $iscuss the nature o( corporate %o.ernance and its relationship ith ethics" *+
2"!>-*b- $iscuss the importance o( corporate %o.ernance and ethics (or &ustralian &$Is both in terms o( complyin% ith re%ulations and e((ecti.ely meetin% the e0pectations o( stakeholders" *+
2"!>-• Corporate governance is the framework of rules, relationships, systems and processes within and
by which authority is exercised and controlled in corporations. It encompasses the mechanisms by which companies, and those in control, are held to account. Corporate governance influences how the objectives of the company are set and achieved, how risk is monitored and assessed, and how performance is optimised.
Pro%ram !
6usiness continuity risk mana%ement 3 inductionBaareness 3
corporate governance and risk management business continuity and disaster risk management regulation and prudential supervision
ob;ectives, policies, procedures, budget, infrastructure disaster risk management organisational structure global best practice
disaster response: recovery control centre, communications,
Pro%ram 2
6usiness continuity risk mana%ement
3 contin%ency plannin% 3
Pro%ram /
6usiness continuity risk mana%ement
3 e0ecuti.e 3
what is a disaster: why is disaster risk management
important?
organisational disaster risk management ob;ectives, policies
and procedures
bank disaster risk management organisational structure risk and the disaster recovery planning process
the disaster recovery response process how to respond in a disaster situation applying learning into practice construction of a contingency plan
risk analysis, business impact analysis and recovery
prioritisation
disaster recovery strategies, service agreements and support
agreements
emergency response teams, divisional recovery teams and
communications
disaster recovery plan testing
• 8lthough corporate governance does not specifically concern Eethical behaviour, it may work
handinhand with a firms statement of ethical or professional conduct.
• For 8=2s, where the confidence of customers and clients is of the utmost importance,
demonstrating strong governance frameworks and ethical behaviour is a very important component of corporate strategy.
FI&CI&+ E:@ C&@E @1?$D
2n Chapter &, the latest addition to the !asel accords, !asel 222, was discussed. 8lthough the new !asel 222 capital ade"uacy re"uirements will be implemented very gradually, changes to capital ade"uacy can have a significant impact on financial institutions. 8ustralian banks weathered the global financial crisis and have tended to maintain capital ratios in excess of those re"uired by !asel 22. They should be well placed to make a smooth transition to !asel 222. 1lsewhere around the world, financial institutions confront more difficult challenges, particularly as they recover from the lingering effects of the @FC and the sovereign debt crisis. 2nterestingly, the approach that banks have taken has been different in different countries. 2n 1urope, banks have taken steps to raise cash in the form of e"uity capital to strengthen their balance sheets. 2n 8merica, leverage ratios remain relatively high. 8ccording to the Financial Times:
Deutsche Bank recently completed a €2.96bn accelerated issue of new shares, fellow erman lender !ommer"bank in #arch said it would raise €2.$bn and reek banks are on the road to raise as much as they can from commercial in%estors to plu& a €2'.(bn e)uity shortfall. This appears to be due to pressure to comply with !asel 222 sooner rather than later. 1ven though regulators will not re"uire full compliance, capital markets and investors have signalled strongly that healthy capital ratios are desirable. For example, =eutsche !anks share price increased by 9 per cent on the day that its latest e"uity capital raising was announced. +rdinarily, e"uity capital raisings dilute the ownership share of the existing shareholders and may be expected to depress rather than inflate the share price J particularly in the current environment where banks share prices are depressed. /aising capital at such low e"uity prices is a very expensive exercise. evertheless, the push for strong capital ratios
dominates the other considerations. 2mportantly, though, the contrast between 1urope and 8merica on this point is stark. 8ccording to the Financial Times:
*t is a %ery different story in the +, where bank in%estors ha%e been pressurin& the likes of -#or&an, oldman achs and !iti&roup to return capital to shareholders throu&h hi&her
di%idends and share buybacks. Four of the best capitalised lar&e &lobal banks are now /uropean 0 +B, B1 aribas, B! and, post3capital raisin&, Deutsche Bank 0 while only one, #or&an tanley, is a + &roup. 4owe%er5 nalysts at !iti note that there is a persistent north3south di%ide across the re&ion. 7hile 1ordic lenders boast Basel *** core tier one ratios of up to '( per cent, e%en the stron&est panish banks are on 8 per cent or less.
#uccumbing to the markets demands for strong capital ratios does not necessarily mean that banks need to raise additional capital by selling shares and diluting the ownership shares of
existing shareholders. !anks in both the $K and 1urope have begun raising capital by other means, including sales of convertible debt. +ther banks have raised capital by issuing dividends in the form of shares rather than cash. +thers have simply raised cash by selling off assets.
!asel 222 is a common thread that explains many of the capital raisings being undertaken by banks around the world. 2t is clear, however, that whatever the regulatory pressure may be, pressure stemming from the markets exerts a strong influence over bankers decisions. 2n
8merica, where investors appear to have different preferences, leverage ratios remain high.
#+$/C1: 8dapted from atrick Lenkins and =aniel #chafer, E1uropes !anks Turn to Capital /aising to ?eet !asel 222, Financial Times, %< ?ay &4%<.
$I@C?@@I PI1@
• utline the steps that European banks ha.e taken in order to comply ith 6asel III"
1uropean banks have taken steps to raise cash through new issues of e"uity. 1ven though !asel 222 will not be fully implemented for some time, banks are under pressure to comply early with the new capital re"uirements.
• E0plore some o( the reasons (or the north3south di.ide mentioned in the article"
2n short, those economies in southern 1urope were hardest hit during the @FC. 8s such, many of the financial institutions in countries such as #pain have been in a considerably weaker
position relative to their northern 1uropean counterparts. Their poor initial starting positions relative to stronger banks has resulted in their lagging behind in the race to comply early with !asel 222.
• $escribe the challen%es that con(ront banks tryin% to balance capital reuirements
a%ainst in.estor demands (or increased di.idends and share buybacks"
!anks that have had a record of strong dividend growth may find this capability curtailed by the new capital re"uirements. Capital that might once have been surplus to re"uirements and able to be paid out in dividends may need to be retained in order to maintain compliance with !asel 222. !anks will need to carefully manage their signals to investors in this regard, particularly those whose shareholder base has a strong Edividend clientele.
• Compare and contrast the preparedness and preparations (or 6asel III in Europe,
orth &merica and &ustralia"
2n general, 8ustralia is in a relatively strong position when compared with 1urope and the $#8. ?any financial institutions were already well on their way to complying with !asel 222 even as the new accords were being developed. The starting position for banks in 8ustralia is also relatively strong because they managed to avoid the ma;or stresses associated with the @FC. hen comparing 1urope with the $#8, it seems that northern 1uropean banks are under considerably more pressure to comply early with !asel 222 and, as such, have taken substantial steps towards this ob;ective. 8s the article notes, the leverage ratios for financial institutions in the $#8 remain relatively high. This has not attracted the same level of concern as it has in northern 1urope.
1rueBFalse uestions
%. 1 The !asel 222 capital ade"uacy re"uirements strengthen and extend the !asel 22 capital accord.
&. F Term deposits are unlikely to be viewed as attractive investments during times of financial markets volatility.
<. 1 !anks offbalancesheet activities have continued to show strong growth in recent years. -. 1 !ank runs are always a possibility in a financial system that does not re"uire banks to hold an amount of reserves that is e"ual to the amount of deposits.
9. 1 The 7C/ and the 5678 are two key components of the new li"uidity standards introduced as part of changes associated with the introduction of !asel 222.
I. 1 8 negotiable certificate of deposit is a discount security that may be issued into the money markets.
3. 1 +ne of the attractions for a bank of funding a client through a bank bill facility is that the security can be sold into the money markets.
. F 8 bank may seek to obtain funds by issuing unsecured notes with a collateralised charge over the assets of the institution.
%4. F !ank regulators restrict the type and amount of securities that commercial banks can issue into the international capital markets.
%%. 1 ?ortgage originators often use the process of securitisation to finance their housing lending activities.
%&. F8 housing loan with an amortised loan re"uires the borrower to make periodic interestonly
instalments and repay the principal at the maturity date.
%<. F #mall to mediumsiAed businesses mainly borrow direct from the capital markets, while
large corporations with good credit ratings prefer to borrow from the banks.
%-. 1 8 reference interest rate such asthe!!# may be used periodicallytoset the interest rate on a variablerate loan.
%D. F The deregulation of the banking sector means that it is no longer necessary for the central bank to concern itself with the overall stability of the financial system.
%9. 1 +ffbalancesheet business is a transaction where a contingent liability exists and therefore it cannot be recorded on the balance sheet.
%I. 1 =erivative products are primarily designed to facilitate hedging risks such as changes in interest rates or exchange rates.
%3. F $nder the !asel 22 capital accord, banks are re"uired to maintain a maximum riskbased capital ratio of 3.44 per cent at all times.
%. F illar < of the !asel 22 capital accord re"uires commercial banks to report directly changes in their capital structure to the !ank for 2nternational #ettlements.
&4. 1 The standardised approach to the measurement of illar % credit risk allows a bank to use external credit ratings.
