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Module 2 – Commercial banking 1
© University of Southern Queensland
Module 2 – Commercial banking
Introduction
In this module the role of intermediation is further developed and students examine financial
institutions in greater detail.
Following the approach adopted by your prescribed text, financial institutions will be divided
into two broad categories: depository institutions and funds management. This categorization
scheme places the emphasis on how institutions raise their funds, and the uses to which these
funds are put.
Learning objectives
On successful completion of this module you will be able to:
● discuss the theory of financial intermediation
● describe the structure and general operation of Australian financial institutions
● identify the components of a bank’s balance sheet in terms of assets and liabilities
● discuss the role of asset, liability and general management in a financial institution’s operation
● relate the key regulatory framework within which both depository and non-depository
institutions operate
● discuss the impact of technology on the financial services sector
● describe the activities of the international commercial and investment banks
● explain the main features of Islamic banking
● discuss the functions of the major international financial institutions.
Resources
Text
Valentine, T, Ford, G, O’Hara, L & Sundmacher, M 2011, Fundamentals of financial markets
and institutions in Australia, Pearson, Frenchs Forest, New South Wales (chapters 4 & 5).
Note: This material is contained in module 2 of your custom publication: FIN8202 Financial
markets and instruments.
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Selected reading
Reading 2.1: Norton Rose 2005, Islamic finance structures, Norton Rose, London,
pp. 1–6, viewed 16 August 2005, <http://www.nortonrose.com/publications/2369-
IslamicFinanceStructuresBriefing.pdf>.
2.1 Financial intermediation
Whilst we have already introduced the ideas of financial intermediation and financial
intermediaries, it is necessary to reconsider these before looking more closely at the workings
of the various financial institutions.
The basic function of financial intermediaries is the ‘purchase of primary securities from
ultimate borrowers and the issue of indirect debt to ultimate lenders’. Apart from holding
primary securities, financial intermediaries may also hold the indirect debt of other
intermediaries.
Although there are numerous types of financial intermediaries, they can be divided into two
broad categories:
● depository institutions which accept surplus unit deposits and lend these funds to deficit units. From an Australian perspective, such institutions include:
● banks
● building societies
● credit unions
● registered financial corporations – finance companies and merchant banks.
● non-depository or funds management institutions which pool the savings of surplus units and purchase the market securities of deficit units. Such institutions include:
● insurance offices
● superannuation and pension funds
● unit trusts.
Due to the nature of the services provided, depository institutions are primarily in the
business of meeting the short term needs of wealth-holders whilst non-depository/funds
management institutions cater to the longer term needs of these people.
In module 1, students noted that financial intermediaries performed the following functions:
● asset transmutation, pooling and matching
● provision of liquidity
● income reallocation
● promotion of exchange efficiency.
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In the process of intermediation, financial intermediaries may gain from the presence of
economies of scale in both borrowing and lending activities. On the lending side these may
arise from:
● portfolio size (allows diversification to reduce risk)
● maturity scheduling (to lessen chances of liquidity crises)
● taxation benefits (to lessen chances of liquidity crises).
On the borrowing side, scale economies may arise from portfolio illiquidity (predictable
schedule of claims allows for holding of less liquid portfolio).
Not only are institutions themselves subject to scale economies, but there may be external
economies available for the community at large. For example, mortgage and consumer
finance markets require efficient intermediation. Further, intermediation plays an important
role in the saving-investment process and promotes the efficient allocation of resources in the
economy.
In performing their role as intermediaries, both depository and non-depository institutions
deal with deficit and surplus units who have differing motives for undertaking financial
transactions. These institutions are actively engaged in the process of market making,
underwriting and dealing.
● Market makers stand ready to buy and sell securities.
● Underwriting consists of agreements to purchase or to guarantee to market securities on behalf of issuers of primary securities.
● Dealing involves bidding for securities with the intention of selling the securities to other
surplus units.
A primary function performed by depository institutions in particular, is making loans to
deficit units. This activity is known as loan contracting. The pricing of loans is a function of
demand and supply, but due to problems of uncertainty, the loan size, underlying market
interest rate, term to maturity and degree of risk will all play a role. Hence, loan contracts
must reflect this diversity.
2.2 Depository financial institutions
As outlined in the previous section, depository institutions are those that accept deposits from
surplus units and lend funds to deficit units. While such institutions have in recent years taken
on a range of non-depository functions, this remains their main activity.
In Australia a distinction is made between:
● Authorised deposit-taking institutions (ADIs) – licensed banks, building societies and
credit unions. These organisations are generally engaged in retail banking, described by
Hunt & Terry (2002, p. 85) as ‘the supply of small value payment and financing services
to individuals and small to medium-sized businesses’. The larger banks are also engaged
in wholesale or investment banking, or the provision of large value financial services to
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large organisations e.g. corporations and government. ADIs are closely supervised by APRA.
● Registered financial corporations – finance companies and money market corporations,
also known as merchant banks.
In this section students are introduced to some of the key features of depository institutions,
including the aspects of structure and management of the balance sheet. Because of their
importance, the focus will be mainly on banks, but the principles discussed have general
applications to depository institutions as a whole.
2.3 Australia’s ADIs
The Australian banking scene is dominated by four organisations: ANZ, Commonwealth
Bank, National Australia Bank (NAB), and Westpac. These banks are engaged in both retail
and wholesale banking, and also operate in other countries. In reality, they are more
appropriately regarded as ‘financial conglomerates’, as they also have interests in areas such
as funds management and insurance. With a view to preventing further economic
concentration in this sector, the government currently has in force the so-called ‘four pillars
policy’, which prevents mergers between the four major banks.
Just as Australian banks operate abroad, so, too, are there a number of foreign-owned banks
with branches or subsidiaries in Australia. Some well known names include Citibank, ING
Bank, Credit Suisse First Boston and JP Morgan Chase Bank.
With regard to building societies and credit unions, as your prescribed text has little to say
about these, some further explanation may prove helpful:
● Building societies:
In their earliest form, building societies were created by a small group of workers who,
because of their common frustration in being unable to directly afford a home, decided to
pool their money and labour to build their homes one by one. As the building society
concept gained acceptance, a more sophisticated system evolved and permanent building societies were established.
Building societies are now the second largest source of first mortgage housing loans in
Australia. Aside from this fact, building societies are still a very small section of the
overall financial system, comprising only 1% of all financial institutions’ assets.
Competition from banks has seen smaller building societies merge, whilst other, again,
have converted into banks. Building societies have also diversified into cash cards, bill
paying services, variable interest rate accounts, investment loans and cash management trusts.
● Credit unions:
Credit unions were developed as providers of personal loans, in direct competition to
finance companies. In Australia, the number of credit unions has declined steadily over
the last twenty years, mainly as a result of mergers which have increased the average size
of the existing credit unions. Credit unions represent only some 2.3% of total financial
system assets; however, there are over 300 credit unions that provide deposit and loan
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facilities for identifiable groups of individuals within mainly the household sector. The
main sources of funds of credit unions are deposits from members and the issue of short-
term paper (for example, promissory notes). Their assets are primarily personal finance to members, including housing loans, personal loans and credit card facilities.
Credit unions derive a strength from what can be termed a ‘common bond of association’
of their members. This may be employment history or community based. That is,
members of a credit union typically belong to, or come from, a similar employment or
geographic background. This common bond of association appears to encourage a sense
of loyalty and ownership towards the institution, but has become weaker as credit unions
have had to seek larger size in order to be competitive.
Students will, no doubt, appreciate that the structure of the banking system, and the
legislative framework governing deposit institutions, differs from one country to another.
Accordingly, if you live abroad, arrangements in your country of residence.
2.4 The bank balance sheet
To appreciate fully the activities in which banks are involved it is necessary to examine the
balance sheet of a banking organisation. Figure 2.1 shows that financial institutions must be
compensated for providing the advantages of intermediation. In the process of receiving,
transforming, and lending funds, financial institutions incur operating expenses (wages,
utility bills, advertising, supplies), administrative costs (executive salaries, directors’ fees,
overhead costs), and taxes. Moreover, the institutions must earn sufficient profit for the
owners (shareholders) and accumulate some retained earnings or reserves if capital is to
continue to flow into the sector at a reasonable cost.
To accomplish these ends, financial institutions must balance the competing desires of
lenders and borrowers. That is, the rates paid to savers must be sufficiently high to attract
savings of lenders, while the rates and fees charged on loans must be low enough to generate
the required flow of income on financial assets (i.e. primary securities). This need requires
financial institutions to have a well-planned strategy for marketing products to both the
borrowers and lenders. The difference between the return on primary securities and the
payments to the holders of secondary securities can be referred to initially as the interest
spread. The spread must be sufficient to absorb operating expenses, administrative costs, and
taxes and still yield an adequate return on the shareholders’ investment (Graddy & Spencer
1990). If an intermediary does not earn an adequate return, shareholders will shift their funds
to another institution or export them to another sector (e.g. non-financial industries).
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Figure 1: Returns from the financial intermediation process
(Source: Graddy, BD & Spencer, AH 1990, Managing commercial banks: community, regional and global,
Prentice-Hall Inc. New Jersey, pp. 26–8, figure 2.2.)
By examining a simplified bank balance sheet and income statement, it is possible to observe
how banks perform their intermediation process.
Figure 2.1 showed that a financial institution’s interest spread is the difference between the
interest received from borrowers (deficit units) and interest paid to the holders of secondary
securities (surplus units). Earnings available for the distribution to shareholders (net income)
remains after the subtraction of operating costs, administrative expenses, and taxes from the
interest spread. The information in figure 2.2 allows us to be more specific about the
computation of shareholder returns. The sum of the interest and fees (e.g. loan handling
charges) paid by deficit units and other financial intermediaries during a given period
represents the bank’s operating income ($1 340 million). Interest expense ($819 million) is
the total amount paid by the bank to depositors on their secondary securities. Operating and
administrative expenses ($300 million) and the tax rate (30%) are given in this illustration.
Subtracting operating and administrative expense and taxes from the interest spread
($521 million) leaves $155 million available for distribution to shareholders. As illustrated in
both figures 2.1 and 2.2, the actual cash flow to shareholders is from dividend distributions.
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Reinvested earnings increase shareholder value by increasing a bank’s growth potential and,
consequently, expected future dividends.
Figure 2: Hypothetical Commercial Bank balance sheet and income statement Commercial Bank balance sheet ($millions)
(Source: Graddy, BD & Spencer, AH 1990, Managing commercial banks: community, regional and global,
Prentice-Hall Inc. New Jersey, pp. 35–6, figure 2.5.)
An obvious point to note from examining a bank’s balance sheet is that banks create short-
term highly liquid liabilities by accepting demand and time deposits. They then use these
funds in the intermediation process to buy longer-term less liquid assets such as loans. As a
consequence banks have a potential liquidity problem – their liabilities are more liquid than
their assets.
2.5 Liability management
Liability management may be defined as the activities involved in obtaining funds from
depositors and other creditors and determining the appropriate mix of funds for a particular
bank. Table 4.7 on page 73 of your prescribed text shows the sources of funds for Australian
banks.
Liability management has meant greater flexibility and risk for banks. Now they can establish
targets for asset growth and seek to acquire the necessary funds by issuing liabilities. New
liabilities can be seen in the market instruments such as negotiable certificates of deposits,
eurodollar borrowings and repo’s (e.g. a sale of securities with agreement of repurchase on
given terms). Banks may also seek to attract deposits by other means such as special
accounts, advertising and ‘tied’ services. Indeed, there are many determinants of deposit
levels for a particular bank. These include:
● interest rate competition
● buildings and personnel
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● services
● location.
2.6 Asset management
This has been defined as the allocation of funds among investment alternatives. Tables 4.3
and 4.4 on pages 69 and 70 of the prescribed text show the pattern of lending by Australian
ADIs. Note the importance of lending for housing.
For banks and other financial intermediaries, asset management refers to conversion of
deposits and capital funds into cash and earning assets. Unlike other business firms, banks
and non-bank financial intermediaries face a trade-off between profitability and liquidity.
This trade-off tempers the activities of such institutions in both asset and liability
management. There are, however, other considerations in asset management. These include
risk, flexibility and regulatory requirements. Let us briefly consider each in turn.
2.6.1 Profitability
Profitability requires that, generally speaking, only those assets whose returns are greater than
the cost of funds should be purchased. Note that the return on an asset needs to be adjusted
for asset transaction and servicing costs and that there may be difficulty in allocating joint
costs.
2.6.2 Liquidity
Liquidity refers to the ability to meet the potential demand for the return of funds from those
holding liabilities of the financial institution (e.g. current deposit holders). Adequate liquidity
is, therefore, a constraint on the intermediary’s desire to lend or acquire profit-making assets.
Liquidity may be split into primary reserves such as cash or assets easily converted into cash
and secondary reserves which can be sold readily if cash is needed (e.g. Treasury Notes). Past
experience is an important ingredient in deciding on the level and nature of liquid assets to
hold, given the liability structure.
2.6.3 Risk
Risk refers to the possibility of a fall in the value of assets held in the bank’s portfolio. This
may arise from three sources: business risk, financial risk, and interest rate risk. Business
risk arises from the inherent nature of the financial products/services (basically, the loans and
investments) produced by the banks and includes:
● Credit or default risk where borrowers are unable to meet their contractual obligations
to make interest and principal payments at the scheduled times and therefore fail to
comply with the terms of their loan agreement.
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● Investment risk where losses may occur due to a decline in the principal value of fixed income obligations (for example, bonds).
● Liquidity risk where the problem is that banks do not know when or how much
borrowers will request or depositors will withdraw.
● Operating risk or uncertainties regarding the actual operations of the bank arising from increasing operating profits.
● Fraud risk which relates to losses that could occur due to dishonesty, deceit or
misconduct by bank officers or customers.
Financial risk arises from the specific financial policies of the bank which may result in an
increased risk premium being applied to returns on banks share prices by shareholders. The
greater the amount of debt relative to equity, the more the bank is leveraged and the greater
will be its debt servicing obligation. Since creditors have prior claims to earnings and assets
over equity holders, as leverage increases there will be an impact on:
● the quality of ratings by credit-worthiness ratings services
● the general perception of reduced ability to service debt obligations.
Interest rate risk, arises from increases in interest rates in the economy. One way of
attempting to handle the problem is to seek better matching of asset and liability structures
e.g. by seeking to attract longer-term depositors in the case of building societies, or by
attempting to reduce asset maturity. Another approach is to introduce loans with variable
interest rates e.g. building society loans for housing.
2.6.4 Flexibility
Flexibility refers to the ability to change in the face of unexpected changes in business
circumstances. Management practices may result in increased flexibility, though possibly at a
cost. For example, shorter asset maturities allow for more frequent investment decisions at
the cost of lower asset earnings. Other practices include ‘staggered’ maturity portfolios and
developing portfolios with an appropriate proportion of marketable assets.
2.6.5 Regulatory requirements
Regulatory requirements refer to regulations imposed by governments on the activity of
financial institutions. By and large these are designed to maintain confidence in the monetary
system and to serve economic policy goals. Depending on their extent these may or may not
seriously constrain asset and liability management activities.
2.7 Capital management
Effective management of capital funds may enhance the profitability of a bank whilst still
maintaining the safety of depositors’ funds. Efficient management of bank capital will result
in rises in the price of bank shares. Retention of earnings to provide equity capital is a cost-
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effective method of increasing capital, as a prospectus and other costly requirements are not
necessary. Regulatory requirements play a major role in dictating levels of capital.
2.8 Other activities of banks
Apart from the standard lending activities discussed thus far, banks typically engage in other
functions to increase fee income. These include:
● loan syndication
● leasing
● travel
● trust management
● foreign exchange dealing
● global assets management
● derivatives.
More will be said about some of these in later modules.
2.9 Regulatory aspects of the balance sheet
In broad terms, the object of regulation is to ensure systemic stability by preventing bank
failure and the possibility of contagion. Australia and other developed countries follow the
regulatory guidelines of the Basel Committee on Banking Supervision of the Bank for
International Settlements (BIS) – see later.
Thus, in managing the balance sheet, banks need to keep regulatory requirements in mind.
2.9.1 Capital adequacy
The capital of a bank serves four functions:
● a cushion to absorb losses
● a pool of financial resources free of external financing costs
● a pool of resources to invest in infrastructure
● evidence the shareholders are willing to commit their own funds to the venture.
Central to the BIS approach to prudential supervision is the concept of ‘capital adequacy’.
This may be explained as follows:
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● The various classes of asset held by a bank are subject to different degrees of default risk
e.g. there is virtually no likelihood of default with Australian government securities.
Accordingly, in determining how much capital should be held as a protective cushion, the bank’s assets must be risk-adjusted.
● Banks also face potential loss from their off-balance sheet activities e.g. guarantees,
derivatives trading. Credit conversion factors are applied to the nominal values of these items so that they can be treated as balance sheet assets.
● A bank must hold capital equivalent to at least 8% of its risk-adjusted assets.
● Basel II: The Three Pillar Approach
Given below is a diagram that succinctly summarises the three pillar approach to banking supervision enshrined in the report of Basel Committee on banking supervision.
URL
Here are the home pages of the four main Australian banks:
● ANZ: <http://www.anz.com.au/>
● Commonwealth: <http://www.commbank.com.au/>
● NAB: <http://www.national.com.au/>
● WESTPAC: <http://www.westpac.com.au/>
● The homepage of Bank for International Settlements is
<http://www.bis.org>
2.10 The impact of technology
Technological change has been a major factor influencing the operations of financial
institutions in recent years. Historically, depository institutions were labour intensive, with
banks, in particular, setting up extensive branch networks in order to deliver their services. In
many countries all this has now changed. Bank delivery systems have become increasingly
automated, with thousands of jobs being lost and many branches closed. Indeed, bank
downsizing and branch closures, especially in rural areas, have become a significant political
issue in Australia!
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Some of the innovations brought about by the use of technology are the following:
● ATM’s (automatic teller machines)
● EFTPOS (electronic funds transfer at point of sale)
● direct entry systems
● credit cards
● smart cards
● Internet and telephone banking
● international payment mechanisms, such as SWIFT, CHAPS and CHIPS.
2.11 International banking
Banks are the key players in the global financial markets, and are central to the international
payments system.
Although banks with international operations can be traced to the 15th century, and even
earlier, there has been a huge expansion in foreign banking since the 1960s. From a bank’s
perspective, two considerations have generally been behind the decision to expand abroad:
● to better serve the bank’s clients, especially the multinational companies
● profit and new market opportunities
Roberts (1999) identifies three types of international bank:
● Commercial – operating mainly in the wholesale markets, these engage in the provision
of trade finance, foreign exchange trading, foreign lending and a variety of other activities.
● Investment – their core activities are in capital raising, market making, corporate finance
and asset management.
● Universal – these are a combination of commercial and investment banks, and are
increasingly becoming the norm.
International banking is today dominated by large institutions from the US, Europe and
Japan. The trend has been for international banks to get bigger through mergers so as to
counter intense competition. Thus it is argued that the ‘four pillars policy’, which prevents
mergers between Australia’s four big banks, puts local institutions at a disadvantage in the
global arena.
2.11.1 Islamic banking
Thus far we have been concerned with what may be described as the ‘Western-based model’
of banking. That is, we have considered the activities of institutions which pay interest on
deposits and charge interest on loans, deriving income from the interest spread.
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In contrast, Islamic banking, found in Muslim countries such as Indonesian, Kuwait,
Malaysia and Pakistan, does not use interest. The Islamic model is based upon the Koran and
teachings of the Prophet Mohammed. In particular, three sharia (Islamic law) rules set
Islamic banking apart:
● a prohibition on involvement in sinful industries e.g. gambling
● a ban on interest
● avoidance of excessive risk-taking.
As a result, Islamic banks have found alternative ways of structuring their operations and
products. For example, various partnership agreements have been developed, with a share of
the profits replacing interest payments. Similarly, instead of granting loans to purchase
products (cars, appliances), the bank buys these, then resells them to clients at a profit.
Western banks have been quick to see the potential of Islamic banking, with large
international banks, such as Citibank and HSBC, setting up Islamic-finance subsidiaries. In
fact, western financiers have been credited with much of the innovation in Islamic banking!
Reading
Selected reading 2.1: Norton Rose 2005, describes Islamic banking financial
products.
2.11.2 International financial institutions
As we saw in module 1, the Reserve Bank of Australia has responsibility for the maintenance
of economic and monetary stability in that country. Indeed, all reserve banks serve a similar
purpose. At the international level, a number of financial institutions have been established,
with the stability and development of the global financial system as their focus. Of particular
importance are the following:
● International Monetary Fund (IMF)
● World Bank
● Bank of International Settlements (BIS).
There are also a number of significant international groupings and discussion forums, such as
the Organization for Economic Co-operation and Development (OECD), the Group of Seven
(G7) and the Group of Ten (G10). The OECD is best described as a ‘think-tank’, and
undertakes studies on international economic and financial issues with a view to assisting
member countries in policy development. Its publications are highly regarded and carefully
monitored by market participants.
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Self assessment 1
Revisions questions ,1 5, 6, 9 & 10; true/ false questions from Valentine et al.,
chapter 4.
Answers are in the solutions manual.
Conclusion
This module has briefly introduced financial institution theory and dealt with some of the
management issues, particularly in relation to banks. Many of the issues also relate to other
non-bank financial institutions. The structure and traditional activities of depository
institutions and funds managers were examined at some length. In addition, attention was
given to the operations of international banks, Islamic banks, and those institutions which
provide a framework within which the international markets operate.
References
Roberts, R 1999, Inside international finance: a citizen’s guide to the world’s financial
markets, institutions and key players, Orion Business Books, London.
Graddy, BD & Spencer, AH 1990, Managing commercial banks: community, regional and
global, Prentice-Hall, New Jersey.
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