Module 2 Commercial banking - CA Sri Lanka...Students will, no doubt, appreciate that the structure of the banking system, and the legislative framework governing deposit institutions,

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.

2 FIN8202 – Financial markets and instruments

�© University of Southern Queensland��

© University of Southern Queensland��

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.



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



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.



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.



● 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:



● 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!

http://www.westpac.com.au/




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.



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.




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.

Documents

Module 2 Commercial banking - CA Sri Lanka...Students will, no doubt, appreciate that the structure of the banking system, and the legislative framework governing deposit institutions,