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1

Week 1 Session 1
Measurement of Money and Monetary Aggregates

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-

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•

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-

-

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Narrow Measures/Money – Includes all physical money such as cash, coins and currency,
demand deposits and other liquid assets held by the central bank
...

M1 – is a narrow measure of money supply and is defined as the sum of currency in the
hands of the non-bank public + the stock of cheque account deposits of the private non-bank
public with banks
...


Broad Measures/Money – measures the amount of money circulating in an economy
...

Broad Money/M4 – is the sum of M3 + the non-deposit borrowings from the private sector
by AFI’S (All financial intermediaries) – fund management institutions, insurance companies,
credit unions and etc
...
g
...

M3 – is a broad measure of money supply and is the sum of M1 + all other bank deposits +
all other ADI (authorised deposit-taking institution) deposits other than banks e
...
credit
unions/building societies
...


Endogenous approach –
Begins with loans that make deposits to banks, then consider reserves afterwards
...

e
...
Bank of Melbourne gives out a loan to person A
...
A percentage of that deposit will go into the reserve (central bank), then
remainder will be given out as part of another loan
...

e
...
Person A places a deposit in Bank of Melbourne, then a percentage of the deposit will go into
the reserve (central bank), then the remainder will be given out as part of a loan
...

•

Required reserves - represents a percentage of a minimum amount of funds a bank must
hold in its cash vault or deposit with the central bank against certain liabilities e
...
deposits
...

•

Excess reserves - are the cash reserves beyond those required
...


-

Holding the assumption that banks do not hold on to any excess reserves means that the
total amount of required reserves for the banking system (RR) will equal the total reserves in
the banking system (R)
Banks must keep a fraction of its deposits as reserves to protect them against the liabilities
of customers demanding their money back

-

Money supply/money creation formula (exogenous approach):
Money supply/money creation = Currency + Demand deposits (M = C + D)

Money Creation Scenarios
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There are two main assumptions for scenarios:

1
...
All currency ends up in a bank (i
...
, no currency drain/leakage)

SCENARIO 1: No Banks
C = $1000
D=0
M = $1,000 + 0
M = $1,000
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SCENARIO 2: 100% Reserve Banking
Suppose that households deposit the $1000 at “FirstBank”
C=0
D = $1,000
M = 0 + $1,000
M = $1,000

FirstBank’s Balance Sheet/T - account
Assets
Liabilities
Reserves
Checkable
$1,000
deposits $1,000
100% Reserve Banking has no impact on size of money supply
...

FirstBank will therefore make $800 (80%) in loans
...

The depositor still has $1,000 in demand deposits, and now FirstBank has given out a loan to a
borrower who holds $800 in new currency
...


SCENARIO 3 (cont
...


This process continues…
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Deposit creation: The Banking System
The Simple Money Multiplier (SMM) or Simple Deposit Multiplier (SDM) = 1/reserve requirement
ratio
It equals the reciprocal of the reserve requirement ratio or the total times money can be multiplied
from the initial amount (expressed as a fraction)
...

This also applies to money deposited into the bank via RBA with the purchase of bonds/securities
...
g
...
10 = 10x
Money creation/increase in money supply = 100* 10 = $1000 (total increase in money supply from
the initial $100 increase in reserves/deposit)
...

This increase can also be described as tenfold
...


e
...


-

-

A single bank can create deposits equal only to the amount of its excess reserves, meaning
that new deposits or the creation of deposits are dependent on the amount of the excess
reserves
...
A single bank cannot
make loans greater in amount than its excess reserves
...


5

Creation of deposits chart
Simple Deposit Multiplier OR Simple Money Multiplier – is the multiple increase in deposits
-

e
...
10 generated from an increase in the banking systems reserves e
...
100, with a reserve
required ratio of 10%

SMM/SDM - (the reciprocal of the required reserve ratio) = 1/0
...
10 in the example)
R = change in reserves for the banking system ($100 in the example)

Therefore:
D = 1/0
...


A formal derivation of this formula is:
D = R × 1/1-(1-r) = 1/r × R

-

-

As mentioned above, with the assumption that banks do not hold on to any excess reserves
means that the total amount of required reserves for the banking system (RR) will equal the
total reserves in the banking system (R)
Therefore RR = R

The total amount of required reserves (RR) or the total reserves in the banking system equals the
reserved requirement ratio (r) times the total amount of checkable deposits (D)
...


The Money Multiplier (exogenous Money creation)
M=m×B

Where:
M = money supply
m = money multiplier
B = Monetary Base – currency + commercial bank reserves held in the central bank

The ‘true’ money multiplier
M = 1+c/rr+e+c

Where:
c = currency deposit ratio (the amount of currency that people hold as a proportion of aggregate
deposits) e
...
a loan of 1000 given to a household may only deposit 60% of that 1000 which equals
600
...

Therefore: the banking system is limited in the amount of money it creates through fractional
reserve banking

SCENARIO 4: Fractional-Reserve Banking
(Continuation from scenario 3)…Suppose banks hold 20% of deposits in required reserves, 5% in
excess reserves and make loans with the rest
...

The money supply now equals $1,750, instead of $1,800(Scenario 3), which acknowledges excess
reserves
...


SCENARIO 4 (cont
...

SecondBank’s Balance sheet will appear as follows:

Assets
Reserves $100
Excess
reserves $40
Loans $360

Liabilities
Checkable
deposits $500

The money supply now equals $2,110 ($1,750 from Scenario 4 + 360 (loan)

Example 1 –
Suppose the currency deposit ratio is 40%, the reserve requirement ratio is 10% and the excess
reserve ratio is 0
...
m = 1+c/(rr+e+c)
2
...
4)/(0
...
005 + 0
...
77
This means a one dollar increase in the monetary base will lead to a $2
...
77 times more than the initial amount
...

It shows that accounting for currency and excess reserves is important

Example 2 –
Suppose c= 0
...
001 and rr = 0
...

Compute the ‘true’ money multiplier:
1
...
m = (1+0
...
10 + 0
...
25) = 3
...


•

If the central bank decides to increase rr to 20%, what happens to the money multiplier and
the money supply as a result
...
m = 1+c/(rr+e+c)
2
...
25)/(0
...
001 + 0
...
77
The higher; the rr; the lower the ‘true’ money multiplier is
...
In other words, a smaller multiplier means that banks create less money
through lending and therefore the money supply will fall
...
2, rr = 0
...
05
1
...
m = (1+0
...
25 + 0
...
2) = 2
...
3, while all other variables remain constant, what would the ‘true’ money
multiplier result to
...
m = 1+c/(rr+e+c)
2
...
3)/(0
...
05 + 0
...
17
Here, we can see that increasing the amount of currency people hold as a fraction of their deposits
causes the money supply to fall
...


Thus
...


The exogenous approach suggests that commercial banks are dependent on the following factors for
money supply and the ability to create money;
c = the size of the currency deposit ratio
rr = the size of the central bank’s reserve ratio;
e = the bank’s amount of excess reserves;
Depositors
Demand for credit
Banks (depository institutions) willingness to lend

Central bank = external party (has influence on money creation as they can increase or decrease the
reserve requirement)
Commercial Banks = internal party (the amount of their excess reserves and willingness to lend)

Criticisms of the Money Multiplier
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Sir Mervyn King (former Governor of the Bank of England):

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“Textbooks assume that money is exogenous"
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Lord Adair Turner (former UK Chief Financial Regulator):

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-

"Banks do not, as too many textbooks still suggest, take deposits of existing money from
savers and lend it out to borrowers: they [banks] create credit and money ex nihilo”
...


Endogenous Money Creation
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The three main types of money
1
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Currency; and
3
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However, the endogenous approach suggests creation of deposits via the act of making new
loans
...
g
...

•

Currency is created by the RBA
...


Commercial banks
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•

New deposit to customer is a liability
New loan to the customer is an asset

Central Bank (RBA)
• New broad money is created without any change in central bank money or ‘base money’
...


Contrasts; endogenous vs exogenous
Endogenous: without loans; there is no money creation, but without loans, there is no deposit
creation
...

A bank does not necessarily depend only on its excess reserves but can raise funds or invest
in treasury bonds and other securities or borrow money to make new loans
...

-

Reserve requirement happens before a new loan is made; therefore, the reserve
requirement is met after the deposits and before new loans
...


Endogenous theory also contrasts with exogenous theory by reordering the sequence of money
creation
Where:
•
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Endogenous: loans make deposits then banks consider reserves afterwards
Exogenous: deposits are placed in banks, then reserves are put aside followed by making
loans
...

The central bank cannot control the money supply
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Credit evaluation of customer
2
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Banks earning targets – if the banks have met their targets they may reduce the amount
of loans vs if they aim to meet certain targets they may increase their loans
4
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c) Regulatory policy – APRA, ASIC and other regulatory bodies that influence that enforce
policies on how much banks and financial institutions can lend or the changes in policy that
determine how much they can lend including other policy that affect its operations;
d) Monetary policy (cash rate impacts the cost of borrowing, as the changes in cash rate will
determine the changes in interests that banks charge to consumers
...
g
...


Exogenous and endogenous theory; central bank’s role
Exogenous; increasing or decreasing reserve requirement ratio thus impacting money multiplier and
money supply
Endogenous; increasing or decreasing the cash rate thus influencing how much banks can lend out;
also impacting money supply
...


•

Money multiplier is limited to identifying changes in the money supply to a given change in
in the monetary base
...
Money supply depends on;
(i)
(ii)
(iii)
(iv)

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monetary base;
currency-deposit ratio;
excess reserve ratio; and
reserve ratio
...
e
...


Week 1 Session 2
Economists definition of money
‘Anything that is generally accepted as a means of payment for goods and services, thus money
must serve as a medium of exchange
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The three primary functions of money

1
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- Money, in this case is the medium of exchange
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Unit of account
- An agreed measure of value – allows different things to be compared against each other
and it evaluates the cost of goods, services, assets, liabilities, labour, income, expenses
and etc
...

3
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g
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Leads to opportunity cost of holding money in certain forms
...


Equation of exchange: M×V=P×T
Where:
M = quantity of money (money supply)
V = velocity of money (average number of times per year that a dollar is spent)
P = average price level
T = volume of transactions in the economy

M × V = the number of purchases = P × T = nominal GDP/Value of sales

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Velocity of money
- The average number of times a dollar is spent in buying the total amount of goods and
services
- It equates to the turnover rate for money in the economy
...


Fisher makes two key assumptions:
1
...


2
...


•

With these two assumptions on board, let us re-examine the equation of exchange:

M×V=P×T
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Since both V and T are constant, changes in M must cause changes in P to preserve equality
between MV and PT
- If money supply (M) doubles, the price level (P) must also double
...


Consequently:
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Movements in the price level (P) result solely from changes in the quantity of money (M)
Money demand becomes a function of income

This supports the Fisherian Theory as it suggests that there is a mechanical and fixed proportional
relationship between changes in the money supply and the general price level
...
investopedia
...
asp

There are other competing models of money demand theory:
Another theory of money demand is by John Maynard Keynes:

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Keynes liquidity preference theory (1936)
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He abandoned the classical view that velocity was constant
Identified a link between money and interest rates

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He outlines that individuals hold money for 3 reason:

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•
•

1
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Demand for money is determined primarily by the level of people’s transactions
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- As income rises, people undertake more transactions and will hold more money
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Precautionary motive
Individuals also hold money for unexpected needs and emergencies (different type of
transaction)
...

3
...


Md /P = f(i,Y)
f is function of

Where:
Md /P = is the demand for real money balances
...

1
...
Perpetual bonds: expected return via interest payment

Keynes then asked:
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•

Why would individuals decide to hold their wealth in the form of money rather than bonds?
- Answer: because income from bonds can be wiped out if bond prices fall in the future
...
a coupon - $70 fixed
coupon/interest payment
July 2019: Bond issued at par value of $1,000, carrying an 8% p
...

You bought the bond in April 2019 but now want to sell on July 2019
...


To determine the market value of the bond before selling, we divide the $70 coupon/interest
payment by 0
...

e
...

1
...
08
2
...
08
3
...
a interest rate, which results to a
capital loss of $125
...


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At a lower interest rate, investors are less likely to utilise bonds to speculate on building
wealth
- Rather, speculative demand for money will be higher
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Hence, money demand is negatively related to interest rates
...


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Note: under Keynes’ theory, expectations are held with certainty and there is an all-or-nothing
behaviour
...
)

Under Keynes Theory, velocity fluctuates with the interest rate
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V = Y/f(I,Y)
f is function of
•

A rise in interest rates (i), encourages people to hold lower real money balances for a given
level of real-income (Y)
- In other words, the higher interest rates the increase in (V) and (Y)
...

- Therefore, the rate at which money turns over (V) must be higher

•

What are the main factor(s) influencing money demand under fisher and Keynes theory?

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Fisher’s theory states that transactions motive is a factor of money demand
...
It also states that if the (V) the average number of times money transactions
repeatedly take place and (T) the volume of transactions, is constant, then it will also
cause price level to increase in proportion to an increase in money supply
...


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-

Keynes theory of money demand states that there is a link between money and interest
rates
...
Transactions motive - use of money as a medium of exchange between buyers and sellers in
the purchase of goods and services – transactions are proportional to income
...
Precautionary motive – unexpected needs such as emergencies, hence demand for
precautionary money is proportional to income
3
...

b) If interest rates are high, individuals would rather store their wealth as money rather
than bonds (as bond price falling can wipe out their income) and vice versa
...


-

However, Keynes abandoned the view that velocity was constant as he instead identified
a link between money and interest rates
...


Developments in Keynes’s Liquidity Preference Theory
Baumol-Tobin (B-T) Transaction demand:

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The B-T model analysed the costs and benefits of holding money for transaction purposes
...


Formula:
Md/ P = f (i,Y,t)
f is function of

Tobin’s speculative demand motive for holding money:
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Tobin shifted the focus to expected returns and risk
...


Factors impacting money demand are:
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•
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Income;
Interest rates; and
Risk-return trade-off
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- Not interested in any motive for holding money
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Thus, demand for money is influenced by:
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Their wealth (as measured by permanent income); and
The expected returns on other assets relative to the expected return on money –
incentives for holding other assets relative to money
...

Money demand is positively related to permanent income
...


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Expected return on money is influenced primarily by the interest payment on money
balances (e
...
deposits)

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Competition among banks keeps the opportunity cost of holding money relatively constant
with other assets, meaning that banks will adjust their interest prices when there are
changes in interest rates of other assets, as banks aim to increase deposits/savings to meet
their objectives
...

- It implies that velocity is predictable

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Velocity arises from permanent income which is more stable than – current income

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Consequently, velocity becomes predictable and stable:
V = Y/f(Yp)

What about the empirical evidence?
Empirical studies on money demand:
•
•

•

Majority of empirical studies show that money demand does appear to be sensitive to
interest rates (inverse relationship)
...


•

What did Baumol-Tobin conclude are factors in influencing transaction money demand?
- Income;
- Interest rates; and
- Risk-return trade-off

•

How does Tobin’s speculative model differ to Keynes’?
- Keynes speculative model focuses on the 2 functions of money demand; interest rates
and income where fluctuations in the interest rates on alternative assets will determine
the store of wealth people choose e
...
higher bond interest rates mean that people may
speculate that it will fall in the future thus people may be willing to invest in bonds,
whereas if the opposite occurs people may prefer to hold money as income
...
He
adopted the portfolio approach of money and bonds to reduce risk
...
He suggested that people
may choose Money with (low risk-return trade-off and zero nominal return) OR Bonds
with (higher risk/higher return which can be negative)
...
These variables constitute
the gaps between expected return of alternative investments to expected interest rate on cash
(deposits) or money
...

Therefore, Friedman concluded that the variables of the alternative investments have a slight impact
on money demand and only permanent income can be directly used to estimate money demand
...


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Keynes identified three motives for holding money
- Transactions: Income impacts Md
...

- Speculative: Interest rates and income impact Md
...

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Friedman employed the theory of asset demand
-

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Did not deal with the motives for holding money
...

Money demand: Essentially a function of permanent income
...


Empirical evidence shows that Md is sensitive to interest rates

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Week 1 Session 3
Monetary policy
In Australia, the Monetary Policy is directed at maintaining inflation rate at 2-3%
...

The Central bank (RBA) uses interest rates as its main tool in implementing monetary policy –
however they undergo a series of evaluating the desired level on economic activity, employment,
balance of payments and exchange rates that should maintain inflation within the target range
...

Any change in interest rates will also affect returns received on investments and the cost of
borrowing – which will flow through to changes in future economic growth and business activity
...

•
-

Loanable funds are the available funds in the financial system for lending
It includes all forms of credit
The demand and supply sectors are integrated to explain interest rate movements
There is an inverse relationship between the interest rate and quantity of loanable funds
demanded

•

The downward slope of the demand (yield) curve implies that the demand for funds will fall
as interest rate rises; conversely
The upward slope of the supply curve implies that an increase in the supply of loanable
funds will allow interest rates to fall
...
g
...
g
...
Business’ demand for funds (B)
- Short-term working capital
- Longer-term capital investment

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The lower the interest rate, with all-else being constant, the greater the volume of debt funds
demanded
...
Government demand for funds (G)
- Finance budget deficits and intra-year liquidity – short-term liquidity requirements e
...
tax,
pensioners purposes
...


•

Net demand for loanable funds = (B+G)

-

Government borrows money regardless of interest rate as they make a commitment to their
expenditure program and when they need money, they borrow whereas; an inverse
relationship exists with interest rate and business’ money demand
...

The last curve (demand for both government sector and business sector) are combined to
give the total demand for loanable demands = G+B
...
Savings of household sectors (S) – drawn with an upward slope on the basis of the
common presumption that as interest rate rises, people will save a larger proportion of
their incomes
...


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2
...
When the change in money supply is added to the savings curve, it simply
changes the location of the curve
...


-

3
...


Term structure of Interest rates
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-

-

•
-

Yield - is the total rate of return on an investment which comprises of interest received and
any capital gain/loss
...

The yield curve - illustrates the term structure of interest rates for a specific security at that
point in time
...

Structure – how interest rate changes with the maturity
...

The relationship between interest rates or bond yields and different terms or maturities
Interest rate for 1-year maturity bond; interest rate for 2 year maturity bond and etc
...


28

What would happen with the interest rate if maturity increases? It is generally stated that an
increase in maturity results to an increase in the yield

1
...


Here is an example of a yield curve following the same direction; treasury bonds:

-

2
...
g
...


3
...
– a 1-year bonds yield is lower than a 5 year bond yield
...
It also shows
that the 3-month bills tend to yield lower than the 10-year treasury notes
...


•

Inverse/negative yield curve - occurs when short-term interest rates are instead higher than
longer-term interest rates (however Is not common)
...
A Large number of investors with similar expectations about the value of future shortterm rates
2
...

3
...

4
...

5
...


•
-

Shape and slope of curve:
Explained by the current short-term interest rate and expectations about future short-term
interest rates
...


Example: suppose one-year rates over the next five years are: 5%; 6%; 7%; 8%; and 9% per annum
...
5%

•
-

The interest rate on the five year-bond is: (average on 5-year bond rates)
5%+6%+7%+8%+9%/5 = 7%

•
-

Thus, interest rates for one to five-year bonds are:
5%;5
...
5%; and 7%
...

Normal yield curve – upward sloping

31

However, an opposite result in these numbers would result to an inverse yield curve -downward
sloping
...


•

An investor will be indifferent as to whether to invest for a short period or a longer period
...
g
...
5% per annum
...


•

Explanation for the shape and slope of the yield curves:

-

Normal yield curve – will result from expectations that future short-term rates will be higher
than current short-term rates

•

Inverse yield curve – will result if the market expects future short-term rates to be lower
than current short-term rates
...
Why is Government demand for Loanable funds inelastic? – Government expenditures
are not discretionary
...

Q2: how is the shape and slope of the yield curve determined under expectations theory?
– how do you calculate the shape and slope of the yield curve
...

32

Q3
...

The characteristic 3 suggests that long-term bond yields tend to be higher than short-term
bond yields
...


Market-segmentation theory/segmented markets theory

•

Segmented markets theory rejects two of the assumptions of the expectations theory that;

-

Investors are indifferent between holding short-term and long-term bonds; and
That all bonds are perfect substitutes for one another

Segmented markets theory is based on the assumptions below:
1
...
Investors will operate within some preferred maturity range; short-term securities vs longterm securities
3
...

4
...


Matching principle
•
•
-

Short-term assets should be funded with short-term (money market) liabilities
Longer term assets should be funded with equity or longer term (capital market) liabilities
Shape and slope of the yield curve – is determined by the relative demand and supply
conditions of securities that exist along the maturity spectrum
...


•

Different maturity bonds are completely segmented – different asset classes
...


•

Liquidity premium theory

Addresses all 3 characteristics:
The liquidity premium theory distinguishes from the expectations theory and holds the characteristic
that long-term to maturity bonds are more susceptible than short-term instruments to a risk of large
price fluctuations
...

2
...

An investor also requires compensation for investing for a longer period – which is the
liquidity premium

•
-

Shape and slope of curve is explained by:
Current short-term interest rate and expectations about future short-term interest rates;
along with compensation for holding a longer-term bond
This compensation is called: liquidity premium

Example: one-year rates over the next five years: are: 5%; 6%;7%;8%;9% per annum
...
25%; 0
...
75%; and 1
...
25% = 5
...
0% = 8%

Thus, interest rates for one to five-year bonds are:
5%; 5
...
5%; 7
...
these essentially form your yield curve

Liquidity premium theory can explain the three characteristics:
•

It explains characteristics one and two since, like expectations theory, long term rates are
essentially tied to expected future short-term rates
...
e
...


•

Hence, the yield curve should normally slope upwards

36

Risk structure of interest rates
•

The relationship among interest rates on bonds with the same term to maturity
...
e
...


•

Investors will require compensation for bearing the extra default risk
...
g
...
g
...
How is the shape and slope of the yield curve determined under segmented markets theory?
-

Lower inflation and rate risk for shorter term bonds; and
Higher inflation and rate risk for longer bond maturities

The shape and slope of the yield curve are determined by the relative demand and supply conditions
that exist along the maturity spectrum for each segmented market
...

Known as: a discontinuity of the yield curve

Q5
...


Q6
...

-

The yield curve is decided by different segments therefore we cannot say they follow the
same trend; they move based on the individual segments (characteristic 1)
They are not connected as yields for short-term and long-term bonds are determined by the
segments e
...
the interest rates for a short-term bond will be unaffected by the changes in
interest rates for long-term bonds
...
How is the shape and slope of the yield curve determined under liquidity premium theory?
Similar to the expectations theory, it is determined by adding the expected yields for each of
the bond maturities and divide it by the number of bond yields, thus gives you the shape and
slope of the curve, which results in an upward slope – normal yield
...


38

Summary
•

The loanable funds framework is conceptually simple

-

It Relies on aggregate supply and demand of funds

•
-

Shape and slope of the yield curve explanations:
Expectations: current short-term rate and expectations about future short-term interest
rates
...


-

The yield curve is an analytical tool employed widely by financial analysts and mangers of
financial institutions

Week 2 Session 4
Australian Payments system infrastructure
•
•
•
•

An exchange settlement account (ESA) is an account between the Reserve Bank of Australia
(RBA) and an approved authorised deposit-taking institution (ADI)
...

A promissory note (legal contract) is a financial instrument which contains a written promise by one
party (the note’s issuer/maker) to pay another party (the note’s payee) a definite sum of money,
either on demand or at a specified future date
...


It is an agreement that is made to:
1
...
Plus, interest for the privilege of borrowing money;
3
...
Once an entity is a surplus or deficit
spending unit, it does not have to maintain that status forever
...


Financial intermediation (indirect finance)
A financial intermediary is an entity that acts as the middleman between two parties in a financial
transaction, such as ADI financial institutions e
...
commercial bank, investment bank, mutual fund,
or pension fund
...
They are financial institutions who do
not take deposits for savings
Banks play an important role in intermediating credit from savers to borrowers
...

The financial system is composed of many different types of firms – commercial banks, investment
banks, bank holding companies, insurance companies, pension funds, and hedge funds, and etc
...


41

Commercial Banks within the financial system engage in credit intermediation and follow a similar
process:

A financial intermediary typically involves a commercial bank
•

•

It is a financing arrangement with two separate contractual agreements
...


Banks issue indirect claims to SSUs in exchange for funds;

2
...
SSUs have claims against intermediaries (not DSUs; and
2
...


Essentially, banks facilitate the flow of funds from SSUs to a DSUs
...
+indirect claim from financial intermediary – assets
2
...

2
...

4
...
Direct claims to financial intermediary – liabilities
2
...
How do SSUs benefit from financial intermediation – indirect finance?
-

SSUs particularly place their money into commercial banks to receive interest payments
on their excess money
...


-

In indirect financing (financial intermediation) SSUs have guaranteed interest payments
from banks, rather than a potential default risk with direct finance, where DSUs may fail
to meet its required payments on their debt obligation
...


Q2
...
Pay a specific money - the principal
2
...
Maturity – over a period of time
b) How can a financial claim be both an asset and a liability at the same time?
A financial claim consists of 2 parties; DSU and SSU
DSU – make a direct claim to obtain money to finance their obligations in which they are
liable(liability) to pay the sum of money at a specified future date
...


Q3
...


Consolidation in the Banking Sector
The large 4 banks/4 pillars – Commonwealth Bank, ANZ, Westpac & NAB
They are the major competing banks in Australia
...


•

Banks are useful; and
There are two principle reasons for this:

Because they:
-

Are good at reducing asymmetric information
Engage in Asset transformation

One principal reason that financial intermediation is so important is because of asymmetric
information between savers and borrowers
...
The two main kinds of asymmetric information emphasized by
economists are adverse selection and moral hazard
...


44

•

Both types of information asymmetries can cause financial markets to break down
...


Basic idea: Presence of ‘bad’ cars (lemons) makes it hard to sell ‘good’ cars (peaches) because buyers
cannot distinguish between the two types
...


•

A bank needs to distinguish between borrowers of good and bad quality (i
...
, the lemons)
-

Otherwise loans are made with an interest rate that reflects average quality
...


Moral hazard in Financial Markets
•

Classic example of moral hazard is that once a bank provides a firm with funding, you cannot
control what it does with it
...

- Firm prefers risky project, but bank does not
...


How banks deal with information asymmetry
•

Adverse selection
- Banks become experts in evaluating firm types and credit risk (decreases adverse
selection)

•

Moral hazard
- Banks can monitor firms by imposing covenants and loan restriction (decreases moral
hazard)
...
g
...


•

Households do not have resources to do either of these things on their own;
- Thus, households provide funds to banks who then lend (indirect finance) rather than
households lending
...


Other financial intermediation benefits
•

In addition to asset transformation, other financial intermediation benefits are:

a) Denomination visibility:
- Intermediaries pool savings of many small SSUs into large investments e
...
from $1 to
many millions
...


Main Bank Sources of Funds
•

Deposit accounts:
- Transaction account (demand deposit)
- Savings account
- Term deposits
- Negotiable certificates of deposit

•

Borrowed funds:
46

•

Wholesale funding

Capital accounts:
- Equity (share capital; retained profits)

Main Bank Source of Funds: Deposit accounts
•

Transaction account (demand deposits)
- Funds held in accounts that can be withdrawn on demand
- Deposit account used directly for payments

•

Savings account
- Interest bearing accounts
- Limits on transactions and some have regular fees

•

Term deposits
Funds lodged in an account for a predetermined period
- Term: one month to five years
- Loss of liquidity owing to fixed maturity
- Higher interest rate than current or call accounts
- Generally fixed interest rate
- Funds cannot be transferred to another party
- Typically held by consumers or other small depositors

•

Term deposits represent a large source of funds for commercial banks, particularly small,
consumer-oriented ones
...

- It specifies repayment of the face value of the CD at maturity
...

Highly negotiable security – can be bought and sold in the money market should the liquidity
preferences of the holder chance
Cannot be cashed in before maturity
...

47

They are attractive to both holders of large funds and commercial banks
They are usually issued to business and wealthy individuals
...


•
-

Long-term – (>1 year)
Examples of long-term wholesale funding including debenture (collateralised) and unsecured
notes (not collateralised)

•

Smaller banks rely less on borrowed funds and more on term deposits
...

Capital has the potential of decreasing debt but it does not result in an increase in profit, and
you cannot lend with capital
...
What do you think were the main reason(s) for the changes to the composition of bank
funding?

48

The global financial crisis (GFC) prompted a new regulatory requirement (imposed by the RBA) to
reduce the composition of short-term debt (source of fund) as a risk management strategy to limit
lower margins resulting from higher volatility in short-term debt
...
What are the main trade-offs between the deposit accounts
• Transaction – more flexibility in withdrawal without fees
• Savings account – higher interest, without no or limited fees and easy access to funds
...

• NCDs – NCDs are issued at a discount and holders are entitled to the increase in face value
...

The amount of interest earned on each deposit account and the liquidity of the deposit accounts
...
What does the low equity composition tell you about the nature of bank funding?
Although Equity is a safe and stable source of fund, it is expensive
...
The Reserve bank of Australia
imposes requirements and rules on the banks leverage composition
...


Bank Use of Funds: Assets
•

Uses of funds appear in the balance sheet as assets
...


Main cash assets include, but are not limited to:

49

•
•
•
-

•
-

Vault cash – consists of coin currency held in the ban’s own vault
...

Vault cash provides banks with funds to meet the cash needs of the public; and banks can count
it as part of their legal reserve requirements
...

After a cheque written on another bank is deposited into a customer’s account, the receiving
bank attempts to collect the funds through the cheque-clearing mechanism
...

Rather than physically transferring funds between banks, the exchange settlement system
operates by simply debiting or crediting a bank’s account at the RBA, although banks must
maintain a surplus balance in these accounts to facilitate this process
...

Short-term investments – are considered to be cash assets because they are convertible into
cash at a very short notice
...


Main Bank uses of funds: Investments
In contrast to loans, investments represent pure financing as the bank provides no service to the
ultimate borrower other than the financing
...

Bank investment portfolios serve several important functions:
1
...
Contains long-term securities purchased for their income potential e
...
specified interest
coupon payments on T-bonds
...
Provides the bank with tax benefits and diversification beyond that possible with only a loan
portfolio
...

Funds are in the form of short-term loans, purchase of Government securities e
...
short-term
treasury notes and long-term treasury bonds
...


50

•

Investment securities are much more important to the portfolios of small and medium-sized
banks than for larger ones
...


•

Banks also hold securities for the purpose of trading or selling them to clients and other market
participants to generate profits on buy and sell differentials and through fees for providing the
securities
...


Main uses of Bank funds: Loans
Bank loans and leases are the primary business activity of a commercial bank and are the most
important earning assets held by banks
...

•
-

Although loans are very profitable to banks:
They take time to arrange;
They are subject to greater default risk;
They have less liquidity than other bank investments (Loans have high yields but are not typically
very liquid)
...


Most bank loans consist of promissory notes
...

Bank loans are mostly secured (via collateral), however some are unsecured
...

Banks make either fixed-rate or floating-rate loans
...

•
-

There are three basic type of business loans:
Bridge loan;
Seasonal loan; and
Long-term asset loan
...


Our focus on bank loans are consumer/household loans
...
g
...
g
...

Increasingly, mortgages operate as line of credit facilities
...


b) Personal loans:
Loans to individuals for cars, holidays, boats and etc
...

Short-term loans often single-payment loans – the growing demand for consumer credit has led
the rapid growth of consumer-oriented financial institutions such as; finance companies, credit
unions and building societies
...


-

c) Bank credit cards:
Used to conduct financial transactions
Significant increases in over the last two decades
Cardholder is guaranteed a credit limit
52

-

Pay a minimum monthly payment set by the bank within 25 days, no interest charged
Interest charged – varies between 1-2% per month or 12-24% per annum
...


Q7
...
However, larger banks have access to more sources of liquid funds therefore, they do not
need to rely or have a lower proportion on investment securities compared to smaller banks
...
Why do banks invest in bonds given they typically offer a low return?
•
•
•
•
•

Low default risk
High liquidity
Enables banks to earn interest income on their reserves
Supports further borrowings
Offsets the high risk of other items in the balance sheet

Q9
...
Although home loans attract higher interest rates
for banks and therefore increasing profits, it can potentially pose higher risks, due to its maturity and
the risk of default
...
This will
result in bankruptcy for banks; therefore, banks should ensure a diverse portfolio in their uses of
funds, e
...
banks can increase investments and other trading securities to balance their uses of funds
activities
...

•
-

The most common sources of commercial bank funds are
deposit accounts, and
borrowed funds
...
g
...


Off-Balance sheet (OBS) Banking Activities
OBS transactions are a significant part of a bank’s business
-

OBS items generate fee income for the bank but also increases bank risk

•

Unlike other free-based activities (such as providing financial planning advice to clients) offbalance sheet activities (OBS) items can either represent contingent assets or contingent
liabilities

-

Contingent asset – a possible asset that may arise because of a gain that is contingent on
future events that are not under an entity’s control
...
g
...

Contingent liability – a potential liability that may occur depending on the outcome of an
uncertain future event
...
g
...


-

•

OBS activities are notionally more than 7 times the total value of assets held by the banks
...


54

•

Three types of loan commitments that may be agreed upon by business borrowers and
commercial banks:

•

Line of credit – an agreement under which a bank customer can borrow up to a
predetermined limit in the short-term (less than one year)
...
The line of credit
does not have to be used but a firm incurs a liability only for the amount borrowed
...

Term loan – a formal legal agreement under which a bank will lend a customer a certain
dollar amount for a period exceeding a year
...

Revolving credit – a formal legal agreement under which a bank agrees to lend up to a
certain limit for a period exceeding a year
...
At the end of the period, all
outstanding loan balances are payable, or if stipulated, the facility may be rolled over into a
new line of credit
...


Letters of credit or an (LOC) is a contractual agreement issued by a bank that involves three
parties:
•
•
•

The bank;
The bank’s customer/client; and
Beneficiary

-

Letters of credit sets up the conditions to be met in order for payment to occur
...

Credit risk is transferred to the buyer’s bank at issuance of a documentary credit
...

The bank acts as a guarantor on behalf of a client for a fee
...

The bank’s obligation under a standby LOC is a contingent liability, because no funds are
advanced unless the contract is breached by the bank’s customer and the bank has to
perform its guaranteed obligation
...
These are called performance
standby LOCs
...
The process of securitisation creates/improves
liquidity in the marketplace for those assets being securitised, e
...
a home loan (the loan is being
sold and the underlying asset is the home)
...
They can sell it
at a discount (higher rate), which means that at that interest rates play a role in how much banks
can sell it for
...


•

•
•
•

•

The securitisation process begins with banks segregating loans into relatively homogenous
pools/tranches/groups/classes with regard to the maturity and type of loan e
...
house loans
with an average maturity up to 25 years
...

Risk rating helps to determine the value of the security
...

The originating bank usually provides some form of credit enhancement, which pays promised
cash flows to the ultimate investors in the event of default
...
First by selling rather than holding loans, banks reduce the amount of assets and liabilities,
reducing reserve requirements and capital requirements
...
Second, securitisation provides a source of funding loans that is less expensive than others –
funds from sale can be used for additional origination activities
...
Finally, banks generate fees from the securitisation process
...
Therefore, banks can also collect underwriting fees in the securitisation process
...
e
...


•

A special purpose vehicle (SPV), a stand-alone legal entity, purchases these assets and then issue
securities
...

Securities are backed by the pools of assets
...


•

The underwriter in turn would sell securities (usually called certificates) on the marketplace
...


-

Originating back can offer credit enhancement, which pays promised cash flows from pooled
mortgages to ultimate investors in an event of a default
...
What are the major benefits of getting assets (loans) off the balance sheet through
securitisation?
Essentially, Banks can earn fee incomes, reduce low-quality loans and their regulatory burdens, e
...

reserve requirements and capital requirements
...
First by selling rather than holding loans, banks reduce the amount of assets and liabilities,
reducing reserve requirements and capital requirements
...
Second, securitisation provides a source of funding loans that is less expensive than others –
funds from sale can be used for additional origination activities
...
Finally, banks generate fees from the securitisation process
...
Therefore, banks can also collect underwriting fees in the securitisation process
...


57

•

Disadvantage – LOC - The possibility that the customer defaults on their payment to the third
party
...

if a bank incurs an unexpected liability from off-balance sheet activities, it may hinder their
cash flows
...

Banks can also raise funding to pay off their ‘liabilities’ (contingent liabilities→liabilities)
...


Q3
...
For example, a credit
cardholder has a $500 balance in their credit card
...
However, at the time of purchase, if the bank has low liquidity to
fund consumer activities, it may need to borrow from other banks or money markets, which can
involve increased costs and may result in a liability
...


Derivative securities
Equity = assets – liabilities
Bank assets change with the interest rate as most of their assets are interest bearing assets- hence
bank’s face this risk of changes in interest rates
...

Derivative securities help to minimise this risk
...

•

Derivatives include:
- Forwards;
- futures;
- options; and
- swaps
...


Banks participation in derivative securities transforms the nature of its sources and uses of funds:
a) Denomination/currency;
b) Maturity; and
c) Interest payment
...


•

OBS activities raise concerns about bank regulation
...


•

Derivative securities are both contingent assets and contingent liabilities because they offer
potential gains as well as potential losses
...


Derivative Securities: Forward Contract
A forward contract is a Legal agreement that exists between two parties (a buyer and seller) to
purchase or sell a specific quantity of a specific commodity/asset, government security, foreign
currency or other financial instruments at:
•
•

an agreed price (irrespective of future market conditions);
at a specified future delivery and settlement date (highly flexible)

A forward contract is a traded over the counter (an over-the counter product):

59

-

That are highly negotiable between two parties
...
g
...


•

Futures market does not maximise profit but focuses on balance between both parties in the
market
...


•

Two popular option contracts are caps and floors:
1
...
Floor – sets a minimum below which interest rates cannot drop
...

Premium compensation - the amount of money transferred from the buyer to the seller for entering
that agreement
Time consideration – options contracts have an expiration date
...
This can be between a week to multiple years
...

Assignment – the seller gives up their item/stock that they have to the option buyer for the agreed
price
...

- If the buyer does not execute the options contract, the premium is a compensation
...


•

By convention:
-

If a firm negotiates a plain vanilla swap, it will provide fixed-rate payments in exchange for
floating-rate payments
...


Derivative securities: Micro & Macro Hedges
Micro Hedge (hedging applied to individual items)
Hedge single asset/liability in the balance sheet
•

E
...
Bank attempts to lock in the cost of funds to protect itself against a possible rise in shortterm interest rates
...

AIM: Best to pick a contract whose underlying deliverable asset is closely matched to the asset
(or liability) position being hedged to prevent basis risk (uncorrelated prices)
...
g
...


Q4
...
This provides the buyer with periodic payments
(protection against losses) based on the difference of the strike rate and exceeding rate
...


•

Floor – At the same time, the bank must offset the cost of the cap premium (periodic payments)
...
The Bank

62

receives periodic payments(premiums) based on the amount by which the strike rate exceeds
the market rate
...
Why are some restrictions placed on commercial banks with respect to using derivatives to
speculate?
Some restrictions are placed to control the bank’s risk
...

Similarly, futures contract and options contract is quite risky, as the bank who takes a sell position, if
the agreed price for the item/security increases in the market, the bank incurs a loss as they then
sell the item for the locked in price, and the difference in the market price is the loss
...

Restrictions can also involve the limit on the use of derivatives reflected in their off-balance sheet
activities, to control the possible risks involved in derivative securities
...


Bank Performance
Bank performance is measured in several ways, such as:
•
•

Return on average assets (ROAA): comprises net income/average total assets
...


63

Net interest income (NII)
NII – is the difference between gross interest income and gross interest expense (interest income interest expense)
•
•

Return on assets (ROA): comprises net income / total assets
Return on equity (ROE): comprises net income / equity capital

Bank profitability

Q6
...
Banks can do this by better managing their
interest income and interest expenses of their assets and liabilities; to ensure that they increase the
gap between their interest income and interest expenses (earning higher income than their
expenses)
...


Q7
...


Summary
•

Banks engage in OBS activities such as:

-

Loan commitments

-

Standby letters of credit

-

Securitisation

-

Derivative securities
...


•

Bank performance post-GFC in Australia declined
...

64

Week 2 Session 6
Non-Bank Financial Institutions

Types of NFBI’s

•
•
•
•
•
•
•
•
•
•

Money market corporations (Investment banks)
Managed funds
Superannuation funds
Cash management trusts
Public unit trusts
Life insurance and general insurance offices
Hedge fuds
Finance companies and general financiers
Building societies and Credit unions
Export finance corporations

The following NFBIs are of importance:
•

Non-ADI financial institutions
- Money market corporations (investment bank)
- Finance companies

•

Insurers and fund managers
- Cash management trusts
- Superannuation funds
- Life insurance companies
- General insurance companies
- Hedge funds

65

•

ADIs
- Building societies
- Credit unions

Money Market corporations

Money market corporations is a non-ADI financial institution that is supervised by ASIC
...


They operate primarily in wholesale markets, borrowing from and lending to large corporations and
government agencies
...


The services include; advisory, relate to corporate finance, capital markets, foreign exchange and
investment management
...


•

They are primarily concerned with earning service fees (fee income) that are obtained from
off-balance-sheet (OBS) advisory services to support high-net-worth individuals, corporate
and government clients
...
g
...


Money market corporations/Investment banks represent less than 1% of the total assets of financial
institutions, which is to say they mainly focus their activities on specialist off-balance sheet advisory
services
...

The pool of loans are then transferred to a trust with the help of the underwriter who
sells the securities (certificates) to ultimate investors
...
g
...


•

Advising clients on how, where and when to raise funds in the domestic and international capital
markets
...
g
...


•

Acting as the underwriter of new share and debt issues
...


•

Providing advice to corporate clients on balance-sheet restructuring
- Seeking the most effective way to fund assets that reflect shifts in interest rate or
exchange rate throughout the business cycle
...

- Providing advice to corporate clients on mergers and acquisitions – in which one
company gains control over another – while generating significant fee income
...


•

Conducting feasibility studies and advising clients on project finance and structured finance
undertakings
...
Corporations and
governments are exposed to a wide range of financial and operational risks
...
Venture capital, also known as risk capital,
is funding provided for new start-up businesses where there is a high level of risk attached to the
future success of the business but the potential for high returns
...


Mergers and acquisitions
As discussed above mergers and acquisition is when a company gain control over another (takeover
company)
...

The economic growth activity directly correlates with the growth of mergers and acquisitions activity
– which can take place in any part of the world (location of little importance) as investment banks
are global institutions
...
(e
...
a toy manufacturer purchases another toy
manufacturer)
...
g
...

when the target company in a merger and acquisition operates in a business related to
that of the takeover company
A conglomerate takeover is business activities by acquiring a existing business of the
takeover said to occur when the company that operates company (e
...
a toy takeover in
a business manufacturer company diversifies its area unrelated to the purchases a
media
when the business of a merger and acquisition target company is unrelated to the
existing business of the takeover company
...

e
...
when a toy manufacturer company takes over certain parts of another company,
despite the merger and acquisition proposal being rejected by the target company
...


•

When companies cannot find buyers willing to pay a desirable price for the division that
it wishes to sell, the company spins off the division and becomes two separate
companies: parent and child
...


Mergers, acquisitions and spin-offs are important examples of the balance sheet restructuring
facilitated by investment banks
...

Finance companies cannot take deposits
Banks started finance companies as a subsidiary company – engaging in borrowing
activities with less restrictions that commercial banks had initially, however they are not
as competitive today, due to deregulation in the commercial banks
...
g
...


Uses of funds
•
•
•

Provide Household/Consumer loans;
Business loans (e
...
small to medium sized businesses); and
Lease finance to households and business sector
...
Why have finance companies dwindled/decrease in numbers?
69

Finance companies have contracted or reduced in numbers as the impact of a deregulated and
competitive market resulted in building societies and other finance companies to merge with other
institutions and absorption of some finance companies into their parent banks or even changing to
become commercial banks
...
Why are investment banks pro-active in initiating potential mergers and acquisitions ideas to
their clients?
Investment banks providing advice to potential mergers and acquisitions particularly generate a
significant fee income, which is an ideal source of funds for investment banks
...
For example, the increased level of mergers and acquisitions activity have been seen to boost
the economic growth in the USA during the 1990s, following a slowed economy growth in the 2000s
when the level of mergers and acquisitions activity also slowed down
...

They are not, therefore, passive players in the market; that is, they do not wait until they are
commissioned by a client on either side of a merger transaction
...


Managed funds
Managed funds are investment vehicles through which the pooled savings of individuals are
invested
...

-

•

E
...
the amount of funds invested in managed funds impacts the flow on domestic and
international capital and money markets
...


Types of managed funds:
Mutual funds – managed funds that are established under a corporate structure, investors purchase
shares in the fund
...
(usually in the UK and Australia)
70

Trust deed – is a document detailing the sources, uses and disbursement of funds in a trust
...


Sources of funds
•
-

Funding from specific contractual commitments of investors
e
...
periodic payments into the fund (e
...
superannuation) / (pooled saving) ; or
a single payment or premium (e
...
an insurance policy)
...


•
-

Passive investing
Buy a portfolio of assets that mimic an index, such the all ordinaries index or the S&P200
index;
Index funds are cheaper as you are not paying for investment expertise
...

Financial intermediaries – are financial institutions who establish a trust fund to manage the
investment fund account
...

The trust deed sets out the rules under which the CMT is to be managed, including the manager’s
responsibility for the day-to-day operation of the trust, and provides for a trustee to be responsible
for the supervision of the trust
...

The type of assets in which the trust may invest is usually restricted to short-term money market
instruments
...

Provides retail investors with access to the wholesale market
...
g
...


Sources of funds
•
-

Superannuation funds accept and manage contributions from their members
...

Contributory (employer and employee contribute)
Non-contributory (only employer contributes)
Currently 9
...
5%
increases commencing from 2021
...


Uses of funds
•
-

Offer members a choice of investment strategies to meet their particular risk and
liquidity preferences e
...
:
Minimise risk exposure prior to retirement (conservative)
Young person may want a more aggressive risk strategy

•
-

Some strategy types:
Capital guaranteed; (less risky)
Capital stable; (less risky)
Balanced growth; (riskier)
Managed growth (riskier)
72

•
-

Funds are controlled by trustees who usually invest in a range of assets depending on
selected strategy by fund member:
Equities
Property
Debt securities
Deposits
...

Risk lies with the superannuation company
It is a risk for the superannuation company/employer as the defined benefit fund
disregards the performance of the investments which can be insufficient to meet the
defined pay-out
...


Accumulation funds
•

Invest contributions of employer and employee on behalf of superannuation fund
member
...


Life insurance companies
Life insurance companies are contractual savings institutions – meaning that you will need to pay the
premium to secure the benefit
...


•

Outflow of funds are quite predictable and stable

The more predictable the funds are, the more the flexibility in investing in various funds, while the
less stable it is the more inflexible liquidity is
...

Very liquid assets to raise cash to meet claims against insurance policies
E
...
T-notes, bills of exchange, commercial paper, NCD and etc
...
g
...


•
-

Can leverage instruments via:
Debt financing or derivatives

•
-

Hedge fund manager skills are imperative
Expectation is to achieve positive returns no matter how the market performs
...
Outline some of the reasons why hedge funds attracted criticisms during and after the GFC
•
•
•
•

Highly risky
Requires skill
Speculative risk – can substantially result in a loss of investment
...


The short-selling strategy was the issue – many investors continued to buy in bulk while the value of
the security/asset dropped
...


Q4
...

In the event that general insurance companies do not ensure preparation for claims and invest in
long-term securities, this can lead to liquidity problems where the long-term investments cannot
generate the return on investments (less liquidity) needed to offset any claims
...
g
...

Q5
...

Defined benefit funds offer a paid amount to an employee on retirement which Is calculated based
on a defined formula at the time the member joins the fund
...

It has become increasingly rare, as superannuation companies have instead transferred the risk
exposure by encouraging employees to move to, or only offer accumulation funds
...


Sources of funds:
-

As ADIs, main source of income is short-term consumer saving deposits – from their
members
...


Uses of funds
•
•

Long-term residential mortgages – housing loans
Consumer loans
...


Some building societies become commercial banks as they operate similar to a bank, instead they
would need a banking licence, e
...
bendigo bank
...


Sources of funds
•

As ADIs, main source of funds is deposits from members (payroll deductions)
...


Uses of funds
77

•
-

Primarily personal finance to members:
Residential housing loans
Consumer loans

Regulation body in Australia
•

As they are ADIs, they are regulated by APRA, which applies the same prudential and
reporting standard for commercial banks
...

They use these short-term funds to invest in longer-term, less liquid assets like
securitised mortgages
...
Credit unions typically have a common bond of association
...

Common bond of association is members who are drawn together from a common background such
as employment/work, industry or community
...

Q7
...

Discuss
...

Q8
...

https://www
...
gov
...
rba
...
au/fin-stability/fin-inst/main-types-of-financialinstitutions
...


The risks faced by FIs are interest rate risk, market risk, credit risk, off-balance sheet risk, technology
and operational risk, foreign exchange risk, country or sovereign risk, liquidity risk and insolvency
risk
...


Credit Risk

79

•

The risk that promised cash flows on financial claims held by FIs such as loans or
bonds/securities may not be paid in full
...

- E
...
banks, building societies, credit unions and life insurance companies are more
exposed to credit risk than; money market managed funds and general insurance
companies
...


•

Unlike systematic credit risk, firm-specific credit risk can be managed through diversification
- It truncates or reduces/limits the probabilities of bad outcomes in the portfolio

•

If the principal on all financial claims held by FIs was paid in full on maturity and interest
payments paid on the promised dates, FIs would face no credit risk
However, if the borrower defaults, both the principal loaned, and the interest payments
expected to be received are at risk
...

Examples of financial claims issued with (return-risk trade-offs) are fixed income coupon
bonds issued by corporations and bank loans
...


•
•

•
•

Reducing Credit Risk of Individual Loans
•

To minimise adverse selection:

•

A key role of FIs involves screening and monitoring loan applicants to ensure that FI
managers fund the most creditworthy loans
...


The 5 C’s of credit

One of the advantages FIs have over individual household investors is:
•

The ability to diversify some credit risk away by exploiting the law of large numbers in their
asset investment portfolios
...


Reducing credit risk of Loan portfolios
•

A high concentration of loans in the same industry within a portfolio increases credit risk of
the portfolio
...

- Do not lend a high concentration of loans to the same type of borrowers

81

Market Risk

•

Market Risk is:
- The risk incurred in the trading of assets and liabilities in a financial institutions’ trading
book due to changes in interest rates, exchange rates and other asset prices
...


•

Market risk is closely related to interest rate risk, equity return risk and foreign exchange risk
in that as these risks increase or decrease, the overall risk of the FI is affected
...
g
...


•

Two types of portfolios:
- Trading portfolio/trading book – contains assets, liabilities and derivative contracts that
can be quickly bought and sold on organised financial markets
...


82

A hypothetical breakdown between banking book and trading book assets and liabilities:

•

Securitisation of bank loans e
...
mortgage-backed-securities pertain fluctuations in value or
value at risk (VAR), in which FIs are mainly concerned with
...


•
•

The subprime mortgage loans that led to huge financial losses resulted from market risk
The global financial crisis illustrates that trading or market risk is present whenever an FI
taken an open or unhedged long (buy) or short (sell) position in bonds, equities and foreign
exchange (as well as commodities and derivative products) and prices change in a direction
to that expected
...


•

This requires FI management (and regulators) to establish controls that limit positions taken
by traders as well as to develop models that measure the market risk exposure of an FI on a
day to day basis
...


83

Measures determine the largest possible loss that would occur as a result of changes in market
prices
-

•

Based on a specified percentage confidence level

Banks continually revise their estimate of market risk (on a day to day basis)
- If market exposure is excessive, it can offset risk via trading positions such as a futures
contract
...

- E
...
internet controls, ATM machines & technology systems are not working
...


•

Technological innovation has seen rapid growth in:
- Automated Clearing houses (ACH)

Major objectives of technological expansion:
-

•
•

To lower operating costs
To increase profits
To capture new markets for the FI

Economies of scale imply an FI’s ability to lower its average costs of operations by
expanding its output to financial services
...


84

Technology risks vs operational risks
•
•

Technology risk: technological investments may not produce the cost savings anticipated
e
...
diseconomies of scale
...

Examples of operational risk: Bank of New York (1985), Wells Fargo Bank and First Interstate
Bank (1996), Citibank (2001), National Australia Bank (2010), Commonwealth Bank and
Westpac (2011)
...
’

•

A number of the risks to FIs can be loosely classified as operational risks (e
...
):
-

•

Fraud (e
...
employee siphons funds from bank’s corporate accounts (ING Australia: $45
million);
Information technology failures/errors (e
...
unable to withdraw funds from ATM;
payments system failures, etc
...


Interest rate risk
•

Interest rate risk is:
- The risk incurred by an FI when the maturities of its assets and liabilities are mismatched
(primary securities – securities/assets bought/invested e
...
treasury bonds/fixed rate
debentures & secondary securities – liabilities/securities issued e
...

deposits/borrowed funds/shares
...


•

The primary securities purchased by FIs often have maturity and liquidity characteristics
different from those of the secondary securities FIs sell
...


85

1st example of FI maturity mismatch
Here an FI issues $100 million of liabilities of one-year maturity to finance the purchase of $100
million of assets with a two-year maturity
...
’ If an FIs assets are longer-term than
its liabilities the FI is viewed as being ‘short funded’
...


SCENARIO 1: Consider an FI that issues $100 million of liabilities of one-year maturity to finance the
purchase of $100 million of assets with a two-year maturity
...


What are the potential first year and second year issues?
•
•

The first year the FI is guaranteed a 1% spread (10% - assets - 9% liabilities) = 0
...

The second years profit is uncertain
...
However, if the interest rates on its liabilities were tor rise from 9% to 11%, there is
a risk of a loss (10% assets - 11% liabilities) = -0
...


To put it into perspective, As an FI holds longer term assets relative to its liabilities, it potentially
exposes itself to refinancing risk
...

E
...
10% - interest rate on asset investments – 2-year period
9% - interest rate/cost of funds(liabilities) – 1st year
86

↑ rises above interest rate on asset investments = loss
11% - interest rate/cost of funds(liabilities) – 2nd year

The $1 million profit earned for the first year holding assets with a longer maturity than its
liabilities would be offset by the $1 million loss in the second year (if interest rates/cost of funds
were to rise more than 1% in the second year (negative spread) the FI would stand to take losses
over the two year period as a whole)
...


•
•

The timeline also represents an FI being ‘long funded
...
This leads to:
Reinvestment risk:
- The risk that the returns on funds to be reinvested will fall below the cost of funds
...


What are the potential first year and second year issues?
•
•

The first year the FI is guaranteed a 1% spread (10% - assets - 9% liabilities) = 0
...

At the end of the first year when the asset matures, the funds that have been borrowed for
2 years have to be reinvested
...

However, if the interest rates on its assets were tor drop from 10% to 8%, there is a risk of a
loss (8% assets - 9% liabilities) = -0
...


To put it into perspective, As an FI holds shorter term assets relative to its liabilities, it potentially
exposes itself to reinvestment risk
...

E
...
9% - interest rate/ cost of funds (liabilities) – 2-year period
10% - interest rate on asset investments – 1st year
↓ below cost of funds = loss
8% - interest rate on asset investments – 2nd year

•

The $1 million profit earned for the first year holding assets with a shorter maturity than its
liabilities would be offset by the $1 million loss in the second year (if interest rates on asset
investments were to fall more than 1% in the second year (negative spread) the FI would
stand to take losses over the two year period as a whole)
...


Additional interest rate risk: Market value risk
In addition to a potential refinancing or reinvestment risk that occurs when interest rates change, an
FI faces market value risk as well
...

Market value/fair value of an asset or liability is equal to the present value of current and future cash
flows from that asset or liability
...


Mismatching maturities of assets and liabilities means that the change in their market value will not
be the same
...

E
...
Equity = Assets – Liabilities means that changing interest rates can impact the FIs net worth
...


b) If interest rates fall:
• The market value of the FIs assets increases by a greater amount than its liabilities (more
assets than liabilities will gain value);
• Thus, increasing the value of the bank’s equity
...


b) If interest rates fall:
• The FIs liabilities increases by a greater amount than the market value of its assets (more
liabilities than assets will gain value);
• Thus, reducing the value of the bank’s equity
...
However, it only hedges in a very
approximate rather than complete fashion
...


•

It is not consistent with an active asset-transformation function for FIs, that is FIs cannot be
asset transformers (e
...
transforming short-term deposits into long term loans) & direct
balance sheet matchers or hedgers at the same time)
...


•

For most FIs, the maturity of assets exceeds the maturity of liabilities
...


•

Banks undertake a controlled mismatch:
-

Short-term deposits comprise the majority of funding for longer-term, higher interest
loans to customers
...


•

Such mismatches are handled by asset-liability management (ALM)
...


Q1
...


90

If banks’ market exposure is found to be excessive, they can diversify their investments in other
inversely related investments as a way to reduce risk
...


Q2
...


Q3
...

Refinancing risk is concerned with the changes in interest rates on borrowed funds/cost of funds, as
the interest rate rises above the return on asset investments it means a negative spread, which can
result in increased losses for the bank
...


Summary
•

Screening and monitoring of loans – as well as loan diversification – can reduce impact of
credit risk
...


•

Operational risk – refers to risk from day-to-day operations of banks
...

Foreign exchange risk is:
•

The risk that exchange rate changes can adversely affect the value of an FIs assets and/or
liabilities denominated in foreign currencies
...


The returns on domestic and foreign direct investing and portfolio investments are not perfectly
correlated for 2 reasons:
1
...

- Given different economic infrastructures, one economy could be expanding while another is
contracting e
...
in the late 200s china’s economy was expanding while the US economy was
in recession
...
Macroeconomic factors – when domestic interest rates go up, foreign interest rates may go
down
...
Foreign exchange rates changes are not perfectly correlated across countries
...
g
...


One potential benefit from an FI becoming increasingly global in its outlook is an ability to
expand abroad directly through branching or acquisitions, or by developing a financial asset
portfolio that includes foreign securities as well as domestic securities
...


Example off foreign exchange risk:
•
•

Suppose that an Australian FI makes a loan to a British company in pounds sterling (£)
...

92

•

Therefore, if the UK pound were to fall far enough over the investment period, when
cashflows are converted back into Australian dollars, the overall return may be negative
...

However, the ratio of its foreign currency to its foreign liabilities will depend on 3 factors;

-

Net long position
•
-

Involves holding more foreign currency denominated assets than foreign currency
denominated liabilities/holds more foreign assets than liabilities
FI loses (gains) when foreign currency falls (rises) relative to the AUD dollar, e
...
as there are
more assets than liabilities, it is a loss for FIs holding foreign currency denominated assets as
the assets also go down in value
...
g
...

The difference between the £100 million in pound loans and £80 million in pound CDs is
funded by Australian dollar CDs, that is £20 million worth of Australian dollars (conversion
price)
...
g
...
83(AUD) = 1
...
60 AUD

93

Risk: if the exchange rate for pounds falls (depreciates) against the Australian dollar over this period,
the FI is exposed to the risk that its net foreign assets may have to be liquidated at an exchange rate
lower than one that existed when the FI entered into the foreign asset-liability position
...


Net short position
•
-

Involves holding fewer currency denominated assets than foreign currency denominated
liabilities/holds more liabilities against fewer assets
...
g
...


e
...

•
•

The Australian FI instead holds £80 UK pound as assets(loans) and funds/financed by issuing
£100 million with UK pound certificates of deposits (CDs)
...


Risk: The FI is exposed to foreign exchange risk if the UK pound increases (appreciates) against the
Australian dollar over the investment period, e
...
(the price of £1-pound increases from $1
...
00)
...


94

Consequently, to be approximately hedged, the FI must match its assets and liabilities in each
foreign currency
...

Country/sovereign risk – is the risk that repayments from foreign borrowers may be interrupted
because of interference from foreign governments
...


Country/sovereign risk differs from credit risk of FIs domestic assets:

Domestic corporation – when a domestic corporation is unable or unwilling to repay a loan, an FI
usually has recourse to the domestic bankruptcy courts and eventually may recoup at least a portion
of its original investment when the assets of the defaulted firm are liquidated or restructured
...


Foreign corporation – may be unable to repay the principal or interest on a loan even if it would like
to
...

•

In the event of such restrictions, rescheduling or outright prohibitions on the payment of
debt obligations by sovereign governments, The FI claimholder/Lender may have little
recourse to local bankruptcy courts of to an international civil claims resort
...
g
...
Offered to creditors
a non-negotiable 30 cents in the dollar from its 2001 debt restructuring of US$103
billion, (the lowest amount on a debt default)
...

- Another example involves the Mexican and Brazilian governments announcing a debt
moratorium (ban) on Western creditors IN 1982
...

(credit risk of foreign assets)/foreign risk
...

-

Otherwise, exposure to foreign interest rate risk is created
...

Off-balance sheet activities affect the future shape of an FIs balance sheet in that they involve the
creation of contingent assets and contingent liabilities that give rise to their potential/future
placement on the balance sheet
...
g
...

- if homeowners’ default on their mortgage loans, this may result in the banks/loan originators losing
their money instead as they will need to pay on behalf of homeowners to bondholders
...

Hence, the ability to earn fee income while not loading up the balance sheet has become an
important motivation for FIs to pursue off-balance sheet business/activities
...


Off-balance sheet (OBS) risk is:
•
•

The risk incurred by an FI due to activities related to contingent assets and liabilities
...

- Increased importance can affect the future shape of FIs balance sheets
...
g
...
Hedging
strategies are only to minimise risk not to make a profit, e
...
options/swaps to hedge the risk
on contingent assets and contingent liabilities
...
org/2007/02/reputation-and-its-risks

Reputational risk is:
•

The risk of a loss resulting from damages to an FIs reputation

•

It can occur through a number of ways:
- Directly as the result of the actions of the company itself;
- Indirectly due to the actions of an employee or employees;
- Tangentially through other peripheral parties, such as joint venture partners or suppliers

•

It is difficult to assign an exact financial value to the risk type
- E
...
it is intangible, it is incidental and it is hard to assign the responsibility to specific
person(s)
...
deloitte
...
html
Conduct risk is:

97

•

The threat of financial loss to an organisation caused by the poor judgement of managers
and employees

•

An impact of conduct risk on the banking sector:
- Financial services sector cited as the least trusted sector (in survey of 28 countries)
- In Australia, such mistrust led to: Royal Commission into Misconduct in the Banking,
Superannuation and Financial Services Industry
...
g
...
g
...


Conduct Risk: No accountability/Lack of monitoring
•

If monitoring and surveillance is non-existent or inadequate, misconduct can go undetected
...


•

Failure to penalise those for ethically or legally questionable behaviours (i
...
misconduct)
...

- Ensure suitable penalties are provided for breaches
- Improved legislation and regulation focusing on monitoring of transactions and
communications
...
g
...

- They must pay close attention to culture, corporate governance and remuneration
...
When country/sovereign risk occurs, what are the realistic options available to a financial
institution?
Country risk/Sovereign risk – FIs may eventually recoup at least a portion of its original investment
when the assets of the defaulted firm are liquidated or restructured
...

Legislation –The country where the risk occurred can involve FIs to persuade
government to solve these issues
...
Why is it difficult to place an exact financial value on reputational risk?
It is hard to pinpoint the direct cause of the risk, the person the risk was caused
...

-

It is hard to measure and place a framework on assessing the financial value unlike
interest rate, foreign exchange, credit risk and etc
...


Q3
...
g
...
can encourage them to perform well meaning increased
accountability, while it reduces conduct risk and promotes high quality work performance and
conduct
...
g
...


Liquidity Risk
Liquidity risk is:
-

The risk that a sudden surge in liability withdrawals (depositors/insurance
policyholders) may require an FI to liquidate part of its assets in a very short period of
time and at less than fair market prices or low prices
...


•

Banks must ensure that depositors do not all demand their money at the same time
...

Further, when all, or many FIs face abnormally large cash demands, the cost of additional purchased
or borrowed funds rises and the supply of such funds becomes restricted
...

•

The cost of purchased and/or borrowed funds rises for FIs:
- FIs may be forced to sell less liquid assets(loans) at low or “fire-sale” prices (the price
that an FI receives if an asset must be liquidated immediately at less than its fair market
value)
...

- Results in a more serious liquidity risk
...

•
•

A ‘run’ can turn the FIs simple liquidity problem into a solvency problem, which can cause it
to fail
...


Insolvency risk
Insolvency risk is a consequence or outcome resulting from; interest rate, market, credit, off-balance
sheet, technological, foreign exchange, country/sovereign, reputational, conduct and liquidity risks
...


e
...

- Continental Illinois National Bank and Trust
103

- In Australia: National Mutual Life Association (NMLA)

•

FI management and regulators focus on capital adequacy to aim to ensure FI solvency
...


Profitability and safety dilemma
•

A bank must balance the demands of three constituencies
- Shareholders: mainly interested in probability
- Depositors: mainly interested in safety as they keep their money in the bank
- Regulators: mainly interested in safety for the whole financial system

104

•
•
•

Increasing equity means lower profitability, however a balance between liquidity and equity
is better for a bank
Lower solvency means higher leverage
Very high liquidity means banks cannot invest as much in securities
...

If mismatch is not controlled bank faces refinancing risk
If a bank has trouble refinancing, it places a strain on liquidity
Can lead to illiquidity

Thinly capitalised
•
•
•

Banks are highly leveraged (low equity base) since debt is a cheaper source of raising funds
With low equity base, small changes in Assets (e
...
bad loans and investments) can lead to
large impacts on equity
...
What does the thinly capitalised nature of banks mean for insolvency risk?
A thinly capitalised entity is one whose assets are funded by a high level of debt and relatively little
equity
...

The factors causing this loss can be due to the above risks e
...
interest rate risks, foreign exchange
risks and etc
...
Insolvency and illiquidity are two ways a bank can fail
...
However, banks can most likely always
find solutions from government, central bank, money market investment securities and etc to avoid
leading up to insolvency
...


Q6
...


Summary
•

Country/Sovereign risk has little recourse
...


•

FIs conducting foreign business are subject to FX risk
...


•

Conduct risk is a major concern and arises when monitoring and oversight is weak

•

Asset and liability management is seen as one way to limit liquidity risk for FIs
...


Week 4 Session 10
Regulation of Financial Institutions
Purpose of banking supervision is to ensure that banks operate in a safe and sound manner
...

106

•

Regulation is a mechanism for preventing failures, or confining their effects

•

The key aspect of regulatory examinations is to detect bank problems in time to correct
them
...

-

•
•

An insolvent company is one that is unable to pay its debts when they fall due for
payment
...


107

The 4 members of the coordinating body (CFR) for Australia’s main financial regulatory agencies are:
•
•
•
•

APRA
ASIC
RBA; and
Treasury

1
...
Financial institutions operate in an asymmetric information environment
- Difficult to expertly gauge a financial institution’s safety or soundness

Regulatory issue: Too big to fail
•

Financial regulators are reluctant to allow a big institution to fail
- Big banks expect their central banks to provide support if they are in danger of failing
- U
...
government implicitly promises full bai lout of the largest institutions
...


It is believed that if a large bank goes bankrupt it can cause negative repercussions within the
economy and can cause a ‘downturn’ in the economy, hence the term ‘too big to fail
...

- Adds to the temptation of the largest institutions to ‘gamble’, thereby increasing moral
hazard incentives
...


Regulation of capital: Basel 1 and Basel 2

Capital adequacy regulation
Basel 1 – 1988
Basel 2 – 2008 – capital adequacy guidelines

108

A minimum capital requirement is required as losses can be absorbed by capital

•

Basel 1
- Simple measure for credit risk
- Not risk sensitive
- No explicit measure for operational risk

•

Basel 2
- Bank’s own internal measure for counterparty level risk parameters
- More emphasis on bank’s own internal methodologies (Pillar 1), supervisory review
(Pillar 3) and market discipline/disclosure (Pillar 3)
- Significant changes to the approaches used to measure credit risk
- More flexibility, menu of approaches, incentives for better risk management
- Increased risk sensitivity
- Inclusion of exploit capital requirements for operational risk

Basel 2 – types of capital and three pillars
•

Tier 1 – capital (core capital): Minimum 4% to be held
- Comprising mainly common stock/equity and retained earnings

•

Tier 2 – capital: Upper and lower (supplementary capital)
- Upper tier 2 – specified permanent hybrid instruments
- Lower tier 2 – specified non-permanent instruments

Tier 1 & Tier 2 – make up 8% minimum capital

Pillar 1
109

Minimum capital requirements:
•
•
•
•

Risk management incentives
New operational risk capital change
Risk weighted assets (RWA) for credit, more risk sensitive
Market risk largely unchanged

Pillar 2
Supervisory review:
•
•
•
•
•

Solvency reports
Regulatory review
Capital determination
Regulatory intervention
Addresses risks that are not captured in Pillar 1 e
...
concentration, interest rate and liquidity
risks
...
Thus: total risk-weighted
exposures = 200
...

Assume: Tier 1 Capital of 12
...
Thus: 6% weighted exposures
Assume: Total capital of 20
...
Thus: 10% weighted exposures
...
Increase in quality of capital
2
...
Constitution of a capital conservation buffer

Leverage
4
...
Introduction of liquidity standards
...

Minimum of 4
...

Introduction of mandatory capital conservation buffer of 2
...

Introduction of discretionary (i
...
counter cyclical) capital buffer of 2
...
(usually duing an
expansion where they need to maintain an extra 2
...


111

Note; maintaining higher capital is costly for the banks – capital is more costly than borrowing funds
...


Basel 3: Leverage ratio

Introduction of a supplementary leverage ratio (SLR):
-

Banks are expected to maintain a 3% ratio of Tier 1 capital to total assets
...


Intent of the change
•

Primary strength is to monitor OBS leverage to reduce the probability of another Lehman
Brothers collapse
...
7 to 1
(30
...


Basel 3: Liquidity ratios

Introduction of the liquidity ratios (LCR)
•
•

Liquidity coverage ratio (short-term): required banks to hold sufficient high-quality liquidity
assets (HQLA) to cover total net cash outflows over 30 days
Net stable funding ratio (long-term: a ratio of the available stable funding to the amount of
stable funding required to cover all illiquid assets and securities held for a period of 1-year
extended stress
...
g
...

NSFR: Likely to increase towards:
- (i) more deposits;
- (ii) reduced short-term wholesale funding reliance; and
- (iii) increase long-term wholesale funding reliance
...
PAIRS is used to assess the probability that a regulated institution will fail
2
...


•

Step 1: Assessing failure probability
- APRA assesses the likelihood of an institution’s failure based on the inherent risk of the
institution, balanced by the management and controls and the capital support available
- The PAIRS probability rating for each institution is derived from the assessed overall risk
of failure
...


•

Step 3: Supervisory attention index
- A relative measure (for internal use only) of how much supervisor and management
time to focus on it
- Supervisory attention increases rapidly with both size and risk
- Relative risk and relative impact are considered of roughly equal importance in
determining overall supervisory concern
...

113

(ii)
-

Oversight – means a significant step-up in information collection and inspection
intensity
...
They may
also increase inspections and enforce higher restrictions
...

Institutions to execute a remediation plan that addresses the area of identified
weakness and restores financial stability
...

APRA may issue directions and take other enforcement actions
...


(iv)
-

Restructure – means institutions risk is very high and they are in serious danger
of failure
APRA applies its full enforcement powers, including issuing directions to replace
persons and service providers and to restrict business activities
...


How regulators monitor Banks: APRA’s SOARS

114

Royal commission findings

Potential impact on ASIC and APRA
•

Clearer division between APRA and ASIC on financial regulation
- APRA retains responsibility for prudential regulation
- ASIC primarily regulate conduct and disclosure
...


Regulation issues and Basel
Q1
...
Hence, it increases moral hazard incentives as banks are tempted to ‘gamble
...
What is meant by ‘capital adequacy’ for financial institutions and why is it so important?
Capital adequacy is the requirement set for banks to maintain a minimum capital
...
It also
strengthens a bank’s financial stability and solvency and improves survival during a sudden industry
downturn (the current situation of covid-19)
...
g
...

Q3
...
7 to 1 before their bankruptcy
...
Explain the purpose of the Probability and Impact Rating System (PAIRS)
The purpose/objective of PAIRS risk assessment process is to:
•
•

Determine APRA’s assessment of the probability that a regulated entity (institution) will fail;
and measure the impact of the potential consequences of that failure
...


Q5
...
It aims to provide supervisory interventions in a targeted and timely manner which
allows APRA to identify potential threats to the interests of investors and other parties
involved with the institution
...


Q6
...
Discuss
...
g
...
However, due to recent concerns with APRA’s actions, the Royal Commission
Findings recommended that APRA needs oversight in their responsibilities as a regulator as they
have failed to do their jobs correctly
...


•

The requirements have become more stringent and are risk adjusted so that banks with
more risk are required to maintain a higher level of capital
...
Minimum capital requirement (addressing risk);
2
...
Market discipline
•

Basel III calls for higher capital, leverage and liquidity requirements to offset bank exposures
...


•

Banks may experience a lower return on equity
...


•

PAIRS is used to assess the probability that a regulated institution will fail and the impact of
that failure

---