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BFF 2401 COMMERCIAL BANKING & FINANCE – EXAM REVISION NOTES (ii)

Non-deposit liabilities Comes from interbank borrowing market or issues of instruments in external market TRENDS IN BANK LIABILITIES To analyse bank’s liabilities, look at The absolute volume of liabilities Work out the proportion of each liability type as a ratio.

Week 5 Liability Management Highlights -

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Distinguish and examoles of deposit and non-deposit sources of funds. Relationship between funding risk (withdrawal risk) and funding cost. Reasons for increasing importance of liability management and Australian Banks’ reponse. Cost involved in raising funds from retail vs wholesale sources Differences between historical weighted average cost of funds, marginal cost of funds for a specific soure, pooled marginal cost of funds and their use. Risk implications of different liability choices Strategic funding : what factors to consider? Why diversify? Liability management is the practice of banks of maintaining a balance between the maturities of their assets and their liabilities in order to maintain liquidity and to facilitate lending while also maintaining healthy balance sheets. In banks liability decisions, there are two factors considered: The dollar amount of borrowing Given the dollar amount, we want to analyze the proportion of each liability choice The difference between total asset and equity capital. Banks determine which asset they want to invest in by summing up the all categories of asset and how do they finance those assets portfolio. 2 main sources of funding : 1. Debt Funding 2. Equity Funding : equity capital must be sufficient in accordance to regulatory capital. Primary Sources of Bank Liabilities Customer deposits : the main purpose of holding current account is for transaction purpose. So the holders wants to access the funds as fast as possible Fixed deposits : offer the saver higher interest income. Certificates of deposits : market instruments. In order to access the funds, savers can sell the instruments in the secondary market so they do not have to go to banks.

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Why is liablity management important? (i) There has always been a hesitation to make active investments in the equity market. If people have access cash flows, the primary venue to access funds is to open banks deposits. Nowadays, it becomes more difficult for banks to attract the flow of savings for various reasons: - superannuation policies : proportion of an individual income mst be placed in a superannuation that effectievely reduce the flow of funds that will be place in bank deposits. - individuals tend to have relationships with multiple financial institutions, they can open their account with multiple banks for different needs. - rise of managed funds - less customer loyalty : when people are more willing to switch banks, banks are more driven to have an incentive to innovate their product in order to retain loyal customers. (ii) There are more alternative sources of non-depossit liabilities in the financial markets due to : Deregulation in external markets and more open market Banks nowadays have more flexibility to raise funds in the external market. Banks have responded to these pressures by developing : Innovative new deposit products and delivery systems If customers are becomes more sophisticated, banks becomes more innovative in their product development to increase the convenient for customers. A greater reliance on non-deposit liabilities Banks have trying to push their market credit ratings and better market profile.

CHOICES OF BANK LIABILITIES The overall aim of liability management is to construct a low-cost, low-withdrawal risk liability portfolio. Trade off between cost of liability and withdrawal risk :

In the diaragam above, funding risk is withdrawal risk. There are two types of liabilities, the Certificate of Deposits and Demand Deposits. As it is shown, the maturity of the CD shows that it carries a low withdrawal risk but high funding costs. On the contrary, since demand deposits can be withdrawn at anytime, it carries a higher withdrawal risk but low funding cost. In order to issue market instruments, banks must be willing to pay the market interest rate which can be higher than the interest rate offered on demand deposits, that is why the funding cost is higher for demand deposits. Therefore, the decision of choosing liability, banks must look at decision on the trade off between cost of funds and risk implications. Cost and Risk profile of each liability product. Types of bank liabilities : Deposits : subject to high degree of withdrawal risk. But in return, bank only need to pay low interest cost. Interest-bearing cheque accounts : low degree of withdrawal risk, the bank can impose a minimum balance requirements. Savings account : stable source of fund. Less liquid. Still subject the bank to withdrawal risk. The major cost of this is the explicit interest payment that is offered to customers.

BFF 2401 COMMERCIAL BANKING & FINANCE – EXAM REVISION NOTES Reputation and size & customer sophistication. Term or fixed-time deposits : Customers are after higher interest payments, so they may be happy to forgo liquidity. Therefore the bank are exposed to lower liquidity risk because customers are less likely to withdraw. Retail and Wholesale certificates of deposit (CDs) Marketable instruments. Can be sold at secondary market Low withdrawl and liquidity risk for the bank. Carry a higher interest rate. Interbank Funds A bank can also borrow from other FI in the interbank market, trhough a short term unsecured loan. Short term money market rate cost When this arrangement matures, the borrowing bank must find a way to refinance it. Repurchase agreements Secured lending agreement. Backed by a set of eligible securities. At the start of the agreement, the bowrring bank will transfer a certain amount of securities to the lending bank. In return for cash. On the repayment date the borrowing bank will repurchase the underlying securities and pay the initial cash amount plus interest. Covered Bonds Secured by the best quality asset on the bank’s balance asset, therefore appealing to inestors. Often over collaterlatixed. Where the amount of underlying collateral is greater than the face value of the bond issue. COSTS OF BANK LIABILITIES Inlfuences on the Cost of Retail Deposits: Interest costs : deposits rate offered by their product must be highly cmpetetive with other banks and other financial institution. Non-interest costs : Advertising costs Convenience and service cost

Influences on the Cost of Market Funding Interest costs : Market interest rates Non-interest costs Legal documentation costs in order to make an issue in the external market. Cost of skilled staff and software with expertise in market dealing Cost of building a profile & credit rating : Market investors are only interested in buying securities issued by reputable banks.

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MEASURING THE COST OF FUNDS Components of the cost of funds Cost of liability (noncapital funding) Interest cost of liabilities Non interest costs of acquiring funds Using historical weighted average cost of funds Using marginal cost of funds from a specific source Using pooled marginal cost of funds Cost of equity funding Historical Weighted Average Cost of Funds Backward looking, only look at the past. Only considers : Cost of liabilities on the balance sheet Interest costs

Advantages Simple approach because all data is available Disadvantages Past performance is not necessarily a good indicator of future costs. Example

a. When interest rates rise When pricing new loan using historical data, our revenues iwill not be sufficient to cover the cost of funds.this led to fall in profit b. When interest rates fall Our loans will be more expensive compared with loans offered by competing banks. Therefore, profits will also fall. Marginal Cost of Funds Represents the most current market condition Look at both interest and non-interest cost. This approach is more likely to be appropriate when pricing new loans because banks will cover any change in market interest rates and will maintain net interest income as well as remain competitive with other banks. Advantages : Effective measure of cost of funds use for loan pricing Helpful in deciding which type of funds a banks should try to attract. Disadvantages To finance a new loan, It is uncommon for a bank to use one liability source. Pooled Marginal Cost of Funds Allow us to incorporate cost of equity Designing a funding pool: a. Which funding sources should be included In the funding pool, and In which proportions? b. The funding pool may include Equity : this is because all new asset carry some degree of risk. And risk must be supported with capital (funded by capital). In choosing liabilities, banks must look at the similarity of maturities between the liabilities itself and the loan maturity, it is better for the bank to choose asset and liability that have the same maturity because the proceeds from the asset can be use to pay the liabilities. Therefore manage interest rate risk and liquidity risk. The majority of liabilities may come from similar group of customers. By matching the asset and

BFF 2401 COMMERCIAL BANKING & FINANCE – EXAM REVISION NOTES liability for the same group, banks can strengthen customer relationship. Advantages : provides the required return on earning assets & maintains competitiveness Disadvantages : Sensitive to the estimations of future sources of funds. MEASURING THE COST OF FUNDS- WHICH METHOD? Historical cost is useful for measuring past performance Marginal cost assists with selection of future funding sources. Reflect the most current cost of funds but its is quite unlikely for banks to finance hundred of new asset by only using one type of liability. Marginal cost and pooled marginal cost may be used for loan pricing. RISK IMPLICATIONS OF ALTERNATIVE LIABILITY CHOICES Liquidity Risk Interest rate risk : arises because bank is not always able to match the maturity of asset and maturity of liability of being used. Foreign exchange risk Credit risk : if the bank ends up borrowing from a source that is expensive, therefore they may be tempted to increase their return on asset through riskier loans. STRATEGIC FUNDING Maximising the risk/return trade off in cost of funding and the risk implication of funding. The diversification of liabilities is important in oder for bank to maintain the flexibility to restructure its liabilities in response to the market. Some source may become unavailable or their cost may increase. Therefore banks need access to variety of sources in order to have a back up source.

BFF 2401 COMMERCIAL BANKING & FINANCE – EXAM REVISION NOTES Week 7 Credit Risk IMPORTANCE OF LENDING Banks make money by taking in funds from depositors and other sources and then lending money out to customers.

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US LENDING PROBLEMS During GFC, ninja loans were occurred very often in the US. Sub-prime lending : A loan offered at a rate above prime to individuals who do not qualify for prime rate loans, therefore may have difficulty maintaining the repayment. Factors that cause the event: The banks would aware the credit risk when they lend out money to those individuals. Since their objective is to maximise profit, they engange in the risky business with a higher risk, banks could earn higher return. At that time, banks believe can transfer the risk to another counterparty, the credit risk is not their focus anymore. The legal system in the US that have provided nonrecourse loans to the borrower. Non-recourse loan : when banks has no further recourse against the borrower to settle any unpaid amounts of the loan default. If the sale of the commercial asset is not enough to pay the debt, the bank cannot asset other asset of the borrowers, therefore the bank would have to accept the loss. THE AUSTRALIAN DIFFERENCE In Australia, If the borrowers fail to pay, banks will have the right to get access to all of the other asset that the borrowers may have to get back the value of the loan. (there are no non-recourse loan) THE LOAN PORTFOLIO Lending is part of the banking book activities of financial intermediaries. Lending is to direct the funds from surplus units to deficit units. Deficit units : corporations, individuals, government. Surplus units Loans can finance the 3 types of deficit units:

a. b. c.

Consumption expenditure for households Investment expenditure for businesses Infrastructure spending for governments TYPES OF LOANS Business loans Secured Loans : collateral is the asset that the borrower pledges with the loan. Unsecured Loans : loan without collateral Syndicated Loans : loans provided by a group of FI (lenders). Loans with large value and higher credit risk. Spot Loans : the loans that are provided by the FIs and the borrowers can drawdown the loans immediately Loan commitments : loan provided by FI where the borrowers can draw upon as needed, up to a predetermined limit (not immediately). Housing Loans Fxed-rate mortages & Adjustable rate mortgages : if the banks want to have more certaintiy in their lending, they would prefer the fixed-rate mortgages because banks would not have to worry about the interest rate in the future. However, if they are willing to take more risk whether the interest rate may go up or down, adjustable rate mortageges may also be chosen. Loan-to-value ratio : the amount of loan over the amount of the appraised value. It is an assessment of lending risk that financial institutions and other lenders examine before approving a mortgage. the higher the loan to value ratio, the higher the bank will have to finance to the same underlying house, therefore higher credit risk. Consumer or Individual Loans Revolving loans : The borrower will have the right to drawdown and to repay as many time whenever is convenient for them during the life of the contract. Non-revolving loans : one time drawdown and payback only.

APRA REGULATIONS ON CREDIT APS 220 Credit Quality Since banks directly face the credit risks on individual loans, banks must have an accurate system to monitor and identify the measurement of its credit risk by recognizing the estimated future losses and impaired facilities on the credit portfolio. APS 221 Large Exposures This is the regulation that require banks to have suitable systems and policies to manage and control the risks when banks exposed in concentration to single parties or a number of counterparties. Credit risk management must implement an adequate diversification of credit portfolios and ensures that exposure limits to single or numerous groups of counterparties. DEFINING CREDIT RISK “Credit risk is the risk to earnings and capital that an obligor may fail to meet the terms of any contract with the bank” A credit risk is the risk of default on a debt that may arise from a borrower failing to make required payments. Credit risk may or may not lead to loan loss. In order to handle the potential loss, the bank must be to manage the loss. CREDIT RISK COMPONENTS The credit risk of a loan portfolio comprises : A portfolio Is a group of individual loans. Intrinsic Risk The inherent risk associated with lending to certain categories of borrowers. Risk related to a particular business, industry, or group. Concentration Risk Risk that specific to a portfolio. The risk that is associated with baving a high proportion of asset in a particular category or type of industry. With individual loans, the bank would only subject to inherent risk. On the other hand, with portfolio of loan will have both intrinsic and concentration risk.

BFF 2401 COMMERCIAL BANKING & FINANCE – EXAM REVISION NOTES (i)

DEFAULT RISK MODELS Qualitative models Borrower-specific factors include : Reputation: to measure the willingness to payback and the ability to payback. Leverage (capital structure) Volatility of earnings Collateral and covenants

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Market-specific factors include : Business cycle : Level of interest rates

Quantitative Models (credit scoring models) Advantages : Objective and consistent Quick and efficient Cost effective Accommodates policy changes Disadvantages : High data requirements Based on past data and causal relationships may change over time Ignores variables outside the model Major types of credit scoring models Linear Probability Model : measures the probability of default. Logit Model : measures the probability of default. Linear discriminant models : give us a score in which measure a credit risk but not a probability. The higher the Z score, the lower the credit risk. Given the variables, it appear to be good if the borrowers have positive in those variables. Therefore, the positive the value, the lower the probability of default. Implications : if the value of Z is higher than 2.99, the bank should accept to lend to the borrowers. On the contrary,

reject if the loan application if Z value falls below 1.81 because it means they have a high credit risk. The Expected Return on a Loan Weaknesses : The models only discriminate the default and nondefault customer without knowing the difference between good customers. Because we only assume either they pay back in full or they don’t pay at all. The potential change in all variables on the calculation of Z value. The weighs of the variabeles may change in the future, therefore not reliable. CALCULATING THE RETURN ON A LOAN The Contractually Promised Return on a Loan • Factors affecting the promised loan return : Loan interest rate Fees Credit Risk premium Collateral Non-price terms such as compensating balances and reserve requirements Loan Rate : base lending rate (BR) + credit risk premium or margin. The lending rate is calculated based on the contractual value of loan. The return on loan is calculated based on the effective value of loan. • Direct and indirect fees and charges : Loan origination fee (f) Compensating balance requirement (b) Reserve requirement (RR)

When banks lends out loan = Loan value – Compensating balance + Reserve Requirementt. Compensating balance : where a borrower must retain a certain percentage of the amount lend in a non-interest deposit account. Reserve Requirement : minimum amount of reserves that must be held by a commercial bank.

LOAN PORTFOLIO RISK Managing Loan Portfolio Risk Portfolio risk = systematic risk + unsystematic risk Unsystematic Risk : Risk that unique to a specific company or industry. It can be reduced through diversification Systematic Risk : Risk that is caused by factors beyond the control of a specific company or individual. SIMPLE MODELS OF LOAN CONCENTRATION RISK (i) Migration Analysis Matrix created using histrocal data (ii) Determination of concentration limits

The 25% means that the bank should only lend up to 25% to a particular group of borrower.

BFF 2401 COMMERCIAL BANKING & FINANCE – EXAM REVISION NOTES Week 8 Interest Rate Risk Interest Rate Risk is the risk to earnings and capital that market rates of interest may change unfavourably. Since interest rate is changing, earnings and capital would also change. Main point : how the changes in interest rate affect the changes the NII.

The decision of the interest rate depends on the market, not the bank itself. The only thing that the bank can control is the dollar amount (volume) and the propotions of those funds (mix).

An upward sloping means the YTM of long term asset is more than the YTM of short term asset. This means that the market expect an increase in interest rate in the future.

Monetary policy implemented by The RBA affect the movement of interest rates. Therefore, interest rate would fluctuate and affect the performance of the bank.

If there is a parallel shift in the curve, it means that the whole yield curve . will be shifted at the same magnitude.

INTEREST RATE RISK AND THE BANKING BOOK Traded interest-rate risk : related to trading activities. the bank will foc...