FINS3630 Final Group Assignment - CBA PDF

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FINS3630 Group Assignment

Ayush, Shirley, Louis, Harman

Interest rate risk is the potential unfavourable changes to the value of bonds or other fixedincome instruments which is caused by sudden fluctuations in interest rates. In bank’s terms, interest rate risks threatens its net interest income as well as the economic value of equity, thus banks must ensure the risk is at an acceptable level and under control. According to Commonwealth Bank’s 2019 Annual Report, since the group has operations worldwide and hence, a large portfolio of interest bearing instruments , the interest rate risk faced by the bank is tremendous. As a result, it is crucial that Commonwealth Bank acknowledge and mitigate interest rate risks by various techniques, including hedging-fixed income instruments with interest rate swaps. After reviewing Commonwealth Bank’s 2019 Annual Report, one may conclude that the bank will be heavily impacted should there be changes in interest rates. As mentioned in the report, Commonwealth Bank is severely affected by the macroeconomic uncertainties which may lead to volatility in global markets, including the trade wars between the world’s largest economies, lower business confidence as well as historically low interest rates with further declines expected. Since interest rates at the moment are extremely low in Australia, changes are amplified, and financial institutions must have a well-managed portfolio of interestbearing assets and liabilities in order to immunize from changes in interest rates. Interest rate & main strategies that CBA has used to manage the risk level To manage and control interest rate risks, Commonwealth Bank has utilised various techniques such as conducting stress tests on a regular basis, repurchasing outstanding longterm debts and hedge against unfavourable changes in interest rates. By performing a scenario analysis covering extreme and adverse operating conditions it would assist CBA to understand its exposure to interest rate risks more comprehensively, allowing the bank to make proactive risk-based decisions. Moreover, CBA has maintained a diversified yet stable mix of potential sources of funding across multiple regions, currencies, instruments and entities. As stated in the report, Commonwealth Bank has also conducted various stress tests on a regular basis to have a clearer image on its portfolio’s performance and determine what actions shall be made in different scenarios. Comparison

FINS3630 Group Assignment

Ayush, Shirley, Louis, Harman

Besides, as detailed in Notes 5.3 of the annual report, CBA holds a considerable number of derivatives for the purpose of hedging against unfavourable changes in interest rates. As of 30 Jun 2019, the fair values of the Bank’s portfolio of interest rate related contract assets and liabilities are 7,578 and 4,353 Million Australia Dollars, including swaps, futures and options. In addition to the aforementioned derivatives, CBA also performed fair value and cash flow hedges. While fair value hedges protect the Bank from decreases in net worth, cash flow hedges protect the bank from decreases in interest income.

Compared to 2018, CBA has had poor management, in terms of interest rate risk. The Bank’s net interest earnings at risk has increased drastically as shown in the 2019 annual report. Improvements for Risk Management Strategies We recommend that CBA should reduce the bank’s net exposure to interest rate risk by further utilising the use of derivatives such as options and interest rate swaps. If CBA’s loan portfolio is dominated by long term fixed rate loans, it is crucial that the bank should investigate the viability of including shorter term assets in its portfolio.

By using investment portfolio to mitigate interest rate risk, CBA may enjoy the benefits of requiring less capital than loans as most bonds that financial institutions would purchase require only a relatively little proportion of the capital that a conventional loan requires. Additionally, CBA may control interest rate risk by using wholesale funding sources, including central bank’s funds, deposits, borrowing in the general public debt markets and foreign deposits. For instance, the bank may match fund its long term fixed rate commercial loans by borrowing an equal amount from the central bank to lock in the spread between the cost of capital and the interest rate charged.

FINS3630 Group Assignment

Ayush, Shirley, Louis, Harman

Credit Risk & main strategies that CBA has used to manage the risk level Credit risk is simply defined as the potential loss from a bank borrower or counterparty who fail to meet their contractual obligations. From CBA’s 2019 annual report, we can analyse the credit default risk level in 2019. Firstly, in page 208, there is a final report of maximum exposure to credit risk by industry and asset class. It is illustrating that the level credit risk of different industries in Australia and overseas. The total gross credit risk is 1,158,148. From this pie chart 1, it shows that maximum exposure to credit risk by top three industries are home loans (598,691), other commercial and industries (217,149), and sovereign (119,733), which are 51%, 19% and 10% respectively. Besides, we can also find that the total gross credit risk in Australia (976,973) are higher than overseas (181,175). However, home loans, other commercial and industries and sovereign are still top three industries both in Australia and overseas. Therefore, home loans is a main industry in total credit risk exposure.

Secondly, in page 211, the report provides information about distribution of financial instrument by credit quality. In this table, investment grade representative of lower assessed default probabilities, pass and weak grades reflect higher default risks. We still can make a pie chart 2 to analysis the credit quality of different financial instruments. Totally, the credit exposures are 919,052, investment grade instruments are 513,762, Pass grade instruments are 372.829, and Weak grade instruments are 32,461, which are 55.9%, 40.6%, 3.5% respectively of total. In addition, investment grade loans, bills and discounted and other receivables are 410,371, which is 54% of the total gross carrying amount of loans. For undrawn credit commitments, investment grade instruments are 92972, which is 65,7% of the total undrawn credit commitments and there are 10,419 investment grade of financial guarantees and other off-

FINS3630 Group Assignment

Ayush, Shirley, Louis, Harman

balance sheet instrument, which is 58.6% of total financial guarantees. It can be found that the proportion of investment grade of loans, bills and discounts are the lowest, which means these instruments are higher default risk than undrawn credit commitments and financial guarantees. In 2009, CBA has used different methods and strategies to control the risk level. In order to reduce unexpected losses, policies and procedures have been developed to provide for the adoption of acceptable and appropriate collateral to reduce credit risk. For loans, bill discounts and other receivables, collateral types are mortgages over residential and commercial real estate, charges over business assets such as cash, shares, inventory, fixed assets and accounts receivables. For credit commitments and contingent liabilities, collateral may be sought depending on the strength of the counterparty and the nature of the transactions. For derivative assets, the group is exposed to counterparty credit risk on derivative contracts. Through netting agreements, whereby derivative assets and liabilities with the same counterparty can be offset and cleared with central counterparties. Therefore, CBA managed credit risk through collateral and derivatives. Comparison In page 208 and 209, we can compare the maximum exposure to credit risk by industries between year 2018 and 2019. As mentioned above, the total gross credit risk is 1,158,148, but in year 2018, the total credit risk amount is 1,155,025, which is less than 2019. Thus, it is concluded that CBA increased total gross credit risk and higher default amount in 2019, there is no improvement in credit risk mitigation. Besides, the credit risk disclosures for year 2018 is provided in pages 214 to 219, which are not directly comparable to the credit risk information as year 2019 provided under pages 211 to 213. So we cannot directly compare these tables from financial report. Through analysis distribution of financial instruments by credit quality, the total carrying value is 1124866, neither past due nor impaired is 1110097, which is 98.7% of total assets. Thus, most of financial instruments are good quality in 2008. Improvements for Risk Management Strategies Lastly, in order to maximizing their risk-adjusted rate of return, CBA can improve the credit risk management through ensuring adequate controls over credit risk. CBA must establish a system for early remediation of credit deterioration. The decline in credit quality should be confirmed at an early stage, when there may be more options to improve credit. The bank's credit risk policy should clearly stipulate how the bank will manage the problem credit. For

FINS3630 Group Assignment

Ayush, Shirley, Louis, Harman

example, CBA can use pricing tool which charging a higher interest rate for more risky borrowers and quantity tool which setting the maximum amount of loans to certain groups of risky borrowers. Besides, CBA can also use credit default swap to hedge credit risk. Default swaps are the most common credit derivatives. If CBA is concerned that borrowers have a higher probability of default, they can use swaps to offset this risk. CBA buys a swap from another investor who agrees to give compensation if the case the borrower defaults. Finally, CBA also can manage credit risk through improve collateral quality. They can set higher standard of collateral quality, such as the liquidity collateral, the ease of collateral custody and the stability of the value of the mortgaged property.

Capital Adequacy & main strategies that CBA has used to manage the risk level The Tier 1 capital ratio measures the percentage of core capital relative to its total riskweighted assets (RWA), and CET1 (common equity tier 1) is the core contribution from the DI’s owners. According to the annual report, the Common Equity Tier 1 (CET1) capital ratio at 30 June 2019 was 10.7%, above APRA’s ‘unquestionably strong’ benchmark ratio of 10.5%. (p.46). Apparently, the CET1 risk-based capital ratio of CBA in 2019 is stronger than APRA’s requirements in Basel 3, which is 4.5%, and even more than the total risk-based capital ratio requirement of 8%. So, we can summarise that CBA is operating with a relatively low risk level, because it has adequate capital to absorb unanticipated losses. The climate strategy is mainly used by CBA to implement a risk management, which can be divided into the climate governance and climate scenario analysis. In order to have an accurate estimation of capital adequacy risk, CBA evaluated climate as a strategic risk and a long-term driver of both financial and non-financial risks, because the climate factor may cause some unfavourable outcome to financial institutions. For example, the sudden price changing of some specific items may cause losses to relevant traders, then they might have a higher demand to bank loans. The CBA climate scenario analysis mostly consist of 4 aspects: – Business lending: transition risks – FirstChoice Australian Share Fund: transition risks – Agribusiness lending: physical risks – Business lending: physical risks for other key portfolios

FINS3630 Group Assignment

Ayush, Shirley, Louis, Harman

Therefore, CBA will add Physical climate risk into the ESG Risk Assessment Tool process for business lending and the Risk Assessment result from ESG can be considered into the new capital level that CBA should own in the coming year. Comparison According to annual reports, CBA has made progress in developing better risk management practises, especially in terms of capital adequacy. The most effective risk in terms of capital adequacy is liquidity risk, which is the potential for loss because a bank may not be able to fund increases in assets and meet obligations as they come due, without incurring unacceptable losses. The role of capital is providing a cushion for absorbing losses from investments that have gone sour and meeting liquidity requirements arising from the unanticipated deposit outflows. To manage liquidity risk, Group Liquidity Risk Management Policy sets limits and standards with respect to the following four categories:  The Liquidity Coverage Ratio, which sets minimum levels for liquid assets;  The Net Stable Funding Ratio, which encourages stable funding of core assets;  Market and idiosyncratic stress test scenarios; and  Limits that set tolerances for the sources and tenor of funding. Furthermore, according to the annual report, CBA has a Risk Management Framework to manage liquidity risk through a diverse and stable pool of funding sources, maintaining adequate liquidity buffers, conducting stress tests regularly and daily monitoring of liquidity ratios. Within this framework, Asset and Liability Committee (ALCO) is mainly responsible for the oversight and strategic management of CBA’s balance sheet, including controlling the management of assets and liabilities, reviewing liquidity and funding policies and scenarios, and also regularly monitoring if CBA have achieved compliance with those policies across the Group. Besides, CBA’s strong Common Equity Tier 1 capital, 10.7%, is also a sufficient guarantee to hedge any risk arising from liquidity, such as loan and deposit demand mismatching.

Improvements for Risk Management Strategies To decrease the risk of capital adequacy, CBA has two main solutions to improve risk management strategies, which are increasing capital ratio and having exclusive supervisory review process.

FINS3630 Group Assignment

Ayush, Shirley, Louis, Harman

Firstly, increasing capital ratio allows CBA to lower the percentage of RWA (risk-weighted assets). A bank can seek to reduce its risk-weighted assets by replacing riskier (higherweighted) loans with safer ones, such as government securities. A second solution is to issue new equity, such as through issuing rights to existing shareholders, an equity offering on the open market or making placements of shares with an outside investor. Because common stocks are the main part of CET1 capital, which is the most reliable and secure part of CBA total capital. This is likely to be the least attractive option, however, given that a new share issue can probably result in reducing the market value of the existing shares. The last strategy to increase capital ratio is tightening dividends payment, in order to leaving more retained earnings. As is shown in the annual report, the dividends per share was increasing from 420 cents to 431 cents during 2015 to 2019, and that can be achieved by increasing the spread between the interest rates it charges for loans and those it pays on deposits.

Secondly, CBA should set its own supervisory review process or make that process more comprehensive to ensure that CBA can have adequate capital to support all the risks in their business and encourage banks to develop and use better risk management techniques. Given this strategy, CBA should take more risks into account when assessing overall capital adequacy. Under the Pillar 1 of Basel 3, it only covers credit risk, market risk and operational risk. So, there have two possible risks can be added into supervisory review process which are the credit concentration risk (the risk of loss to a financial institution as a result of having too many outstanding loans concentrated in one particular instrument or one particular type of borrower) and contagion and reputation risks (a larger business group is more sensitive to financial or reputational damage by virtue of its association with other members from the same group that may burden more form of risk events).

Ethical and Social Responsibility Analysis Licensees’ main object was to generate revenue but instead compromised the standard of financial services that should be delivered to customers. Excellent service for a client is accomplished only when the financial advisor spends sufficient time with their clients despite difficultly of challenging multiple client’s workloads. The core issue arises as, licensees such as AMP, avoided regulating clients and thus allowed advisors to treat their clients’ portfolios as a tradeable asset and provide “buyer of last resort” arrangements. As a result, advisors could not effectively provide advice to all their clients as their main focus was deviated towards sales commissions. This is lack of social responsibility as not only did it create a

FINS3630 Group Assignment

Ayush, Shirley, Louis, Harman

negative image for the advisors, but the ability to provide quality advice was decreased and the institutions were presented as “profit driven” rather than those who valued their clients.

Furthermore, advisors and licensees failed to maintain up to date records and disregarded monitoring and analysis. A vital aspect of any organisation is to ensure the relationship and information between the advisor and client is monitored and always current but many licensees failed to accomplish this which shows those clients who left a while as still “linked” to company advisors. Since the records weren’t updated, even those clients who had no connection, encountered ongoing fee charges to their investment accounts without receiving the financial service/advice. This resulted in a lack of social responsibility as licensees clearly showed negligence through inadequate monitoring of the records. This further elucidated the lack of importance, they placed on the clients who were treated poorly. Licensees continuing in such an unfaithful manner by not conducting an analysis of their clients’ accounts shows poor ethical and social responsibility. The service charges for ongoing fees were not well defined. Clients never were notified nor received information of the specification of the charges and were charged for such services without receiving any financial service. The clients received no notification of charge, but amounts were subtracted from their investment accounts as a result for “financial services”. Thus, licensees did not establish a clear relationship with their clients thus not abiding but the regulations of a successful client-advisor relationship which resulted in a lack of ethical and social responsibility.

Justice Hayne’s conclusions have not addressed many major issues in relation to the economic outcomes, cost and accessibility of financial advice. His conclusions have included a lack of scope initiating areas for criticism. AFA’s, General Manager, Policy and Professionalism, Phil Anderson, compiled a report as an argument to the Banking Royal Commission Final Report (Anderson, 2019), in which he exemplified the value of financial advice while highlight the disadvantages. Anderson believes, Hayne’s conclusion “challenges” the ethical value of financial advice as he believes the enforcement an “annual opt-in” will be classified as a “real cost impediment and major obstacle” (Anderson, 2019). He further continues to highlight how this will create major problems as clients will have a disadvantage of “limited capacity to pay” and will only be reason for “high touch clients”.

FINS3630 Group Assignment

Ayush, Shirley, Louis, Harman

In the fast-dynamic financial industry, the effect of annual reviews will be negative as it “reduces revenue” and “increases compliance costs” making objectives hard to accomplish (Lumsden & Saxson). With Australia’s progression, its baby boomers approach retirement and thus will require advice “crucial” for their financial wellbeing but Hayne’s assumption, will result in n...