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(a) Chapter 1 Why are financial institutions special? Answers to end-of-chapter questions Questions and problems What are five risks common to financial institutions? Default or credit risk of assets; interest rate risk caused by maturity mismatches between assets and liabilities; liability withdrawal or liquidity risk; underwriting risk; and operating cost risks. Explain how economic transactions between household savers of funds and corporate users of funds would occur in a world without FIs. In a world without FIs, the users of corporate funds in the economy would have to approach the household savers of funds directly in order to satisfy their borrowing needs. This process would be extremely costly because of the upfront information costs faced by potential lenders. Cost inefficiencies would arise with the identification of potential borrowers, the pooling of small savings into loans of sufficient size to finance corporate activities and the assessment of risk and investment opportunities. Moreover, lenders would have to monitor the activities of borrowers over each loan’s life span. The net result would be an imperfect allocation of resources in an economy. Identify and explain three economic disincentives that probably would dampen the flow of funds between household savers of funds and corporate users of funds in an economic world without FIs. Investors generally are averse to purchasing securities directly because of (a) monitoring costs, (b) liquidity costs and (c) price risk. Monitoring the activities of borrowers requires extensive time, expense and expertise. As a result, households would prefer to leave this activity to others and, by definition, the resulting lack of monitoring would increase the riskiness of investing in corporate debt and equity markets. The long-term nature of corporate equity and debt would likely eliminate at least a portion of those households willing to lend money, as the preference of many for near-cash liquidity would dominate the extra returns that may be available. Third, the price risk of transactions on the secondary markets would increase without the information flows and services generated by high volume. Identify and explain the two functions in which FIs may specialise that enable the smooth flow of funds from household savers to corporate users. FIs serve as conduits between users and savers of funds by providing a brokerage function and by engaging in the asset transformation function. The brokerage function can benefit both savers and users of funds and can vary according to the firm. FIs may only provide transaction services—such as discount brokerages—or they also may offer advisory services which help reduce information costs, such as full-line firms like Merrill Lynch. The asset transformation function is accomplished by issuing their own securities, such as deposits and insurance policies that are more attractive to household savers and using the proceeds to purchase the primary securities of corporations. Thus, FIs take on the costs associated with the purchase of securities. In what sense are the financial claims of FIs considered secondary securities, while the financial claims of commercial corporations are considered primary securities? How does the transformation process, or intermediation, reduce the risk, or economic disincentives, to the savers? The funds raised by the financial claims issued by commercial corporations are used to invest in real assets. These financial claims, which are considered primary securities, are purchased by FIs whose financial claims are therefore considered secondary securities. Savers who invest in the financial claims of FIs are indirectly investing in the primary securities of commercial corporations. However, the information-gathering and evaluation expenses, monitoring expenses, liquidity costs and price risk of placing the investments directly with the commercial corporation are reduced because of the efficiencies of the FI. Explain how FIs act as delegated monitors. What secondary benefits often accrue to the entire financial system because of this monitoring process? By putting excess funds into FIs, individual investors give to the FIs the responsibility of deciding who should receive the money and of ensuring that the money is utilised properly by the borrower. In this sense the depositors have delegated the FI to act as a monitor on their behalf. The FI can collect information more efficiently than individual investors. Further, the FI can utilise this information to create new products, such as commercial loans, that continually update the information pool. This more frequent monitoring process sends important informational signals to other participants in the market, a process that reduces information imperfection and asymmetry between the ultimate sources and users of funds in the economy. What are five general areas of FI specialness that are caused by providing various services to sectors of the economy? First, FIs collect and process information more efficiently than individual savers. Second, FIs provide secondary claims to household savers which often have better liquidity characteristics than primary securities such as equities and bonds. Third, by diversifying the asset base FIs provide secondary securities with lower price–risk conditions than primary securities. Fourth, FIs provide economies of scale in transaction costs because assets are purchased in larger amounts. Finally, FIs provide maturity intermediation to the economy, which allows the introduction of additional types of investment contracts, such as mortgage loans, that are financed with short-term deposits. What are agency costs? How do FIs solve the information and related agency costs when household savers invest directly in securities issued by corporations? What is the ‘free-rider’ problem? Agency costs occur when owners or managers take actions that are not in the best interests of the equity investor or lender. These costs typically result from a failure to adequately monitor the activities of the borrower. Because the cost is high, individual investors may do an incomplete job of collecting information and monitoring under the assumption that someone else is doing these tasks. In this case, the individual becomes a free rider. But if no other lender performs these tasks, the lender is subject to agency costs as the firm may not satisfy the covenants in the lending agreement. Because the FI invests the funds of many small savers, the FI has a greater incentive to collect information and monitor the activities of the borrower. How do large FIs solve the problem of high information collection costs for lenders, borrowers and financial markets in general? One way FIs solve this problem is that they develop secondary securities that allow for improvements in the monitoring process. An example is the bank loan that is renewed more quickly than long-term debt. The renewal process updates the financial and operating information of the firm more frequently, thereby reducing the need for restrictive bond covenants that may be difficult and costly to implement. How do FIs alleviate the problem of liquidity risk faced by investors who wish to invest in the securities of corporations? Liquidity risk occurs when savers are not able to sell their securities on demand. Banks, for example, offer deposits that can be withdrawn at any time. Yet the banks make long-term loans or invest in illiquid assets because they are able to diversify their portfolios and better monitor the performance of firms that have borrowed or issued securities. Thus individual investors are able to realise the benefits of investing in primary assets without accepting the liquidity risk of direct investment. How do FIs help individual savers diversify their portfolio risks? Which type of financial institution is best able to achieve this goal? Money placed in any FI will result in a claim on a more diversified portfolio. Banks lend money to many different types of corporate, consumer and government customers, and insurance companies have investments in many different types of assets. Investment in a mutual fund may generate the greatest diversification benefit because of the fund’s investment in a wide array of stocks and fixed-income securities. How can FIs invest in high-risk assets with funding provided by low-risk liabilities from savers? Diversification of risk occurs with investments in assets that are not perfectly positively correlated. One result of extensive diversification is that the average risk of the asset base of an FI will be less than the average risk of the individual assets in which it has invested. Thus individual investors realise some of the returns of high-risk assets without accepting the corresponding risk characteristics. How can individual savers use FIs to reduce the transaction costs of investing in financial assets? By pooling the assets of many small investors, FIs can gain economies of scale in transaction costs. This benefit occurs whether the FI is lending to a corporate or retail customer, or purchasing assets in the money and capital markets. In either case, operating activities that are designed to deal in large volumes typically are more efficient than those activities designed for small volumes. What is maturity intermediation? What are some of the ways in which the risks of maturity intermediation are managed by financial intermediaries? If net borrowers and net lenders have different optimal time horizons, FIs can service both sectors by matching their asset and liability maturities through on- and off-balance-sheet hedging activities and flexible access to the financial markets. For example, the FI can offer the relatively short-term liabilities desired by households and also satisfy the demand for long-term loans such as home mortgages. By investing in a portfolio of long- and short-term assets that have variable- and fixed-rate components, the FI can reduce maturity risk exposure by utilising liabilities that have similar variable- and fixed-rate characteristics, or by using futures, options, swaps and other derivative products. What are five areas of institution-specific FI specialness and which types of institutions are most likely to be the service providers? First, banks and other depository institutions are key players for the transmission of monetary policy from the central bank to the rest of the economy. Second, specific FIs are often identified as the major source of finance for certain sectors of the economy. For example, regional banks, building societies and credit unions tend to concentrate on the credit needs of the residential home market. Third, life insurance and superannuation funds are commonly encouraged to provide mechanisms to transfer wealth across generations. Fourth, depository institutions efficiently provide payment services to benefit the economy. Finally, managed funds and unit trusts provide denomination intermediation by allowing small investors to purchase pieces of assets with large minimum sizes such as negotiable CDs, commercial property and commercial paper issues. How do depository institutions such as banks assist in the implementation and transmission of monetary policy? The Reserve Bank of Australia (RBA) involves banks directly in the implementation of monetary policy through changes in the reserve requirements and the official rate. The open market sale and purchase of treasury securities by the RBA in the RBA’s open market operations also involves the banks the implementation of monetary policy in a less direct manner. What is meant by ‘credit allocation regulation’? What social benefit is this type of regulation intended to provide? Credit allocation regulation refers to the requirement faced by FIs to lend to certain sectors of the economy, which are considered to be socially important. These may include housing and farming. For example, it is presumed that the provision of credit to make houses more affordable or farms more viable leads to a more stable and productive society. Which intermediaries best fulfil the intergenerational wealth transfer function? What is this wealth transfer process? Life insurance and superannuation funds often receive special taxation relief and other subsidies to assist in the transfer of wealth from one generation to another. In effect, the wealth transfer process allows the accumulation of wealth by one generation to be transferred directly to one or more younger generations by establishing life insurance policies and trust provisions in pension plans. Often this wealth transfer process avoids the full marginal tax treatment that a direct payment would incur. What are two of the most important payment services provided by FIs? To what extent do these services efficiently provide benefits to the economy? The two most important payment services are payments clearing and transmission of funds services. Any breakdown in these systems would produce gridlock in the payment system, with resulting harmful effects to the economy at both the domestic and potentially the international level. What is denomination intermediation? How do FIs assist in this process? Denomination intermediation is the process whereby small investors are able to purchase pieces of assets that normally are sold only in large denominations. Individual savers often invest small amounts in managed funds, for example. The managed funds pool these small amounts and purchase negotiable CDs, which can only be sold in minimum increments of $100 000, but which are often sold in million dollar packages. Similarly, commercial paper is often sold only in minimum amounts of $500 000 lots and, of course, multi-million dollar commercial property is often purchased by managed funds. Therefore, small investors can benefit in the returns and low risk which these assets typically offer. What is negative externality? In what ways does the existence of negative externalities justify the extra regulatory attention received by FIs? A negative externality refers to the action by one party that has an adverse effect on some third party who is not part of the original transaction. For example, in an industrial setting, smoke from a factory that lowers surrounding property values may be viewed as a negative externality. For financial institutions, one concern is the contagion effect that can arise when the failure of one FI can cast doubt on the solvency of other institutions in that industry. If financial markets operated perfectly and without cost, would there be a need for financial intermediaries? To a certain extent, financial intermediation exists because of financial market imperfections. If information is available without cost to all participants, savers would not need intermediaries to act as either their brokers or their delegated monitors. However, if there are social benefits to intermediation, such as the transmission of monetary policy or credit allocation, then FIs would exist even in the absence of financial market imperfections. Why are FIs among the most regulated sectors in the world? When is net regulatory burden positive? FIs are required to enhance the efficient operation of the economy. Successful financial intermediaries provide sources of financing that fund economic growth opportunity that ultimately raises the overall level of economic activity. Moreover, successful financial intermediaries provide transaction services to the economy that facilitate trade and wealth accumulation. Conversely, distressed FIs create negative externalities for the entire economy. That is, the adverse impact of an FI failure is greater than just the loss to shareholders and other private claimants on the FI’s assets. For example, the local market suffers if an FI fails and other FIs may also be thrown into financial distress by a contagion effect. Therefore, since some of the costs of the failure of an FI are generally borne by society at large, the government intervenes in the management of these institutions to protect society’s interests. This intervention takes the form of regulation. However, the need for regulation to minimise social costs may impose private costs on the firms that would not exist without regulation. This additional private cost is defined as a net regulatory burden. Examples include the cost of holding excess capital and/or excess reserves and the extra costs of providing information. Although they may be socially beneficial, these costs add to private operating costs. To the extent that these additional costs help to avoid negative externalities and to ensure the smooth and efficient operation of the economy, the net regulatory burden is positive. What forms of protection and regulation do regulators of FIs impose to ensure their safety and soundness? Regulators have issued several guidelines to insure the safety and soundness of FIs: FIs are required to diversify their assets. For example, banks must get special permission from the regulators to lend more than 10 per cent of their equity to a single borrower. FIs are required to maintain minimum amounts of capital to cushion any unexpected losses. In the case of banks, the Basel standards require a minimum core and supplementary capital of 8 per cent of their risk-adjusted assets. The Australian Banking Act requires regulators to protect Australian dollar depositors and, as such, while this does not represent a guarantee of deposits, it requires positive action by regulators to protect depositor funds. Regulators also engage in periodic monitoring and surveillance, such as on-site examinations, and request periodic information from the FIs. In the transmission of monetary policy, what is the difference between inside money and outside money? How does the Reserve Bank of Australia (RBA) try to control the amount of inside money? How can this regulatory position create a cost for the depository financial institutions? Outside money is that part of the money supply directly produced and controlled by the RBA, for example, coins and currency. Inside money refers to bank deposits not directly controlled by the RBA. The RBA and central banks more generally can influence this amount of money by reserve requirement and official interest rate policies. In cases where the level of required reserves exceeds the level considered optimal by the FI, the inability to use the excess reserves to generate revenue may be considered a tax or cost of providing intermediation. What are some examples of credit allocation regulation? How can this attempt to produce social benefits create costs to the private institution? In the US, the qualified thrift lender test (QTL) requires savings and loans organisations to hold 65 per cent of their assets in residential mortgage-related assets to retain the thrift charter. Some US states have also enacted usury laws that place maximum restrictions on the interest rates that can be charged on mortgages and/or consumer loans. These types of restrictions often create additional operating costs for the FI and almost certainly reduce the amount of profit that could be realised without such regulation. There is no such regulation in Australia. How do regulations regarding barriers to entry and the scope of permitted activities affect the charter value of FIs? The profitability of existing firms will be increased as the direct and indirect costs of establishing competition increase. Direct costs include the actual physical and financial costs of establishing a business. In the case of FIs, the financial costs include raising the necessary minimum capital to receive a charter. Indirect costs include permission from regulatory authorities to receive a charter. Again, in the case of FIs, this cost involves acceptable leadership to the regulators. As these barriers to entry are stronger, the charter value for existing firms will be higher. What reasons have been given for the growth of superannuation funds and investment companies at the expense of ‘traditional’ banks and insurance companies? The recent growth of superannuation funds and investment companies can be attributed to three major factors: (a) Investors have demanded increased access to direct securities markets. Investment companies and superannuation funds allow investors to take positions in direct securities markets while still obtaining the risk diversification, monitoring and transactional efficiency benefits of financial intermediation. Some experts would argue that this growth is the result of increased sophistication on the part of investors; others would argue that the ability to use these markets has caused the increased investor awareness. The growth in these assets is inarguable. Recent episodes of financial distress in both the banking and insurance industries have led to an increase in regulation and governmental oversight, thereby increasing the net regulatory burden of ‘traditional’ companies. As such, the costs of intermediation have increased, which increases the cost of providing services to customers. The legislation requiring compulsory superannuation for all working people in Australia since the late 1980s has significantly increased the funds of superannuation funds and a consequent reduction in savings in traditional forms of investment such as bank deposits. What significant events in the US in particular, but which spread globally, resulted from the trend for banks to shift from the traditional banking model of ‘originate and hold’ to a model of ‘originate and distribute’? A major event that changed and reshaped the financial services industry was the financial crisis of the late 2000s. As FIs in the US moved to an ‘originate and distribute’ model, one result was a dramatic increase in systemic risk of the financial system, caused in large part by a shift in the banking model from that of ‘originate and hold’. In the traditional model, banks take short-term deposits and other sources of funds and use them to fund longer term loans to businesses and consumers. Banks typically hold these loans to maturity and thus have an incentive to screen and monitor borrower activities even after a loan is made. However, the traditional banking model exposes the institution to potential liquidity, interest rate and credit risk. In attempts to avoid these risk exposures and generate improved return–risk trade-offs, banks shifted to an underwriting model in which they originated or warehoused loans and then quickly sold them. Indeed, most large banks organised as financial service holding companies to facilitate these new activities. These innovations removed risk from the balance sheet of financial institutions and shifted risk off the balance sheet and to other parts of the financial system. Since the FIs, acting as underwriters, were not exposed to the credit, liquidity and interest rate risks of traditional banking, they had little incentive to screen and monitor activities of borrowers to whom they originated loans. Thus, FIs failed to act as specialists in risk measurement and management. How did the boom in the housing market in the early and mid-2000s exacerbate FIs’ transition away from their role as specialists in risk measurement and management? The boom (‘bubble’) in the housing markets began building in 2001, particularly after the terrorist attacks of 9/11. The immediate response by regulators to the terrorist attacks was to create stability in the financial markets by providing liquidity to FIs. For example, the Federal Reserve lowered the short-term money market rate that banks and other financial institutions pay in the federal funds market and even made lender of last resort funds available to non-bank FIs such as investment banks. Perhaps not surprisingly, low interest rates and the increased liquidity provided by central banks resulted in a rapid expansion in consumer, mortgage and corporate debt financing. Demand for residential mortgages and credit card debt rose dramatically. As the demand for mortgage debt grew, especially among those who had previously been excluded from participating in the market because of their poor credit ratings, FIs began lowering their credit quality cut-off points. Moreover, to boost their earnings, in the market now popularly known as the ‘sub-prime market’, banks and other mortgage-supplying institutions often offered relatively low ‘teaser’ rates on adjustable rate mortgages (ARMs) at exceptionally low initial interest rates, but with substantial step-up in rates after the initial rate period expired two or three year later and if market rates rose in the future. Under the traditional banking structure, banks might have been reluctant to so aggressively pursue low credit quality borrowers for fear that the loans would default. However, under the originate-to-distribute model of banking, asset securitisation and loan syndication allowed banks to retain little or no part of the loans and hence the default risk on loans that they originated. Thus, as long as the borrower did not default within the first months after a loan’s issuance and the loans were sold or securitised without recourse back to the bank, the issuing bank could ignore longer term credit risk concerns. The result was deterioration in credit quality, at the same time as there was a dramatic increase in consumer and corporate leverage. Web questions Go to the APRA website, and list the features and bank ‘specialness’ described in this chapter and identify the related regulation and legislation for each of the ‘specialness’ features. The answer will depend on the date of the assignment. At the APRA website, click on ‘Authorised Deposit-taking Institutions’. Then click on ‘ADI Prudential Standards and Guidance Notes’ and investigate the various legislation and its match to the key items of specialness identified in the chapter. 1. Deposit Taking Institutions (DTIs): • Specialness: Banks are authorized deposit-taking institutions (ADIs) that accept deposits from the public and provide various banking services such as savings accounts, transaction accounts, and term deposits. • Regulation/Legislation: The Banking Act 1959 is the primary legislation governing DTIs in Australia. APRA oversees the prudential regulation and supervision of DTIs to ensure their safety and stability. 2. Capital Adequacy: • Specialness: Banks are required to maintain adequate levels of capital to absorb potential losses and protect depositors' funds. Capital adequacy ensures that banks can withstand financial shocks and continue to operate safely. • Regulation/Legislation: APRA implements the Basel III framework, which sets international standards for capital adequacy. In Australia, the prudential standards issued by APRA, such as APS 110• Capital Adequacy, specify the capital requirements for ADIs. 3. Liquidity Management: • Specialness: Banks must manage their liquidity to ensure they have sufficient funds to meet their obligations as they fall due. Adequate liquidity management is essential for maintaining confidence in the banking system and avoiding liquidity crises. • Regulation/Legislation: APRA's prudential standards, such as APS 210• Liquidity, prescribe requirements for liquidity risk management and liquidity measurement for ADIs. 4. Credit Risk Management: • Specialness: Banks are exposed to credit risk from lending activities, including loans to businesses, individuals, and other financial institutions. Effective credit risk management is crucial for assessing and mitigating the risk of borrower default. • Regulation/Legislation: APRA's prudential standards, such as APS 220• Credit Risk Management, outline requirements for ADIs to establish sound credit risk management practices, including credit assessment, lending standards, and loan provisioning. 5. Market Risk Management: • Specialness: Banks are exposed to market risk from fluctuations in interest rates, exchange rates, and other market variables. Managing market risk is essential for protecting banks' financial health and stability. • Regulation/Legislation: APRA's prudential standards, such as APS 116• Capital Adequacy: Market Risk, prescribe requirements for ADIs to measure, monitor, and manage market risk in their trading activities. 6. Corporate Governance: • Specialness: Banks are required to have robust corporate governance frameworks to ensure effective oversight, accountability, and risk management. Strong corporate governance is essential for maintaining trust and confidence in the banking sector. • Regulation/Legislation: APRA's prudential standards, such as CPS 510• Governance, outline requirements for ADIs to establish and maintain sound corporate governance practices, including board composition, risk management oversight, and internal controls. These are some of the key features and aspects of banks regulated by APRA in Australia, along with the related regulation and legislation governing each aspect. For specific details and updates, it is recommended to refer to the APRA website and relevant legislative documents. Go to the website of the Reserve Bank of Australia and find details of the way the RBA implements monetary policy. See www.rba.gov.au/monetary-policy/about.html, for example, and answer the following questions: What are the tools used by the RBA to implement monetary policy? 2 How does a decrease in the target cash rate affect credit availability and money supply? 3 Which of the monetary tools available to the RBA is used most often? Why? The answer will depend on the date of the assignment. At the website, click on ‘Monetary Policy’ and then read the material provided on the site to answer the questions asked. 1. Tools Used by the RBA to Implement Monetary Policy: • Open Market Operations: The RBA buys and sells government securities in the open market to influence the level of reserves in the banking system and thereby the cash rate. • Target Cash Rate: The RBA sets a target for the overnight cash rate, which is the interest rate at which banks lend to each other on an overnight basis. Changes in the cash rate influence interest rates across the economy. • Standing Facilities: The RBA offers overnight loans and deposits to banks through its standing facilities, the "exchange settlement" (ES) account and the "marginal lending facility" (MLF), to help keep the cash rate close to the target. 2. Effect of a Decrease in the Target Cash Rate on Credit Availability and Money Supply: • Decreasing the target cash rate makes it cheaper for banks to borrow money from the RBA and from each other. As a result, banks are more likely to lower their lending rates to consumers and businesses, making borrowing more attractive. • Lower interest rates encourage increased borrowing and spending, leading to an expansion of credit availability and an increase in the money supply. This stimulates economic activity and can help boost consumption, investment, and employment. 3. Most Often Used Monetary Tool by the RBA and Why: • The most often used monetary tool by the RBA is typically the target cash rate. This is because changes in the cash rate have a direct and immediate impact on interest rates across the economy, influencing borrowing and spending decisions by households and businesses. • By adjusting the cash rate, the RBA can effectively signal its monetary policy stance and influence economic conditions, such as inflation and employment growth. • Additionally, the target cash rate is a flexible tool that allows the RBA to respond quickly to changes in economic conditions and financial markets, making it a preferred choice for implementing monetary policy adjustments. For the most up-to-date and detailed information on the RBA's implementation of monetary policy, it is recommended to visit the official RBA website or refer to publications and statements released by the RBA. Chapter 2 The financial services industry: depository institutions Answers to end-of-chapter questions Questions and problems How have the risks and products sold by the financial services industry changed since 1950? The financial services industry today is very different from that in 1950. In 1950, the financial institutions (FIs) were more specialised, each offering a distinct set of products/services. Today, however, the activities and products of the various FI types are more blurred, with many overlapping functions and risks. The risks faced by modern FIs are becoming increasingly similar because of this. Describe the structure of the banking industry and discuss the reasons for any changes. Since the 1980s the number of banks has increased from 13 in 1985 to 63 in 2012. Moreover, there are many foreign banks (either subsidiaries or branches), which make up 48 of the total number of banks. However, while the number of banks has grown, there has been considerable consolidation of the industry over the 30 years to 2012. Despite this, the industry is highly concentrated. Reasons for the changes are many and include the following. Many building societies gained banking licences and most of these—plus other smaller banks—have been taken over by the larger banks. The four major banks hold 77 per cent of all bank assets and 79 per cent of total bank loans (as at January 2012). While there was intense competition for banks during the 1990s and early 2000s from building societies, credit unions and other mortgage originators—particularly in the residential housing loan market—the competition diminished through the global financial crisis (GFC). The main reason for this was that as the GFC had been caused by the failure of appropriate risk assessment of many mortgage-backed securitisation (MBS) programs, access to securitisation markets essentially closed after 2008. As many of the smaller Australian depository institutions (DIs) including building societies used securitisation for funding their increasing asset base, they lost competitiveness as this source of funds dried up. Despite government support for the MBS market and the same regulations for all DIs, banks were perceived as safer institutions and they increased their market share of housing mortgages. Moreover, the banks were also able to capture a higher proportion of deposits as Australian households became more cautious and increased savings. What are the major sources of funds for banks in Australia? What are the major uses of funds for banks in Australia? Sources of funds: local deposits local wholesale funding (interbank funds) international wholesale funding equity (and other capital components). Uses of funds: loans and advances: home mortgages commercial loans bank accepted bills commercial bills promissory notes corporate bonds and debentures interbank lending securities including: government securities other bank securities corporate bonds securitised assets foreign currency and foreign currency assets cash and deposits with the RBA. Contrast the activities of the four major Australian banks with those of the regional banks. The four major banks cover most financial services including retail banking, commercial banking, investment banking, life and general insurance, and funds management. Regional banks tend to operate in the retail market only—consumer and small business market. The four major banks have a national focus and offer banking at corporate and retail levels, not only throughout Australia but also through small operations overseas. Many of the regional banks were building societies that converted to banks and thus tended to conduct their activities within the confines of the region or state where they had traditionally operated. More recently the regional banks have started to expand across state borders, moving away from their traditional markets. Owing to their origins, the assets of the regional banks have been predominantly in residential housing loans. The large banks have enhanced their margins by offering a full range of services to retail, small and large corporate customers, and through international diversification. Owing to their size, global presence and reputation, they can access funds more cheaply than the regional banks and can often offer funds to their customers at a slight premium because of the additional services provided. The large banks also have greater access to the international markets for funding because of their size and consequent reputation—which is often a key factor in the Euromarkets for example. Why did bank net interest margin fall from 2000 to 2013? Why wasn’t bank ROE affected? Australian bank net interest margins have been falling since the 1980s due to deregulation of the financial markets and new technologies as well as regulatory change and the focus on improvements in quality capital. However, their return on equity has remained at a long-term average of 16 per cent. Total bank returns are made up of interest income and fee income, and fee income has represented one-quarter of bank operating income since 2004. Why was the structure of Australian banks’ liabilities in 2008 found to be a weakness? What have the banks done to change this? A trend in the structure of bank liabilities was an increased reliance on offshore wholesale funding. In 2008 with the collapse of Lehman Brothers, credit markets essentially froze, as did access to global funding markets. As nearly 25 per cent of bank funding came from offshore lenders, Australian banks needed to attract more stable types of liabilities, such as domestic deposits. The government introduced a number of measures to assist the banking (DI) industry, including the Financial Claims Scheme and investment in local mortgage-backed securities. Prior to the GFC much of the funding for MBS had come from international investors. What is driving the banks’ changing capital base, and in particular the emphasis on common equity? Banks are improving the quality of their capital for two main reasons: bank regulations require it—and emphasise common equity and increased capital adequacy ratios for Tier 1 capital, as the lower quality forms of regulatory capital were not effective in absorbing the many bank losses during the GFC for global competitive reasons, banks have recognised that there is a need to strengthen their capital base, knowing that many large banks failed during the GFC. Describe the factors influencing the decline in the number of building societies. Building societies were originally set up to pool small deposits from individuals and households in order to finance mortgage lending. Residential home ownership was highly desired by Australians and as it was difficult to obtain home finance from banks in the regulated environment, building societies were able to fill the breach and thrived. With the deregulation of banks and the growth of the securitised mortgage market, the value of the intermediation function performed by building societies and credit unions (funnelling small savings into home mortgage lending or shorter term lending) was eroded by competition. Deregulation of the financial industry freed the banks’ capacity to extend home loans to individuals, which resulted in increased competition from the banking sector, making it more difficult for NBFIs to survive in their previous form. As a result many smaller societies and credit cooperatives have merged, while larger building societies converted to banks, allowing them to offer more services (although more recently building societies have been able to expand the range of services on offer) and giving them instant access to clearing house funds. This conversion from building society status to bank status resulted in an overall loss in market share for building societies. What are the similarities and differences between the three major groups of authorised deposit-taking institutions in Australia? The two types of non-bank DIs in Australia are building societies and credit unions. Generally, both began life as cooperative organisations, regulated under state or territory legislation (building societies increasingly now have issued share capital). However, with regulatory restructure in the late 1990s, both are now regulated in the same way as the banks—by APRA. Credit unions tend to provide retail finance and their members are usually linked by a common bond such as an employer or profession, which is not the case with building societies. While credit unions have moved into longer term lending and specifically into housing loans, building societies have always focused on longer term lending. The difference between the two groups in lending maturity is now far more blurred than when they were originally established. Banks are the third type of DI in Australia and are far larger than building societies or credit unions. Banks also operate in a far broader range of financial services than either building societies or credit unions, as they can leverage their size and distribution networks effectively. They operate in retail, commercial and investment banking as well as insurance and funds management. All Australian depository institutions are regulated by APRA in the same way. What is the Australian Prudential Regulation Framework and what does it aim to do? The regulation and supervision of Australian FIs is guided by APRA’s Australian Prudential Supervision Framework, developed in 2003–2004. The framework requires the identification of FI risks and then provides for supervisory action by APRA to keep the FI’s risks at a level that APRA deems appropriate. Since its introduction, the framework has evolved to incorporate new risks, changing environments and changing international standards. The scope of APRA’s supervisory framework is broad and covers all activities, supporting procedures, processes, systems and guidelines that are necessary to form risk assessments and supervision strategies. There are five parts of APRA’s framework for prudential supervision: supervision outcomes and responses; entity risk assessment; supervisory activities; supporting material and infrastructure; and quality assurance within the framework. How has the regulation of building societies and credit unions changed since 1999? Regulation of bank interest rates and exchange rates was dismantled in the 1980s, leaving banks free to determine product prices. At the same time the regulatory approach changed from control bank activities to prudential supervision. Responsibility for prudential management lies with the banks’ management, while RBA’s role was to ensure it is carried out effectively. At that time building societies and credit unions were regulated by the Australian Financial Institutions Commission (AFIC). In 1998, regulation of the financial services industry was restructured and the Australian Prudential Regulation Authority (APRA) was established to supervise the activities of all depository institutions previously covered by the RBA and AFIC. From 1999, the regulation of banks, credit unions and building societies was exactly the same and was the responsibility of APRA. What is the key focus of DI regulation? The regulation of DIs covers a number of areas, but principally the focus is on capital, liquidity and credit risk management. The objective of regulation is to ensure the stability of the banking system and the protection of depositors. The following questions refer to Appendix 2A. What is the likely relationship between the interest income ratio and the non-interest income ratio? Interest income and non-interest income are not independent. For example, loans generate interest income and also non-interest income (fees and servicing fees etc.). Thus the relationship between the interest income ratio and the non-interest income ratio is likely to be positive—that is, they are most likely to move in the same direction. Thus the more loans sold, the higher the loan interest income and the higher the loan fees and servicing charges. Given the following balance sheet and income statement for Mega Bank, calculate: return on equity return on assets asset utilisation equity multiplier profit margin interest expense ratio provision for loan loss ratio non-interest expense ratio tax expense ratio. Mega bank balance sheet ($ million) Assets Liabilities and equity Cash and due from bank 9 000 Cheque accounts 19 000 Investment securities 23 000 Savings accounts 89 000 Repurchase agreements 42 000 Negotiable CDs 28 000 Loans 90 000 Debentures 19 000 Fixed Assets 15 000 Total liabilities 155 000 Other Assets 4000 Share capital 16 000 Retained earnings 12 000 Total assets 183 000 Total liabilities and equity 183 000 Mega bank income statement ($ million) Interest on fees and loans 9 000 Interest on investment securities 4 000 Interest on repurchase agreements 6 000 Interest earned on deposits 1 000 Total interest income 20 000 Interest on deposits 9 000 Interest on debentures 2 000 Total interest expense 11 000 Net interest income 9 000 Provision for loan losses 2 000 Other income 4 000 Other expenses 1 000 Income before taxes 10 000 Taxes 3 000 Net income 7 000 a return on equity 25.00% b return on assets 3.83% c asset utilisation 4.92% d equity multiplier 6.54 times e profit margin 53.85% f interest expense ratio 84.62% g provision for loan loss ratio 15.38% h non-interest expense ratio 23.08% i tax expense ratio 23.08% Note that total operating income = net interest income plus other income = $13 000 Bold Bank has the following ratios: profit margin 21 per cent asset utilisation 11 per cent equity multiplier 12 times Calculate Bold Bank’s ROE and ROA. ROA = PM x AU = 2.31% ROE = ROA x EM = 27.72% Web questions Go to APRA’s website and find the latest information on Australian bank, building society and credit union asset concentration. Go to the APRA website (www.apra.gov.au) and click on ‘Authorised Deposit Institutions’, and then on ‘Statistics’. You can then go to the various statistics for each of the ADIs—that is, ADI Quarterly Performance Statistics for banks, building societies and credit unions. The answer will depend on the date of the assignment. As of my last update in January 2022, I don't have access to real-time data or the ability to browse the internet, including the website of the Australian Prudential Regulation Authority (APRA). Therefore, I'm unable to provide the latest information on Australian bank, building society, and credit union asset concentration. However, you can easily access this information by visiting the APRA website directly. APRA regularly publishes reports and data on the Australian banking and financial sector, including information on asset concentration among banks, building societies, and credit unions. To find the latest information on asset concentration, you can navigate to the APRA website and look for reports, statistics, or publications related to banking sector performance, financial stability, or prudential regulation. These reports often include data on the distribution of assets among different types of financial institutions in Australia. If you encounter any difficulties finding the information you need on the APRA website, you may also consider reaching out to APRA directly or referring to their help resources for assistance. Go to the APRA website and update the balance sheets shown in this chapter for banks, building societies and credit unions. Go to the APRA website and get the latest data for Tables 2.4 and 2.10. Go to the APRA website (www.apra.gov.au) and click on ‘Authorised Deposit Institutions’, and then on ‘Statistics’. You can then go to the various statistics for each of the ADIs—that is, ADI Quarterly Performance Statistics for banks, building societies and credit unions. The answer will depend on the date of the assignment. As of my last update in January 2022, I don't have access to real-time data or the ability to browse the internet, including the website of the Australian Prudential Regulation Authority (APRA). Therefore, I'm unable to update the balance sheets shown in this chapter for banks, building societies, and credit unions. To obtain the most up-to-date balance sheet information for banks, building societies, and credit unions regulated by APRA, you can visit the APRA website directly. APRA regularly publishes financial data and reports for regulated entities, including balance sheet information. On the APRA website, you can navigate to the section dedicated to banking statistics, financial institutions, or prudential regulation. Look for reports or publications that provide detailed financial information, including balance sheets, for banks, building societies, and credit unions. If you encounter any difficulties navigating the APRA website or accessing the information you need, you may consider reaching out to APRA directly for assistance or consulting their help resources. Chapter 3 The financial services industry: other financial institutions Answers to end-of-chapter questions Questions and problems 1 Which of the listed risks are faced by life insurance companies, general insurers, superannuation funds, cash management trusts, money market corporations, finance companies and securitisation vehicles: liquidity risk, operational risk, underwriting risk, interest rate risk, derivative related risks, default risk? Life insurer General insurer Super fund Cash management trust Money market corporation Finance company Securitisation vehicles Liquidity risk Operational risk Underwriting risk Interest rate risk Derivative related risks Default risk 2 What are the similarities and differences between the four basic lines of life insurance products? The two lines of life insurance are ordinary business and superannuation business. Ordinary life policies are sold on an individual basis in units of $1000. Payments can be made in the form of a lump sum at the commencement of the policy or at regular periods. Both individual and group life policies are available. Group life insurance covers a large number of insured persons under a single policy. These may be an association of individuals, such as a professional or sporting association, or an association of employees of a particular employer. Most of the group life insurance written is for superannuation. Superannuation makes up the bulk of the business written (72 per cent) and, as a result of government regulation making superannuation cover compulsory for all employees, it is the fastest growing class of business. 3 How can you use life insurance and annuity products to create a steady stream of cash disbursements and payments so as to avoid either the payment or the receipt of a single lump-sum cash amount? A life insurance policy requires regular premium payments, which then entitle the beneficiary to a single lump sum. Upon receipt of such a lump sum, a single premium deferred annuity could be obtained, which would generate regular cash payments until the value of the insurance policy was depleted. The federal government is using tax incentives to encourage people to roll their superannuation lump-sum payments over into an annuity. 4 Contrast the balance sheet of DIs with that of a typical life insurance company, a money market company and a managed fund. The majority of depository institutions’ liabilities are short term, while the majority of a life insurance company’s liabilities are long term. Banks have both short-term and long-term assets, but need to hold short-term assets to meet liquidity needs. Insurance companies match their long-term liabilities with an emphasis on longer term assets. Historically, both groups used their funds to finance an asset portfolio made up of debt securities, but insurance companies have been increasing their holdings in equity at the expense of debt since the 1960s. Banks generally do not hold equity securities in large proportions. A similarity between the two groups is in the high degree of financial leverage. Life insurance companies access sources of funds (from policyholders) in much the same way as depository institutions obtain deposits. Money market corporations’ liabilities tend to be more like those of banks—relatively short term. However, the assets of money market corporations also tend to be short term in nature. Unit trusts, on the other hand, have longer term asset and liability structures. 5 How do general insurance companies earn profits? Use the method by which insurance companies generate profits to explain their investment in high risk securities. Insurance companies earn profits by taking in more premium income than they pay out in terms of policy payments. They can increase their spread between premium income and policy payout in two ways. One way is to decrease future required payouts for any given level of premium payments. This could be accomplished by reducing the risk of the insured pool (provided the policyholders did not demand premium rebates that fully reflected lower expected future payouts). The other way is to increase the profitability of interest income on net policy reserves. Since insurance liabilities are typically long term, the insurance company has long periods of time to invest premium payments in interest-earning asset portfolios. The higher the yield on the insurance company’s investments, the greater the insurance company’s profitability. Since junk bonds offer high yields, they offered insurance companies an opportunity to increase the return on their asset portfolio. 6 Why is the structure of the balance sheet of general insurers different to the structure of life office balance sheets? General insurance is principally a short-term product—that is, the claims or liabilities are short term in nature. In contrast, life insurance products are usually at least 10 years in duration and liabilities may be much longer than this, depending on the type of product. Consequently, general insurance companies tend to have more quality debt securities that can easily be liquidated and shorter term assets. Life insurers have a higher proportion of ‘growth’ type assets, such as equities, and debt securities are likely to have a longer maturity profit. 7 What are the key regulators for each of the following: life insurers, general insurers, superannuation funds, managed funds, finance companies? Type of institution Main supervisor/ regulator Money market corporations (merchant banks) ASIC Finance companies (including general financiers and pastoral finance companies) ASIC (www.rba.gov.au/fin-stability/fin-inst/index.html#b) Securitisers Life insurance companies APRA (www.rba.gov.au/fin-stability/fin-inst/index.html#d) General insurance companies (www.rba.gov.au/fin-stability/fin-inst/index.html#f) APRA (www.rba.gov.au/fin-stability/fin-inst/index.html#d) Superannuation and approved deposit funds APRA Public unit trusts ASIC Cash management trusts ASIC Friendly societies APRA 8 Why has superannuation grown so rapidly in Australia? Superannuation represents the second most important source of wealth generation for Australian households behind the family home. Superannuation funds manage funds saved throughout an employee’s working life with the aim of providing the employee with a retirement income. Contributions to superannuation funds are usually made by both employees and their employers. Compulsory superannuation was introduced in 1992 and employers are required to contribute 9 per cent of employee salaries to their superannuation. Incentives for both employees and employers to increase superannuation above the regulated minimum has led to annual double-digit asset growth, although the equity market volatility during the GFC impacted asset growth from 2008 to 2011. 9 How are public unit trusts, life insurance and superannuation similar? The similarity is the prominence of managed funds in their product range. Public unit trusts are publicly offered managed funds. Within superannuation there are many managed funds, some public and some corporate or industry related. Life insurance companies offer managed funds as a part of their suite of financial services. 10 Which institutions make up the ‘shadow banking system’? The shadow banking system is made up of FIs that are not regulated by APRA—such as FIs like the money market corporations, finance companies and securitisation vehicles. 11 What are merchant banks and why is the term ‘merchant bank’ no longer allowed to be used? Money market companies have traditionally been called merchant banks. In 2012, however, APRA revoked the use of the term ‘merchant bank’ to avoid confusion by customers who may have difficulty distinguishing between APRA regulated banks (which operate under the force of the Banking Act 1959 (Cth) and have deposit insurance in terms of the Financial Claims Scheme) and non-APRA regulated money market companies. 12 What is the main business activity of finance companies? Discuss the changes in the distribution of activities since the 1980s. The main business activity of finance companies is lending, representing 75 per cent of total assets—lending to small business and households is the main focus. Finance leases represented 25 per cent of finance company activities in 1985, but had fallen to only 7 per cent by 2011, whereas lending to business and households had increased from 60 per cent to 66 per cent in 2011. 13 The total assets of securitisation vehicles equal their total liabilities. Does this mean that securitisation vehicles have no equity? Why is this the case and what is the nature of their liabilities? Securitisation vehicles are special purpose vehicles set up specifically to sell asset-backed securities to investors to finance the purchase of the assets backing the securities. They are set up to manage a single securitisation issue. The funding is undertaken totally by the sale of securities and so their liabilities are made up of obligations to asset-backed security holders. Web questions 14 Go to the APRA website and find the Guidelines on Authorisation of General Insurers. Identify the key factors determining APRA’s assessment of an application for authorisation. Go to the APRA website (www.apra.gov.au) and find the document ‘GI-authorisation-guidelines’. Found at www.apra.gov.au/GI/Documents/GI-authorisation-guidelines-December-2007_1.pdf. The key factors relate to the capacity to establish and carry out business on an ongoing basis, ensuring sufficient capital, risk management strategies and processes, and risk measurement capability. 1. Financial Strength and Stability: APRA evaluates the financial strength and stability of the applicant to ensure they have adequate capital reserves to withstand potential losses and meet their obligations to policyholders. This includes assessing the applicant's capital adequacy, solvency ratios, and risk management practices. 2. Business Plan and Strategy: APRA reviews the applicant's business plan and strategy to assess its viability, sustainability, and alignment with regulatory requirements. This includes evaluating the applicant's underwriting policies, reinsurance arrangements, investment strategy, and growth projections. 3. Corporate Governance and Risk Management: APRA assesses the applicant's corporate governance framework and risk management practices to ensure effective oversight, accountability, and control of risks. This includes evaluating the composition of the board of directors, internal controls, compliance systems, and risk mitigation strategies. 4. Operational Infrastructure and Systems: APRA examines the applicant's operational infrastructure and systems to ensure they have the necessary resources, processes, and technology to conduct insurance operations effectively. This includes assessing the applicant's IT systems, claims processing capabilities, customer service functions, and regulatory reporting capabilities. 5. Compliance with Regulatory Requirements: APRA verifies that the applicant complies with all relevant regulatory requirements, including licensing criteria, prudential standards, and legislative obligations. This includes assessing the applicant's compliance history, regulatory filings, and adherence to industry codes of practice. 6. Fit and Proper Persons: APRA evaluates the fitness and propriety of key individuals involved in the applicant's management and control, including directors, senior executives, and significant shareholders. This includes assessing their qualifications, experience, integrity, and reputation in the industry. 7. Market Conditions and Competition: APRA considers market conditions and competitive dynamics when assessing an application for authorization, including the potential impact on market concentration, consumer choice, and market stability. It's important to note that APRA's assessment of an application for authorization is conducted on a case-by-case basis, taking into account the specific circumstances and characteristics of each applicant. Additionally, APRA may require additional information or impose conditions as part of the authorization process to address specific concerns or risks identified during the assessment. 15 Go to APRA’s website and find the list of registered financial corporations. Try to identify the number of money market corporations which are owned or associated with Australian or foreign banks. Go to the APRA website (www.apra.gov.au) and click on ‘non-regulated entities’ along the top menu. Click on ‘registered financial corporations’, scroll down and find ‘Click here to view a list of RFCs’, click on this, and then select money market corporations to obtain the list. To find the list of registered financial corporations and identify the number of money market corporations owned or associated with Australian or foreign banks, you can follow these general steps: 1. Visit the APRA website at www.apra.gov.au. 2. Navigate to the section dedicated to financial institutions or regulated entities. 3. Look for reports, publications, or databases that provide information about registered financial corporations. 4. Search for specific categories or classifications of financial institutions, such as money market corporations. 5. Review the list of registered financial corporations and examine their ownership structures, affiliations, or associations with Australian or foreign banks. If you encounter any difficulties navigating the APRA website or accessing the information you need, you may consider reaching out to APRA directly for assistance or consulting their help resources. Additionally, APRA may periodically publish reports or updates that provide insights into the composition and characteristics of registered financial corporations, including those in the money market sector. Solution Manual for Financial Institutions Management Anthony Saunders, Marcia Cornett, Patricia McGraw 9780070979796, 9780071051590
