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Chapter 13 Foreign exchange risk Chapter outline Foreign exchange rates and transactions Foreign exchange rates Foreign exchange transactions Sources of foreign exchange risk exposure Foreign exchange rate volatility and FX exposure Foreign currency trading FX trading activities Interaction of interest rates, inflation and exchange rates Purchasing power parity Interest rate parity Foreign asset and liability positions The return and risk of foreign investments On-balance-sheet hedging Managing FX risk using derivative instruments Hedging with forwards Hedging with futures Estimating the hedge ratio Using options to hedge FX risk Using currency swaps to hedge FX risk Multicurrency foreign asset–liability positions Learning objectives 13.1 Gain knowledge of foreign exchange rates and transactions. 13.2 Understand the sources of foreign risk exposure. 13.3 Learn how foreign exchange volatility affects an FI. 13.4 Learn how foreign exchange and related products are traded. 13.5 Discover how foreign exchange exposures affect the value of global assets and liabilities. 13.6 Gain knowledge of techniques for managing foreign exchange exposure and hedging issues. 13.7 Understand theories of the ways in which interest rates affect the values of different currencies. 13.8 Learn how an FI manager can use derivative instruments to manage foreign exchange risk. Overview of chapter The globalisation of the financial services industry has meant that FIs are increasingly exposed to foreign exchange (FX) risk. FX risk can occur as a result of trading in foreign currencies, making foreign currency loans (e.g. advancing a loan in sterling to a corporation), buying foreign-issued securities (such as UK sterling-denominated gilt-edged bonds or German euro-denominated government bonds), or issuing foreign currency-denominated debt (e.g. US$ certificates of deposit) as a source of funds. Extreme foreign exchange risk was evident in 1997 when a currency crisis occurred in Asia, starting when the Thai baht fell nearly 50 per cent in value relative to the Australian dollar, and leading to contagious drops in the value of other Asian currencies, and eventually other developing nation currencies (such as the Brazilian real and Russian ruble). The risk need not be market related. For example, in 2002, a single trader at Allfirst Bank in the US hid $211 million of foreign currency trading losses. National Australia Bank, in 2004, announced that it had lost $180 million in foreign currency trading due to unhedged foreign currency exposures of nearly $2 billion. Market changes in the currency can also lead to increased volatility in earnings by corporations. For example, high commodity prices led to a strengthening Australian dollar during 2011, improving the sales of importers, but lowering the revenues of Australian exporters. The fall in the euro during 2011, resulting from fears of sovereign default within the Eurozone provides another warning of the risks from foreign currency fluctuation. This chapter looks at how FIs evaluate and measure the risks that FIs face when their assets and liabilities are denominated in foreign (as well as in domestic) currencies and when FIs take major positions as traders in the spot and forward foreign currency markets. The chapter finishes with a discussion of the ways in which futures, options and swap contracts can assist an FI manager in managing foreign exchange risk. Chapter 13 Teaching Suggestions As FX risk and its management is usually a key part of any subject covering international finance, you may choose to ignore this chapter if your course is a part of a comprehensive finance program. However, even if you do ignore the chapter, you should explain to students why—that is, that you are not covering the chapter as you would be repeating material, and not because FX risk is not important to the management of an FI. You could cover this point in your introductory lectures—that is, introduce FX risk along with other risks—and then explain why it is not a part of your subject (refer to Chapter 4). I would suggest that in doing so, you also alert students to some examples of large trading losses (e.g. NAB in the early 2000s—see Industry Perspective box in introduction in Chapter 13), and, as FX risk is a part of the risk assessment for capital adequacy purposes, any course on FI management should not ignore this fact. You may also choose to only cover part of the chapter. For example, if another finance subject covers the basics of FX, FX exposure, rates and trading, purchasing power parity and interest rate parity, you may wish to focus attention on the foreign assets and liabilities in an FI portfolio and the way the ensuing FX risk in the balance sheet can be hedged/managed using both on-balance-sheet and off-balance-sheet transactions. With this in mind, I will divide my suggestions for this chapter into four parts: Foreign exchange rates and transactions; exposure and volatility; trading; and purchasing power parity and interest rate parity It is this section of the chapter that is likely to be covered in other finance subjects. Hence, for most courses, I would suggest that this be left to student reading/revision, followed by some summary revision questions in lectures. However, if it is all new material, then as the material is very descriptive, it is useful to engage students by using plenty of examples. For example, Table 13.1 has details of exchange rates as at July 2014. You may wish to bring the latest rates from the RBA website or the Financial Review or similar. Ask students to find various rates, and to identify direct and indirect quoting—noting that the AUD is quoted most often as an ‘indirect quote’. You may then revise the sources of FX risk in FI balance sheets—and for this, you could refer to Tables 13.2 and 13.3. Alternatively, you could ask students to update Tables 13.2 and 13.3—from the RBA website—and discuss the changes (increase or decrease in FX exposure) since those printed in the book. This discussion will assist in identifying volatility in FX rates and exposure of FIs. The Industry Perspective box covering the liberalisation of the Chinese renminbi is interesting. You could also ask students to examine the article and discuss why this is so important for (a) Australia, and (b) the global FX market. The purchasing power parity and interest rate parity theorems can be introduced by asking students what they think determines FX rates and volatility in those rates (when floating, of course). Following this, show the two theorems and provide examples for students to work through (see Examples 13.1 and 13.2 in the chapter) Foreign asset and liability positions The introduction of FI balance sheet positions in foreign currency loans and deposits is potentially new material for many finance students. The book describes the calculation of return on FX transactions for an FI by way of an example. I suggest that you work through Example 13.3 in class, as this is the most interesting way to show how the returns are calculated, as well as providing practice in exchange calculations. On-balance-sheet hedging Similarly, the on-balance-sheet hedging discussion is best handled by way of a worked example, as shown in Example 13.4—which uses the same data as that in Example 13.3—and shows how you can lock in a positive return despite a change in FX rates. Off-balance-sheet hedging Forwards, futures, options and swaps were introduced earlier in the course, in Chapter 7, and so are not introduced again here. That knowledge is assumed. The chapter discusses the ways each of these derivative instruments can be used to manage FX risk. Note that in each case the examples show an individual FX transaction only. The chapter does not cover the macrohedging of FX risk. The section details many examples and uses these to describe the way the hedging takes place and the outcomes. The reason for this is that we have found that the use of examples improves understanding. There is nothing particularly difficult in the calculations, but there is a process—and the examples make this process clearer for most students. As for interest rate risk, basis risk is examined, when explaining how futures can be used to hedge FX positions. This is more difficult than the ‘no basis risk’ case, and so can be ignored in more basic courses. Similarly, the section following, which covers ‘estimating the hedge ratio’ when determining the number of futures contracts, may be ignored in more basic courses. The use of options contracts is relatively straightforward and can be explained by way of a simple example. The final derivative instrument is currency swaps. These are extremely important, and as shown in Figure 13.2 represent the largest by volume of Australian dollar FX transactions. For all aspiring FX traders/dealers, an understanding of currency swaps is essential. So you could use that fact to create some excitement among the aspiring bankers in your lecture. Again, the section on currency swaps has many examples. The final section of the chapter covers multicurrency asset–liability positions—briefly and by way of completion. As mentioned previously, the rest of the chapter is devoted to examples of single currency exchanges only. Don’t forget to also use the concept questions throughout the chapter to challenge students and to introduce and/or revise key points. Chapter 14 Liquidity risk Chapter outline Causes of liquidity risk Liquidity risk at depository institutions Liability-side liquidity risk Asset-side liquidity risk Measuring a depository institution’s liquidity exposure Liquidity planning Liquidity risk, unexpected deposit drains and bank runs Bank runs, the discount window and deposit guarantees Liquidity and financial system stability Liquidity risk in other financial institutions Life insurance companies General insurers Managed funds Chapter objectives 14.1 Discover what is liquidity risk and what are its sources. 14.2 Learn how a depository institution (DI) can utilise either stored liquidity or purchased liquidity. 14.3 Learn how liquidity risk arises on both the liability side and asset side of the balance sheet of a DI. 14.4 Learn how to measure a DI’s liquidity risk and determine its liquidity needs. 14.5 Discover the importance of liquidity planning to a DI. 14.6 Understand why liquidity risk is generally more critical for DIs than for other FIs. 14.7 Discover the main reasons why depositors of DIs which are perceived to be in trouble may have very strong incentives to engage in bank runs. 14.8 Understand the ways in which the Australian government, the RBA and APRA support liquidity in the Australian financial system. 14.9 Understand liquidity risk in life insurance companies, general insurers and managed funds. Overview of chapter Chapters 5 through 13 examine how the major problems of interest rate risk, credit risk, market risk, sovereign risk and foreign exchange risk can threaten the solvency of a financial institution (FI). This chapter looks at the problems created by liquidity risk. Unlike other risks that threaten the very solvency of an FI, liquidity risk is a normal aspect of the everyday management of an FI. For example, depository institutions (DIs) must manage liquidity so that they can meet their obligations to depositors (cash withdrawals) and the needs of borrowers (loan commitment drawdowns). Only in extreme cases do liquidity risk problems develop into solvency risk problems, where an FI cannot generate sufficient cash to pay creditors as promised. This chapter identifies the causes of liquidity risk on the liability side of an FI’s balance sheet as well as on the asset side. We discuss methods used to measure an FI’s liquidity risk exposure and consequences of extreme liquidity risk (such as deposit or liability drains and runs) and briefly examine the regulatory mechanisms put in place to ease liquidity problems and prevent runs on FIs. Moreover, some FIs are more exposed to liquidity risk than others. At one extreme, depository institutions are highly exposed; in the middle, life insurance companies are moderately exposed; and at the other extreme, managed funds (also known as mutual funds), superannuation funds and general insurance companies have relatively low exposure. However, all FIs are exposed to some liquidity risk. Chapter 14 Teaching Suggestions (should be read in conjunction with notes on Chapter 15) Liquidity risk is of key concern to all FIs, and so an understanding of liquidity risk and its management is critical for all FI managers. This chapter focuses on the risk itself and how liquidity risk occurs on both the liability side as well as the asset side of the balance sheet. In Chapter 15, we explore liability and liquidity management. Both chapters discuss the APRA liquidity regulations, although they are covered in more detail in Chapter 15 as a part of the management of the risk. The easiest way to describe liquidity risk is to ask students what happens when they have no money at the end of the week—and yet they must pay their credit card account? That is, personalise it. Running out of cash—or, more correctly, access to cash—is the risk faced by all economic entities whether they are individuals, companies or banks. The key difference is that for FIs it is much worse, as their business is supposed to be the management of money. Also, the suspicion of any liquidity issue in an FI may cause a run on the FI—which could be critical. Following the simple introduction of liquidity, you could use the example in the first Industry Perspective box in the chapter to explain the lack of liquidity in the global market during the global financial crisis (GFC), and what this meant for all FIs, and the economy more generally. Once there is an understanding of the risk, the next topic to be discussed should be the causes of liquidity risk, with a particular focus on depository institutions. It should be clear from the earlier discussion of the GFC why a focus on DIs is necessary. (Note that liquidity risk in other FIs is discussed at the end of the chapter.) In discussing the risk on the liability side, ensure that you explain the stored liquidity (liquid assets) and purchased liquidity (hot money) available to banks, and why purchased liquidity was in short supply during the GFC. You may also want to further highlight the fates of those banks which used purchased liquidity management versus those which relied more on core deposits following the GFC. I would refer you back to Table 2.4 in Chapter 2, and in particular the ‘non-resident liabilities’. Overseas borrowing is one part of purchased liquidity for the banks—and the growth in overseas borrowings (nearly 19 per cent of all liabilities in 2013) was one reason why the government brought forward the deposit protection scheme —the Financial Claims Scheme (discussed in Chapter 15). Figure 14.6 shows the funding composition of Australian banks and highlights the increase in domestic deposits since the GFC—that is, a move to increase core deposits or stored liquidity. On the asset side, you should explain the liquidity characteristics of different assets—and, in particular, the liquidity risk inherent in loan commitments. Loan commitments are a very common form of business lending. Their growth has increased the liquidity risk in the banks’ portfolios. The potential critical risk is that in a liquidity crisis, most of the bank loan commitment customers may exercise their options to draw down loans—at the worst possible time for the bank. That is, not all assets provide stored liquidity, which is particularly comprised of a portfolio of liquid assets—available if necessary for ready cash. The liquid asset portfolio should be made up of those assets which are easily liquidated, but which also have low price/value volatility. The Industry Perspective box covering liquidity risk management at the ANZ Bank may be a useful reading exercise for students, followed by a discussion of the key aspects of the policy—and why ANZ may want these published. The discussion of the measurement of the liquidity exposure of a DI is relatively straightforward, and descriptive, and also provides a number of simple examples to assist understanding. You may wish to ask students about the funding mix shown in Figure 14.6 and the impact of the changes in funding mix (and liquidity management) for interest rate risk. It is a good opportunity to commence linking the various risks faced by a DI, so that students understand that in solving a particular risk problem, they need to be mindful of other risks that may be created—that is, unintended consequences. The section covering liquidity planning is also descriptive and provides some indication of the types of issues which need to be considered by those managing liquidity of a DI. In particular, it is important for students to understand the need for a DI to analyse and predict its liquidity needs, so that it has sufficient funds to cover any situation. The best analysis is undertaken by observing and analysing the past, and then stressing under different scenarios. However, unexpected situations do arise, despite the best planning, and the worst-case example of a run on deposits could send a DI to the wall! So the chapter describes this, and the contagion effect, and the back-up mechanisms that the RBA puts in place so that the risk of any bank run is reduced. After all, this is all because the financial stability of the economy could be impacted if there was a run on any bank—and so it is the central bank’s interest to ensure that this does not happen. The different mechanisms provided by the RBA are introduced here, but described in more detail in Chapter 15. Finally, the liquidity risk of other FIs—life insurers, general insurers and managed funds—is described. Again, this material is very straightforward and possibly best presented by way of a table which shows the various liquidity characteristics of each type of FI relative to a DI. DIs are highly exposed to liquidity risk, whereas life insurers are moderately exposed (given the long-term nature of their assets and liabilities), and at the other end of the spectrum, general insurers and managed funds have relatively low liquidity risk. Highlighting this, and discussing why this is the case, is a nice way to both finish the discussion on liquidity risk and to highlight the key sources of such risk. The management of liquidity and liabilities is the subject of Chapter 15; the preparation of any lecture on liquidity risk and its management should cover the topics in both chapters. Chapter 15 Liability and liquidity management Chapter outline Liquid asset management Monetary policy implementation reasons Taxation reasons The composition of the liquid asset portfolio Return–risk trade-off for liquid assets The liquid asset reserve management problem for depository institutions Management of exchange settlement funds Liquidity management as a knife-edge management problem Liability management Funding risk and cost Choice of liability structure Deposit liabilities Cheque accounts and other demand deposits Savings accounts Cash management / Investment savings accounts Fixed-term deposits Negotiable certificates of deposit (NCDs) Non-deposit liabilities Interbank funds Repurchase agreements (REPOS) Covered bonds Other borrowings Liquidity regulation Minimum quantitative requirements Liquidity coverage ratio regime ADIs Minimum liquidity holdings regime ADIs Net stable funding ratio (NSFR) Improved global liquidity? Depositor protection and deposit guarantees Australian depositor protection mechanisms Learning objectives 15.1 Understand the role of liquid assets in the management of liquidity risk and the reasons for the use of liquid assets. 15.2 Determine the different ways that the liquid asset portfolio can be constructed and the risk–return characteristics of holding liquid assets. 15.3 Understand the meaning of liability management and the factors that determine the choice of liability structure. 15.4 Discover the characteristics of different DI liabilities and their associated withdrawal risks and costs. 15.5 Gain an understanding of the regulatory liquidity requirements and how these impact a DI’s choice of liquid assets and liability mix. 15.6 Learn about the Basel III liquidity reforms and their implementation in Australia. 15.7 Discover the reasons why governments provide deposit guarantees. 15.8 Learn about the Australian financial claims guarantee schemes for DI depositors and general insurance policyholders. Overview of chapter Depository institutions and life insurers are especially exposed to liquidity risk (see Chapter 14). The essential feature of this risk is that an FI’s assets are relatively illiquid in the face of sudden withdrawals (or non-renewals) of liability claims. The classic case of liquidity risk is a bank run where depositors demand cash as they withdraw their claims from a bank and the bank is unable to meet these demands because of the relatively illiquid nature of its assets. For example, it could have a large portfolio of non-marketable commercial business loans. To reduce the risk of a liquidity crisis, DIs can insulate their balance sheets from liquidity risk by efficiently managing their liquid asset positions or managing the liability structure of their portfolios. Most DI managers incorporate both asset management and liability management as part of their overall liquidity management strategy. In reality, a DI manager can optimise both its liquid asset portfolio and the structure of its liabilities to insulate against liquidity risk. This chapter discusses the various liquid assets and liabilities a DI might use to manage liquidity risk, and the risk–return trade-off associated with various liability and liquidity strategies employed. In addition to ensuring DIs meet expected and unexpected liability withdrawals, two additional motives exist for holding liquid assets; monetary policy implementations and regulation/taxation reasons. The chapter also discusses the Australian regulator’s liquidity requirements for Australian DIs, including those required under the Bank for International Settlements’ Basel III reforms. Finally, the chapter discusses deposit guarantee schemes introduced by governments to deter runs on FIs. Chapter 15 Teaching Suggestions (should be read in conjunction with comments on Chapter 14) While Chapter 14 principally covers liquidity risk and its source, this chapter identifies liquidity and liability management strategies available to the FI manager. We commence with a discussion of the liquid asset portfolio—what it should contain and how it can be used. This is very descriptive and not difficult. There is always a risk–return trade-off with any portfolio of liquid assets, and it may be useful to ask students whether banks would hold a liquid asset portfolio if there was not a regulation to do so. For example, look at Table 2.4, and the first asset item ‘cash and deposits with RBA’. While this line does not tell the whole story, it does provide an indication of bank behaviour. Prior to 2000, there were liquid asset regulations, and we see that bank holdings of cash and RBA deposits represented 1.2 per cent of the portfolio. However, from 2000 to 2010, when there were no specified requirements for liquid assets, these represented less than 0.6 per cent. In 2013, when again regulations stipulated a minimum amount of liquid assets, we see cash and RBA deposits rising again to 0.9 per cent. This provides a nice introduction to composition of the liquid asset portfolio and its characteristics—the optimal liquid asset portfolio (if one actually exists). And it also provides a prelude to the discussion of liquidity facilities provided by the RBA to assist DIs in the management of liquidity—that is, the management of exchange settlement funds—which follows. The different types of RBA liquidity facilities are described; the discussion should highlight each, and when they can and should be used, as well as the penalties for using them. From management of the liquid asset portfolio, the chapter then moves to the management of liabilities. Here, there is a focus on low cost and low withdrawal risk—which in theory is the way to go. However, in practice this does not work, as such a strategy would eliminate most of the deposit products offered by DIs to their customers. In the discussion of the choice of liability structure, you could ask students a number of questions, such as: What type of deposit forms the majority of deposits of a bank? Why would a bank want to raise deposits from international markets? What risks are associated with foreign deposits—in addition to liquidity risk? What are the characteristics of foreign deposits? Are all the influences on a bank’s liability structure internal? If not, what external forces may influence the liability structure? Is there an optimal liability structure? Is it practical? From here, you may want to identify the different types of deposits and then use the material in the book to discuss the risks associated with each of these. The book discusses withdrawal risk and the costs of the following deposit product types: cheque account and other demand deposits savings accounts cash management/investment savings accounts fixed-term deposits negotiable certificates of deposit (NCDs). The chapter then describes the same two items for a number of non-deposit liabilities, including: interbank funds repurchase agreements covered bonds. The material is very descriptive and the identification of risk and costs for each of the deposit products is probably easily understood by students. A way to cover this is to ask students to read the section on the different deposit liabilities before class, so that you can immediately head into a comparison of the withdrawal risk and cost of each. The non-deposit liabilities may require a little more explanation in lectures, as these will be less familiar to the students. Liquidity regulation is next and is pretty dry in content. The discussion of liquidity risk so far should have influenced the students’ thinking as to whether regulation is necessary or not. So maybe you should ask students to show (by raising their hands or standing up) whether they believe that liquidity regulation is necessary—as a good way to get the students moving prior to a rather dry stretch in the lecture. Alternatively, you may wish to leave the section on regulation to student reading, followed by appropriate questions in the next lecture—you could use the Concept questions in this section of the book as a guide. You may also want to refer to the Regulator’s Perspective box in this section of the chapter, which provides a perspective of the chairman of the Basel Committee on Banking Supervision. The final section of the chapter covers depositor protection and deposit guarantees schemes. The Australian version, the financial claims scheme, is discussed here. Again the topic is dry, and descriptive. So one way to introduce the topic could be to ask students what they would do if they were the government during the global financial crisis (GFC); that is, what they would do to assist Australian bank liquidity when international markets had dried up. Note that prior to the GFC, Australia had no depositor protection scheme, and the introduction of the Financial Claims Scheme was brought forward because of the crisis. The changes since the crisis are worth exploring—or more correctly the motivation of the government to make the changes is worth exploring. That is, what is the scheme trying to achieve, and why were the limits set higher during the crisis and subsequently lowered? Note that there are protection schemes for both depositors at DIs and policyholders of general insurers. Chapter 16 Off-balance-sheet activities Chapter outline Off-balance-sheet activities and FI solvency Returns and risks of off-balance-sheet activities Loan commitments Documentary letters of credit and standby letters of credit Derivative contracts: futures, forwards, swaps and options Forward purchases and sales of when-issued securities Loans sold The role of OBS activities in reducing risk Learning objectives 16.1 Gain an appreciation of the different types of off-balance-sheet activities used by FIs. 16.2 Discover how these activities can impact the solvency of an FI. 16.3 Gain an understanding of the risks and returns associated with off-balance-sheet activities. 16.4 Learn about the ways off-balance-sheet activities are used by FIs. 16.5 Learn how off-balance-sheet activities can reduce the risk of FI balance sheets. Overview of chapter This chapter shows that an FI’s net worth or economic value is linked not only to the value of its traditional on-balance-sheet activities, but also to the contingent asset and liability values of its off-balance-sheet activities. The risks and returns of several off-balance-sheet items are discussed in detail: loan commitments; documentary and standby letters of credit, derivative contracts such as futures, options and swaps; forward purchases and sales of when-issued securities; and loans sold. In all cases, it is clear that these instruments have a major impact on the future profitability and risk of an FI. The chapter concludes by pointing out that although off-balance-sheet activities can be risk increasing, they can also be used to hedge on-balance-sheet exposures, resulting in lower risks as well as generating fee income for the FI. Chapter 16 Teaching Suggestions The topic of this chapter is off-balance-sheet risk. However, as derivative products have been covered at some length in other chapters (Chapters 7, 10 and 13, for example), the emphasis in this chapter is to highlight the general exposure to an FI of off-balance-sheet items, and to discuss in some detail the non-derivative related OBS items—that is, loan commitments, etc. Of key importance in this chapter is the message that OBS items can threaten the solvency of an FI if not managed appropriately. With the shadow of the global financial crisis (GFC) still darkening many OBS markets—and in particular swap markets—the regulators have taken a renewed interest in OBS activities of FIs. Remember that the investment in OBS activities (and in particular credit swaps underpinning the collateralised mortgage obligations) were a key concern during the GFC, with many investors losing due to the large losses on the swaps. So in this regard, the Regulator’s Perspective near the beginning of the chapter may bring the issue to life for the students. Table 16.2 may also help in this regard, as it reports some of the large trading losses (through derivatives) incurred since 1995. Another useful factor about these instruments is their growth. Table 16.4 shows the significant change in the use of OBS by Australian banks—and in particular how direct credit substitutes and trade related OBS have not grown as quickly as loan commitments and derivative instruments. Another fact that should be emphasised is the growth in credit derivatives. Having hopefully excited students about the importance of OBS risk—and the need to manage it—you can then move to the descriptive discussion of loan commitments. The risks identified in the discussion are interest rate risk, draw-down risk, credit risk, liquidity risk more generally, etc. Hence, the example of loan commitments shows that when using OBS activities there are inherent risks (already covered in the course) involved. OBS risk is not a risk per se, but the products house many different types of finance risks, which, if not understood, can be damaging for any FI. While FIs use derivative instruments principally for hedging, the issue of credit risk and contingent credit risk in derivative products is something which FI managers cannot ignore. Given the high growth in derivative products within FIs, this issue is probably one of the most important for FI managers—and so it should be emphasised in your lecture. The submission by the Australian Financial Markets Association (AFMA) to the Financial System Inquiry is reported in part in the chapter, and may assist students better understand the market for derivatives. The last two products discussed are forward purchases of securities (such as tendering for Treasury Notes) and loans sold. The risks associated with the former are relatively easy to understand as the market could move between the time you agree to purchase (or win the tender) and the time you are able to actually take delivery. However, the issue of loans sold is not as clear. The key concern here is when loans are sold with recourse. This means that the original issuing FI retains the credit risk of the loan. The final section of the chapter summarises the arguments for derivatives as risk management tools. Despite this, the growth in derivatives, and in particular over-the-counter derivatives, has attracted the interest of regulators, and we can expect more regulation of derivatives in the future. Note that there is an integrated mini case at the end of the questions which covers the calculation of income on OBS activities. Chapter 17 Technology and other operational risks Chapter outline What are the sources of operational risk? Technological innovation and profitability The impact of technology on wholesale and retail financial service production Wholesale financial services Retail financial services Advanced technology requirements The effect of technology on revenues and costs Technology and revenues Technology and costs Testing for economies of scale and economies of scope The production approach The intermediation approach Empirical findings on cost economies of scale and scope and implications for technology expenditures Economies of scale and scope and X-inefficiencies Technology and the payments system Trends in retail payments Trends in high-value payments Risks that arise in an electronic payment system Other operational risks Regulatory issues and technology and operational risks Operational risk and FI insolvency Consumer protection Appendix 17A: Selection of research articles on the efficiency of Australian financial institutions (online at book website) Learning objectives 17.1 Learn the sources of operational risk. 17.2 Understand how technology has impacted on service delivery and profitability. 17.3 Discover how to determine the financial benefits of implementing new technology. 17.4 Learn about economies and scale and economies of scope. 17.5 Determine the impact technology has had on the payments system and the risks it creates. 17.6 Learn what specific problems arise from sources of operating risk other than technology. 17.7 Gain an understanding of regulations and how they seek to address operational risk. Outline of chapter Chapters 4 to 16 concentrated on the financial risks that arise as FIs perform their asset-transformation and/or brokerage functions on or off the balance sheet. However, financial risk is only one part of a modern FI’s risk profile. As with regular corporations, FIs have a real or production side to their operations that results in additional costs and revenues. This chapter focuses on (1) factors that impact the operational returns and risks of FIs (with an obvious emphasis on technology), and (2) on the importance of optimal management and control of labour, capital and other input sources and their costs. In particular, well-managed FIs can use operational cost savings to increase profits and thus reduce the probability of insolvency. Central to FIs’ decision-making processes is the cost of inputs or factors used to produce services both on and off the balance sheet. Two important factors are labour (tellers, credit assessment staff, business development staff) and capital (buildings, machinery and furniture). Crucial to the efficient management and combination of these inputs (which result in financial outputs at the lowest cost) is technology. Technology and operational risks are closely related and in recent years have caused great concern to FI managers and regulators alike. The Bank for International Settlements (BIS), the principal organisation of central banks in the major economies of the world, defines operational risk (inclusive of technological risk) as ‘the risk of losses resulting from inadequate or failed internal processes, people, and systems or from external events’. This chapter introduces operational risk and technology risk through an examination of the sources of operational risk and the role that technology plays in the improvement of FI efficiency and profitability. We then discuss the impact of technology on the types of services which are delivered by FIs, followed by a more detailed discussion of the impact of technology on FI costs and revenues. The chapter then considers economies of scale and scope, and the related empirical evidence. The use of technology to transform the Australian payments system is discussed including the increased risks associated with an electronic payments system. The chapter concludes with a discussion of regulatory issues related to operational risk and technology. Chapter 17 Teaching Suggestions This chapter covers operational risk generally, but puts a strong focus on technology and its inherent risks. As leaders in the corporate adoption of technology, FIs face particularly high risk. Some people describe FIs as communication and technology firms—and with the progression of digital interaction between banks and customers, this is becoming more and more a reality. So my suggestion for commencing this lecture is to ask students how they, their parents and grandparents interact with their banks. Their answers are likely to give you a comparison between the way banks used to operate and the way they now do. Clearly, the way students interact with their banks is the future. As important is the range of services now available—through technology. You may wish to refer students to Figure 17.1 which shows the amount of spending on ICT by different industries. We see that the financial services industry is the highest spender in the Australian economy—higher than the total government sector (which is second). A key point is the transition that banks have had to make to move from the old style of operations and products to the new. A further point is that the speed of change has quickened, and so FIs are under even more pressure to continue improving their technology interface to be competitive. Having introduced the subject, you should then discuss that technology and technology risk is a major part of operational risk, but that it is not the only part and the sources of operational risk also include human error, contractual issues, real asset risks (i.e. fire, destruction of capital items) and external threats (robbery and fraud). You could then ask students which of the sources of operational risk are controllable by management and the implications if they are not controlled/managed. Here you may wish to introduce the concept of a ‘risk profile’ of the FI—and the reputation, costs and benefits which go with a good or bad risk profile. Back to technology; in the previous discussion, you should also have covered why FIs innovate—that is, to improve competitiveness and profitability. You may also wish to engage students in a discussion of whether the production of new products and services requires technological innovation—or does technology drive the product development? This is a worthy discussion which should assist students’ understanding of the reliance of FIs on technology. This brings you to a discussion of the production of wholesale and retail services—and the long list of advanced technologies. The lists of many wholesale, retail and advanced technology requirements could be used to ensure the key services are identified. You may also want to refer students to Figure 17.2, which shows customer satisfaction with the four major banks—and claims that the increase in satisfaction rates is due to better technology interface for customers. The section on technology and revenues and costs is useful so students understand that innovation may be revenue related, cost related or both. Some of the empirical results of research of scale and scope economies in Australian financial institutions are provided in Appendix 17A (at the book website). Then follows a discussion on the importance of technology for payments—both domestic and international. A good way to introduce this could be through a discussion of the International Perspective box in the chapter on ‘The future of global payments’. Following the global perspective, you could then discuss the changes in the way cash payments are made (see Table17.1 and Figures17.5 and 17.6, in particular). A discussion of the risks faced by FIs arising from electronic payments systems naturally follows. To initiate a discussion of crime and fraud, you could ask students why they must use PINs only when they use their debit and credit cards. The discussion should raise the issue of the cost of surveillance and monitoring of card use, and the means needed to detect fraudulent and other illegal activity. New initiatives to be taken by the Australian Payments Board are described in the Regulator’s Perspective box in the chapter ‘Initiatives underway to reduce card payment fraud’. Your discussion of technology would not be complete without some mention of the way that technology enables non-FI firms to enter the financial services markets. For example, you may use the article in the Industry Perspective box ‘Competition from supermarket giants’ as a discussion starter for this. The web link is from the ABC and you could possibly show the podcast from ABC 7.30 in the lecture, or ask students to view it privately. As well as fraud in the payments systems, there are other potential illegal activities—and these are covered in the latter sections of the chapter—that is, the four other sources of operational risk. Table 17.3 is a good summary of the types of risks faced, categorised by the different sources of operational risk. Finally, regulatory issues and technology cannot be ignored as the increased digitisation of transactions produces risks not only for the FI but also for its customers. Consequently, the need for consumer protection should be discussed. Chapter 18 Capital management and adequacy Chapter outline Capital and insolvency risk Capital The market value of capital The book value of capital The discrepancy between the market and book values of equity Arguments against market value accounting Capital management Regulation of capital of Australian DIs Basel Accords: the evolution of DI capital regulation Pillar 1: capital adequacy Measurement of regulatory capital Measuring risk-adjusted assets Calculating the capital adequacy ratios Leverage ratio Capital buffers Pillar 2: DI risk assessment and supervision Pillar 3: capital and risk disclosure Appendix 18A: Market risk capital charge for interest rate risk using the standardised approach Appendix 18B: Criticisms of the risk-based capital ratio Appendix 18C: Capital regulation of life insurers and general insurers Learning objectives 18.1 Learn about the measurement of FI capital and its functions. 18.2 Gain an understanding of the difference between the simple leverage ratio and risk-based measures of capital. 18.3 Discover the evolution of capital regulation for Australian depository institutions (DIs). 18.4 Understand the three-pillar framework for capital regulation used in Australia. 18.5 Learn how the Australian Prudential Regulation Authority (APRA) measures capital. 18.6 Understand the meaning of risk-weighted assets and their use in measuring capital adequacy. 18.7 Ascertain how to calculate the adequacy of an FI’s capital base. 18.8 Appreciate the definition and use of the regulatory leverage ratio. 18.9 Learn about the regulated capital buffers and their use. 18.10 Understand the role of Pillar 2 in capital regulation. 18.11 Appreciate the role of Pillar 3 and its use in market discipline. Outline of chapter This chapter reviews the role of an FI’s capital in insulating it against credit, market, interest rate, operational and other risks. According to economic theory, capital or net worth should be measured on a market value basis as the difference between the market values of assets and liabilities. However, usually regulators use book value accounting concepts. While a book value capital adequacy rule accounts for credit risk exposure in a rough fashion, it overlooks the effects of interest rate changes and interest rate exposure on net worth. The chapter highlights that due to the many FI failures or near failures during the GFC, new capital regulations, Basel III, introduced by APRA from 2013, increased the quality of capital with a higher focus on common equity, increased the minimum capital adequacy requirements and introduced a leverage ratio and two capital buffers above the regulated minimum capital requirements. Further, the chapter examines in some detail the capital rules for Australian DIs set out in APRA’s capital regulation regime under the three pillars, in particular, Pillar 1, which outlines how the measurement of regulatory capital adequacy requires an adjustment of book values to account for the different types of risk. The approaches to the calculation of the various components of the risk-based capital adequacy ratios are covered in some detail, along with a description of the leverage ratio and capital buffers which complement the capital adequacy ratios. The chapter concludes with a discussion of both Pillar 2, the supervisory process which determines DI specific risk, and an examination of the disclosure regime established by Pillar 3. Chapter 18 Teaching Suggestions The risk of insolvency is mentioned throughout all the other chapters of this book. Chapter 18 covers this risk specifically—although it is important at this stage to remind students that all of the other risks contribute to changes in the value of capital. Hedging and managing the various risks covered in the rest of the book has the aim of protecting the value of capital. So it makes sense for insolvency risk and capital management to be the last risk covered. The chapter is divided into two parts. The first part should not be new to students of finance, and describes the importance of capital, book value versus market value discussions, and insolvency risk (a risk which should be obvious to all finance students). It may be useful to point out the different balance sheet structure of FIs relative to other firms—that is, the highly leveraged nature of the FI balance sheet. You probably mentioned this in one of the introductory lectures, but I suggest that it is worth mentioning again at this point. The need for regulation of capital will also not be new to students given the introductory chapters, but you may also want to remind students of the reasons for this—that is, refer back to Chapters 1, 2 and 3. You could possibly commence the discussion by asking students the question – why do we need the regulation of capital? The second part of the chapter covers capital regulation of Australian depository institutions. Note that the regulation of both life and general insurers is covered in Appendix 18C (online at the book website). There is a lot of material here, and the structure of your course will determine how much detail you need to go through. At the very least, I would suggest that you cover in brief the evolution of capital regulation globally, so that students are aware that this is a global system, which was supposed to make the global financial system safer and fairer. Then I would suggest that you take students through the three-pillar approach to capital adequacy. Then you can begin describing in more detail Pillar 1 and the concept of the capital adequacy ratio and its components—that is: How capital is measured Risk-adjusted assets—what are they and what determines them Credit risk—on and off balance sheet, and securitisation Market risk of trading book Operational risk Etc. The calculation of the capital adequacy ratios and the minimum regulatory requirements for the various ratios. The leverage ratio requirement. Capital buffer requirement. You could provide a simple example if you are summarising the method—that is, use the summary of Example 18.6. Or you could go through each of the examples leading up to Example 18.6 to demonstrate the complex nature of the calculation of the risk-adjusted asset base of the DI. This of course will depend on how much time you have. You could ask students to read through the detail of the calculation of the risk-adjusted assets prior to the lecture so that you can then ask questions in class, for example: How complex are the calculations of risk-adjusted assets—both on and off balance sheet? How do you think banks handle these calculations—especially given the millions of transactions? Why is there a standardised approach and an internal model approach? Alternatively, you may wish to divide the group into five and ask each group to go through an example from the book (Examples 18.1 through to 18.5) and then you can put them altogether (as in Example 18.6) for the whole class. Alternatively, you could run through basic credit-risk-adjusted assets (on balance sheet) in class and then set the other types of risk for reading. There is no easy way to do this. However, as the material is very dry, my suggestion is to ensure that there is activity in the class—that is, ensure that students have to do something rather than just listen to a very dry description of regulatory requirements. After the discussion of capital adequacy ratios, you should outline the new leverage ratio and capital buffers. It is worth discussing the original intent in the 1989 Basel Accord to move to a risk-adjusted asset approach on the one hand, whereas on the other, regulators have now moved back to (at least in part) the old leverage ratio. The simple leverage ratio was the norm prior to the first Basel Accord in 1989. The capital buffers are new and untested. Note Appendix 18B which contains some criticisms of the Basel capital adequacy ratios; you may wish to include these in your lecture too. Pillars 2 and 3 complete the capital regulation discussion. These are relatively descriptive, relating to risk assessment and supervision, and disclosure regime, respectively, This chapter completes the book, and I suggest that the contents of this chapter also complete any course on FI or bank risk management. The fact that all other activities and risks in the FI impact the value of capital leads to the discussion and its management as the ultimate lecture. For students, it is important that they understand that in the end it is the value of capital that counts, and that the management of any of the risks discussed in your course (and in the book) have the objective of, at the least, maintaining/protecting, and at best enhancing and potentially optimising the value of the FI’s capital. Here of course, we mean the market value of the FI’s capital. Instructor Manual for Financial Institutions Management Anthony Saunders, Marcia Cornett, Patricia McGraw 9780070979796, 9780071051590

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