CH-17 Technology and other operational risks – Financial Institutions Management : Book Guide

Chapter 17 Technology and other operational risks Answers to end-of-chapter questions Questions and problems 1 Explain how technological improvements can increase an FI’s interest and non-interest income and reduce interest and non-interest expenses. Use some specific examples. Technological improvements in the services provided by financial intermediaries help increase income and reduce costs in several ways: (a) Interest income: By making it easier to draw down on loans directly via computers, as well as by processing loan applications faster. (b) Interest expense: By enabling banks to access lower cost funds that are available directly from brokers and dealers through computers and screen-based trading. (c) Non-interest income: By making more non-loan products available to customers through the computer, such as letters of credit and commercial paper and derivatives. (d) Non-interest expense: By reducing processing and settlement fees—an area that has changed drastically for most FIs, especially in trading activities and in the use of automated teller machines (ATMs). 2 Compare the effects of technology on an FI’s wholesale operations with the effects of technology on an FI’s retail operations. Give some specific examples. Generally the wholesale efforts have centred on the banks’ ability to improve the management of float for the bank and for large corporate customers. These efforts include services dealing with lockboxes, funds concentrations, treasury management software, etc. The effect on retail banking primarily has been to make it easier for individuals to obtain banking services as exemplified by ATMs and home banking products. 3 What are some of the risks inherent in being the first to introduce a financial innovation? One risk is that the innovation may not be successful, because of either lack of acceptance by the clients of the bank or problems with the design and delivery of the product. If the product is successful, competitors may be able to quickly duplicate the product without incurring development costs similar to the original innovator. Another risk involves agency issues in which an employee recommends and/or pushes for new products or expansion, which may not be in the best interests of the shareholders, such as ‘empire-building’ by individual FI employees. 4 The operations department of a major FI is planning to reorganise several of its back-office functions. Its current operating expense is $1 500 000, of which $1 000 000 is for staff expenses. The FI uses a 12 per cent cost of capital to evaluate cost-saving projects. (a) One way of reorganising is to outsource overseas a portion of its data entry functions. This will require an initial investment of approximately $500 000 after taxes. The FI expects to save $150 000 in annual operating expenses after tax for the next seven years. Should it undertake this project, assuming that this change will lead to permanent savings? This is a traditional capital budgeting problem. Investments = $500 000, and annual cost savings = $150 000. NPV = CF× PVAk=12%, n=7 – Investment, where k = bank’s cost of capital and CF = cash flows or cost savings. NPV = –500 000 + $150 000 PVAk=12%, n=7 = –$500 000 + $684 563.48 = $184 563.48. Yes, the FI should undertake this project. (b) Another option is to automate the entire process by installing new state-of-the-art computers and software. The FI expects to realise more than $500 000 per year in after-tax savings, but the initial investment will be approximately $3 000 000. In addition, the life of this project is limited to seven years, at which time new computers and software will need to be installed. Using this seven-year planning horizon, should it invest in this project? What level of after-tax savings would be necessary to make this plan comparable in value creation to the plan in part (a)? NPV = –$3 000 000 + PVAk=12%, n=7($500 000) = –$718 121.73. No, the FI should not undertake the project under these terms. The level of after-tax savings necessary to make the plan comparable to part (a) is NPV = –$3 000 000 + PVAk=12%, n=7(Savings) = $184 563.48,  Annual savings = $697 794.34 over the seven-year period. 5 City Bank upgrades its computer equipment every five years to keep up with changes in technology. Its next upgrade is two years from today and is budgeted to cost $1 000 000. Management is considering moving up the date by two years to install some new computers with some breakthrough software that could generate significant savings. The cost for this new equipment is also $1 000 000. What should be the savings per year to justify moving up the planned update by two years? Assume a cost of capital of 15 per cent. The equivalent annual cost for the planned five years is $1 000 000/PVAk=15, n=5 = $298 315.56. Since the cost of the planned improvement is the same as the original investment, the savings generated should be the present value of $298 315.56 in years 1 and 2, or a total of $484 974.26. 6 Distinguish between economies of scale and economies of scope. Economies of scale refer to the average cost of production falling as output of a firm increases, and thus reflect the benefits of a single product firm getting larger. Economies of scope refer to the average cost of production falling through the use of joint inputs producing multiple products, and thus reflect the benefits of a single-product firm becoming a multi-product firm. 7 What information on the operating costs of FIs does the measurement of economies of scale provide? If economies of scale exist, what implications do they have for regulators? Economies of scale provide a measure of the average costs of producing a unit of output and are usually measured as total costs over total assets, total loans or total deposits. If average costs decline as the size of the firm increases, large FIs will be able to offer more competitive rates than their smaller counterparts and possibly drive them out of business. This is easier today because the costs of incorporating new technology can be very expensive to small FIs. Regulators have to be concerned about economies of scale, because, if it is true that larger firms have lower operating costs, policies on restricting mergers, especially vertical mergers, may be counterproductive, since social benefits may outweigh the social costs of mergers. 8 What information on the operating costs of FIs is provided by the measurement of economies of scope? What implications do economies of scope have for regulators? Economies of scope measure the synergistic cost savings to banks that offer multiple products or services. For example, if an FI offers both banking and insurance services and offers them at lower costs than a bank and an insurance company offering them separately, economies of scope are said to exist. For regulators, this would mean being less restrictive on horizontal mergers where FIs are able to offer multiple services. 9 Buy Bank had $130 million in assets and $20 million in expenses before the acquisition of Sell Bank, which had assets of $50 million and expenses of $10 million. After the merger, the bank had $180 million in assets and $35 million in costs. Did this acquisition generate economies of scale or economies of scope? Neither. The costs as a percentage of assets have increased from 15.38 per cent to 19.44 per cent for the bank. This represents diseconomies of scale. 10 What are diseconomies of scale? What are the risks of large-scale technological investments, especially to large FIs? Why are small FIs willing to outsource production to large FIs against whom they are competing? Why are large FIs willing to accept outsourced production from smaller FI competition? Diseconomies of scale occur when the average cost of production increases as the amount of production increases. The risks of large-scale technological investments have to do with whether the uncertain future cash flows will be sufficient to cover the fixed costs of development and installation of the systems. The costs of excess capacity and cost overruns due to integration problems can easily absorb the expected benefits from the expansions. As a result, large FIs will accept production from smaller, competitor FIs if such acceptance will assure that the desired cost benefits are obtained. At the same time, small FIs are willing to outsource production in an attempt to gain the benefits of lower production expenses that may be unattainable through their own technology upgrades. 11 A bank with assets of $2 billion and costs of $200 million has acquired an investment banking firm subsidiary with assets of $40 million and expenses of $15 million. After the acquisition, the costs of the bank are $180 million and the costs of the subsidiary are $20 million. Does the resulting merger reflect economies of scale or economies of scope? This situation would represent economies of scope since different but joint operations are involved. The average cost of the separate firms was $215 million/$2.04 billion or 10.54 per cent. After the merger, the average costs are $200 million/$2.04 billion or 9.8 per cent. 12 What are diseconomies of scope? How could diseconomies of scope occur? Diseconomies of scope occur when the average cost of production is higher from the joint production of services than the average costs from the previous independent production of the services. This situation can occur if the technology used in the production of a portion of the services is not sufficiently efficient for the production of the remaining services. 13 A survey of a local market has provided the following average cost data: Mortgage Bank A (MBA) has assets of $3 million and an average cost of 20 per cent. Life Insurance Company B (LICB) has assets of $4 million and an average cost of 30 per cent. Corporate Pension Fund C (CPFC) has assets of $4 million and an average cost of 25 per cent. For each firm, average costs are measured as a proportion of assets. MBA is planning to acquire LICB and CPFC with the expectation of reducing overall average costs by eliminating the duplication of services. (a) What should be the average cost after acquisition for the bank to justify this merger? Average cost: Bank A = 0.20 × $3 000 000 = $ 600 000 Insurance Company B = 0.30 × $4 000 000 = $1 200 000 Pension Fund C = 0.25 × $4 000 000 = $1 000 000 Total costs = $2 800 000 The average cost after merger = $2 800 000/$11 000 000 = 25.45 per cent. If Bank A can lower its average costs to less than 25.45 per cent, it should go ahead with the merger. (b) If MBA plans to reduce operating costs by $500 000 after the merger, what will be the average cost of the new firm? If Bank A lowers its operating costs by $500 000, the new average cost of the new firm will be $2 300 000/$11 000 000 = 20.91 per cent. 14 What is the difference between the production approach and the intermediation approach to estimating costs functions of FIs? In the production approach, firms are assumed to use labour and capital to produce two outputs: deposits and loans. In the intermediation approach, the function of the FI is to intermediate between borrowers and lenders. As a result, the inputs consist of capital, labour and deposits. 15 What are some of the conclusions of empirical studies on economies of scale and scope? How important is the impact of cost reductions on total average costs? What are X-inefficiencies? What role do these factors play in explaining cost differences among FIs? Earlier studies have shown very little economies of scale except for small banks. More recent studies have shown economies of scale to exist for banks in the $100-million to $5-billion sector. Unfortunately, tests for these studies are very sensitive and can be influenced by the models used. Recent studies also suggest that cost-inefficiencies (X-inefficiencies) or costs associated with managerial ineptness and other factors may account for cost variations among FIs. Similarly, economies of scope studies are not very conclusive. Most find no evidence of benefits to offering multiple services. Finally, it is possible that some of the cost inefficiencies could be overshadowed by efficiencies in revenue generation. 16 Discuss some of the factors that may have resulted in the decline of the usage of cheques in favour of electronic payment methods. Generally, the major factors would be cost, convenience and access to new payments technologies. The cost of handling cheques and the associated internal control issues have meant that customers have increasingly preferred to handle transactions electronically. The banks have cooperated by encouraging the shift towards electronic processing because it lowers their operating costs per transaction. While these technologies were pioneered in the big business sector to cater for large volumes of cheques, they have also been able to be delivered in a cost-effective manner to small business and households, thus eliminating the need to physically visit a branch and the real possibility of a cheque being dishonoured. 17 What is the RTGS and how does it reduce risk in the payment system? The real time gross settlement system (RTGS) is an online, instantaneous and continuous system of interbank settlement. It replaced the old ‘deferred settlement system’ under which transactions cumulated during the business day and were not settled until 9.00 am the following morning, which created a possibility overnight that default could occur in the intervening hours—default that might in turn have led to contagion. Also, under the old system the central bank had no way of knowing of developing problems until the following day. Under RTGS, any settlement problem will show up quickly to the authorities, who can then act to prevent it spreading. The window for overnight settlement risk in the banking system is drastically reduced. 18 What does it mean when the central bank acts as a ‘settlement agent’ and how does this minimise settlement risk for a central bank? The RBA encourages banking institutions to implement procedures to reduce their daylight overdraft exposures. To this end, the RBA requires each bank to maintain an ‘exchange settlement account’ (ESA) with the RBA, through which all the banks’ transactions are cleared. This helps the RBA monitor each bank’s cash position, and also to place disciplinary restrictions on banks to ensure proper cash management. 19 How have crime and fraud risk and the avoidance of regulation been made easier by rapid technological improvements in the electronic payment systems? The massive increase in the use of electronic payment mechanisms has greatly increased the level of sophistication required to commit unauthorised transfers by accessing computers illegally. However, knowledge of specialised technical information has created a new type of white-collar crime and thus security problems. 20 How has technology altered the competition risk of FIs? Competition in the financial services industry has increased because of the entrance of non-traditional financial service providers through the use of technology. Thus, the franchise values of traditional service providers, such as banks, savings and loans, etc., are under increasing pressures from the new, technology-based, non-traditional providers. 21 What action has the BIS taken to protect depository institutions from insolvency due to operational risk? In 1999 the Basel Committee (of the BIS) on Banking Supervision said that operational risks ‘are sufficiently important for banks to devote necessary resources to quantify the level of such risks and to incorporate them (along with market and credit risk) into their assessment of their overall capital adequacy’. In its follow-up consultative document released in January 2001, the Basel Committee proposed three specific methods by which depository institutions (DIs) would hold capital (effective 2005) to protect against operational risk. Web questions 22 Go to the RBA website and examine the statistics for the payments system and the use of electronic payments to verify the continued growth in this sector. Has the strong growth continued? Discuss the trends apparent in the use of electronic payment methods in Australia. However, I can provide insights into the general trends and factors that have been driving the growth of electronic payment methods in Australia based on historical data and industry trends up to that point: 1. Shift from Cash to Electronic Payments: Over the years, there has been a noticeable shift away from cash towards electronic payment methods such as credit cards, debit cards, and digital wallets. This trend is driven by factors such as convenience, security, and the proliferation of digital technology. 2. Contactless Payments: Contactless payment methods, enabled by technologies such as Near Field Communication (NFC) and mobile payments, have become increasingly popular in Australia. Contactless transactions offer speed and convenience, particularly for small-value transactions, leading to widespread adoption among consumers and merchants. 3. E-commerce Growth: The growth of e-commerce and online shopping has fueled the adoption of electronic payment methods. Consumers are increasingly making purchases online, and electronic payment options provide a seamless checkout experience for online transactions. 4. Mobile Payments and Digital Wallets: The use of mobile payment apps and digital wallets has grown significantly in Australia. These platforms allow consumers to store multiple payment methods, make in-store and online purchases, and transfer funds easily, driving the adoption of electronic payments. 5. Government Initiatives: Government initiatives to promote electronic payments and digital financial inclusion have also contributed to the growth of electronic payment methods. Initiatives such as the New Payments Platform (NPP) and the rollout of real-time payments have modernized Australia's payment infrastructure and facilitated faster and more efficient payments. 6. COVID-19 Pandemic: The COVID-19 pandemic has accelerated the adoption of electronic payment methods as consumers and businesses increasingly prioritize contactless and digital transactions to minimize physical contact and adhere to social distancing measures. Overall, the use of electronic payment methods in Australia has been on a strong growth trajectory, driven by technological advancements, changing consumer preferences, and industry innovation. While I can't provide real-time data, examining statistics on the RBA's website would likely show continued growth in electronic payments, reflecting these underlying trends and developments in the payments ecosystem. 23 Go to the Australian Payments Clearing Association website and find the most recent APCA payments fraud data. Discuss the findings. The APCA website is www.apca.com.au. Click on ‘payments information’, then click on ‘payment statistics’ and finally click on ‘payment fraud statistics’. However, I can provide insights into common trends and findings typically observed in payments fraud data, based on historical patterns and industry reports: 1. Types of Fraud: Payments fraud can encompass various types, including card fraud (e.g., counterfeit cards, card-not-present fraud), online banking fraud, identity theft, and payment scams. Understanding the distribution of fraud types helps identify areas of vulnerability in the payments ecosystem. 2. Trend in Fraud Volume: Payments fraud data often track the overall volume and value of fraudulent transactions over time. Trends may indicate fluctuations in fraud activity, seasonal patterns, or the effectiveness of fraud prevention measures. 3. Fraud Detection and Prevention: The effectiveness of fraud detection and prevention measures is a crucial aspect of payments fraud data analysis. Monitoring the rate of successful fraud prevention, detection methods employed, and the proportion of fraud losses recovered provides insights into the resilience of the payments system against fraudulent activities. 4. Sector-specific Insights: Payments fraud data may also offer sector-specific insights, such as fraud trends in card payments, online transactions, mobile payments, or specific industries like retail, banking, or e-commerce. 5. Regional Variances: Payments fraud data may vary across different regions within Australia, reflecting differences in payment preferences, technological adoption, regulatory environments, and fraud mitigation strategies. 6. Impact on Consumers and Businesses: Understanding the impact of payments fraud on consumers, businesses, and financial institutions is essential for assessing the overall risk and implications of fraudulent activities. This includes financial losses, reputational damage, customer trust, and regulatory compliance obligations. To obtain the most recent APCA payments fraud data and discuss the findings, you can visit the Australian Payments Clearing Association website (if it exists) and navigate to the section dedicated to fraud prevention or industry insights. Look for reports, publications, or data releases related to payments fraud statistics, and analyze the findings to identify trends, patterns, and areas for improvement in fraud prevention efforts. Chapter 18 Capital management and adequacy Answers to end-of-chapter questions Questions and problems 1 Identify and briefly discuss the importance of the five functions of an FI’s capital. Capital serves as a primary cushion against operating losses and unexpected losses in the value of assets (such as the failure of a loan). FIs need to hold enough capital to provide confidence to uninsured creditors that they can withstand reasonable shocks to the value of their assets. In addition, the FDIC, which guarantees deposits, is concerned that sufficient capital is held so that their funds are protected, because they are responsible for paying insured depositors in the event of a failure. This protection of the FDIC funds includes the protection of the FI owners against increases in insurance premiums. Finally, capital also serves as a source of financing to purchase and invest in assets. 2 Why are regulators more concerned with the levels of capital held by an FI compared to a non-financial institution? Regulators are concerned with the levels of capital held by an FI because of its special role in society. A failure of an FI can have severe repercussions for the local or national economy, unlike non-financial institutions. Such externalities impose a burden on regulators to ensure that these failures do not impose major negative externalities on the economy. Higher capital levels will reduce the probability of such failures. 3 What are the differences between the economic definition of capital and the book value definition of capital? The book value definition of capital is the value of assets minus liabilities as found on the balance sheet. This amount is often referred to as accounting net worth. The economic definition of capital is the difference between the market value of assets and the market value of liabilities. (a) How does economic value accounting recognise the adverse effects of credit and interest rate risk? The loss in value caused by credit risk and interest rate risk is borne first by the equity holders and then by the liability holders. In market value accounting, the adjustments to equity value are made simultaneously, as the losses due to these risk elements occur. Thus, economic insolvency may be revealed before accounting value insolvency occurs. (b) How does book value accounting recognise the adverse effects of credit and interest rate risk? Because book value accounting recognises the value of assets and liabilities at the time they were placed on the books or incurred by the firm, losses are not recognised until the assets are sold or regulatory requirements force the firm to make balance sheet accounting adjustments. In the case of credit risk, these adjustments usually occur after all attempts to collect or restructure the loans have occurred. In the case of interest rate risk, the change in interest rates will not affect the recognised accounting value of the assets or the liabilities. 4 Why is the market value of equity a better measure of an FI’s ability to absorb losses than book value of equity? The market value of equity is more relevant than book value since if claims are made, the liquidation (market) values will determine the FI’s ability to pay the various claimants. 5 State Bank has the following year-end balance sheet (in millions of dollars):
Assets Liabilities and equity
Cash $ 10 Deposits $ 90
Loans 90 Equity 10
Total assets $100 Total liabilities and equity $100
The loans primarily are fixed-rate, medium-term loans, while the deposits are either short-term or variable-rate deposits. Rising interest rates have caused the failure of a key industrial company and, as a result, 3 per cent of the loans are considered to be uncollectable and thus have no economic value. One-third of these uncollectable loans will be charged off. Further, the increase in interest rates has caused a 5 per cent decrease in the market value of the remaining loans. (a) What is the impact on the balance sheet after the necessary adjustments are made according to book value accounting? According to market value accounting? (i) Under book value accounting, the only adjustment is to charge off 1 per cent of the loans. Thus, the loan portfolio will decrease by $0.90 and a corresponding adjustment will occur in the equity account. The new book value of equity will be $9.10. We assume no tax effects since the tax rate is not given. (ii) Under market value accounting, the 3 per cent decrease in loan value will be recognised, as will the 5 per cent decrease in market value of the remaining loans. Thus, equity will decrease by 0.03 × $90 + 0.05 × $90(1 – 0.03) = $7.065. The new market value of equity will be $2.935. (b) What is the new market to book value ratio if State Bank has $1 million shares outstanding? The new market to book value ratio is $2.935/$9.10 = 0.3225. 6 What are the arguments for and against the use of market value accounting for FIs? Market values produce a more accurate picture of the bank’s current financial position for both stockholders and regulators. Stockholders can more easily see the effects of changes in interest rates on the bank’s equity, and they can evaluate more clearly the liquidation value of a distressed bank. Among the arguments against market value accounting are that market values are sometimes difficult to estimate, particularly for small banks with non-traded assets. This argument is countered by the increasing use of asset securitisation as a means to determine value of even thinly traded assets. In addition, some argue that market value accounting can produce higher volatility in the earnings of banks. A significant issue in this regard is that regulators may close a bank too quickly under the prompt corrective action requirements of FDICIA. 7 Identify and discuss the weaknesses of the leverage ratio as a primary measure of capital adequacy. First, closing a bank when the leverage ratio falls below 2 per cent does not guarantee that the depositors are adequately protected. In many cases of financial distress, the actual market value of equity is significantly negative by the time the leverage ratio reaches 2 per cent. Second, using total assets as the denominator does not consider the different credit and interest rate risks of the individual assets. Third, the ratio does not capture the contingent risk of the off-balance-sheet activities of the bank. 8 What is Basel III? Basel III is the third Basel Accord, setting out the guidelines for the measurement of regulatory capital, the definition and calculation of risk-based capital ratios, leverage ratio and capital buffers. It also sets out the minima for the three regulated capital adequacy ratios. Basel III, developed by the Basel Committee on Banking Supervision, a committee of the Bank for International Settlements (BIS), sets out a three-pillar approach to the prudential supervision of capital, agreed upon by the member countries of the BIS. Pillar 1 relates to the measurement of capital adequacy, Pillar 2 covers internal risk assessment and APRA supervision, and Pillar 3 defines market disclosure. 9 What are the major features in the estimation of credit-risk-adjusted assets under the capital regulations? The major features of the measurement of credit-risk-adjusted assets are: the adjustment of all on-balance-sheet assets for the embedded risk the addition of credit risk for off-balance-sheet activities. 10 What are the three capital adequacy ratios? What are the minimum requirements for each? The three capital adequacy ratios and their minima are: Common Equity Tier 1 must be at least 4.5 per cent of risk-weighted assets at all times; that is: Common Equity Tier 1 Capital Ratio = Total Tier 1 capital must be at least 6 per cent of risk-weighted assets at all times; that is: Tier 1 Capital Ratio = Total Capital (Tier 1 capital plus Tier 2 capital) must be at least 8 per cent of risk-weighted assets at all times. Total Capital Ratio = 11 What are the definitional differences between Tier I and Tier II capital? Tier 1 capital is the primary form of funding for a DI. Tier I capital is made up of two components. Common equity Tier 1 capital is the highest quality component of capital made up of common equity and related items only. Additional Tier 1 capital contains items which are non-common equity, but are able to absorb losses while the DI remains a going concern, are subordinated, have fully discretionary non-cumulative dividends and have neither a maturity date nor an incentive to redeem. Tier 2 capital proves loss absorption on a gone-concern basis, and must be subordinated to depositors and general creditors and have an original maturity of at least five years. 12 Explain the process of calculating credit-risk-adjusted on-balance-sheet assets. Balance sheet assets are assigned to five categories of credit risk exposure (0 per cent, 20 per cent, 50 per cent, 100 per cent and 150 per cent). The dollar amount of assets in each category is multiplied by an appropriate weight. The weighted dollar amounts of each category are added together to get the total credit-risk-adjusted on-balance-sheet assets. (a) What is the basis of risk weighting of assets to account for credit risk? The risk weighting is based on risk classes determined by either an external credit ratings agency (S&P, Moody’s or Fitch) or a fixed risk weight prescribed by APRA. Residential mortgages are treated differently, and their risk weighting is based on two factors—loan to valuation ratio and mortgage insurance. (b) What are the appropriate risk weights for each category (excluding residential mortgages)? Table 18.4 Basel II Risk weights and external rating agency grades
Panel A: Long Term Exposures
Basel II risk weight External rating grade Standard & Poor’s Moody’s investor service Fitch ratings
0% Cash, cash equivalents, claims on the Australian government, deposits with the RBA
20% 1 AAA AAA AAA
AA+ AA1 AA+
AA AA2 AA
AA- AA3 AA-
50% 2 A+ A1 A+
A A2 A
A- A3 A-
100% 3 BBB+ BAA1 BBB+
BBB BAA2 BBB
BBB- BAA3 BBB-
100% 4 BB+ BA1 BB+
BB BA2 BB
BB- BA3 BB-
150% 5 B+ B1 B+
B B2 B
B- B3 B-
150% 6 CCC+ CAA1 CCC+
CCC CAA2 CCC
CCC- CAA3 CCC-
CC CA CC
C C C
D D
Panel B: short term exposures
20% 1 A-1 P-1 F-1
50% 2 A-2 P-2 F-2
100% 3 A-3 P-3 F-3
100% 4 Others Others Others
Source: updated Kidwell 2E, Table 12.2, page 434 using APS 112 Capital Adequacy: Standardised Approach to Credit Risk, December 2010, www.apra.gov.au/adi/Documents/APS_112_Dec%20_2010_Update_Final_reformatted_Jan2012.pdf and APS 120 Securitisation January 2012, www.apra.gov.au/adi/Documents/APS_120_Securitisation_FINAL_Jan2012.pdf. 13 Mercantile Bank has the following balance sheet (in millions of dollars) and has no off-balance-sheet or securitisation activities.
Assets Liabilities and equity
Cash $20 Deposits $980
Australian Treasury Bonds 40 Subordinated debt 40
Insured standard residential mortgages with LVR of 84% 600 Common equity 40
Other loans rated BB+ 430 Retained earnings 30
Total assets $1090 Total liabilities and equity $1090
What is the value of the regulated capital measures (i.e. common equity Tier 1, total Tier 1, total capital) CET1 = 40 + 30 = $70 Total T1 = $70 Total Capital = 70 + 40 = $110 What is the value of credit-risk-weighted assets?
Asset $ Risk weight (%) Risk-weighted value ($)
Cash $20 0 0
Australian Treasury Bonds 40 0 0
Non-insured standard residential mortgages with LVR of 84% 600 50 300
Other loans rated BB+ 430 100 430
Total assets $1090 730
Assuming that operational risk and market risk are zero, calculate the three capital adequacy ratios. CET1 CAR = $70/730 = 9.59 per cent Total T1 CAR = $70/730 = 9.59 per cent Total Capital CAR = $110/730 = 15.07 per cent 14 Onshore Bank has $20 million in assets, with risk-adjusted assets of $10 million. Tier I capital is $700 000, and Tier II capital is $300 000. How will each of the following transactions affect the value of the Tier I and total capital ratios? What will the new values of each ratio be? (a) The bank repurchases $100 000 of ordinary shares. Tier I decreases to $600 000 and the total ratio decreases to 9 per cent. (b) The bank issues $2 million of CDs and uses the proceeds for standard residential mortgages in the 50 per cent risk weighting category. Risk-weighted assets increase by $1 million (i.e. 2 million × 50 per cent) Tier I decreases to $700 000/$11 million = 6.36 per cent, and the total ratio decreases to $1 million 000/$11 million = 9.09 per cent. (c) The bank receives $500 000 in deposits and invests them in Australian government bonds. Both ratios remain unchanged as neither capital nor risk-adjusted assets are affected. (d) The bank issues $800 000 in ordinary shares and lends it to help finance a new shopping mall. Tier I capital increases to $1.5 million and risk-adjusted assets increase by $1.2 million (i.e. $800 000 × 150 per cent) to a total of $11.2 million. Thus, the Tier 1 CAR increases to (1.5/11.2) = 13.39 per cent and the total ratio increases to (1.8/11.2) = 16.07 per cent 15 Explain the process of calculating risk-adjusted non-market-related off-balance-sheet contracts. The first step is to convert the off-balance-sheet items to credit equivalent amounts of an on-balance-sheet item by multiplying the notional amounts by an appropriate conversion factor as given in Table 18.7 in the textbook. The converted amounts are then multiplied by the appropriate risk weights as if they were on-balance-sheet items. (a) What is the basis for differentiating the credit equivalent amounts of non-market-related off-balance-sheet transactions? The factors used in the conversion are arbitrary selections from the list of choices approved by the regulators. While a subjective relationship undoubtedly exists between the factors and the respective credit risks to the bank, no theoretical valuation models were utilised to determine the specific weights that are used. (b) On what basis are the risk weights for the credit equivalent amounts differentiated? The appropriate risk weights are determined by the counterparty to off-balance-sheet activity. The risk weights vary depending on the creditworthiness of the counterparty or borrower. For example, exposures to sovereigns, central banks, and certain highly rated institutions may carry lower risk weights compared to exposures to lower-rated entities or unrated counterparties. 16 Explain how off-balance-sheet market contracts, or derivative instruments, differ from non-market-related off-balance-sheet or contingent guarantee contracts. Off-balance-sheet contingent guarantee contracts in effect are forms of insurance that banks sell to assist customers in the financial management of the customers’ businesses. Bank management typically uses market contracts, or derivative instruments, to assist in the management of the bank’s assets and liability risks. For example, a loan commitment or a standby letter of credit may be provided to help a customer with another source of financing, while an over-the-counter interest rate swap likely would be used by the bank to help manage interest rate risk. (a) What is counterparty credit risk? Counterparty credit risk is the risk that the other party in a contract may default on their payment obligations. (b) Why do exchange-traded derivative security contracts have no capital requirements? Counterparty obligations of exchange-traded contracts are guaranteed by the exchange on which they are traded. Thus, there is no counterparty risk to the bank. (c) What is the difference between the potential exposure and the current exposure of over-the-counter derivative contracts? The potential exposure is the portion of the credit equivalent amount that would be at risk if the counterparty to the contract defaulted in the future. The current exposure is the cost of replacing the contract if the counterparty defaulted today. (d) Why are the credit conversion factors for the potential exposure of foreign exchange contracts greater than they are for interest rate contracts? The credit conversion factors for the potential exposure of foreign exchange contracts are greater than they are for interest rate contracts because research indicates that foreign exchange rates are more volatile than interest rates. (e) Why do regulators not allow banks to benefit from positive current exposure values? Regulators fear that allowing banks to gain from a counterparty default would create risk-taking incentives that would not be in the best interests of the bank or the financial services industry. 17 How does the risk-based capital measure attempt to compensate for the limitations of the static leverage ratio? The risk based capital ratio (i) more systematically accounts for credit risk differences between assets, (ii) incorporates off-balance-sheet risk exposures, and (iii) applies similar capital requirements across all of the major banks. 18 Identify and discuss the problems in the risk-based capital approach to measuring capital adequacy (see Appendix 18B online). First, the risk weights may not be true representations of the correct or necessary weights, or they may not be in the correct proportion to each other. For example, does a weight of 100 per cent imply twice as much risk as a weight of 50 per cent? Second, the fact that the exact weighting process is known by bankers as well as regulators may give bankers an incentive to manipulate the balance sheet assets to achieve desired RBC ratios. Third, the RBC ratio does not consider the effects of portfolio risk diversification. In effect, RBC assumes the correlation between assets is one. Fourth, rating all commercial loans with the highest credit risk may cause banks to reduce lending in this area, an action that could have negative effects on the monitoring function performed by the financial services industry. Fifth, all commercial loans are given equal weight, even where the credit ratings of two companies may otherwise be significantly different. Sixth, the BIS plan does not include factors to measure interest rate risk, foreign exchange risk, operating risk, etc. Finally, tax and accounting differences across different banking systems will probably preclude the BIS plan from being perfectly successful in creating a level playing field for comparison purposes in an international or global environment. 19 What is the contribution to the asset base of the following items under the capital adequacy requirements?
Item Effect
(a) $10 million cash reserves. 0
(b) $50 million 91-day Australian government securities. 0
(c) $25 million cash items in the process of collection. 5 million
(d) $5 million UK government bonds, AA rated. 1 million
(e) $5 million OECD short-term government bonds, AA rated. 1 million
(f) $500 million insured standard residential mortgages (LVA is less than 80 per cent). 175 million
(g) $500 million business loans, BBB rated. 500 million
(h) $100 000 performance-related standby letters of credit to a BBB rated corporation. 50 000
(i) $100 000 performance-related standby letters of credit to an organisation rated A+. 25 000
(j) $7 million trade related letter of credit to a BB+ rated foreign corporation. 1.4 million
(k) $17 million three-year loan commitment to a private agent with a B+ rating. 12.75 million
(l) $17 million three-month loan commitment to a private agent with an S&P rating of A-3. 8.5 million
(m) $30 million standby letter of credit to back a CCC-rated corporate issue of commercial paper. 45 million
(n) $4 million interest rate futures position 0
(o) $6 million two-year currency swap with $500 000 current exposure (the counterparty has a rating of A+). 475 000
20 How does the leverage ratio test impact the stringency of regulatory monitoring of bank capital positions? The stringency of regulatory monitoring is increased because even if the bank can reduce its capital requirement by adjusting its portfolio towards less capital-intensive assets, the primary assets ratio test sets a minimum required capital level against balance sheet assets. 21 Third Bank has the following balance sheet (in millions of dollars) with the risk weights in parentheses.
Assets Liabilities and equity
Cash (0%) $20 Deposits $175
Interbank deposits with AA rated banks (20%) 25 Subordinated debt (5 years) 3
Standard residential mortgages non-insured with LVR of 85% (50%) 70 Cumulative preference shares 5
Business loans to BB rated borrowers (100%) 70 Common equity 2
Total assets $185 Total liabilities and equity $185
In addition, the bank has $30 million in performance-related standby letters of credit (SLCs), $40 million in two-year forward FX contracts that are currently in the money by $1 million, and $300 million in six-year interest rate swaps that are currently out of the money by $2 million. Credit conversion factors (taken from Tables 18.6 and 18.7 in the textbook) are:
Performance-related standby LCs 50%
1–5 year foreign exchange contracts 5%
1–5 year interest rate swaps 0.5%
5–10 year interest rate swaps 1.5%
(a) What are the risk-adjusted on-balance-sheet assets of the bank as defined under the Basel Accord? Risk-adjusted assets:
Cash 0 × 20 = $0
Interbank deposits 0.20 × 25 = $5
Mortgage loans 0.50 × 70 = $35
Business loans 1.00 × 70 = $70
Total risk-adjusted assets = $110 = $110
(b) What is the total capital required for both off- and on-balance-sheet assets? Standby LCs: $30 × 0.50 = $15 = $15 Foreign exchange contracts: Potential exposure $40 × 0.05 = $2 Current exposure in the money = $0 Interest rate swaps: Potential exposure $300 × 0.015 = $4.5 Current exposure out of the money = $2 = $8.5 × 0.50 = $4.25 Total risk-adjusted on- and off-balance-sheet assets = $129.25 × 0.08 Total minimum capital required = $10.34 (c) Does the bank have enough capital to meet the regulatory capital requirements? If not, what minimum Tier 1 or total capital does it need to meet the requirement? No, the bank does not have sufficient capital to meet the regulatory capital requirements. Tier 1 capital is only $7 million, producing a Tier 1 CAR = 7/129.25 = 5.42 per cent. Further, the common equity Tier 1 CAR = 2/129.25 = 1.54 per cent. Total CAR = 10/129.25 = 7.73 per cent. Consequently, the bank fails all three CARs. In fact, it needs common equity Tier 1 = 129.25 × 0.045 = $5.82 and if it raises sufficient equity to meet the common equity Tier 1 CAR, then it will then satisfy all CARs. New balance sheet:
Cash $23.82 Deposits $175
Interbank deposits $25 Subordinated debt (over 5 years) $3
Mortgage loans $ 70 Cumulative preferred stock $5
Business loans $70 Equity $5.82
Total $188.82 $188.82
22 What is the general approach to the measurement of operational risk capital charge using the standardised approach? Operational risk is found by first dividing activities into retail, commercial and other activities. The total operational risk regulatory capital charge (KOR-Standard) under the standardised approach is found using the following formula which averages the last six half-yearly observations of both adjusted gross income and loans and advances outstanding: where: m = a fixed scaling factor of 0.035 (as set out in APS 114) LARt = total gross outstanding loans and advances for retail banking LACt = total gross outstanding loans and advances for commercial banking AGIt = adjusted gross income earned over a six-month period at the end of each financial year and half-year. t = half-yearly observation period (at end of each financial year and half-year) Each of the six half-yearly observations of retail and commercial total loans and advances is scaled by a factor of 3.5 per cent, and then multiplied by risk weight of 12 per cent for retail business and 15 per cent for commercial business. For all other activity, the capital charge is 18 per cent of each of the last six half-yearly income observations. Averages are then taken for each area of business. As loans and advances are a ‘stock’ measure, then these are averaged by dividing by six. However, as all other activity income is a ‘flow’ measure, the sum of the observations is divided by three to determine an average full year result. 23 Why does market risk measure both general market risk and specific market risk? Market risk is the risk of loss of market value due to movements in market prices of assets and liabilities. Such movements may be the result of general market influences which are external to the DI, whereas others may be due to DI specific events or activities. Specific risk is further decomposed into idiosyncratic risk and event risk. Idiosyncratic risk measures the price volatility difference between an individual security and the general market in day-to-day trading. Event risk is the risk that the price of an individual security drops significantly relative to the market as a result of a particular event such as a takeover, default or other DI specific shock. 24 Why is there a need for an additional regulation covering non-traded interest rate risk? Interest rate risk in the banking book is not included in the market risk capital charge, and as such, APRA requires those DIs using advanced measurement approaches to also calculate a charge for interest rate risk in the banking book. 25 What are the two capital buffers under Pillar 1 of the capital adequacy regulations and when are they used? The capital conservation buffer is 2.5 per cent of risk weighted assets, comprised of common equity Tier 1 only. This means that DIs must hold a minimum of 7 per cent common equity Tier 1 capital to risk weighted assets (CAR of 4.5 per cent and capital conservation buffer of 2.5 per cent). With this buffer, DIs will build up capital to absorb losses during periods of financial and economic stress. If a DI’s capital conservation buffer falls below 2.5 per cent, then constraints are imposed on the DI’s distributions (e.g. dividends and bonuses), providing further incentive for DIs to meet the buffer at all times. The countercyclical capital buffer has a macroeconomic focus, and aims to ensure that financial system capital requirements are sufficient given the macro-financial environment in which DIs operate. The buffer is designed to ensure the financial system has an additional buffer of capital to protect it against future potential losses. It acts like an extension to the capital conservation buffer, but is not permanent. APRA determines when the countercyclical capital buffer is to be applied, that is, when excess aggregate credit growth is associated with a build-up of system-wide risk, and it is expected that it will be deployed on an infrequent basis. APRA reviews the need for the buffer in consultation with RBA, and publicly announces if it is to be applied. The buffer will vary between zero and 2.5 per cent of total risk-weighted assets and is to be met with common equity Tier 1 capital only. Web question 26 Go to APRA’s website and find the most recent changes to the three pillars of APRA’s capital adequacy regulation regime. The answer will depend on the date of the assignment. The website is www.apra.gov.au. Search for the three pillars and find articles which best suit the discussion required. However, I can provide an overview of the three pillars of APRA's capital adequacy regulation regime based on general knowledge up to my last update: 1. Pillar 1: Minimum Capital Requirements: Pillar 1 of APRA's capital adequacy framework establishes minimum capital requirements that authorized deposit-taking institutions (ADIs) in Australia must meet. These requirements are primarily based on the Basel Committee on Banking Supervision's standards and include minimum capital ratios such as the Common Equity Tier 1 (CET1) ratio, Tier 1 capital ratio, and Total Capital Ratio. ADIs are required to maintain capital adequacy ratios above the regulatory minimums to ensure financial soundness and resilience. 2. Pillar 2: Supervisory Review Process (SRP): Pillar 2 involves the supervisory review process conducted by APRA to assess an ADI's overall risk profile, risk management practices, and capital adequacy relative to its specific risk profile and business activities. APRA conducts regular risk assessments and engages in dialogue with ADIs to evaluate their risk management frameworks, internal controls, and capital planning processes. The goal of Pillar 2 is to ensure that ADIs maintain adequate capital buffers to cover their risk exposures and comply with regulatory requirements. 3. Pillar 3: Market Discipline and Disclosure: Pillar 3 focuses on market discipline and transparency by requiring ADIs to disclose relevant information about their capital adequacy, risk exposures, and risk management practices to stakeholders, including investors, regulators, and the public. ADIs are required to publish standardized disclosures on their capital position, risk profile, and risk-weighted assets to enhance market transparency and facilitate informed decision-making by market participants. To find the most recent changes to APRA's capital adequacy regulation regime, including updates to the three pillars, you can visit the APRA website and navigate to the section related to prudential standards, regulatory updates, or publications. Look for announcements, consultations, or regulatory documents issued by APRA that address changes to capital adequacy requirements and related frameworks. 27 Go to the website of one of Australia’s major banks—ANZ, Commonwealth Bank, National Australia Bank or Westpac Bank. Find the bank’s latest Pillar 3 disclosure document—often called A330 disclosure—and comment on the bank’s capital position. The websites for each of the banks are www.anz.com.au; www.commbank.com.au; www.nab.com.au and www.westpac.com.au. In most cases the A330 disclosure is found in the shareholder section of the website. However, I can guide you on how to find the latest Pillar 3 disclosure document for one of these major banks and offer general insights into what you might expect to find in such a document: 1. Visit the Bank's Website: Start by visiting the official website of the bank you're interested in, such as ANZ, Commonwealth Bank, National Australia Bank, or Westpac Bank. 2. Navigate to Investor Relations or Regulatory Disclosures: Look for a section or tab on the bank's website related to investor relations, financial reporting, or regulatory disclosures. This section typically contains information relevant to investors and stakeholders, including Pillar 3 disclosure documents. 3. Search for Pillar 3 Disclosure Document: Within the investor relations or regulatory disclosures section, search for the latest Pillar 3 disclosure document or Annual Pillar 3 Report. This document may be labeled as A330 disclosure or similar, as per regulatory requirements. 4. Review the Capital Position: Once you've accessed the Pillar 3 disclosure document, review the sections related to capital adequacy, capital ratios, and risk-weighted assets. Look for information on the bank's Common Equity Tier 1 (CET1) ratio, Tier 1 capital ratio, Total Capital Ratio, and any other relevant capital metrics. 5. Consider Commentary and Analysis: The Pillar 3 disclosure document may include commentary, analysis, and management discussion on the bank's capital position. This may involve explanations of changes in capital ratios, risk exposures, capital management strategies, and regulatory compliance. 6. Assessing the Capital Position: Based on the information provided in the Pillar 3 disclosure document, assess the bank's capital position in relation to regulatory requirements, industry benchmarks, and internal targets. Consider factors such as capital adequacy, capital quality, risk appetite, and the bank's ability to absorb potential losses. By following these steps, you should be able to find and review the latest Pillar 3 disclosure document for one of Australia's major banks and gain insights into the bank's capital position. 28 Go to the APRA website and find Prudential Statement APS 113, and go to Attachment A. Examine the various risk weightings and discuss the logic implied by their structure. Identify the assets that require ratings higher than 150 per cent and discuss why the high ratings may apply in these cases. The answer will depend on the date of the assignment. The website is www.apra.gov.au. Search for Prudential Statement APS 113 0 and find Attachment A. However, I can provide general insights into the logic behind the structure of risk weightings in regulatory frameworks such as Prudential Statement APS 113, and discuss the assets that may require risk weightings higher than 150 percent: 1. Logic Behind Risk Weightings: • Risk weightings in regulatory frameworks like APS 113 are typically based on the credit risk associated with different types of assets and exposures. • The risk weight assigned to an asset reflects the probability of default and potential loss severity associated with that asset. • Higher-risk assets are assigned higher risk weightings, requiring banks to hold more regulatory capital against these assets to absorb potential losses. 2. Assets Requiring Ratings Higher than 150 Percent: • Assets that require risk weightings higher than 150 percent typically represent higher-risk exposures or assets with greater credit risk. • Examples of assets that may require higher risk weightings include: a. Unrated Exposures: Assets that lack credit ratings or have insufficient credit information available may be assigned higher risk weightings to account for the uncertainty and potential default risk. b. Low-Rated Exposures: Exposures to entities with low credit ratings or weak creditworthiness may require higher risk weightings to reflect the increased probability of default and potential loss severity. c. Specialized Lending: Assets related to specialized lending activities, such as project finance, leveraged finance, or commercial real estate lending, may require higher risk weightings due to their inherently higher risk profiles and exposure to sector-specific risks. d. Higher-Volatility Exposures: Assets with higher volatility or market risk, such as equity investments, may require higher risk weightings to account for the potential for significant fluctuations in value and increased credit risk. 3. Rationale for High Ratings: • High ratings, such as risk weightings exceeding 150 percent, are applied to assets with higher credit risk to ensure that banks maintain sufficient capital reserves to cover potential losses. • By requiring higher levels of regulatory capital against these assets, regulators aim to enhance the resilience and stability of banks' balance sheets and mitigate the systemic risk posed by higher-risk exposures. • The rationale for high ratings reflects the regulatory focus on prudential soundness, risk management, and financial stability within the banking sector. While specific details of risk weightings and asset classifications may vary across regulatory frameworks and jurisdictions, the overarching principle remains the same: to align capital requirements with the underlying credit risk of bank assets and exposures, ensuring the safety and soundness of the banking system. Solution Manual for Financial Institutions Management Anthony Saunders, Marcia Cornett, Patricia McGraw 9780070979796, 9780071051590