Week 2 Tutorial Solutions - Commercial Banks & NBFIs PDF

**[Chapter-Commercial banks]** **14.1 What are the major sources of bank funds?** Solution: The most important source of funds is deposits, which are more important for small banks than large banks. Large banks get more of their funds directly from the money markets. Following the GFC the relative...

**[Chapter-Commercial banks]** **14.1 What are the major sources of bank funds?** Solution: The most important source of funds is deposits, which are more important for small banks than large banks. Large banks get more of their funds directly from the money markets. Following the GFC the relative importance of deposits increased as offshore funds declined in volume and increased in cost. The Australian government also acted to inject funds by buying securities from the markets to provide liquidity and capital. **14.2 What are the major uses of funds for a bank? What are the differences between large and small banks? Explain the difference.** A bank's major uses of funds are lending and investing. Investment securities are more important to the portfolios of smaller banks than to those of larger banks. Larger banks have access to many more sources of liquid funds than do smaller banks, and therefore they do not need to rely as heavily on investment securities for liquidity. Smaller rural banks are more likely to carry significant portfolios of agricultural loans. Smaller banks are less likely to supplement their lending activities with leasing. **14.3 Why do banks hold Treasury securities and state government bonds investment portfolios?** Such securities are held as they are highly liquid and hence can be quickly turned into cash to meet obligations. This is part of what is called the profitability-versus-safety dilemma facing bank management where the conflicting goals of solvency and liquidity on the one hand and profitability on the other need to be balanced. Unfortunately, it is a set of conflicts not easily resolved. For example, liquidity could be achieved by holding only Treasury securities. In this strategy, bank management would sleep well but eat poorly because profits would be low. At the other extreme, the bank could shift its asset portfolio into high-yielding, high-risk loans at the expense of better-quality loans or liquid investments. Bank management would eat well temporarily because of increased profits but would sleep poorly because of the possibility of a bank failure later on caused by large loan losses or inadequate liquidity. Government securities are also low risk securities. **14.4 What do we mean by 'off-balance-sheet' activities? If these things are not on the balance sheet, are they important? What are some off-balance-sheet activities?** "Off-balance-sheet" activities are financial services which earn revenue but do not directly or immediately put assets or liabilities on the balance sheet. Examples include loan commitments & standby letters of credit. These activities are important: They are a growing component of the revenue of the world's largest banks, they materially affect a bank's overall risk profile and profitability, and yet they are not readily apparent on bank's financial statements. Assessment of their full effect requires in-depth analysis of notes to financial statements. **14.5 What is a contingent asset? What is a contingent liability? Provide an example of each.** For a fee a financial institution will agree to provide services upon the request of a customer. A loan commitment to lend over a period of time is a contingent asset. The customer holds an option to borrow. The asset is contingent upon the request of the customer. Letters of credit in support of customers is an example of a contingent liability. The bank has a contingency of an obligation if the customer does not meet its obligation with its supplier. **14.6 Why do you think small banks have a higher proportion of assets in investments than do large banks?** Small banks rely more on investments for liquidity. Large banks are more able to "buy" liquidity directly in the money market. Small banks thus tend to have more assets invested in Treasuries, which are safe and highly liquid. The investment securities permitted to banks are highly liquid, highly marketable, and relatively low-risk. Loans are personalised contracts, lower in marketability unless participated or securitised and higher in risk unless exceptionally well-secured. **14.7 How does loan portfolio composition differ between large and small banks? Can you provide an explanation?** Large banks have a much higher proportion of commercial loans, which they compete for in a national market. Smaller banks tend to operate in more local markets and have more of a retail emphasis. Smaller banks tend to have a higher proportion of agriculture and real estate loans than large banks, which have more of a wholesale emphasis. The loan portfolio of a small bank will be, to a large extent, a function of the local economy in which it operates. Small banks are also likely to be more conservatively managed, affecting their choices about what kinds of risk to underwrite, and under what conditions. **14.8 Discuss the uses of standby LOCs. What benefits do they offer to a bank's commercial customers?** In an SLC transaction, the bank acts as a third party in a commercial transaction between the bank's customer and a beneficiary, substituting the bank's creditworthiness for that of its customer. Thus, if the bank's customer fails to meet the terms and conditions of the commercial contract, the bank guarantees the performance of the contract as stipulated by the terms of the SLC. **14.9 Why has noninterest income become so important to banks?** Such income is important to banks as it supplements the income they earn on interest margins through intermediation services and is subject to less risk and provides a more stable income to banks during uncertain conditions in the economy and the financial markets. This is particularly important as competition for deposits has risen dramatically with technology and international institutions impacting on this. Non-interest income, particular fees based sources, have also become politicised as consumer groups and governments have begun to look at the reasonableness (relative to the actual cost incurred by the financial institutions) of many of these fees. Interestingly as margin's widened in the post GFC period a number of the banks began winding back some of these fees. **14.10 Discuss the profitability versus safety dilemma in banking.** The central problem for bank management is reconciling the conflicting goals of\ solvency and liquidity on the one hand and profitability on the other. Unfortunately,\ it is a set of conflicts not easily resolved. For example, liquidity could be achieved by holding only treasury securities. In this strategy, bank management would sleep well but\ eat poorly because profits would be low. At the other extreme, the bank could shift its asset portfolio into high-yielding, high risk\ loans at the expense of better-quality loans or liquid investments. Bank management\ would eat well temporarily because of increased profits but would sleep poorly because of the possibility of a bank failure later on caused by large loan losses or inadequate\ liquidity. Finally, bank liquidity is ultimately related to bank solvency. That is, most bank\ runs are triggered by depositors and other creditors\' expectations of extraordinary losses in the bank\'s loan or investment portfolios. **[Chapter- Nonbank financial institutions]** **14.1 What are the different types of nonbank financial institutions in Australia?** A modern financial system usually has a diverse range of financial institutions that offer a diverse range of financial products. In addition to the commercial banks the Australian financial system includes building societies, credit unions and finance companies. By number there are far more of them than banks, however they are significantly smaller in scale, often regionally based or, in the case of finance companies, offer a limited set of financial products. Historically, building societies have specialised in making consumer mortgage loans, while credit unions (also referred to as credit cooperatives) have traditionally specialised in short-term consumer loans. Over time both have developed into more diversified institutions and are, as are banks, authorised deposit-taking institutions (ADIs) in that they are approved by the Australian Prudential Regulation Authority (APRA) to accept retail deposits. Finance companies issue both consumer and business loans, however they do not accept deposits from the public to obtain funds. Rather, they rely on short-term and long-term funding from the sale of commercial paper, notes, bonds or stock. **14.2 What are (a) the major regulations and (b) the major regulatory bodies that oversee building society and credit union operations? How do these regulations and regulatory bodies affect them?** Building societies and credit unions are authorised deposit taking institutions (ADIs) and regulated by APRA. As APRA applies the same supervisory and regulatory framework to all ADIs, credit unions are regulated in the same way as Banks. One of the key issues for credit unions and building societies is to convince customers of their safety and security relative to the larger banks. This has particularly been the case as financial institutions and other corporate failures around the globe have been more regular occurrences in recent years. The financial institutions regulatory framework in Australia has proven effective with few bank, building society and credit union failures in recent decades. **14.3 How do finance companies differ from banks, credit unions and building societies?** Finance companies cannot issue demand deposits. They cannot issue savings instruments unless chartered as "industrial banks" under detailed regulatory guidelines. Thus they have almost nothing to do with the money supply or with safety, soundness, or public confidence in the banking system. They chiefly obtain loanable funds by borrowing from other financial institutions (particularly commercial banks), issuing commercial paper in the money markets, and issuing notes or bonds in the capital markets. As private firms, which simply lend money, they are regulated more for the sake of consumer protection than for any of the other rationales associated with regulation of depository institutions. They typically underwrite higher credit risks and longer maturities than depository institutions, differentiate themselves in speed and convenience, and consequently charge higher interest rates. **14.4 Describe the common bond of association of credit unions?** The board of directors establishes major credit union policies and chooses and changes, if necessary, its management. The strength of credit unions traditionally comes from the common bond of association. Traditionally, to be a member of a credit union, a person had to qualify under the credit union\'s common-bond requirements. Common bonds relate to occupation (e.g. members work for the same employers or in the same industry); association (e.g. members belong to the same religion, trade association, or trade union); or residence (e.g. members live in a qualifying sparsely populated rural area or in specified low-income areas). **14.5 Why were credit unions first created? What need did they fulfil and how does this differ from their operations today?** Credit unions first appeared in Australia in the mid 1940s. Like building societies, credit unions were started both to provide an outlet for savers to deposit small amounts of funds and as organizations that would provide loans on relatively lenient terms to their members. Credit unions tended to focus on consumer lending. They are credit co-operatives, which are owned and operated democratically by their members. Accordingly the financial wellbeing of members is central to their mission. They are organised like clubs whose members pool their savings and loan them to one another. The strength of credit unions traditionally comes from the common bond of association. Traditionally to be a member of a credit union, a person had to qualify under the credit union's common bond requirements. Common bonds relate to occupation (e.g., members work for the same employers or in the same industry); association (e.g., members belong to the same religion, trade association, or trade union); or residence (e.g., members live in a qualifying sparsely populated rural area or in specified low-income areas). Over time however, most credit unions have relaxed the common bond requirements to allow others to join. This is in part due to intense industry competition and the need for scale to achieve cost efficiencies to fund modern banking services such as internet banking. **14.6 What types of finance companies exist and what does each do?** Consumer finance companies primarily make loans to consumers. Sales finance companies primarily finance sales made by retail dealers by buying the credit contracts (" dealer paper") generated by those sales. Captive finance companies are sales finance companies that were started to finance the sales of their parent companies' goods and services. Factors finance business firms by buying and collecting their accounts receivable. Business finance companies finance business loan needs in general. Leasing companies purchase equipment needed by their customers and lease it to their customers. **14.7 How do finance companies fund their operations?** Most have lines of credit at commercial banks, and larger finance companies issue commercial paper to obtain short-term funding. They also issue long-term debt. Captive finance companies can borrow (obtain "transfer credit") from their corporate parents.