BEO3001 Session 1: Bank Risk Management PDF

**Session structure for BEO3001** Session 1: Bank risk management Session 2: FinTech, Blockchain and Banking Session 3: Bank Culture and Governance Session 4: Bank Regulation, Competition and Market Power Session 5: Bank Failures Session 6: Group presentations Session 7: Financial Crises: Cau...

**Session structure for BEO3001** Session 1: Bank risk management Session 2: FinTech, Blockchain and Banking Session 3: Bank Culture and Governance Session 4: Bank Regulation, Competition and Market Power Session 5: Bank Failures Session 6: Group presentations Session 7: Financial Crises: Causes and Consequences Session 8: Islamic Banking and Finance Session 9: Banking in the Green Economy Session 10: Socially Responsible Investing & Future of Banking Session 11: Final assessment **[1a: Preliminary Notes (5%: Friday - Week 1 \[11:59pm\])]** 150 words excluding references and appendices. Take notes on how you will address key aspects of case study questions. ***[1b: Case Study Group Presentations (15%: Week 2, session 6 in-class)]*** 12-15 minute presentation with 3-4 persons in each group. Upload PowerPoints to dropbox NO LATER than 11:59pm the night before session 6. ***[2: Case Study Group Research Report (30%: Week 3, session 9)]*** 2000 words +/- 10% excluding references and appendices. Upload to assessment dropbox NO LATER than 11:59pm. ***[3: Online in-class assessment (50%: Week 4, session 11)]*** 90 minute test requiring respondus lockdown browser. 15 randomised MCQ (1 mark each) & 3 randomised typed questions (10 marks each). **[BEO3001 SESSION 1:]** **TABLE OF CONTENTS** BEFORE SESSION 1: VIDEO IN RISK MANAGEMENT IN BANKING........................................................................3 IN CLASS ACTIVITIES SESSION 1: BANK RISK MANAGEMENT..............................................................................4 **CREDIT RISK**.........................................................................................................................................4 **MARKET RISK**.......................................................................................................................................6 **OPERATIONAL RISK**.............................................................................................................................6 **LIQUIDITY RISK**.....................................................................................................................................9 **INSOLVENCY RISK**..............................................................................................................................10 **SUMMARY**...........................................................................................................................................11 READINGS.............................................................................................................................................11 **Before session 1: Video in Risk Management in Banking.** ========================================================== Definition of risk as probability of negative occurrences. \- In finance, risk relates to actual vs. expected investment returns. \- Banks face various risks: credit, operational, foreign exchange, interest rate, market, liquidity. \- Post-financial crisis, risk management gained attention from supervisory bodies. \- Importance of a risk management framework for banks to manage key risks. \- Risk treatment methods: avoidance, reduction, transfer, retention. \- Efficient risk management is crucial for banks in competitive environments. \- Future banking success relies on sound risk management systems. Risk is generally known as a probability or threat of damage, injury, liability, loss, or any other negative occurrence that is caused by external or internal vulnerabilities, and that may be avoided through pre-emptive action. In finance, risk is specifically defined as the probability that an actual return on an investment will be lower than the expected return. The risk exposure of a bank is driven by its core strategic profile. The risks faced by a bank are categorized into several types: credit risk, operational risk, foreign exchange risk, interest rate risk, market risk, and liquidity risk. In recent years, particularly following the global financial crisis, risk management issues have garnered increasing attention from international supervisory bodies. A bank must establish a risk management framework to provide a coherent foundation for the effective management of key risks. This framework should identify emerging risks to the bank\'s capital, mitigate these risks in a timely manner, and maintain satisfactory capital levels. The risk management framework encompasses risk management governance, risk culture, risk appetite, and risk management architecture. Management should appropriately address the risks faced by banks. The treatment of these risks includes risk avoidance, risk reduction, risk transfer, and risk retention. The ultimate objective should be to bring the residual risk within the bank\'s risk appetite framework. Banks should manage risk efficiently to survive in a highly competitive environment. In an uncertain world, the future of banking will depend on a sound risk management system. Only those banks that possess a robust risk management system will be able to survive in the market in the long run. **In class activities session 1: Bank Risk Management** ======================================================= **Learning Outcomes** With respect to learning outcomes, you should be able to: a. Evaluate the significance of pillar one risks (credit, market and operational) on bank activities; b. Understanding liquidity risk as a source of bank failure; c. Understanding insolvency risk as a source of bank failure *Credit Risk* ------------- - Credit risk is the biggest bank risk. It occurs when borrowers or counterparties fail to meet contractual obligations (e.g. default on a principal or interest payment of a loan). ### **Individual Loans** - A key role of banks involves screening and monitoring loan applicants. ### **Loan Portfolios** - A high concentration of loans in the same industry increases credit risk. Thus, need to set concentration limits. ### Activity 1: Credit Risk Borrowers seek funds from banks for business or personal needs. \- Banks lend money after credit assessment; borrowers repay with interest. \- Credit risk arises when borrowers fail to repay loans as agreed. \- Forms of credit risk include non-repayment and default on obligations. \- Credit risk has transaction risk and portfolio risk components. \- Internal factors are bank-specific; external factors include economic conditions. \- Banks manage credit risk through proactive policies and diversified portfolios. \- Credit risk management includes organizational structure and credit strategies. \- Standardized credit processes involve assessment, approval, and monitoring. \- Timely remedial actions and provisioning are essential for managing credit risk. A person or an institution, referred to as a borrower, may need money for conducting business or meeting personal needs. In such cases, the borrower approaches a bank for financial assistance. The bank lends money to the borrower after conducting a credit assessment. After some time, the borrower is expected to repay the loan to the bank along with interest. However, some borrowers may fail to repay the bank according to the agreed terms, which introduces the concept of credit risk. Credit risk in a bank can manifest in various forms, including non-repayment of interest on loans or the principal amount. It can also arise from the inability to meet contingent liabilities, such as letters of credit or guarantees issued by the bank on behalf of the client. Other forms of credit risk include defaults by counterparties in treasury operations, failure to meet settlement obligations in security trading, defaults in foreign exchange transactions related to cross-border obligations, and defaults due to restrictions on remittances out of the country. Credit risk comprises two main components: transaction risk and portfolio risk. Transaction risk is further divided into the risk of default and the risk of a borrower being downgraded due to delayed payments or other criteria. Portfolio risk includes concentration risk, which refers to banks taking on exposure to certain industries, and intrinsic risk, which is the risk inherent in an activity due to the operating environment. Two primary factors affect credit risk: internal factors, which are specific to the bank, and external factors, which encompass the state of the economy, fiscal deficit size, inflation, internal trade, and capital markets. Banks implement various practices to manage these credit risk factors. Internal factors are managed through proactive loan policies, high-quality credit analysis, loan monitoring, remedial actions, a sound credit culture, strong monitoring and internal control systems, and clear delegation and accountability. External factors are managed by maintaining a diversified loan portfolio, employing scientific credit appraisal methods to assess the financial and commercial viability of loan proposals, and establishing norms for single and group borrowers as well as sectoral deployment of funds. Credit risk management practices adopted by banks include developing an appropriate organizational structure, formulating credit risk strategies, policies, and procedures tailored to the bank\'s needs, and setting credit limits and indicators. Standardized credit granting processes are essential, which include robust credit assessment, review, approval, disbursement, and administration. Developing an internal credit risk assessment and rating system is crucial for making credit decisions based on ratings. Continuous credit risk monitoring is necessary to enhance credit performance within the bank, along with taking remedial actions and initiating recovery processes for deteriorating credits and problem loans. Timely provisioning processes and the allocation of necessary capital charges are also vital components of effective credit risk management. #### Of the six options, which is typically the most common form for credit risk? - Default due to restrictions on remittances - Non-settlement of security trading terms - Inability to meet contractual obligations (e.g. letter of credit) - Non-repayment of the interest or loan principal: Correct answer. - Default of cross-border obligations - Default on Treasury operations obligations #### What is meant by a 'bank's inherent risk'? A bank's inherent risk refers to the natural level of risk that exists within its operations, independent of any internal controls or risk management efforts. It represents the baseline exposure to potential financial losses that a bank faces due to factors like lending activities, economic conditions, and industry concentration. In the context of credit risk, inherent risk includes the possibility of borrowers defaulting on loans, delays in repayments, and risks associated with specific economic sectors or activities in which the bank is involved. Inherent risk is considered before any mitigating actions, such as credit assessments or portfolio diversification, are applied. Bank credit risk monitoring. Record notes below. Your group may be called upon to provide a 2 minute synopsis as to how banks monitor credit risk. Banks monitor credit risk through a combination of systematic processes and tools aimed at assessing, controlling, and mitigating potential defaults or delayed payments. Key methods include: 1. **Credit Risk Assessment and Rating Systems:** Banks assign internal ratings to borrowers based on their financial health, creditworthiness, and ability to repay. These ratings help identify high-risk clients. 2. **Loan Monitoring:** Banks regularly review and monitor loan portfolios to track the repayment status of borrowers. This includes reviewing financial statements, conducting site visits, and checking market conditions affecting borrowers. 3. **Early Warning Systems**: Banks use data analytics and monitoring systems to detect early signs of credit deterioration. Factors such as late payments or declining borrower financial health are red flags. 4. **Stress Testing:** Banks simulate various economic scenarios (e.g., recession or market downturns) to evaluate how their credit portfolios would perform under adverse conditions. 5. **Credit Limits and Exposure Monitoring:** Limits are set on the amount a bank can lend to a single borrower or sector. Regular checks ensure these limits aren't exceeded, reducing concentration risk. 6. **Diversification of Loan Portfolio:** By spreading loans across industries and geographic regions, banks reduce the impact of defaults within any specific sector. 7. **Regular Reviews and Audits:** Independent internal audits assess whether credit risk policies and procedures are effectively implemented, providing an additional layer of monitoring. 8. **Provisioning for Bad Loans:** Banks monitor the likelihood of defaults and set aside capital (provisions) for potential loan losses based on the level of credit risk associated with different loans. 9. **Remedial Action for Deteriorating Loans:** When early signs of credit issues are detected, banks initiate recovery strategies, such as restructuring loans or enhancing collateral requirements. These combined efforts help banks stay proactive in identifying and managing credit risk. *Market Risk* ------------- Market risk mostly occurs from a bank's activities in capital markets or trading. By trading securities, banks take positions in the market. - This exposes them to adverse market movements (e.g. bond prices and changes in yield). Banks can measure their exposure to market risk (e.g. DEaR, VaR, etc.) Banks continually revise their estimate of market risk. - If market exposure is excessive, can offset risk via trading positions such as a futures contract. *Operational Risk* ------------------ Operational risk is the loss due to errors, interruptions, or damages caused by people, systems, or processes. - Typically low for simple business operations such as retail banking and asset management. - Losses occur due to human error such as internal fraud. - (e.g. employee siphons funds from bank's corporate accounts \[ING Australia: \$45 million\]). External fraud occurs via breaching a bank's cybersecurity. - (e.g. hackers steal customer information & money from the bank). - Banks lose capital and trust from customers. ### Activity 2: Operational Risk Risks are inherent in any kind of business, including banking. Risks and uncertainties form an integral part of banking industry, which by nature entails taking risks. Operational risk is perhaps one of the most significant components of risk faced by banks. According to Basel Committee on Banking Supervision, operational risk results from inadequate or failed internal processes, people, systems and external events. Examples of operational risks a risk of loss arising from various types of human or technical error business interruption by riots risk of fraud by employees unauthorized transaction by employees hacking bank system by outsider etcetera. Some of the banks and financial institutions lost their existence in the past whilst others have undergone major transformations as a consequence of operational risk events. For example, Barings bank collapsed in 1995 due to loss amount exceeding us dollar one 4 billion incurred as a consequence of action of a single rogue trader. Sauciate general lost over us dollar 7 billion during 2007 to 2008 due to unauthorized trading activities of another rogue trader. Basel Committee on Banking supervision requires banks to classify operational risk under seven event types, which internal fraud external fraud, employment practices and workplace safety clients, products and business practices damage to physical assets business disruption and system failures and execution delivery and process management and eight business lines which corporate finance, trading and sales retail banking, commercial banking, payment and settlement agency services, asset management and retail brokerage. Banks classify and report operational risks under seven events and eight business lines. Accordingly, out of three pillars of Basel II, the capital adequacy requirements pillar sets out minimum capital requirement for credit risk, market risk and operational risk. Capital charge for operational risk has been prescribed under three distinct basic indicator approach, standardized approach and advanced measurement approaches. The first two approaches are also called top-down approach whilst the last approach is called bottom up approach. Advanced measurement approaches are classified into internal measurement approach, scorecard approach and loss distribution approach. The quantification of operational risk is difficult as it is difficult to build a clear mathematical or statistical link between individual risk factors and the likelihood of a loss, so banks generally assess this risk based on its likelihood and significance. Likelihood is further classified into five rare, unlikely, possible, likely and certain significance is classified into insignificant, minor, significant, major and catastrophic operational risk. Heat maps are created to give readily accessible and visual representation of the risk profile of a bank or business unit. The heat map shows low risk as represented by green color, moderate risk represented by yellow color, high risk represented by light red colour and extreme risk represented by dark red color. The heat map helps management to concentrate more on high risk areas. Whenever there is operational risk, we need to look back its cause as well as potential impact. If the impact is significant, we need to mitigate the risk. Operational risk is mitigated by designing effective controls. The control could be preventive, detective corrective and directive. #### Are rogue traders a sign of poor bank governance? Why/why not? Yes, rogue traders are often a sign of poor bank governance. Rogue trading typically occurs when a trader engages in unauthorised and high-risk transactions, sometimes to cover losses or exploit weaknesses in the system. Several factors point to poor governance in such cases: 1. **Lack of Oversight**: Effective governance requires robust oversight mechanisms to monitor traders' activities. Rogue trading incidents often reveal gaps in supervision, where management fails to detect irregularities or risks in trading behaviour in time. 2. **Weak Internal Controls**: Banks with poor governance may lack strong internal controls, such as checks and balances or segregation of duties, which are critical to preventing unauthorised transactions and fraud. 3. **Inadequate Risk Management**: Rogue trading thrives in environments with weak risk management frameworks. If a bank fails to enforce risk limits or adequately monitor financial exposures, traders may take excessive risks without repercussions. 4. **Cultural and Ethical Failures**: In some cases, rogue traders operate in environments where ethical behaviour is not emphasised, or the culture rewards risk-taking over compliance. This reflects a failure in governance to cultivate a responsible and ethical working environment. 5. **Failure in Reporting Mechanisms**: Poor governance may include ineffective reporting systems, where risk and irregularities are not communicated to senior management or flagged through automated systems, allowing rogue activities to go unchecked. Thus, rogue traders expose serious flaws in governance, internal controls, and risk management within the banking system. However, isolated incidents do not always mean systemic failure, but repeated or significant rogue trading points to fundamental weaknesses in the institution's governance. #### Under Basel II, what was the minimum total capital requirement? - 10% - **8%. Correct answer.** - 2% - 6% - 4% #### Spend the next 5 minutes researching the 4 supervisory stances for APRA relating to likelihood (i.e., probability) and significance (i.e., impact). Record your notes here. Your group may be called upon to provide a 2 minute synopsis on this. APRA\'s supervisory stances for assessing institutions are designed to evaluate both the probability (likelihood) and the impact (significance) of potential risks within regulated entities. Under APRA\'s Supervision Risk and Intensity (SRI) model, these stances categorize risks based on how likely they are to occur and their possible effects on the financial system. 1. **Likelihood (Probability)**: APRA evaluates the likelihood of an adverse event occurring, such as financial mismanagement or non-compliance. This likelihood is measured based on historical data, control frameworks, and risk management systems in place. 2. **Significance (Impact)**: The significance focuses on how severe the consequences of these risks could be. It considers financial exposure, reputational damage, and the potential for systemic disruption within Australia\'s broader financial landscape. APRA uses a tiered model, adjusting its level of intervention based on these evaluations. If an institution is assessed as having high risk in both likelihood and significance, APRA\'s supervisory stance will be more intrusive and proactive. Conversely, if risks are deemed low, supervision will be less intense​ ### ACTIVITY 3: BANK CYBER ATTACK In groups, read the case study 'Cyberattack at Cosmos Bank: Regaining Customer Trust' pp. 3-12 (Access through VU Collaborate) and answer the following case study questions: - **Question 1:** Discuss the impact of the cyberattack incident on Cosmos Bank? - **Question 2:** Assess the main challenges faced by banks posed by cyber terrorism. - **Question 3:** Examine the strategies implemented by Cosmos Bank management to regain customer trust in the aftermath of the cyberattack. #### Question 1: Discuss the impact of the cyberattack incident on Cosmos Bank. The 2018 cyberattack on Cosmos Bank had far-reaching consequences, both financially and reputationally. Hackers infiltrated the bank's systems using malware to manipulate the SWIFT payment system and ATM switches, resulting in a coordinated withdrawal of ₹94.42 crore from 28 countries. This breach exposed serious cybersecurity flaws in the bank\'s infrastructure, leading to substantial financial loss. Beyond the monetary impact, the attack severely damaged the bank\'s reputation, eroding customer confidence in its ability to protect sensitive financial information. The breach also prompted heightened scrutiny from regulatory bodies, adding operational challenges in terms of compliance and reporting. #### Question 2: Assess the main challenges faced by banks posed by cyber terrorism. Banks are increasingly targeted by cyber terrorists due to the high-value information and assets they manage. One of the main challenges is the constant evolution of cyber threats, requiring banks to continuously update their cybersecurity frameworks to prevent breaches. Many financial institutions operate on outdated legacy systems, which can be particularly vulnerable to sophisticated attacks. The global nature of banking further complicates security, as cross-border transactions are often exploited by hackers. Additionally, banks face the challenge of ensuring compliance with stringent regulatory standards while maintaining user-friendly services. The threat of reputational damage, financial losses, and potential legal repercussions makes cyber terrorism one of the most pressing concerns in modern banking. #### Question 3: Examine the strategies implemented by Cosmos Bank management to regain customer trust in the aftermath of the cyberattack. In the aftermath of the cyberattack, Cosmos Bank employed a multi-pronged approach to restore customer trust. The bank prioritised enhancing its cybersecurity framework by deploying advanced IT security systems and conducting thorough audits to identify vulnerabilities. Furthermore, they collaborated closely with law enforcement and cybersecurity experts to track down the attackers and ensure justice. Cosmos Bank also ensured transparency in its communication with customers by providing regular updates about their recovery efforts and offering assurances that no customer funds were permanently lost. Compensation for affected customers and stronger customer support services were also rolled out to mitigate the negative impact and restore faith in the bank's security systems. *Liquidity Risk* ---------------- Liquidity risk refers to the ability of a bank to access cash to meet funding obligations. - (e.g. allowing customers to take out their deposits). Inability to provide cash in a timely manner to customers can result in a snowball effect. - (e.g. can lead to a bank run). Liquidity problems include: - over-reliance on short-term sources of funds, - having a balance sheet concentrated in illiquid assets, - loss of confidence in the bank on the part of customers, - mismanagement of asset-liability duration. ### ACTIVITY 4: LIQUIDITY RISK  One of the important scopes of asset liability management is management of liquidity risk. Measuring and managing liquidity needs are vital for effective operation of banks and financial institutions. In a bank, maturity terms of assets and liabilities generally will not match. This creates a liquidity gap. If the gap is positive, there will be no risk to the bank. However, there will be opportunity loss of excess funds being utilized for earning returns. On the other hand, if this gap is negative, it creates a risk to the bank. Banks compute maturity profile of assets and liabilities divided into different time buckets. The time buckets may be distributed into 1 90 days, 91 180 days, 181 270 days, 271 365 days, and over 1 year. Within each time bucket, there could be mismatches depending on cache inflows and outflows. Mismatches up to one year, that is, first four buckets, would be relevant since these provide early warning signals of impending liquidity problems. Banks monitor their cumulative mismatches, that is, cumulative net financial assets, across all time buckets by establishing internal prudential limits with the Approval of Asset Liability Management Committee. In case of higher limits, approval of the Board of Directors may be required. Liquidity risk refers to the risk of the bank being unable to meet any of its obligations at any point of time. In the given example, the 91 to 180 days' time bucket shows that there will be a liquidity shortfall, a liquidity gap. The bank will have to either raise funds from an external source before the end of the period or try to liquidate some of the assets falling under next bucket. Liquidity gap analysis helps a bank to manage liquidity risk as well as to plan for future investment. A negative liquidity gap means future fund raising is required whilst a positive gap means future investment is required. The costs of raising funds and returns from utilization of funds can be forecast by the term structure of assets and liabilities of a bank. #### Why does a positive liquidity gap lead to opportunity loss? A positive liquidity gap occurs when a bank\'s assets maturing within a certain time frame exceed its liabilities, meaning the bank has excess funds that are not immediately needed to cover liabilities. This leads to opportunity loss because these excess funds are not being actively utilised to generate returns. Instead of earning interest or profits through investments or loans, the idle funds remain unproductive, resulting in a loss of potential income that could have been gained from more efficient allocation of resources. #### How banks can take advantage of the normal yield curve (i.e., term structure) to help with the bank's bottom line. Record your notes here. Your group may be called upon to provide a 2 minute synopsis on this. Banks can take advantage of a normal yield curve, where long-term interest rates are higher than short-term rates, to enhance their profitability. A key strategy involves borrowing at lower short-term interest rates and lending or investing at higher long-term rates, a practice known as \"maturity transformation.\" For instance, banks can offer short-term deposit products like savings accounts at relatively low interest rates, while providing long-term loans, such as mortgages, at higher interest rates. The difference between the interest earned on loans and the interest paid on deposits -- known as the net interest margin -- directly contributes to the bank's bottom line. By carefully managing the maturity mismatches and liquidity risk associated with this strategy, banks can optimise their profits. However, they need to ensure that market conditions remain favourable and that interest rate changes are monitored to avoid potential risks from sudden shifts in the yield curve. Insolvency Risk --------------- Insolvency risk is when a bank may not have sufficient capital to offset a sudden decline in its asset values relative to its liabilities.  Summary ------- - Screening and monitoring of loans -- as well as loan diversification -- can reduce impact of credit risk. - Market risk can be incurred for their trading portfolios of assets and liabilities if adverse movements in prices occur. - Operational risk refers to risk from day-to-day operations of banks. - Asset and liability management is seen as one way to limit liquidity risk for banks. - Banks face insolvency risk when their overall equity capital is insufficient to withstand the losses they incur. **READINGS** ============ **RISKS OF FINANCIAL INSTITUTIONS** INTRODUCTION A major objective of FI management is to increase the FI\'s returns for its owners. This often comes, however, at the cost of increased risk. This chapter overviews the various risks facing FIs: interest rate risk, credit risk, liquidity risk, foreign exchange risk, country or sovereign risk, market risk, off-balance-sheet risk, technology and operational risk, risk of digital disruption and fintech, and insolvency risk. Table 7-1 presents a brief definition of each of these risks. By the end of this chapter, you will have a basic understanding of the variety and complexity of the risks facing managers of modern FIs. In the remaining chapters of the text, we look at the measurement and management of the most important of these risks in more detail. As will become clear, the effective management of these risks is central to an FI\'s performance. Indeed, it can be argued that the main business of FIs is to manage these risks. **[BEO3001 SESSION 2:]** Contents {#contents.TOCHeading} ======== [**Before session 2 : Video in What is fintech** 15](#before-session-2-video-in-what-is-fintech) [**session 2 : FinTech, Blockchain and Banking** 16](#_Toc180416903) [Financial Technology (FinTech) 16](#financial-technology-fintech) [Evolving Relationship between Fintech Startups and Banks 16](#evolving-relationship-between-fintech-startups-and-banks) [Sectors of Innovative Services 17](#sectors-of-innovative-services) [Distributed Ledger Technology (DLT) 18](#distributed-ledger-technology-dlt) [Banking Business Models 19](#banking-business-models) [Banking Business Models 20](#banking-business-models-1) [Central Bank Digital Currency (CBDC) 21](#central-bank-digital-currency-cbdc) [Summary 23](#summary-1) **Before session 2 : Video in What is fintech** =============================================== If you've ever paid for something with your phone, transferred money using an app or checked your bank statement online, then you're already part of a multi-billion-dollar industry. It's called fintech, and it's changing economies around the world. Fintech is short for financial technology - seems simple, right? Well, the term fintech includes a huge range of products, technologies, and business models that are changing the financial services industry. It refers to everything from cashless payments, to crowdfunding platforms, to robo-advisors, to virtual currencies. So every time you donate to someone's Kickstarter campaign - that's fintech. Or if you transfer money to someone using Venmo - that's also fintech. And that's just the beginning. Here at a major fintech conference in Amsterdam, hundreds of companies are trying to disrupt the banking and finance industries by changing the way we pay and borrow money. And investors are buying it. Global investment in the fintech sector has added up to nearly \$100 billion since 2010. In 2017 alone, fintech investment surged 18%. Startups focusing on payment and lending technologies received the majority of those funds. It's not just startups that are getting into fintech. Some of the world's biggest companies from Apple to Alibaba are going big on it, too. Just think of Apple Pay or Alipay. One reason for all of this investment? Consumers are adopting fintech - fast. One out of every three people across 20 major economies report using at least two fintech services in the last six months China and India are leading the way with more than half of consumers using services like money transfers, financial planning, borrowing and insurance. Financial technology has filled a void for people around the world who don't have access to traditional banking services. In fact, it's estimated nearly two billion people worldwide are without bank accounts. Now, thanks to fintech, all you need is your phone to take out a loan or insurance. Take Kenya, which pioneered a mobile banking system called M-Pesa. Kenyans access their M-Pesa accounts directly on their mobile phones to transfer money, pay bills or take out loans. Today, an estimated 96% of households in Kenya use M-Pesa and one study found it has helped lift roughly 2% of Kenyan households out of extreme poverty. The rise of fintech has forced traditional lenders, insurers and asset managers to embrace new digital technologies. For example, wealth managers now have to compete with robo-advisors - which are automated financial planning services. I mean talk about rise of the robots, right? Thanks to high-tech algorithms, these services are available 24/7 and can be more affordable than traditional asset managers. That helps explain why robo-advisors already have billions of dollars under management. Like any growing industry, fintech isn't without risks. And some regulators have struggled to keep up with the fast pace of innovation. Think of peer-to-peer lending platforms, where individuals borrow and lend without going through a bank. Compared to traditional banks, these services might not be required to set aside as much money in case customers default on their loans. This can be risky for companies and consumers. Data privacy is another major concern. As more financial services go digital, cyber attacks become a bigger risk. The challenges facing financial technology are likely to grow as more and more businesses go digital. But for many of the companies and consumers here - fintech is more than a buzzword. It's a big business opportunity. []{#_Toc180416903.anchor}**session 2 : FinTech, Blockchain and Banking** **Learning Outcomes** With respect to learning outcomes, you should be able to: a. Evaluate the significance of FinTech in the banking sector; b. Understanding blockchain and banking business models; c. Review the future of central bank digital currencies. Financial Technology (FinTech) ------------------------------ Fintech is the combination of finance and technology enabling financial innovation that could result in: - new business banking models, - applications (e.g. mobile banking), - processes (e.g. payment processing), or - products (e.g. payment apps). Emerging digital technologies have generated the disruptive innovation of Fintech. - (e.g.) artificial intelligence, blockchain, big data, cloud computing, etc. ### Evolving Relationship between Fintech Startups and Banks  ### Sectors of Innovative Services #### Activity 1: FinTech & Banking The banking sector has seen a lot of changes in recent years. The integration of fintech has led to improved usability and delivery. The fintech industry is consistently evolving since its origin. The industry has become a game changer since the pandemic caused users to opt for online financial services. With fintech, financial firms are using technologies like blockchain, artificial intelligence, biometrics, and e-commerce to ease the use of their services. They are serving consumers with the best user experience through cashless transactions, mobile wallets, and contactless payments. Fintech can handle issues such as security, cyber crimes, confidentiality, and digital fraud to build trust and loyalty between the company and the consumers. Modern technologies like artificial intelligence and machine learning are making banking easier to use. These technologies will lower the cost of providing multiple financial services up to 22% in the next five years. Users are getting accustomed to using a single platform for multiple services like bill payments, loan procurement, and dmat account handling. As the need for secure payment processes and easy accessibility of transactions keeps increasing, so does the value of fintech serving these demands. It is evident that the future of fintech is bright. Now we only have to see up to what extent the fintech market grows. **Your instructor will allocate one of the five fintech trends to research. Once allocated, spend the next 10 minutes researching that trend. Record your notes below. Your group will be called upon to provide a 2 minute synopsis on this.** Distributed Ledger Technology (DLT) ----------------------------------- - A ledger is a book or collection of accounts in which accounting transactions are recorded. - Banks employ a centralised ledger where they are responsible for maintaining their own records as they are trusted not to distort ledgers. - A distributed ledger is a database held and updated independently by each participant (or node) in a large network. - Blockchain is a particular type of a DLT. #### Group activity 2: Understanding Blockchains Blockchains are very popular nowadays, but what exactly is a blockchain and how does it work? A blockchain is a chain of blocks that stores information. This concept was first introduced in 1991 by a group of researchers to timestamp digital documents in a way that prevents backdating or tampering. However, it didn\'t gain much attention until it was adopted by Satoshi Nakamoto in 2009 to create the digital cryptocurrency Bitcoin. A blockchain is a distributed ledger that is open to everyone. Once data is recorded in a blockchain, it\'s very difficult to change. Each block contains data, the hash of the block, and the hash of the previous block. The data stored in a block depends on the type of blockchain. For example, the Bitcoin blockchain stores transaction details such as sender, receiver, and amount of coins. Blocks are linked together using hashes, which are like fingerprints and uniquely identify each block and its contents. If something in a block is changed, the hash will also change, making it easy to detect any alterations. Additionally, each block contains the hash of the previous block, creating a chain of blocks and ensuring security. To prevent tampering, blockchains use a mechanism called proof-of-work, which slows down the creation of new blocks. In the case of Bitcoin, it takes about 10 minutes to calculate the required proof-of-work and add a new block to the chain. This makes it very difficult to tamper with blocks, as tampering with one block would require recalculating the proof-of-work for all subsequent blocks. Blockchains also rely on being distributed, using a peer-to-peer network where anyone can join. When a new block is created, it is sent to everyone on the network for verification. Each node in the network verifies the block and, if valid, adds it to their blockchain. Consensus is reached among all nodes in the network about which blocks are valid. To tamper with a blockchain successfully, one would need to tamper with all blocks, redo the proof-of-work for each block, and control more than 50% of the peer-to-peer network, making it nearly impossible. Furthermore, blockchains are constantly evolving, with the introduction of smart contracts, which are simple programs stored on the blockchain that can automatically execute exchanges based on certain conditions. The potential uses of blockchain technology have expanded beyond just cryptocurrency, including storing medical records, creating digital notaries, and collecting taxes. **Why is it difficult to change an earlier block in the chain?** **How is decentralisation practiced in the blockchain and why is this important?** Decentralisation in blockchain is practiced by distributing control and verification responsibilities across a peer-to-peer network, where no single entity has full authority over the system. Each participant, known as a node, holds a copy of the entire blockchain and verifies new transactions or blocks independently. When a new block is created, it is broadcast to all nodes in the network for validation, and only if the majority of nodes reach a consensus is the block added to the chain. This consensus mechanism ensures that the blockchain remains secure and trustworthy without relying on a central authority. Decentralisation is important for several reasons: 1. **Enhanced Security**: Since control is spread across many nodes, it becomes extremely difficult for a single party or malicious actor to alter or corrupt the data. To successfully tamper with the blockchain, an attacker would need to control more than 50% of the network, which is both resource-intensive and impractical for most blockchains. 2. **Trustlessness**: Decentralisation eliminates the need for trust in a central authority or intermediary. Instead, participants trust the system and its consensus protocol. This is particularly important for financial systems, where trust issues have historically been a concern. 3. **Transparency**: In a decentralised system, all nodes have access to the same information, making it transparent and reducing the risk of hidden manipulations. This openness builds confidence in the integrity of the blockchain. 4. **Resilience**: Decentralised networks are less vulnerable to outages or failures. If one node goes offline, the rest of the network continues functioning without disruption. This makes the system more robust and reliable compared to centralised systems. Overall, decentralisation is a key feature that underpins the security, transparency, and trustworthiness of blockchain technology. Banking Business Models ----------------------- **Better Bank** - Incumbent banks digitise and modernise to retain the customer relationship and core banking services. **New Bank** - Incumbents cannot survive and replaced by new technology-driven banks that are more cost effective and innovative. - Need to obtain banking licence. **Distributed Bank** - Fragmentation of financial services where consumers use multiple providers. - Banks and fintech companies operate as joint ventures (e.g. Raisin). Banking Business Models ----------------------- **Relegated Bank** - Fintech and bigtech use front-end customer platforms to offer a variety of financial services. - Incumbent banks relegated to risk management and operational processes with no direct customer relationship. **Disintermediated Bank** - Incumbent banks are no longer relevant since: - the need for balance sheet intermediation, or for a trusted third party, is removed. - Banks are displaced by more agile platforms and technologies. - Currently, only limited examples of this exist. - (e.g.) cryptocurrencies, such as Bitcoin, can effect value transfer and payments without the involvement of incumbent banks. #### Activity 3: Neobank Business Model In groups, read the case study 'Chime Neobank: A New Business Model in the Banking Sector'pp. 3-12 (Access through VU Collaborate) and answer the following case study questions: - **Question 1:** Explain how neobanks are able to offer services to consumers denied banking services otherwise. - Neobanks provide services to consumers who may be denied traditional banking services due to several factors, such as a lack of credit history, lower-income levels, or geographic limitations. These digital-only banks often have lower operational costs compared to traditional banks, allowing them to offer services with minimal fees, and in many cases, without requiring a minimum balance. Neobanks use technology and automation to streamline onboarding processes, which can simplify account creation for individuals who may lack certain documentation or who are unable to visit physical branches. Entrepreneurs are venturing into neo banking due to its scalability, the growing reliance on digital banking solutions, and the opportunity to serve underserved market segments, such as gig workers, freelancers, and the unbanked population. - **Question 2:** Why do you think neobanks cannot attract more profitable banking customers, unlike traditional banks? - Neobanks may struggle to attract more profitable banking customers for several reasons. Unlike traditional banks, they do not typically offer a full range of financial services, such as wealth management or business loans, which can be lucrative. Additionally, many neobanks focus on serving lower-income individuals or those with limited credit histories, which may result in lower deposit balances and less profitability. Traditional banks also have established relationships, a broader range of financial products, and a level of trust built over decades, making it harder for neobanks to attract high-value clients who seek more complex financial solutions. Central Bank Digital Currency (CBDC) ------------------------------------ - CBDCs can be regarded as a digital extension of existing forms of central bank money (e.g. notes and coins). - Unlike most cryptocurrencies, value is fixed by central bank and equivalent to fiat currency - 130+ countries exploring CBDC. - Retail CBDCs to be used by business and individuals (e.g. currency in mobile wallet). - To be issued to banks who would then issue to customers. - Can help with financial inclusion and influence monetary policy (e.g. expiration on spending, etc.). #### Activity 4: Central Bank Digital Currency In one of our previous videos, we discussed that central banks were experimenting with their form of digital currencies to counter the tsunami of cryptocurrencies we are currently witnessing. Central banks dislike private decentralized money like bitcoin because they can\'t control its supply, and it threatens the sovereignty of their national currencies. Numerous central banks around the world, from countries like China to Sweden and South Africa to the European Union\'s ECB (European Central Bank), are working on their state-issued CBDCs. So, what exactly are these CBDCs or central bank digital currencies? How will they affect you? Let\'s dive straight in. A CBDC is a digitized version of a domestic currency that\'s equal to physical cash that you and I use or the reserves that your commercial bank holds at the central bank. You might be thinking, \"Wait a minute, my money is already digital - from my payment apps to my bank transfers to my credit cards. We\'re not, after all, physically transferring cash when we pay each other, right?\" Well, these transfers where we pay each other online are account-based debits and credits that are essentially happening between commercial banks. I pay you, my account is debited, your account is credited, and that settlement takes place between our respective banks. These accounts are not stored at the central bank level. Central bank digital currencies, however, are a direct liability of the central bank and are most likely token-based, where these tokens would be represented on a blockchain established by the central bank. Unlike public blockchains like Bitcoin and Ethereum, where the information recorded is available to all, these are private or permissioned blockchains to which only the central bank and the parties it chooses can have access. Now, there are two kinds of CBDCs: wholesale CBDCs that facilitate payments between commercial banks and central banks or entities that hold their accounts with central banks. These have more to do with the infrastructure and the plumbing of the financial system and don\'t affect you and me directly. The other one is retail CBDCs that can be used by businesses as well as people like you and me. Imagine holding currency in your mobile wallet and having the currency directly issued by the central bank. This could have enormous implications for any country. There are so many unbanked or underbanked people in countries like ours and other developing nations around the world. Retail CBDCs could make a strong case for financial inclusion because the central bank could directly transfer funds to the unbanked as long as they have a mobile phone. Imagine funds being transferred for COVID relief and to help people during natural disasters. The central bank could also utilize CBDCs as a tool to influence monetary policy and spur spending to kick-start the economy during recessionary periods. The central bank could theoretically add an expiration date to the money transfer so that people would be compelled to make purchases with that money instead of holding it. This would increase the velocity of money in the economy. The opportunities are plenty, but there are a few risks involved as well. If we could all hold our money with the central bank, why hold money at your neighbourhood branch of a commercial bank? This could lead to a run on your commercial bank and could have grave consequences for the entire banking industry. Now, it\'s doubtful that central banks would want to risk that because a robust banking system is crucial for the financial health of an economy, and central banks aren\'t designed to deal with millions of retail customers. So, the approach is most likely to be two-tiered: issue the CBDC to the banks, who then issue it to the retail customers. This would allow the authorities the room to experiment with this new financial tool without disrupting the entire banking model. Technology is changing money as we know it, so let\'s embrace it with open arms. ***Is the notion of permissioned blockchains a cause for concern?*** Permissioned blockchains in CBDCs raise concerns about **control, privacy, and transparency**. Unlike decentralized systems like Bitcoin, permissioned blockchains are centrally controlled by the government or central bank. This could reduce user autonomy and allow for closer monitoring of transactions, raising **privacy issues**. Additionally, the limited transparency of permissioned systems could lead to **trust concerns**, as central authorities can control or modify information. There\'s also potential for **misuse**, with governments possibly freezing accounts or restricting spending. While they offer **security** and **regulatory control**, these systems may compromise **financial freedom** for users. ***What do you think would be the impact of CBDCs on cryptocurrencies?*** The introduction of Central Bank Digital Currencies (CBDCs) could significantly impact cryptocurrencies in several ways: 1. **Regulatory Scrutiny**: CBDCs may lead to increased government oversight of the cryptocurrency market, resulting in stricter regulations that could affect adoption. 2. **Competition**: CBDCs might compete with cryptocurrencies by offering a stable, government-backed alternative, making them more attractive to consumers. 3. **Market Dynamics**: The launch of CBDCs could reduce demand for certain cryptocurrencies, as users may prefer the reliability of a central bank-backed currency. 4. **Innovation**: CBDCs may stimulate innovation in the cryptocurrency space, prompting developers to enhance features like privacy and scalability. 5. **Public Perception**: The acceptance of CBDCs might change how cryptocurrencies are viewed, potentially leading some users to see them as less necessary. 6. **Integration**: CBDCs could foster collaboration between traditional finance and cryptocurrencies, resulting in hybrid models that leverage the strengths of both systems. Overall, while CBDCs could pose challenges, they may also create opportunities for innovation in the digital financial landscape. Summary ------- - Fintech is the combination of finance and technology enabling financial innovation. - Move from product banking to adaptive banking. - Unlike centralised entries, a distributed ledger is a database held and updated independently by each participant (or node) in a large network. - Blockchain is a particular type of a DLT. - CBDCs can be regarded as a digital extension of existing forms of central bank money. []{#_Toc179545025.anchor}**BEO3001: Session 3:** [**Before session 3 : Video in Features of Effective Corporate Governance Compliance** 21](#_Toc179545025) [**Session 3: Bank Culture and Governance** 22](#session-3-bank-culture-and-governance) [Bank Corporate Governance 22](#bank-corporate-governance) [Main Bank Board Committees 23](#main-bank-board-committees) [Bank Culture 23](#bank-culture) [Bank Culture and Misconduct 24](#bank-culture-and-misconduct) [Summary 24](#summary-2) **Before session 3: Video in Features of Effective Corporate Governance Compliance** ==================================================================================== The compliance function is tasked with assisting senior management, executive management, and business lines and divisions in managing risks associated with regulatory non-compliance, supervising regulatory compliance, and further developing internal controls. Finance, treasury, and HR services are responsible for managing regulatory compliance. Almost all activities involve compliance risk and responsibilities, and the management of risks rests with the business lines and divisions. The president and CEO is responsible for the company\'s compliance activities. Compliance activities and related recommendations issued to the business lines and divisions are regularly reported to the board of directors, often through various committees. Compliance aims to prevent the materialization of compliance risks. The compliance function should prepare and maintain guidelines on key matters related to practices, advise and train employees on these matters, support business lines and divisions in planning development measures for managing compliance risks, and keep senior and executive management informed of upcoming regulatory changes. Additionally, they must monitor the business lines and divisions\' preparation for these changes and supervise compliance with the current regulatory framework, ethical practices, and internal guidelines. The compliance function also regularly reports to senior and executive management on recommendations, control results, and observations related to compliance risk exposure. Now that you understand the compliance role, let\'s recap what you have learned. **Session 3: Bank Culture and Governance** ========================================== **Learning Outcomes** With respect to learning outcomes, you should be able to: a. Evaluate bank corporate governance via the role of board of directors and board committees; b. Understanding bank culture and its impact on bank behaviour; c. Review the importance of bank governance from the point of view of society at large and the financial system. Bank Corporate Governance ------------------------- - Corporate governance is the system of rules, practices and processes by which a firm is directed and controlled. - Governance in banking can occur via: - regulation - market discipline from the bank's shareholders. - Bank ethical behaviour - Bank behaves in a manner that not only complies with the law but also the spirit of regulation. - Banks are subject of stricter regulations because they are responsible for: - protecting the rights of the depositors, - ensuring the stability of the payment system and - reducing systemic risk - Other unique aspects of banks include: - very low capitalisation of banks; - fundamental need for trust; - frequently recurring banking crises; and - banks seen as 'too big to fail' - Basel Committee on Banking Supervision (BCBS) Guidelines Corporate Governance Principles for Banks - 13 major principles for effective bank governance (e.g.) - role of board of directors - role of committees, - compliance, - risk management, - auditing, - compensation (remuneration), - disclosure and transparency. Main Bank Board Committees --------------------------  Bank Culture ------------ - A weak risk culture cannot inhibit excessive risk-taking or poor standards of behaviour. - Inappropriate risk-taking can impact customers and impair trust in the financial system. - Banks are focusing more on developing "safety-oriented" cultures to prevent future risks for the solvency of banks. - Increase stability of the global financial system itself. - Banking culture is carefully examined by bank regulators to foster new ethics of responsibility and prudence. - The governance approach adopted by a firm needs to reflect the culture of the firm. - A sound culture requires that all employees feel responsible for risk issues. - Four groups of indicators to diagnose the soundness of the risk culture in a financial institution: - tone from the top; - accountability; - effective communication and challenge; - incentives. Bank Culture and Misconduct --------------------------- - Misconduct risk is substantially related to banking culture - Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry. - Remuneration system leads to conflicts of interest. - Failure to penalise those for ethically or legally questionable behaviours (i.e., misconduct). - Primary responsibility for misconduct lies with boards and senior management. - Need to pay close attention to culture, governance and remuneration. Summary ------- - Banks are subject of stricter regulations because they are responsible for: - protecting the rights of the depositors, - ensuring the stability of the payment system and - reducing systemic risk - Banking culture can be used to prevent future risks for the solvency of banks and for the stability of the global financial system itself. - Royal Commission found that the primary responsibility for misconduct lies with boards and senior management. **[BEO3001 SESSION 4:]** Contents {#contents-1.TOCHeading} ======== [**Before session 4 : Video in What is fintech** 26](#before-session-4-video-in-what-is-fintech) [**Session 4: Bank Regulation, Competition & Market Power** 27](#_Toc180414211) [Banks and Small Shocks 27](#banks-and-small-shocks) [Why Regulate Banks? 28](#why-regulate-banks) [Regulatory Issue: Too Big To Fail 28](#regulatory-issue-too-big-to-fail) [***Basel III Key Changes*** 29](#basel-iii-key-changes) [Activity 1: bank supervision and regulation 29](#activity-1-bank-supervision-and-regulation) [Bank Regulation & Cyber Risk 30](#bank-regulation-cyber-risk) [Bank Regulation & Stablecoins 30](#bank-regulation-stablecoins) [Future of Regulation? 30](#future-of-regulation) [Bank Competition 31](#bank-competition) [***Bank Market Power*** 31](#bank-market-power) [Summary 32](#summary-3) **Before session 4 : Video in What is fintech** =============================================== Hi, I\'m Sebastian. And I\'m Helena. We work for the Federal Reserve, the central bank of the United States. One of the five key functions of the Federal Reserve is to supervise and regulate banks and other financial institutions to ensure they operate safely. While we all rely on these institutions for traditional services like savings and checking accounts, credit cards, and loans, they also play an increasingly complex role in the broader economy. That\'s why the Fed, along with other regulatory agencies, has the responsibility to supervise and regulate these entities, which range from small community banks to some of the largest and most recognized financial institutions in the nation and the world. The operations, activities, and characteristics of financial institutions have evolved and expanded tremendously over the years, and so has the Fed\'s approach to ensuring they operate safely. The Fed monitors this changing banking landscape through both a wide and narrow lens. It monitors the financial system as a whole for its broader impact on the US economy, paying close attention to how financial institutions interact with each other and public institutions, including governments participating in our economy. For more than a hundred years, the Fed has supervised and regulated the operations of individual institutions, ensuring they are safe, sound, and following the laws and regulations established by Congress and regulators like the Fed. The Fed sends examiners into a supervised bank to check that it's operating safely, testing whether it has enough capital to cover risks from the loans it has made. The Fed tailors its bank exams depending on the size of the institution and the potential impact on the financial system and economy. The largest global banks and the smallest community banks are treated differently. The largest banks have received greater attention since the financial crisis of 2007 to 2009 when many large financial institutions either failed or were on the brink of failure, contributing to a global economic downturn. When the Fed finds evidence that an institution hasn't followed laws or regulations, it requires the problem to be fixed and may issue penalties. If trends or recurring activities are noticed across the financial system, the Fed may enact new regulations that apply more broadly. In the end, these efforts help ensure that banks and the financial system support the US economy and serve the public, so our communities, households, and businesses remain vibrant and growing. []{#_Toc180414211.anchor}**Session 4: Bank Regulation, Competition & Market Power** **Learning Outcomes** With respect to learning outcomes, you should be able to: a. Understand why banks are regulated and key Basel III requirements b. Determine the regulatory stance on cyber risk and cryptocurrency; c. Review the importance of the effects of bank competition and market power on consumers and regulatory bodies. Banks and Small Shocks ---------------------- - A small shock can have devastating effects on a bank. - Leverage (Debt relative to Equity on the liability side) amplifies shocks - Amplification of small shocks. Why Regulate Banks? ------------------- - Bankruptcy filings in Australia - 6,070 in previous 12 months (zero banks) - Banks regulate because: - Negative Externalities (bank runs) - Information Asymmetry (predatory behaviour) - Three-sided bank regulation approach: - Asset side (Volcker rule; Consumer protection laws) - Liability side (Capital; Liquidity) - Other (e.g. Cyber & FinTech) Regulatory Issue: Too Big To Fail --------------------------------- - Financial regulators are reluctant to allow a big bank to fail. - Big banks expect their Central Banks to provide support if they are in danger of failing. - Governments *implicitly* promise full bailout of the largest institutions. - A major bank with a government safety net will act differently to those without one. - This creates a 'two-tiered' banking industry. - Adds to the temptation of the largest banks to 'gamble', thereby increasing moral hazard incentives. ***Basel III Key Changes*** --------------------------- - **Changes to capital requirements** - New Tier 1 capital requirement to 6% from 4% - Introduced *mandatory* capital conservation buffer of 2.5% - Introduced *discretionary* capital buffer of 2.5% - **Introduction of a supplementary leverage ratio (SLR)** - Banks to maintain a 3% ratio of Tier 1 capital to total assets. - **Introduction of the liquidity ratios (LCR)** - Banks to hold sufficient high quality liquid assets (HQLA) to cover total net cash outflows over 30 days. - Banks had to increase their stable sources of funding. ### Activity 1: bank supervision and regulation There are all kinds of businesses in our economy, and they all have one thing in common: they want to earn money to run operations, provide services, and offer a return for their owners. A bank is no different. Banks earn money by lending to community members who can repay, charging them interest. This is the main way banks remain profitable and healthy. The Fed wants to ensure banks stay healthy because the healthier the banks, the healthier the economy and the communities they serve. Since the 2008 financial crisis, the Fed and other supervisors have conducted stress tests on the largest financial institutions to ensure they have enough capital to withstand downturns. The Fed now looks at risk across multiple banks, not just individual ones, to ensure the financial system remains resilient. This approach, called macro-prudential regulation, strengthens the financial system against systemic shocks. To ensure safety, the Fed requires banks to keep a percentage of deposits as reserves and sends examiners to inspect banks. They ask key questions like whether the bank makes sound investments, follows safe banking rules, and takes care of depositors\' money. Examiners use reports like Bank Call Reports and the Camels Rating system, assessing components such as capital adequacy, asset quality, management, earnings, liquidity, and sensitivity to risk. Banks receive a confidential rating from 1 to 5. Poorly rated banks undergo further examination, guidance, and, in severe cases, can be shut down. However, depositors are protected up to \$250,000 by the FDIC. The Fed also ensures fair lending practices through Consumer Compliance, making sure loans are judged based on the ability to repay, not factors like race or religion. They ensure compliance with consumer protection laws and investigate complaints to keep banking safe and communities thriving. how the Australian Prudential Regulation Authority (APRA) supervises and monitors Australian banks with a focus on the Supervision Risk & Intensity (SRI) Model, specifically the  Rating Scale and Staging. Your group may be called upon to provide a 3-4 minute synopsis on this. For your synopsis on how the Australian Prudential Regulation Authority (APRA) supervises and monitors Australian banks using the Supervision Risk & Intensity (SRI) Model, here\'s a brief overview that you can use: APRA\'s supervision of Australian banks centres on its Supervision Risk & Intensity (SRI) Model, which aims to proactively assess and address risks. The SRI Model incorporates a Rating Scale and Staging framework to evaluate the financial health, governance, and risk management of banks. **Rating Scale**: Banks are rated on a scale that measures their risk level across various dimensions such as financial soundness, internal controls, and governance. Each institution is assigned a rating that indicates its relative risk, which helps APRA determine the intensity of its supervisory activities. **Staging**: This aspect of the model involves categorising banks into different stages based on their risk profiles. Institutions facing higher risks or exhibiting signs of distress are placed in more advanced stages, triggering closer scrutiny and intervention by APRA. Conversely, banks with a lower risk profile undergo less intensive supervision. The combination of the Rating Scale and Staging ensures that APRA\'s resources are focused on banks that pose the greatest potential threat to the stability of the financial system, allowing for targeted, efficient supervision. Through this model, APRA is able to maintain a robust banking sector, promoting financial stability across Australia. Bank Regulation & Cyber Risk ---------------------------- - APRA directly supervises around 680 financial institutions - However, there are approx. 17,000 interconnected entities. - Number and severity of cybersecurity incidents continues to increase - Approx. 55% of reported data breaches are malicious. - Banks and regulators are focusing on cyber resilience - APRA launched its Cyber Security Strategy in 2020. - The borderless nature of cyber risks requires global regulatory coordination. Bank Regulation & Stablecoins ----------------------------- - Digital Assets (Market Regulation) Bill 2023 - Stablecoins are a form of crypto-asset designed to maintain a stable value relative to a fiat currency or a commodity. - Regulating 'payment stablecoins' are a priority. - Potential to become widely used as a means of payment (i.e., medium of exchange) and a store of value in the economy. - Focus is on incorporating payment stablecoins into the proposed regulatory framework for stored-value facilities. Future of Regulation? --------------------- - Regulation is likely to move towards supervising the technology and its application. - Need to focus on delivery of banking and payment services that will become embedded in a service or experience. - Can be provided by a financial institution or a company operating outside of the regulatory perimeter. - Belief that new 'regtech' tools, powered by AI should enable more efficient and effective supervision. - Regulators can use these technologies to share information with one another (both nationally and internationally) to combat financial crime. Bank Competition ---------------- - Bank competition can support financial stability. - Prevents excessive concentration in the financial system. - Competition is a method to reduce the incentives for excessive risk taking by financial providers. - Can remove the 'too big to fail' concept. - Competition can also deliver: - More consumer-oriented products. - Lower interest rates in the economy which should reduce the risk of borrower default. - Regulators fear that strong competition could erode standards of prudent conduct - Banks make higher lending risks to maintain profitability - Can come at a cost to system-wide stability. - APRA goal is for financial system stability - However, need to ensure competition is not eroded by having stability as the default regulatory position.  ***Bank Market Power*** ----------------------- - Big-4 banks have a high concentration of market power - In 2024, it accounts for between 75%-80% of market share - For comparison: Germany, US and UK approx. 40% - Big-4 banks market power has structural advantages - Do not have to compete vigorously on interest rates. - Results in poor consumer outcomes in Australia. - Enabled them to remain highly profitable during contractionary periods. - Have lower operating costs, including lower costs of funds. - Rod Sims -- Former Chairman (ACCC): - "A cosy banking oligopoly is surely at the heart of recent problems, so we must and will find ways to get more effective competition in banking." - Smaller banks and other financial institutions tend to behave as market 'followers'. - Results in prices tending to cluster and reflecting the costs of the *least* efficient major bank. - Service competition is more apparent than price competition in banking. Summary ------- - Banks regulate due to negative Externalities (bank runs) and information asymmetry (predatory behaviour). - Three-sided bank regulation approach: (i) Asset side; (ii) Liability side (Capital; Liquidity); and (iii) Other (Cyber; FinTech, Climate risk). - Bank competition is a method to reduce the incentives for excessive risk taking by financial providers. - Smaller banks tend to behave as market 'followers' when faced with banks that have high market power. []{#_Toc180414223.anchor}**BEO3001: Session 5** [**BEO3001: Session 5** 32](#_Toc180414223) [**Session 3: Bank Failures** 33](#session-3-bank-failures) [Bank Connectedness 33](#bank-connectedness) [History of Major Bank Failures until 1930s 33](#history-of-major-bank-failures-until-1930s) [Major Bank Failures & the Great Recession (GFC) 34](#major-bank-failures-the-great-recession-gfc) [Main Causes of Bank Failures -- Bank Run 34](#main-causes-of-bank-failures-bank-run) [Bank Failures: 2001-2020 34](#bank-failures-2001-2020) [Recent Bank Failures 34](#recent-bank-failures) [Concentrated Deposits 35](#concentrated-deposits) [Large Valuation Losses on Securities Holdings 35](#large-valuation-losses-on-securities-holdings) [Regulation and Supervision Impact 35](#regulation-and-supervision-impact) [Characteristics of Recent Bank Failures 36](#characteristics-of-recent-bank-failures) [U.S. Bank Failures: 2001-2023 36](#u.s.-bank-failures-2001-2023) [Summary 36](#summary-4) **Session 3: Bank Failures** ============================ **Learning Outcomes** With respect to learning outcomes, you should be able to: a. Gain an understanding of bank connectedness and previous major bank failures; b. Review the main causes of bank failure; c. Examine the causes and impacts of recent bank failures. Bank Connectedness ------------------ - Bank failure is considered more important than other business failures due to their interconnectedness. - Direct connectedness: - interbank lending, - interbank deposits, - trading with each other in derivatives markets - RBA study found that over 50% of ADI exposure is to Big 4 Banks. - Indirect connectedness: - making loans to the same borrowers, - holding similar portfolios of assets. - Connectedness increases the risk of financial contagion. - Financial difficulties at one bank spill over to a large number of other banks - Contagion evident in credit bubbles and financial crises. - Bankruptcy of Lehman Brothers quickly spread to other financial institutions - Exposed numerous connections throughout the financial system. - Bank Term Funding Program (BTFP) created in March 2023 - Followed collapse of SVB to prevent financial contagion. History of Major Bank Failures until 1930s ------------------------------------------ - One of the earliest bank failures occurred with the Second Bank of the United States in 1821. - As customers lost their deposits, it led to a bank panic. - Three other bank panics occurred prior to the onset of the Great Depression of 1929. - In late 1930, unprecedented bank runs occurred in the US. - Resulted in the failure of approx. 9,000 banks throughout the 1930s. - Consequently, the FDIC guaranteed deposits in the event of a bank failure (up to a certain limit). - Some felt that bank runs would no longer pose a major threat to the U.S. banking system. Major Bank Failures & the Great Recession (GFC) ----------------------------------------------- - Years of cheap credit and excessive risk taking eventually led to the great recession (GFC). - Many banks incurred large losses as customers began defaulting on their mortgage repayments. - Banks were overly exposed to the real estate sector - More than 500 banks failed between 2008 and 2015, compared to a total of 25 in the preceding seven years.  - Insured deposits were safe. ### Main Causes of Bank Failures -- Bank Run - A bank run occurs when a large group of depositors withdraw their money from banks at the same time. - Based on fears that the institution will fail. - Banks use up their cash reserves and end up in default. - Bank runs and the 2008 financial crisis. - (e.g.) Washington Mutual - Customers withdrew \$16.7 billion in 9 days. - (e.g.) Wachovia Bank - Depositors withdrew more than \$15 billion over a two-week period. - 'Silent' run of \$5 billion in one day. - The market value of the bank\'s assets falls below the market value of the bank\'s liabilities. - (e.g.) A bank loses too much on its investment and/or loans. - Sudden declines in the asset value might mean that a bank does not have sufficient capital to cover these losses. - Consequently, it can not meet their obligations to creditors and depositors. - The bank then become insolvent. Bank Failures: 2001-2020 ------------------------ - There were 561 bank failures between 2001 and 2020. - The largest bank failure in U.S. history was Washington Mutual Bank (\$307 billion in assets and \$188 billion in deposits). - Most depository institutions that failed were relatively small banks, with a large majority having less than \$1 billion in deposits. - Post GFC, the Dodd-Frank Act (2010) was enacted to reform the financial regulatory system. - The act permanently increased the deposit insurance limit from \$100,000 to \$250,000. - Stricter regulations for banks with at least \$50 billion in assets. Recent Bank Failures -------------------- - Three U.S. banks failed in March 2023 a. Silvergate Bank b. Signature Bank c. Silicon Valley Bank - The bank failures were triggered by similar vulnerabilities d. Concentrated deposits e. Large valuation losses on securities holdings f. Poor risk management and less stringent regulation and supervision Concentrated Deposits ------------------------------------------- Large Valuation Losses on Securities Holdings --------------------------------------------- Regulation and Supervision Impact --------------------------------- - The three U.S. banks were below the \$250 billion asset threshold to be considered systemically important. - Subject to less stringent regulatory and supervisory requirements due to rollback of Dodd-Frank Act. - There have been limited flow-on effects to Australian banks from recent events in the United States and Europe. - All Australian banks are held to high liquidity and capital standards, and are closely monitored by APRA. - APRA requires all banks to hold additional liquidity or capital if it has concerns about their risk profile or risk management quality. Characteristics of Recent Bank Failures --------------------------------------- - Three of the four largest bank failures occurred in 2023. - Three bank losses greater than (see next slide): - 25 that failed in 2008, - 140 in 2009, - 157 in 2010. - Interestingly, the three are considered smaller banks. U.S. Bank Failures: 2001-2023 ----------------------------- Summary ------- - Bank failure is considered more important than other business failures due to their interconnectedness. - A bank run occurs when a large group of depositors withdraw their money from banks at the same time. - The most common cause of bank failure is when the value of the bank\'s assets falls below the market value of the bank\'s liabilities. - The recent bank failures were triggered by similar vulnerabilities. []{#_Toc180416947.anchor}**BEO3001: Session 7** [**BEO3001: Session 7** 39](#_Toc180416947) [**Session 3: Financial Crises: Causes and Consequences** 39](#session-7-financial-crises-causes-and-consequences) [Asset Price Boom: Nature of Participants 39](#asset-price-boom-nature-of-participants) [Basis for Bubble Formation 40](#basis-for-bubble-formation) [Mathematics of a Rise and Fall 40](#mathematics-of-a-rise-and-fall) [The Boom-Bust Cycle 40](#the-boom-bust-cycle) [S&P 500 Bear Markets 40](#sp-500-bear-markets) [Financial Crises 41](#financial-crises) [The Great Lockdown 41](#the-great-lockdown) [To Intervene or Not to Intervene? 41](#to-intervene-or-not-to-intervene) [Non-intervention 41](#non-intervention) [Intervention 41](#intervention) [Why Do Financial Crises Re-occur? 42](#why-do-financial-crises-re-occur) [Summary 42](#summary-5) **Session 7: Financial Crises: Causes and Consequences** ======================================================== **Learning Outcomes** With respect to learning outcomes, you should be able to: - Review the main causes of financial crises; - Gain an understanding of historical financial crises; - Examine the impacts of recent financial crises. Asset Price Boom: Nature of Participants ---------------------------------------- - Asset price bubbles occur when market prices are far higher than fundamentals would suggest. - Sign of market inefficiency. - Two types of participants in these booms - True believers: Expect the market to stay up and go up, perhaps indefinitely. - Astute speculators: Aware of the speculative mood of the moment and the likelihood that it will come to an end. - The nature of speculative booms involves an inevitable, and sudden, decisive collapse. Basis for Bubble Formation -------------------------- - The basis for a bubble formation include, but not limited, to: i. Exogenous shocks ii. New technology iii. Domino effect (bubble contagion) iv. Money supply and interest rates v. Financial innovation Mathematics of a Rise and Fall ------------------------------ - Not widely understood. - When the price of an asset doubles (increases by 100%) it only requires a 50% drop to restore it to its original price. - Even a moderate drop from the high point can erase a substantial percentage of the previous gains. The Boom-Bust Cycle ------------------- - There is a basic and recurrent process: - **Step 1**: As prices rise (e.g. stocks, real estate, etc.) this attracts the attention of buyers. - **Step 2** This produces higher prices. Expectations are thus justified by the very action that sends prices up. - **Step 3**: The process continues and prices go up even more. - **Step 4**: Then, comes the end. A sudden descent akin to puncturing a balloon. - There have been 12 major bear markets since 1950. These occurred in: 1956, 1961, 1966, 1968, 1973, 1980, 1987, 1990, 2000, 2007, 2020 and 2022. - Declines in these bear markets ranged from 20% to 57%. - Bear market akin to a 20% decline from near-term highs. S&P 500 Bear Markets --------------------  Financial Crises ---------------- - The following major financial crises are reviewed in this session: 1. Great Depression (1930s) 2. Dot-Com Bubble (2000) 3. GFC (2007-2008) 4. Greek Debt Crisis (2010) 5. The Great Lockdown (2020) The Great Lockdown ------------------ - The Great Lockdown began on March 11, 2020, was triggered by the COVID pandemic. - Equity market indices experienced large declines but rebounded after barely a month. - The immediate cause of the great lockdown was: - decreased consumer expenditure; - disrupted supply chains; - price war in oil markets that sent oil prices plunging. - Great Lockdown was different from past crises - It dealt a uniquely large blow to the services sector (i.e., larger than manufacturing). - It is seen in advanced and emerging market economies alike. To Intervene or Not to Intervene? --------------------------------- ### Non-intervention - The best remedy is to let it run its course and allow the economy to adjust to the decrease in household wealth. - According to this view, the likelihood and the scope of future losses are reduced. ### Intervention - Authorities always feel compelled to intervene. - The cost of these ventures are in the trillions of dollars - Since the Government does not have these funds, it has to borrow them. Why Do Financial Crises Re-occur? --------------------------------- 1. The short financial memory (or ignorance of history) that makes investors oblivious of previous financial disasters. 2. The expectation that the Government and central banks will ''bail out'' speculators. 3. Reliance on paper assets as a source of wealth. Summary ------- - Asset price bubbles occur when market prices are far higher than fundamentals would suggest. - The basis for a bubble formation include, but not limited, to: (i) Exogenous shocks; (ii) New technology; (iii) Domino effect (bubble contagion); (iv) Money supply and interest rates - The nature of speculative booms involves an inevitable, and sudden, decisive collapse. []{#_Toc180416961.anchor}**BEO3001: Session 8** [**BEO3001: Session 8** 43](#_Toc180416961) [**Session 8: Islamic Banking and Finance** 43](#session-8-islamic-banking-and-finance) [Islamic Finance 43](#islamic-finance) [Islamic Finance Main Objectives 44](#islamic-finance-main-objectives) [Islamic Banking 44](#islamic-banking) [Conventional and Islamic Banking Similarities 44](#conventional-and-islamic-banking-similarities) [Islamic Financial Intermediation: Two-Tier Mudarabah Model 46](#islamic-financial-intermediation-two-tier-mudarabah-model) [Sukuk: Islamic Bonds 46](#sukuk-islamic-bonds) [Non-Generic Islamic Bank Risks 46](#non-generic-islamic-bank-risks) [Shariah Supervisory Board (SSB) 47](#shariah-supervisory-board-ssb) [Main Challenges Faced by Islamic Banks 47](#main-challenges-faced-by-islamic-banks) [Islamic Banking in Australia 47](#islamic-banking-in-australia) [Summary 47](#summary-6) **Session 8: Islamic Banking and Finance** ========================================== **Learning Outcomes** With respect to learning outcomes, you should be able to: - a\. Gain an understanding of Islamic banking and finance; - b\. Review the main similarities and differences between conventional banking and Islamic banking; - c\. Examine the main challenges faced by Islamic finance. Islamic Finance --------------- - Islamic finance is the provision of financial services in accordance with Shariah Islamic law, principles and rules. - Shariah does not permit: - receipt and payment of 'riba' (interest), - 'gharar' (excessive uncertainty), - 'maysir' (gambling), and - short sales or financing activities harmful to society. - Need to identify a suitable alternative to the interest-based mechanism. - So, how does it operate? - Riba (interest) is replaced with a profit and loss sharing (**PLS**) mechanism. - Parties must share the risks and rewards of a business transaction. - Transaction should have a *real* economic purpose. - No undue speculation or exploitation of either party. - **Mudarabah** - A lender or investor provides 100% of the capital for the project - Borrower uses their entrepreneurial skills to manage the project. - Profits are distributed via a predetermined ratio, while the loss is borne entirely by the investor. - **Musharakah** - Joint partnership agreement where two or more persons combine either their capital or labour, forming a business. - Partners share the profit according to a specific ratio, while the loss is shared according to the ratio of the contribution. - Islamic finance comprises: - Banking - Sukuk (equity based security) - Equity markets (restricted use) - Leasing - Investment funds - Insurance ('Takaful') - Banking and Sukuk comprise approx. 95% of total Islamic finance assets. ### Islamic Finance Main Objectives The main objectives of Islamic finance are: i. To design financial products and services in conformity with Shariah objectives. ii. To contribute toward economic development and prosperity within the principles of Islamic justice. iii. To facilitate efficient allocation of resources. iv. To help achieve stability in the economy. v. To alleviate poverty and income inequalities. vi. To remove social inequalities and to improve the standards of living. Islamic Banking --------------- - All financial arrangements in the Islamic banks are linked to real assets in a sector. - Depositors become partners in businesses (equity participation system). - If a bank loans money to a business, the business will pay back the loan without interest and instead give the bank a share in its profits. - If the business defaults or does not earn a profit, then the bank also does not benefit. - Islamic bank inherent risk relates to the risk sharing focus. - Islamic banks are expected to have long-term focus that will improve social well-being and the environment. Conventional and Islamic Banking Similarities --------------------------------------------- - Islamic banks have some similarities to conventional banks. i. Both are licensed by the central bank i. Can collect deposits and apply those funds to borrowers. ii. Both offer current accounts, payment facilities, cheque books, debit cards and without any interest or profit. iii. Customers can deposit their funds for a fixed period ii. Conventional banks is a fixed interest while for Islamic banks it is a pro-rata share in the profit. iv. Both use the interbank market for liquidity management.  Islamic Financial Intermediation: Two-Tier Mudarabah Model ---------------------------------------------------------- - Capital completely provided by Rab al Maal. - Business managed by Mudarib. - Tier 1 is liability side of the bank's balance sheet. - Tier 2 is asset side of the bank's balance sheet. - In both tiers separate contracts are executed. - Profit is shared on a pre-agreed ratio. - Financial loss borne solely by Rab al Maal. Sukuk: Islamic Bonds -------------------- - Sukuk differ from conventional bonds. - Conventional bonds repay a debt with a specified interest rate. - Sukuk requires an underlying asset. - With Sukuk, the principal amount is not guaranteed and the return to investors is linked to underlying asset performance. - Sukuk tend to be asset backed where investors have a claim on the underlying asset. - It can assume a variety of structures (e.g. partial ownership; lease-based; profit and loss sharing, etc.) Non-Generic Islamic Bank Risks ------------------------------ . Shariah Supervisory Board (SSB) ------------------------------- - SSB are an additional layer of monitoring and oversight. - It is best practice for institutions offering Shariah-compliant products to have a SSB. - SSB examines Shariah compliance - Reviews the structure and documentation of a proposed transaction or product. - SSBs can restrain boards of directors and management from aggressive lending and major risk taking activities. Main Challenges Faced by Islamic Banks -------------------------------------- Islamic Banking in Australia ---------------------------- - APRA officially authorised the first Australian Islamic bank to have a restricted deposit-taking license under the Banking Act. - The Islamic Bank Australia would offer banking services that are compliant with Sharia Law. - It was meant to commence operations in 2023. - However, as the result of challenges in raising the capital required in the current market, they have returned their banking licence to APRA.  - Thus, as of 1 October 2024, they are not an ADI and are not an entity conducting banking business in Australia. Summary ------- - Islamic banking is also referred to as Islamic finance or Shariah-compliant finance. - It refers to finance or banking activities that comply with Islamic law. - There are many differences between Islamic and mainstream finance - e.g. sharing of profit and loss, and the prohibition of the collection and payment of interest by lenders and investors. - Islamic banks make a profit through equity participation, which requires a borrower to give the bank a share in their profits rather than paying interest. []{#_Toc180416974.anchor}**BEO3001: Session 9** [**BEO3001: Session 9** 48](#_Toc180416974) [**Session 9: Banking in the Green Economy** 48](#session-9-banking-in-the-green-economy) [Green Banks 48](#green-banks) [Green Banking 48](#green-banking) [Green Banking Implementation Challenges 48](#green-banking-implementation-challenges) [Examples of Green Banking Products 49](#examples-of-green-banking-products) [Growth of Green Bonds 49](#growth-of-green-bonds) [Challenges of Green Banking 49](#challenges-of-green-banking) [Bank's Exposure to Climate Related Risks 50](#banks-exposure-to-climate-related-risks) [Banking Regulators and Climate Risk 51](#banking-regulators-and-climate-risk) [Summary 51](#summary-7) **Session 9: Banking in the Green Economy** =========================================== **Learning Outcomes** With respect to learning outcomes, you should be able to: - a\. Gain an understanding of green banking and green banks; - b\. Review the main challenges of green banking; - c\. Examine banks' exposures to climate related risks; and - d\. Review banking regulators approach to managing climate risk. Green Banks ----------- - Green banks pursue clean energy projects that reduce emissions. - Commits to never invest in the fossil fuel industry or other climate damaging industries. - Green Banks are mission-driven financing institutions - Facilitates environment management - Focus is more on deploying clean energy rather than maximising profit. - Pursues sustainable practices (internally and externally). - Actively develop a pipeline of clean projects and seek out opportunities in the market. Green Banking ------------- - Green banking promotes environment-friendly practices in banking sector. - Guides the bank's core operation towards sustainability. - Bank undertake in-house and external environmental sustainability. - Reduces the bank's carbon footprint. - Green banking combines environmental and social responsibility while providing excellent banking services. - Change internal operations to lower environmental impact - Initiatives like green IT and energy-efficient premises. ### Green Banking Implementation Challenges - There is a lack of awareness amongst the customers and bank employees about the concept of green banking. - A gap between what banks do for green banking and what people think banks do regarding green banking. - Green washing has led consumers to doubt green banking initiatives - Scepticism towards institution's environmental advertising has led to greater weariness - Has a negative influence on green brand equity. ### Examples of Green Banking Products  ### Growth of Green Bonds A colorful circle with text Description automatically generated with medium confidence ### Challenges of Green Banking - Banks are increasingly under pressure to shift their investment and lending patterns. - Divest from fossil-fuels and invest more in low carbon and energy efficient technologies. - Move towards green banking requires a change in the composition of business activities. - Can lead to unintended consequences. - Valuation of collateral and assets could be downgraded - e.g. extreme hot weather can decrease agricultural productivity leading to lower valuations - e.g. banks could bear higher insurance risk premiums. - Banks would be expected to reserve more capital or require more collateral to offset the shortfall. - Reputational risks by banks could also arise from not shifting/transitioning. - Investing in carbon-intensive assets could be seen as a breach of fiduciary duty for failing to consider long-term investment value drivers. Bank's Exposure to Climate Related Risks ---------------------------------------- - In advanced economies, banks' exposures to emissions-intensive industries are estimated to be 5--15 per cent of their total balance sheet assets. - Globally, large banks' financing to fossil fuel companies (both direct lending and through facilitating capital raising in debt and equity markets) has been broadly flat since 2016. - **Physical risks** relate to financial losses from the direct physical effects of climate change (e.g. collateral underlying a loan is exposed to natural hazards intensified by climate change). - **Transition risks** relate to poten