Authorized Deposit-Taking Institutions PDF

Module 3 Authorised Deposit-Taking Institutions Part A. Introduction to Intermediation E.g. banks and play a big role in financial system. What is Intermediation? Intermediation or indirect financing is where financial institutions (mostly banks) acquire funds from surplus units, mainly as depos...

Module 3 Authorised Deposit-Taking Institutions Part A. Introduction to Intermediation E.g. banks and play a big role in financial system. What is Intermediation? Intermediation or indirect financing is where financial institutions (mostly banks) acquire funds from surplus units, mainly as deposits and make loans to deficit units. ADIs are the only instructions authorised to undertake banking business We refer to all ADIs as banks, including credit unions and building societies ADIs facilitate the flow of funds between surplus and deficit units rather than directly through an exchange Benefits of Intermediation Banks manage mismatch of preferences between surplus and deficit They transform; - Many small deposit balances into fewer larger loans - Short term deposits into long-term loans - Deficit unit risk into risk that is acceptable by depositors - Returns that are acceptable by surplus to borrowing costs acceptable by deficit Banks face challenge of balancing demand for depositing to demand of loans Banks manage balance sheets by adjusting interest rates offering a range of deposits and loan products and managing liquidity and funding risk Banks earn a spread between interest rate they charge borrowers and rate they pay depositors Bank Balance Sheet Banks face a maturity mismatch between their assets (mostly long term loans) and liabilities (mostly short term deposits or securities) Maturity Mismatch Maturity Mismatch; Loans may have long time period whereas deposits at have a short time period. E.g. mortgages (loans) vs deposits (short term deposits and individual would make through a banking app which can be withdrawn quickly) - Banks need to match maturity dates of assets and liabilities as best they can - They need to ensure sufficient funds are available to meet short term obligations like deposit withdrawals, whilst also earning enough incomes from larger assets to cover costs Maturity mismatch poses two risks; - A liquidity risk of not having sufficient funds to withdraw - A funding risk of not being able to rollover maturing sources of funds. - As bank hold long term assets but have mainly short term deposits, they are vulnerable to a change in market conditions such as interest rates, which can effect their ability to obtain funding - E.g: loan money for 5%, pay 3% on deposits, have guaranteed income of 2% - If interest rates increase 6%, these deposits have to keep track of int rate - As loan rates are fixed, banks are paying a higher int rate on deposits and are receiving low interest. Rates on loan made. - This means banks are left with funding shortfall. Net Interest Income Bank earns net interest income: The interest received on bank assets minus the interest paid on bank liabilities - Can be expressed as a margin (or spread). The difference between the average interest rate earned and the average interest rate paid by banks on their funds. - Margin of the major banks has declined over period 1999 to 2022] - Bank fees (such as accounting servicing fees) also form part of the cost of intermediation. Net income represent the net revenue a bank makes on it’s interest earning activities, after deducting the interest paid on it’s funding services. Net Interest Income helps evaluate the profitability of a bank, and can indicate that a bank is effectively managing their funding and income sources. - Investors are looking for strong or weak net interest income. - If strong banks are effective at managing, - If weak they aren’t managing well and suggests challenges of liquidity, credit risk and interest rate risk. Primary driver of bank earnings Deposits in bank are used to finance the mortgages. - Banks pay interest on deposits and earn interest on loans. Interest income can be affected by interest rate changes, changes in credit quality of borrowers and shift in demand for loans and deposits. From 2000 to 2022, domestic banks’ major banks’ net interest margin, have decreased since 2000 mainly due to; 1 Low interest rates over last 20 years - Interest rates have increased in last year. Worldwide too due to global financial crisis in 1980 - As interest rates were low, this led to lower yields on loans and investments for banks whilst rates paid on deposits and other funding sources have remained relatively stable. - Low interest rate environment will have a low interest rate margin too 2 Competition - Banking industry has become increasingly competitive with new entrants - Big 4, fintech companies, online banks that have challenge traditional banks for market share - Put pressure on banks to lower int. Rates to attract and keep new and current customers 3 Regulatory Changes in Response to GFC - In response to GFC, regulators have implemented stricter capital and liquidity requirements for banks - Regulators require banks have to keep certain amount of capital in reserve incase investors or depositors would want money back. - Banks have thus shifted their funding sources to more expensive, less flexible forms of funding such as long term debt and equity 4 Changing Customer Preferences - Customers increasingly demanded more convenient and accessible banking services like global banking and digital payments - Banks have had to invest in technology and infrastructure to meet demands - Has put pressure in NIM Australia’s Banking System APRA (Australian Prudential Regulatory Authority) places ADIs into one of five subgroups; 1 Australian Owned ADIs; - Big Four who are financial conglomerates; Commonwealth, WBC, NAB, ANZ - Others including MQB 2 Foreign Subsidiary Banks; - Provide retail banking services - Oversees but have subsidiary in Australia - APRA allows you to do retail banking (individual households and clients) if you have a Subsidiary - E.g. ING, HSBC, Rabobank 3 Branches of Foreign Banks; - Provide investment banking services for business clients (importer/exporter that facilitates foreign transactions) - E.g. BNP, Paribas, Deutsche Bank 4 Restricted ADIs; - Operating under Limited Services like probation period - Banks or newly listed banks that operate and would eventually become possibly complete Australian owned ADIs. - E.g. Avenue Bank 5 Provides of Purchased Payment Facilities; - Facilitate payments - Not a strict bank, don’t borrow money or invest - e.g. PayPal APRA oversees and regulates finance banks and other financial institutions in Australia APRA promotes safety and soundness of financial system by setting prudential standards- setting standards the ensure financial instructions comply with them. Part B. The Sources of Bank Funding (Equity & Liabilities) Bank Balance Sheet Sources of Funding (Liabilities and Equity) owed money. Where they get their money from sources of funding - Retail deposits - Financial Markets - ST Debt - NCDs - LT Debt - Bonds - Securitisation - Equity In Aus Currently, most banks get only from domestic deposits, households, companies that keep money at bank as deposit. Then ST Debt, LT Debt, Equity, Securitisation and Term Funding Facilities. - Prior to GFC, major source of bank funding was the financing markets (ST Debt + LT Debt = financial markets) - Now fallen to around 28% as of mid 2022 The crisis in these markets caused banks to change their funding sources and domestic retail deposits are now seen as more reliable source of funding - Now around 60% as of mid 2022 - Banks paid higher interest rates to attract more deposits. E.g. banks have higher savings rates for savers, depositors to attract Banks rely more now on retail deposits Banks pay higher interest rates to attract more deposits Retail Deposits All bank accounts are; 1 Very safe; Risk taking by banks is constrained by APRA prudential supervision. Deposits up to $250K are insured by government. Increases stability and attractiveness - Banks play major role in stability of financial systems. Match deposits with surplus and deficit units and this is the governments guarantee that this system will be sustained long term. 2 Liquid; All deposits can be withdrawn by depositor 3 Pay Interest; and/or provide non cash benefits such as payment services. Fixed term and some savings accounts serve an investment purpose - 25% of SMSFs assets are bank deposits Defensive investments, meaning low interest and return and capital stability Attitudes to deposits changed as a result of heavy losses during GFC and by intro in 2008 of Aus Gov guarantee of deposits up to $250K Financial Markets Debt markets both domestic and overseas, are divided into short term and long term securities. Banks borrow from financial markets to; - Diversify their funding sources beyond deposits - Extend maturity of liabilities - Raise additional funds that can be lent out Funding decisions will be influenced by relative cost of funds, reliability of funding sources and regulatory requirements.  Major banks tend not to borrow a lot of equity Major banks have ability to borrow offshore as they have higher credit rating than smaller domestic banks - Seen as too big to fail - Raise large amounts and so achieve economics of scale in relation to their issuing of costs This gives them a funding advantage over smaller competitors Short Term Debt ST Debt securities are usually unsecured promises by issuer to pay face value on maturity - No Interest payment, int embedded into face value. - Lender pays less to borrower and borrower pays more to include interest, risk at the end. - FV - PV = Interest Main ST Security issues by banks domestically is negotiable certificates of deposits (NCDs) such as treasury bills. Main offshore source is commercial paper, mostly in US dollars Banks rely less on ST markets since GFC to reduce their funding risk Negotiable Certificate of Deposit - A wholesale deposit ($5 mill or more) that has a fixed term with an agreed interest rate that can be traded in the money market. - It is effectively a promissory note where bank promises to repay the deposit with interest on the maturity date - NCDs cannot be withdrawn before maturity, but can be traded in the money market to provide the depositor with liquidity (can trade for cash) - Negotiable as they can be bought or sold in secondary market before they mature. - Higher interst rates than traditional savings rates with maturity from days to years with majority under a year. - Bought by institutional investors such as company and financial institutions - Not often traded by individual households. Long Term Debt Bond is a long term security where borrower makes regular interest repayments to their holder and pay face value upon maturity Banks issue domestic and offshore bonds Usually large amounts with terms of four to six years Most are unsecured though banks also issue smaller amounts of covered, hybrid and asset-backed bonds. Securitisation Residential Mortgage Backed Securities (RMBS or MBS) Issued through securitisation which is the process of assigning cash flows form illiquid assets (holding loans) to securities (MBS) that are sold to investors. Banks pol together their assets in forms of the mortgages they have and sell it through mortgage backed securities. Enables ADI to sell large bundle of their existing housing loans Securitisation is conducted by special purpose vehicles (SPVs) who issue mortgage backed securities. The loans become property of investors in the MBS - They receive most of the borrower’s repayments. Equity Equity comprises proceeds from he issue of shares and retained earnings, it is considered a permanent source of funds, given it doesn’t repay Shareholders require higher returns than debt holders given they face greater risk - Major banks ROE around 12-15% Equity strengthens a bank’s financial positions, protects debt holders including depositors and as such, APRA enforces minimum capital requirements. Part C: The Use of Funds Uses of Funds (assets) - Securities - Housing Loans - Other Loans; Household Loans & Business Loans Securities APRA requires 20% of bank assets to be held as cash and liquid securities - Include money market securities, government bonds, notes and coins, ES funds and loans to the overnight market. - Reason; store of liquidity (to help manage outflows), to trade in markets, to earn income on low risk/return investments. Housing Loans As of June 2022, - Loans to owner occupiers were 65% of housing loans - Most have a reducible structure (meaning loan is repaid over term) - Can have a range of optional features such as redraw facilities and mortgage offset accounts - Remaining 34% are investment loans (to help investor purchase property for rent) - Interest only loan has continued to fall overall (13.9% in 2021) however, represents 19% of new loans. Interest Only Loan; borrower’s repayments interest only and do not reduce principal - Borrower may intend to rollover loan at maturity or repay it by selling the property Return to the Investor; The net rental income (after all costs, including interest) and maybe capital gains or losses, form the change in the property’s value. When property’s net rental income is negative, the loss can be offset against other income in a practice known as negative gearing Negative Gearing; investor buys property and rents the property to receive rental income. If rental income is less than interest on loan and other expenses such as maintenance and management fees exceeds the rental income, then there would be a negative net rental income, less than cost of property - Investor can claim loss against taxable income which can reduce overall tax liability. - Controversial as wealthier society now get tax advantage. - Investor is making ST loss but relying on overall LT cost. Prudent Lending Standards (APRA) Other countries have poor lending practices and we don’t have this as APRA has prudent lending standards APRA guidelines to ensure banks maintain responsible lending practices National Consumer Credit Protection Act (NCCPA) APRA has authority to oversee and regulate lenders to ensure they’re acting in best interest of customers and financial system APRAs lending standards require lenders (banks) and banks have to assess Borrower’s ability to repay loan. This assessment is based on 1. Income 2. Expenses and 3.Other Financial Commitments Banks must verify income and expenses and including verifying payslips Ensures repayment capacity Can;t rely on theory of value increasing due to GFC Bank looks as borrowers ability to repay loan such as expenses; credit, school expenses Stress testing to assess ability to meet loan repayment in event of changes in financial situation e.g. job loss These standards are set to ensure loans are suitable for borrowers Housing Loans (Continued) Most widely used indicator of ousting interest rates is a lender’s standard variable rate (SVR) - SVR; is a type of interest rate charged on mortgages that fluctuates over time based on changes in the banks; base rate or market conditions - Most borrowers receive discounts which mean they pay less than the SVR e.g. SVR + 2% or SVR - 1% - Anything between 5-8% in Aus Important indication of lending quality is proportion of non-performing loans (Where borrowers are 90days or more behind on payments) - These have been low for decades (