125220_16(T3): Depository Institutions

  1. NZ Banking History
    • 1840: Union Bank formed
    • 1861: NSW & BNZ formed
    • 1934: Central bank (RBNZ) formed
    • Prior to 80's: banks tightly regulated
    • 80's: deregulation of banks
    • 1989: NZ Reserve Bank Act registers new banks, does supervision
  2. Why Banks are Important?
    • Payments and settlements services.
    • Key financial intermediaries (maturity, credit risk transformation& liquidity transformation & denomination/size intermediation = asset transformation & economies of scale).
    • Transmission of government monetary policy.
  3. Overview of Functions of Banks - "Sources of funds"
    Through active liability management
  4. Overview of Functions of Banks - "Use of funds is through"
    • Provide loans to customers
    • Investment in securities
  5. Major source of bank income
    • Net interest income (or net interest margin)
    • Non-interest bank income
    • Major source of bank income = interest & fees earned on loans (their assets) to customers.
  6. Net interest income (or net interest margin)
    Difference between gross interest & fee income & gross interest expense
  7. Non-interest bank income
    • From fees & other services.
    • Traditionally, banks borrow short & lend long- review of topic 2 with yield curve- steeper yield curve the better profit
  8. Sources of Funds (Bank liabilities or equity) may be classified into 1. Deposits
    • a) Current or call deposits
    • b) Fixed term deposits
    • c) Certificate of deposits (CDs) - egotiable, discount instruments for S/T funding
    • d) L/T funding instruments
  9. Sources of funds - Bank Deposits (a. Current deposits)
    • Funds in cheque accounts
    • Highly liquid funds
    • May be interest or non-interest bearing
  10. Sources of funds - Bank Deposits (b. Fixed term deposits)
    • Offer choice of terms of investment
    • Loss of liquidity (fixed maturity) – break penalty
    • Higher rates of return – more maturity risk
    • Generally a fixed interest rate
  11. Sources of Funds - c. Certificates of Deposit (CDs)- short-term bank funding
    • S/T security issued by a bank in its own name
    • Issued at a discount to face value directly into money markets
    • Repayment of face value of the CD at maturity by the issuing bank
    • Highly negotiable, wholesale security
    • S/T (30 to 185 days)
    • Useful as S/T funding as yield adjusted quickly
  12. d. Sources of Funds - Non-Deposit
    • Apart from deposits as a source of funds, other sources have arisen due to removal of restrictions on FX & deregulation of product controls on banks.
    • Non-deposit sources of funds include fees & other income:
  13. d. Sources of Funds - Non-Deposit - "a. Fees from Bills acceptance (important in Australasia)"
    A borrower (e.g. large company) draws an instrument that is an order on another party (usually bank) to pay the bearer face value of instrument, on maturity
  14. Bills acceptance procedure
    • If bank accepts (guarantees payment), the bill is sold in money markets at stated interest rate.
    • The bank accepts primary liability for repayment of the face value of a bill at its maturity date.
    • Under separate arrangement, it repaid funds by company
    • It charges a fee for this service - earning income
    • It effectively guarantees funding for a customer
  15. e. Sources of funds - Debt Liabilities - "From..."
    • From money markets
    • From capital markets
  16. e. Sources of funds - Debt Liabilities - "from Money markets"
    Issues certificates of deposits (CDs)
  17. e. Sources of funds - Debt Liabilities - "From Capital markets'
    • - issues of unsecured notes,
    • - debentures (bonds with backing)
    • - transferable certificates of deposit (TCDs) 3 to 5 years
  18. f. Sources from foreign Currency Liabilities - (borrowing) - Debt raised in international capital markets
    • i.e. Banks issue debt instruments $500m to $1 billion) into large international capital markets (euromarkets)
    • Then these funds are used as loans for customers
  19. f. Sources from foreign Currency Liabilities - (borrowing) - "Deregulation of FX market has led to..."
    • Allows diversification of funding sources into international markets
    • Allows matching of FX denominated assets
    • Large source of demand for foreign banks
    • Meet demand of corporate customers for foreign exchange products
  20. g. Sources of funds - Loan capital and shareholders’ equity - examples
    • Ordinary shares listed on exchange
    • Retained earnings from profits
    • Preference shares (equity) e.g. ASB Capital No. 2 – features- perpetual, resetable interest rate
    • Bonds &
    • Subordinated notes (hybrid security) & debentures (debt),
  21. Recent source of funding - covered bonds
    • Bond issued by commercial bank that is secured by mortgage assets held by bank
    • 10 Dec. 2013, registered banks may only issue covered bonds under a registered covered bond programme
    • Reserve Bank imposes a limit (10%) on banks' issuance of covered bonds
  22. Bank assets - Uses of Funds by banks
    • 1. Notes and coins
    • 2. Lending  
    • 3. Other bank assets
  23. Bank assets - Uses of Funds by banks - "Three types of lending"
    • To government by buying govt. securities
    • To businesses - Commercial lending
    • To individuals - Personal finance
  24. Bank assets - Uses of Funds by banks - 2a. Lending to Government
    Buying Treasury bills & Govt bonds
  25. Reasons for buying t-bills and govt bonds:
    • • They hold Govt securities for liquidity reasons
    • • Investment alternative
    • • Collateral as part of borrowing
    • • Income stream
    • • Manage interest rate risk
  26. Bank assets - Uses of Funds by banks - 2b. Commercial Lending
    Loans to business sector & other institutions
  27. 2b. Commercial Lending - Term loans – fixed or floating rates
    • Overdraft facilities
    • Commercial bills- bank bills held, rollover facilities
    • Lease finance
  28. Bank assets - Uses of Funds by banks - 2c. Personal Lending - Categorised into:
    • Owner-occupied housing finance (Mortgages) with fixed or floating interest rates & other housing finance
    • Fixed loans such as overdrafts, credit cards
  29. A bank’s balance sheet identity starts with:
    Assets = Liabilities + equity capital
  30. A bank’s balance sheet identity starts with cont - And becomes...
    C + S + L + MA = D + NDB + EC
  31. C + S + L + MA = D + NDB + EC where C, S, L, MA, D, NDB, EC is...
    • C = cash in vault & deposits held at other depository FIs
    • S = Security holdings- backup of source of liquidity
    • L = Loans made to supply income
    • MA = miscellaneous assets (plant & equipment)
    • D = deposits - main source of funding
    • NDB = nondeposit borrowing
    • EC = equity capital = long-term base of fin
  32. Off Balance Sheet (OBS) Business
    • Transactions that represent a contingent liability.
    • Therefore, not recorded on balance sheet
    • Significant part of bank's business
  33. OBS transactions include
    • 1. Direct credit substitutes
    • 2. Trade & performance-related items
    • 3. Commitments
    • 4. Market-rate related transactions.
  34. 1. Direct Credit Substitutes
    • The bank acts as guarantor on behalf of client for fee.
    • Client has financial obligation to a third party.
    • So bank ensures client gets funds, say directly from markets.
    • Lender knows either borrower or bank will repay at maturity
    • Bank is only required to make payment if the client defaults on payment to third party.
  35. 2. Trade and Performance-Related Items
    • Banks act as guarantor.
    • – Documentary letters of credit where exporter will require importer to arrange with its bank to provide documentary letter of credit for trade transactions

    • Client has non-financial obligation (agreement) to a third party, e.g. for goods & services
    • – Bank pays compensation if client fails to fulfil the obligation.
  36. 3. Commitments
    Bank undertakes to advance funds, or make a purchase of assets at some time in future.
  37. 3. Commitments - "Examples include"
    • Forward purchases such as buying foreign currency
    • Repurchase agreements – banks sells securities temporarily.
    • Underwriting - cover any shortfall in funds
    • Credit card limit approvals (not fully drawn)
  38. 4. FX, interest rate contracts & market-rate
    • related contracts
    • Futures (usually on interest rates) & forwards
    • Options (usually on interest rates)
    • Foreign exchange contracts
    • Swaps e.g. currency swaps
    • Forward rate agreements (FRAs)
  39. Volume of off-balance sheet business
    • Approx. 94% of OBS is business-market-rate related contracts, commitments 3.77% and
    • Trade- & performance related 0.27% & direct credit 0.17%
  40. B. Depository Institutions Credit Unions [non-bank deposit takers]
    Co-operative deposit-taking institutions whose main aim is “promotion of thrift among members & wise use of credit” & lending of those savings back to members.
  41. B. Depository Institutions Credit Unions [non-bank deposit takers] - "Source of funds"
    • From public who sign up as members
    • Low cost financial services as operate under special controls
  42. B. Depository Institutions Credit Unions [non-bank deposit takers] - "Uses of funds"
    Most loans - for relatively small sums & for S/T although some of larger ones also lend on house mortgage
  43. C. Savings Institutions (Building Societies)
    • [Non-bank deposit takers]
    • Non-bank FIs specialising in home mortgages.
    • Since deregulation, their number in NZ has been declining with some merging to become banks
    • Total assets standing around $3,105,186,000 concentrated in local regions
  44. C. Savings Institutions (Building Societies) - "Sources of funds"
    Accept public savings in shares & deposits (liabilities)
  45. C. Savings Institutions (Building Societies) - "Uses of funds"
    • are used mainly for housing loans (assets).
    • Operate under Building Societies Act 1965.
  46. Philosophy of Financial regulation - "So specialised regulation is needed to ensure..."
    • 1. Markets work efficiently & competitively includes rules to promote adequate disclosure, prevent fraud & ban anticompetitive behaviour
    • 2. Consumers are protected
    • 3. Adverse consequences of breaching financial promises
    • 4. Mechanisms exist for low-cost means to resolve disputes
  47. Costs of Financial regulation can include...
    • Moral hazard where consumers & regulators become complacent if they know a regulator is acting as watchdog
    • “Undermining efficiencies”: e.g., import quotas protect a domestic firm’s activities
    • Creating monopoly situations
    • Transfer of wealth as well-intentioned regulation can have perverse effects
    • Costs of regulatory structures
  48. Why should banks be supervised?
    • 1. Role of Banking System in Economy
    • 2. A Market Failure Basis for Supervision
    • 3. Investor Protection issues
  49. Why should banks be supervised? - 1. Role of Banking System in Economy
    • a) Provides the means of settlement within the economy & across countries.
    • b) Major financial intermediaries in most economies.
    • c) Important source of liquidity for an economy payments need access to deposits.
  50. Why should banks be supervised? - 2. A Market Failure Basis for Supervision
    • Limits risks that banks can take with other people’s money.
    • Public must have confidence that money borrowed will be repaid in full together with interest.
    • Bank has a very high debt: equity ratio. If a bank gets into trouble, not much equity as cushion
    • Need to ensure banks undertake conservative portfolio management behaviour & maintain this
  51. Why should banks be supervised? - 3. Investor Protection Issues
    • Depositors in many countries have protection against loss due to insurance cover or govt guarantee.
    • NZ doesn't. Argues under such insurance, banks may take higher risks than necessary e.g. US Savings & Loan crisis.
  52. Why should banks be supervised? - 3. Investor Protection Issues - 'Banks themselves want stable banking systems due to"
    • a) large exposures against each other.
    • b) the payment services based on public confidence.
    • c) risk reduction & monitoring arrangements to counter the risk of one bank’s failure flowing on to others.
    • d) represent themselves as being monitored under a credible set of banking supervision arrangements (banks’ competitive advantage).
  53. In New Zealand, banking supervision requires:
    • a) A registration licensing or chartering process. Intended to limit ownership of banks to persons of integrity & standing.
    • b) Prudential regulation
    • c) Monitoring arrangements for on-site inspections/public disclosure requirements.
    • d) Failure intervention powers that enable a supervisor to take control of the bank when its own funds have been exhausted.
  54. NZ Banking supervison
    • b) Prudential regulation
    • i) Minimum capital paid up $30m.
    • ii) Max exposure limits to which a bank's capital is exposed to a single risk = 30%.
    • iii) Lending limits to persons connected with bank's owners.
  55. Main purpose of bank supervision
    • Maintain public confidence in the operations and soundness of the financial system
    • Avoid significant damage to the financial system resulting from failure of registered bank
  56. Three main strands in New Zealand
    • 1. Promoting self-discipline by banks in their management of their risks through emphasis on director discipline
    • 2. Fostering effective market discipline
    • 3. Implementing regulatory discipline through imposition of rules such as capital adequacy requirements
  57. Background to capital adequacy standards - "Capital has number of functions"
    • Source of equity funds
    • Shows commitment of shareholders to company
    • Enables growth
    • Needed in order to write off occasional losses
  58. Capital adequacy standards based on this idea
    • Banks will be able to use their equity as a cushion for losses write-off.
    • Need to have adequate capital
  59. Capital adequacy standards and Basel Accords
    • The central banks met initially in Basel after a couple of bank collapses  need for international rules
    • Established a committee whose recommendations known as Basel I capital accord(1988)- adopted by most countries
    • Then review  Basel II & then 2008  Basel III- meant to be fully implemented globally by 2019
Card Set
125220_16(T3): Depository Institutions