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
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.
Overview of Functions of Banks - "Sources of funds"
Through active liability management
Overview of Functions of Banks - "Use of funds is through"
- Provide loans to customers
- Investment in securities
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.
Net interest income (or net interest margin)
Difference between gross interest & fee income & gross interest expense
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
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
Sources of funds - Bank Deposits (a. Current deposits)
- Funds in cheque accounts
- Highly liquid funds
- May be interest or non-interest bearing
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
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
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:
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
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
e. Sources of funds - Debt Liabilities - "From..."
- From money markets
- From capital markets
e. Sources of funds - Debt Liabilities - "from Money markets"
Issues certificates of deposits (CDs)
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
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
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
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),
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
Bank assets - Uses of Funds by banks
- 1. Notes and coins
- 2. Lending
- 3. Other bank assets
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
Bank assets - Uses of Funds by banks - 2a. Lending to Government
Buying Treasury bills & Govt bonds
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
Bank assets - Uses of Funds by banks - 2b. Commercial Lending
Loans to business sector & other institutions
2b. Commercial Lending - Term loans – fixed or floating rates
- Overdraft facilities
- Commercial bills- bank bills held, rollover facilities
- Lease finance
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
A bank’s balance sheet identity starts with:
Assets = Liabilities + equity capital
A bank’s balance sheet identity starts with cont - And becomes...
C + S + L + MA = D + NDB + EC
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
Off Balance Sheet (OBS) Business
- Transactions that represent a contingent liability.
- Therefore, not recorded on balance sheet
- Significant part of bank's business
OBS transactions include
- 1. Direct credit substitutes
- 2. Trade & performance-related items
- 3. Commitments
- 4. Market-rate related transactions.
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.
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.
Bank undertakes to advance funds, or make a purchase of assets at some time in future.
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)
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)
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%
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.
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
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
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
C. Savings Institutions (Building Societies) - "Sources of funds"
Accept public savings in shares & deposits (liabilities)
C. Savings Institutions (Building Societies) - "Uses of funds"
- are used mainly for housing loans (assets).
- Operate under Building Societies Act 1965.
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
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
Why should banks be supervised?
- 1. Role of Banking System in Economy
- 2. A Market Failure Basis for Supervision
- 3. Investor Protection issues
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.
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
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.
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).
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.
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.
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
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
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
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
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