Notes cover content for entire semester
Topics covered:
* Introduction and overview of the financial system and the role of Banks
* Interest rate risk: measurement
* Market risk: measurement and the application of Value at Risk
* Credit risk: individual loan risk measurement
* Credit risk: ...
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Summary Financial History & Intermediation Part 1
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BANK3011 Bank Financial Management (BANK3011)
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BANK3011 NOTES
LECTURE 1: OVERVIEW
1. MAIN QUESTIONS
• In this lecture we will answer the following questions:
o What roles do Financial Institutions (FIs) perform in the financial market and why are they ‘special’, especially
commercial banks?
o What happens if FIs are not managed properly? What are the consequences of FI failures?
o What should we (as market participants, regulators, policy makers) do to prevent FI failures?
2. WHAT DO FIS DO? (ESPECIALLY THE COMMERCIAL BANK)
• Types of financial institutions – commercial banks, investment banks, fund management and insurance
• Financial markets facilitate transfer of loanable funds from the net savers to the net borrowers
o Net savers aim is to transfer current financial resources to future consumptions
o Net borrowers require funds to
§ Undertake profitable investments to generate larger net returns or to
§ Fund current consumption above disposable income (e.g. mortgage loan)
• Both parties will need to ‘find’ each other and assume the counterparty default risk
• In this case, the default risk is mostly from the Corporations, so the Households must assess the default risk and seek
adequate compensation
• The search and transaction costs are minimized by both parties dealing only with FIs, and not with each other
• FIs take fiduciary relationships with both parties.
• They perform
o Brokerage service to minimize the search and transaction costs,
o Asset transformation services
• In general, Financial intermediation occurs across many different types of financial instruments
• In the past, institutions were typically allowed to work in only type of intermediation in the specialist system countries
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,2.1. TIMING INTERMEDIATION
• FIs accept funds from households with surplus funds even though there may not be an immediate demand for those funds
• FIs make commitments to lend funds to corporations often in anticipation of receiving funds in the future
• The resultant timing mismatches create Liquidity Risk and these are managed through liquidity management processes
2.2. MATURITY INTERMEDIATION
• The maturity of most deposits accepted by banks are typically short term, say, less than two years. However, the maturity
of the loans made by a bank are often considerably longer
• In the absence of a bank, a borrower would have to borrow for a shorter term or find an entity that is willing to invest for
length of loan sought; and or depositors have to commit their funds for a longer length of time than they typically want
• The resultant maturity mismatches create Interest Rate (Market) Risk and these are managed through market risk
management processes
2.3. RISK REDUCTION VIA DIVERSIFICATION (CREDIT ALLOCATION)
• FIs when accepting deposits and other similar funds do so in their own name
• They use these funds to lend to/invest with corporations. By investing or lending to a broad range of counterparties or
customers they enhance the creditworthiness of their portfolios
o This is consistent with modern portfolio theory which holds that a portfolio of diversified investments will
reduce aggregate portfolio risk
• The creditworthiness of the bank is a function of the creditworthiness of its investments and hence the bank’s overall
creditworthiness is improved
• The lending/investment activities create Credit Risk and these risks are also now able to be actively managed
2.4. REDUCING TRANSACTION AND INFORMATION COSTS
• Involves reducing the costs of contracting and the costs of information processing/monitoring
o Agency costs
o Information and monitoring: It is costly for individual savers to collect information and monitor the managers
• FIs act as delegated monitors by agglomerating funds of individual households
o To reduce costs of information collection and monitoring
o To develop new securities to more effectively monitor borrowers, for example, shorter‐term debt contracts
• Liquidity costs, matching when investors want to invest and when borrowers wish to borrow
• Lower transaction costs translate to lower borrowing costs
2.5. PROVIDING A PAYMENTS MECHANISM
• Most transactions made today are not settled with cash, payments are made using cheques, credit cards, debit cards, and
electronic funds transfer
• These functions are provided by financial intermediaries, often referred to as “depository institutions”
• The ability to make payments without the use of cash is critical for the functioning of a modern financial market
2.6. TRANSMISSION OF MONETARY POLICY
• Banks are the key mechanism through which the central banks effect monetary policy
• This can done by:
o Buying securities from banks increases the amount of cash held by banks thus reducing interbank interest rates
o Selling securities to banks thus reducing the amount of cash held by banks and therefore increasing the
interbank interest rates
o The purchase and sale of securities is commonly in the form of Repurchase agreements (Repos)
• In the current environment of zero interest rates, alternative forms of expansionary policies are
o US quantitative easing where the US Fed has been purchasing mortgage scurries of banks
o The BOJ has an active stock purchase program (buying ETFs) started in 2010
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,2.7. RISK INTERMEDIATION
• As a result of their financial activities, corporations and households may wish to alter the risks that they incur, e.g.
o A housing loan borrower has variable interest rate obligations under their mortgage, but wishes to have a fixed
rate
o A corporate borrower has borrowed AUD but needs to fund its operations in the US so really wants to borrow
USD
• FI’s facilitate the transfer of these risks through:
o Altering the underlying transactional arrangements; or
o Through the use of derivative transactions
• So, given the important functions FIs, especially commercial banks perform, the modern economy cannot survive
without an efficient financial system with the commercial banks at the centre
• So, FIs (Banks) are special!
3. INVESTMENT BANKS
• Investment banks to a large extent operate in markets to facilitate financial intermediation
• The three types of markets:
• Primary markets
o The origination, underwriting and placement of securities
• Secondary Markets
o Trading, broking and market making in the above securities as they are exchanged
• Tertiary Markets
o Facilitation of risk management activities for issuers and holders of securities (derivative and futures markets)
4. WHAT ARE THE RISKS THAT FIS FACE?
4.1. DEFINITION OF RISK
• “Risk is a condition in which there is a possibility of an adverse deviation from a desired outcome that is expected or
hoped for”
o E Vaughan, Risk Management, John Wiley and Sons, 1997, p8
• This implies that in order to measure risk we need to assess:
o The possibility (or probability) of a risk event occurring; and
o The likely impact of the event should it occur, often thought of in terms of the change in earnings but, as Dembo
(following) suggests and we will see during the Course, also in terms of changes in value
• (Financial) “Risk is a measure of the potential changes in the value that will be experienced by a portfolio as a result of
differences in the environment between now and some future point in time.”
o Ron Dembo, The Rules of Risk, p35
• This suggests that another way to assess the impact of risk events is to assess the change in the value of a portfolio or
portfolios of assets and liabilities that are exposed changes in value as a result of risk events
• In aggregate bank is however nothing more than a set of portfolios, hence risk events result in changes to value of banks
4.2. TYPE OF RISK
• Market Risk* – intermediation risk (loan and broking) and counterparty risk
o Interest Rate Risk*
o Foreign Exchange Risk
o Credit Risk*
• Sovereign Risk*
• Liquidity Risk*
• Operational Risk – competition risk
• *These risks will be examined during the course.
• Banks, as intermediaries, are subject to following
o Maturity mismatch
§ Longer term assets and shorter term liabilities, thus exposed to interest rate risk
o Liquidity mismatch
§ Illiquid assets and liquid liabilities, and so face liquidity risk
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, 5. RISK MANAGEMENT AND REGULATIONS
• The nature of risks faced by FIs continue to change and new risks arise (such as operational risk)
• The increasing complexity and scale of international bank activities
• The increasing complexity of operations and changing nature of market conditions
o Growing focus on originate and distribute model which shifts risks away from originators
• Technological developments, Regulatory controls, Compliance
o Fintech disruption
• Leads to the increasing importance of the management of bank risk at all levels within banks
o Bank holding companies (US) and universal banks (Europe) play in multiple segments of the financial system
• Evolving banking regulations that require significant changes in behavior
• FIs receive special regulatory attention because
o Negative externalities of FI failure: costly to households and firms using financial services
o Special services provided by FIs
o Institution M3 = M1(357.7b) + Other deposits (1,762.5b) =2,120.2.1b functions such as monetary transmission,
credit allocation, payment services etc
o There are costs of regulation
§ Net regulatory burden is the difference between the private costs of regulations and the private benefits
for the producers of financial services
• Example: Credit creation
o Money Base = Notes & Coins = 75.8b AUD, Jan 2019
o M1 = MB (75.8b) + Current Deposits (281.9b) = 357.7b
o M3 = M1(357.7b) + Other deposits (1,762.5b) = 2,120.2.1b
o M3/MB = 28, or MB/M3 = 0.04
o Banks created 96% of M3 as credits via intermediation activities
• The risk management cycle
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