ACFI1003 Workshop 2 – Commercial Banks

In this workshop we will be completing a problem set based on Topic 2 – Commercial

Banks.

Topic 2 covered the following learning objectives:

• Evaluate the functions and activities of commercial banks

• Identify the main sources and uses of funds for commercial banks

• Outline the nature and importance of banks’ off-balance-sheet business

• Examine the main risk exposures and consider related issues of regulation and
prudential supervision of banks

• Examine the background and application of the capital adequacy standards

Reviewing the online material prior will greatly facilitate your understanding of the workshop
questions.

Workshop tasks
We will be completing and discussing the following today:

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Workshop Problems
Problem 1 (Main activities of commercial banking)

Over the last 30 years the dominance of commercial banks has increased with banks now
holding over 50% of total financial institution assets.

(a) Briefly explain the importance of banks in the financial system.

(b) Explain what has happened to the regulation and practice of banks in the last 50
years.

Problem 2 (Sources and uses of funds)

Using an example explain how you have used or intend to use the services of a commercial
bank. Name the service, what need it fulfilled from your point of view and describe from the
banks point of view if it is a source of funds or a use of funds.

How does the bank generate income from providing you with this service?

Problem 3 (Off-balance sheet business)

(a) Describe why direct credit substitutes, trade and performance related items,
commitments and foreign exchange, interest rate and other market rate- related
contracts are termed “Off Balance Sheet” transactions.
(b) Either as an individual or a business explain how you could use a direct credit
substitute or trade and performance related item to protect you from risk.
(c) Refer to the following website:

https://www.anz.com.au/business/international-foreign-exchange/foreign-
exchange/fx-risk-management/

Assume you are importing goods into Australia and need to pay in a foreign
currency. You order the goods to be produced today, however the goods will not be
delivered for three months. You will pay USD (US Dollars) on delivery. If your
business is in Australia and you earn AUD (Australian Dollars) what are you worried
about?

Explain how you could use a Forward exchange contract as well as a foreign
currency option to protect you from risk. (Note: These derivative contracts can also
be used to speculate, we will cover this in the topic on derivatives)

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Problem 4 (Regulation, prudential supervision and background to capital adequacy
standards)

(a) Explain the main reasons behind the supervision and regulation of banks, then give
an example of one of the major ramifications if a bank were to fail.
(b) Refer to the following article:
http://theconversation.com/explainer-banks-are-raising-capital-but-should- we-be-
worried-45884

Explain in general terms why banks over the past few years have been raising
more capital, explain what the impact of more capital will have on the financial
stability of banks as well as the impact for investors who hold bank shares.

Problem 5 (Basel II and III Capital Accord)

(a) Briefly outline the three types of risk identified under the Basel II Accord and
provide an example of each.
(b) It has been argued that banks have been using aggressive lending practices has
helped fuel the increase in housing prices in places like Sydney, Melbourne, and
Newcastle. This may be of concern if in the future a rising debt burden faced by
borrowers is coupled with falling house prices. Using your answer to Part A,
explain what risk this is under Basel II and explain what banks are required to do to
mitigate this risk.

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(c) Read the following article:

 In January 2004, it was revealed that the National Bank of Australia lost hundreds of
millions of dollars from un-authorised trading in foreign exchange markets and
ultimately the traders went to gaol as a result of their dishonesty.

 HOW?

 In 2003, traders conducted un-authorised off-balance sheet foreign exchange market

transactions where they speculated that the Australian dollar would depreciate (and US
dollar would appreciate). As you can see from the graph below the Australian dollar
appreciated over that period. Therefore, these traders were losing the bank’s money
from their un-authorised trades as they were speculating (betting) that the Australian
dollar would depreciate.

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 AUD/USD Exchange Rate 2003
0.8

0.7

0.6

0.5

0.4

0.3

0.2

0.1

0
1 2 3 4 5 6 7 8 9 10 11 12

In the context of capital adequacy requirements explain what this risk constitutes.

(d) The 2018 Royal Commission into the banking sector uncovered many unethical
practices that should not have occurred if strong governance frameworks were in
place. One of the most important issues discussed was the provision by a bank of
financial advice on its own products. A 2018 ASIC report titled Financial Advice:
Vertically Integrated Institutions and Conflicts of Interest noted that 75% of
customer files reviewed demonstrated the financial adviser had not acted in the
best interests of the client. Other issues discovered by the Royal Commission
were the Commonwealth Bank which was found to be in breach of money
laundering regulations, and the ANZ and NAB banks which were fined a total of
$100 million for manipulation of interest rates (i.e. the Bank Bill Swap Rate
BBSW).

In the context of capital adequacy requirements explain what these risks

constitute, explain the issue with banks providing advice on their own products
how banks could prevent this from occurring again?

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Review Multiple Choice Questions

Circle the letter that corresponds to the correct answer for each of the 5 questions below.

Question 1

Which of the following statements is false?

a) Commercial banks offer a full range of financial services
b) Sources of funds for a bank appear as liabilities and equity on the balance sheet
c) Banks currently practice asset management
d) Off balance sheet transactions (OBS) are a significant part of a bank’s business

Question 2

Which of the following is not a source of funds for a bank?

a) Negotiable certificate of deposit
b) Bill acceptance liabilities
c) Ordinary share capital
d) Leasing

Question 3

If a bank suffers a loss as a result of exchange rates moving adversely, this is an example of a/n:
a) Market risk
b) Operational risk
c) Country risk
d) Credit risk

Question 4

Which of the following statements about capital adequacy is false?

a) Capital adequacy standards are designed to promote stability in the financial system
b) Adequate capital is needed as a buffer so that banks can write off abnormal business
losses
c) Banks must maintain a minimum risk-based capital ratio of 4%
d) Capital is necessary to provide funding for growth

Question 5

Uses of funds for a bank appear as assets on the balance sheet. Uses of funds include:
a) Buying treasury notes
b) A fixed term loan to a business
c) Credit cards for individuals
d) All the given answers are uses of funds

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