CHAPTER 14

Commercial bank operations

Prepared by Erkan Yalcin

University of Adelaide
 Learning Objectives

• By studying this chapter, you should be able to:

– Describe the size and structure of the banks within the Australian
financial sector
– Discuss banks’ sources and uses of funds as reflected in their balance
sheets
– Explain the various off-balance-sheet activities of banks
– Discuss the performance of Australian banks in terms of sources of
income and expenses
– Discuss how banks manage their liquidity risk
– Describe the capital requirements faced by banks
– Explain the methods employed by banks to manage credit risk
– Describe how banks measure and manage their interest rate risk
The Australian banking industry

• The Australian banking industry is characterised by a

few large players and a group of smaller competitors.
• The Australian banking sector is dominated by four large
institutions. Further consolidation between these is
restricted by the four pillars policy.
• The big four banks account for 87 per cent of the total
assets of the group of 19 institutions.
The Australian banking industry
cont’d
• Banking Regulation
– Regulation has played a key role in maintaining the stability of
the banking sector and retains significant influence over
banking operations, especially during the global financial
crisis.
– In recent decades, the banking sector has been characterised
by consolidation through both mergers and takeovers and
branch consolidation.
The Australian banking industry
cont’d
• Consolidation in the Banking Sector
– Consolidation through mergers and takeovers has characterised the
Australian banking sector over the last twenty years.
– Banks have used mergers and takeovers to grow quickly, diversify
their operations and improve their geographical spread.
– While Australian banks have undertaken takeovers of foreign
entities, the Australian government has required no further
consolidation of the local market.
– This is the ‘four pillars’ policy that aims to maintain competition in
the banking sector.
Balance sheet for a commercial
bank
•  
Balance sheet for a commercial
bank cont’d
• The Source of Bank Funds
– The principal source of funds for banks is deposit accounts:
demand, savings and term deposits.
– Funds sourced from deposits are similar to funds sourced
elsewhere except that deposits take precedence in the event
of a bank failure.
– For large banks, borrowed funds are a more important source
of funds than deposits. Increased demand for loans has
outpaced the growth of deposits and banks rely on borrowed
funds to finance their operations.
Balance sheet for a commercial
bank cont’d
• Deposit Accounts
– Deposit accounts may take three main forms:
• Demand Deposits : in which the owner is entitled to receive their
funds on demand, which transfers ownership of the funds to
others by cheque or EFTPOS.
• Savings Deposits : interest bearing accounts of individuals and
partnerships.
• Term Deposits: are legally due on a maturity date and the funds
cannot be transferred to others.
Balance sheet for a commercial
bank cont’d
• Borrowed Funds
– Borrowed funds are short-term borrowings by commercial
banks from the wholesale money markets.
– These borrowings may include:
• Banker’s acceptances;
• Debt issues;
• Loan capital (notes and debentures).
Balance sheet for a commercial
bank cont’d
• Capital Accounts
– Bank capital is the ownership funds of the bank.
– Loan and security losses are charged against this account.
– Bank capital includes:
• Share capital
• Retained profits
• Reserve accounts
Balance sheet for a commercial
bank cont’d
• Bank Uses of Funds
– Once raised, the funds are used for issuing loans or purchasing
investments.
– Loans are contracts between a borrower and the bank and
represent an ongoing relationship between the bank and the
customer.
– Investments are contracts issued by large borrowers and
purchased by banks. These are more impersonal and are
usually resold by the bank on the secondary markets.
 Off-balance-sheet banking

• There has been a large increase in off-balance-sheet

banking over the last twenty years.
• Off-balance-sheet items earn a fee income for the bank.
• However, these items are contingent assets or liabilities
and may include loan commitments and unrealised
gains or losses on derivative securities.
• Banks’ major off-balance-sheet activities include loan
commitments, standby LOCs, loan brokerage,
securitisation and derivative securities.
Off-balance-sheet banking cont’d

• Loan Commitments
– Bank loans usually begin as formal promises by a bank to lend
money according to certain terms.
– These loan commitments may be of three types:
• Lines of credit
• Term loans; and
• Revolving credit facilities
 Bank performance

• Profitability
– Generally, the profitability of banks has trended upwards over
time.
– This profitability is measured in a number of ways:
• Rate of return on average assets
• Rate of return on average equity
– The return on average assets is the key ratio in evaluating the
quality of bank management because it tells how much profit
bank management can generate with a given amount of
assets.
 Bank performance cont’d

• Sources of Income
– Interest income on loans is the major source of income for
banks.
– This is supplemented by income from:
• ATM surcharges;
• Credit card fees;
• Fees from the sale of managed funds;
• Trust operations;
• Investment services, insurance and financial products.
 Bank performance cont’d

• Profitability versus Safety

– Banks can increase profit by taking on more risk.
– However, this jeopardises bank safety.
– The bank must, therefore, balance the demands of
shareholders, depositors and regulators.
– Banks must always balance the trade-off between profitability
and solvency.
 Liquidity management

• Banks have two basic tools for maintaining sufficient

liquidity: asset management and liability management:
– Asset Management: maintaining sufficient cash and noncash
assets that can be quickly converted to cash.
– Liability Management: acquiring liquidity from the liability
side of the balance sheet.
 Bank capital management

• Bank capital performs several important roles:

– Provides a financial cushion.
– Helps maintain public confidence.
– Provides some protection to depositors.
– Serves as a source of funds for expansion.
 Managing credit risk

• The primary risk that banks have traditionally faced is

the risk of loan defaults.
• The credit risk associated with an individual loan
concerns the losses the bank may suffer if the borrower
defaults.
• To cover losses when loans become nonperforming,
banks set aside resources. At the end of 2018, Australian
banks held almost $6 billion in these provision accounts.
 Managing credit risk cont’d

• The Credit Risk of Individual Loans

– Once a loan is made, banks must monitor its performance.
– This involves several indicators:
• Failure to make loan repayments;
• Adverse changes in a customer’s credit rating;
• Adverse changes in deposit balances, sales and earnings;
• Delays in supplying financial statements.
 Managing credit risk cont’d

• The Credit Risk of Loan Portfolios

– Banks increasingly rely on internal credit risk ratings to
measure the risk of loan portfolios.
– These internal credit risk ratings are used to:
• Identifying problem loans
• Determining the adequacy of loan reserves
• Loan pricing and profitability analysis
– A system that is used to assess the overall quality of a bank’s
condition is the CAMELS rating system.
 Managing credit risk cont’d

• CAMELS
– The CAMELS ratings system may be outlined as follows:
• Capital adequacy
• Asset quality
• Management
• Earnings
• Liquidity
• Sensitivity to market risk
 Managing interest rate risk

• Because of increased interest rate volatility, interest rate

risk is a concern for banks and regulators.
• Banks manage interest rate risk to ensure that the bank
will always earn a spread between its borrowing rates
and the rates it can earn on investments.
• Interest rate risks must be measured and controlled.
 Managing interest rate risk
cont’d
•  
 Managing interest rate risk
cont’d
•