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BFF1001

Interactive Study:
Financial Institutions
Please join the active FLUX session upon entering class.

1
Key Topic Aspects discussed in the Pre-load …

1. Role in the Economy 

2. Sources & Uses of Funds 

We now complete …

3. Bank Profitability & Risk

4. Bank Regulation & it’s impacts

5. Non-Bank Financial Institutions

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 Commercial Bank
Profitability
How
  do banks make money?
1. Charging interest on assets (loans) – Interest paid on liabilities (deposits)
 This difference between interested earned from loans and interest paid on sources
of funds is known as the interest rate margin (IRM).

IRM =

… where IR = interest received, IP = interest paid, TA = Total Assets

 Size of the IRM is affected by …
 Capital adequacy and Reserve requirements
 Product marginal costs
(FLUX Q1)

2. Fixed Fees & Commissions

3. Returns on investment products.

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 FLUX 1

Briefly read the gist of the following articles contained in the Moodle Interactive
Study section for this topic:
• Westpac shares walloped after revealing massive interest margin drop.
• Adelaide bank and Suncorp join Westpac in raising rates.

1. What were the two reasons given for why Westpac's NIM fell?

2. What was Westpac's response to the fall in profitability?

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 FLUX 1 Solution

Briefly read the gist of the following articles contained in the Moodle Interactive
Study section for this topic:
• Westpac shares walloped after revealing massive interest margin drop.
• Adelaide bank and Suncorp join Westpac in raising rates.

a. What were the two reasons given for why Westpac's NIM fell?

Higher wholesale funding costs and lower interest earned from customers
switching from interest-only loans to lower risk amortising loans.

b. What was Westpac's response to the fall in profitability?

Westpac increased interest rates for loan customers.

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 Commercial Bank
Profitability

Why have NIMs been

falling over time? Source: https://www.rba.gov.au/chart-pack/banking-indicators.html

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 Commercial Bank
Profitability

Why have NIMs been

falling over time? Source: https://www.rba.gov.au/chart-pack/banking-indicators.html

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 Commercial Bank
Profitability

(FLUX Q2)
Why have NIMs been
falling over time? Source: https://www.rba.gov.au/chart-pack/banking-indicators.html

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 FLUX 2

In 2016, the only country with banks more profitable by NIM than Australia was...

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 FLUX 2 Solution

In 2016, the only country with banks more profitable by NIM than Australia was...

2.5

2.2

ANSWER: US
Why do you think that is? Why are US banks more profitable?
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 Commercial Bank
Risk

Bank risk can be defined as uncertainty arising from cash

flows of the banks assets and liabilities.
It is important to know the primary risks that commercial
banks face …
1. Credit risk
2. Interest rate risk.
3. Liquidity risk

 Credit risk arises from the possibility of default in the bank

loan book; causing a loss of a portion or all of loan principal
and interest earnings. Measured by default rate.
(Concept check & Subject link: What is ? Which unit do you learn about ?)

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 Commercial Bank
Risk

 Interest rate risk arises from unforeseen changes in the

interest rate margin due to volatility in asset earnings and cost
of funds. Measured by IRM

 Liquidity risk the possibility of not being able to meet required

payments to depositors and creditors. Measured using the
liquidity gap; difference cash inflow and outflows.
(FLUX Q3)

Other relevant risks discussed in your self-study reading were…

 Operational risk
 Market risk (measured through VAR)

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 FLUX 3

Breaking news reports that CBA customers are unable to withdraw their deposits.

Fearing for their money, NAB, Westpac and ANZ customers all rush to the ATMs
and bank branches to withdraw their deposits.
This is an example of what type of bank risk?

A. Credit risk

B. Interest rate risk

C. Liquidity risk

D. Operational risk

E. Market risk

What is the name for this phenomena?

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 FLUX 3 Solution

Breaking news reports that CBA customers are unable to withdraw their deposits.

Fearing for their money, NAB, Westpac and ANZ customers all rush to the ATMs
and bank branches to withdraw their deposits.
This is an example of what type of bank risk?

A. Credit risk

B. Interest rate risk

C. Liquidity risk
D. Operational risk

E. Market risk

What is the name for this phenomena? Bank Run

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 APRA Regulation
As discussed in Topic 2, bank failure has the most wide spread
repercussions upon the economy and so banking experiences the most
extensive regulation of all industries. This regulation deeply affects the
management and profitability of banks.

Two important areas of bank regulation aim to minimise bank failure …

1. Liquidity
2. Capital

The objective of such regulation is to allow for sufficient liquid assets

and capital adequacy to …
 meet deposit withdrawals and daily requirements, and maintain
public and private sector confidence in the bank’s ability to do so.
 buffer against bank losses that arise from risk taking.

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 Liquidity Regulation
Liquidity Regulation:
 Liquidity refers to the availability of sufficient funds to meet day-to-day
requirements. A common example is being able to meet on-demand
withdrawal of deposits at branches and ATMs. Liquidity management aims to
ensure that banks have sufficient funds to meet their obligations.
 APRA mandates that smaller banks must maintain a minimum liquidity
requirement of 9% of their total liabilities as liquid assets. An example of
liquid assets is cash stored in bank branches and in ATMs. Large banks do
not have any mandated minimum liquidity requirement and can set their own,
flexible % of total liabilities held as liquid assets.
 The management of bank liquidity involves:
• Asset management: maintaining sufficient cash and non-cash assets
that can be quickly converted to cash.
• Liability management: Acquiring liquidity quickly and easily through debt
while ensuring diversification in creditor obligations.

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 Capital Regulation
Bank capital performs several important roles:
1. It serves as a source of funds for asset investment
2. It provides a financial cushion or buffer against asset losses
3. It helps maintain investor and public confidence
4. It provides some protection to depositors

APRA is the primary regulator for ADIs and applies both domestic and
international capital adequacy regulation.

From Topic 6, Capital Adequacy regulation stipulates that banks cannot

invest all their capital. Some must be kept in reserve to absorb asset
losses (e.g. loan defaults). This is achieved through the…
 Capital Adequacy Ratio: The ratio of capital to risk-adjusted assets must be
at least 8%. (FLUX Q4)
(Risk-adjusted assets & capital tiers are outside the scope of this unit and are taught in Commercial Banking &
Finance.)
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 FLUX 4

If the CAR falls to 6% from the current level of 8%, identify the consequences
on bank profitability and risk...

A. Profit increases, Risk increases

B. Profit decreases, Risk decreases

C. Profit increases, Risk decreases

D. Profit and risk are unchanged

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 FLUX 4 Solution

If the CAR falls to 6% from the current level of 8%, identify the consequences
on bank profitability and risk...

A. Profit increases, Risk increases

B. Profit decreases, Risk decreases

C. Profit increases, Risk decreases

D. Profit and risk are unchanged

A lower CAR means less capital must be kept in highly liquid but poorer
performing assets. This allows more capital to be used for risker assets that
earn a higher return.

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 Capital Adequacy

For BFF1001: Our scope of Capital Adequacy is

1. Understanding what capital adequacy is
2. Why such regulation is needed
3. How changes in the CAR will affect the operation/profit of banks & the flow of
funds/cost of debt in the economy.

Understanding Capital Adequacy

Unlike all other businesses, banks cannot invest all their capital and a certain amount has
to be kept in reserve. That amount is 8% of assets; CAR.

Why such regulation is needed

If banks lend out all their capital, in the event a borrower defaults and does not repay part
or all of the loan, the bank suffers a loss. As banks obtain their money to lend from
deposits, other creditors and shareholders, a loan loss means these capital providers
have lost some or all of their money. News of this loss can cause other capital providers to
withdraw their funds in mass, resulting in the collapse of the bank. Such a situation is
called a run on banks. Regulators wish to avoid this, as such can result in a loss of faith
and collapse of the entire financial system.
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 Capital Adequacy Regulation

Current state of Major Bank CAR:

Ignore CET, D-SIB acronyms which are not within the scope of the subject.

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 Impact of CAR

How changes in the CAR will affect the operation/profit of banks & the flow of
funds/cost of debt in the economy

When CAR :
 Banks will have to hold more capital in reserve, so will have less capital to lend out and
invest.
 Capital held in reserve earns a poorer return than when invested in high interest earning
loans.
 IR (interest received) will , IRM will  as will bank profitability.
 Banks are likely to  the interest cost of their loans to offset the fall in profitability.
 This  cost of debt, makes banking more expensive and  the flow of funds.

When CAR :
 Banks will have to hold less capital in reserve, so will have more capital to lend out and
invest.
 Capital invested in high interest earning loans earns a better return than held in reserve.
 IR (interest received) will , IRM will  as will bank profitability. PBL1

 Banks are likely to  the interest cost of their loans to compete for market share
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 PBL 1

Monash Bank has $100 million in interest earning assets upon which it earns an
average of 6%. Creditor obligations sum to $80 million which on average costs 5%.
The bank has total assets of $120 million.
a. What is the interest rate margin of the bank?

b. If capital adequacy requirements increase, what is likely to happen to this interest

rate margin and bank risk?

c. In reality, do you think banks will accept a reduction in profitability, i.e. a lower
return, as a consequence of lower risk due to higher capital adequacy and explain
why/why not?

d. What action have banks historically taken when faced with higher capital
adequacy requirements and what are the flow on effects to the cost of banking for
everyday Australians?  

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 PBL 1 Solution

Monash Bank has $100 million in interest earning assets upon which it earns an average of
6%. Creditor obligations sum to $80 million which on average costs 5%. The bank has total
assets of $120 million.
 a. What is the interest rate margin of the bank?
ANSWER:

b. If capital adequacy requirements increase, what is likely to happen to this

interest rate margin and bank risk?
The IRM is likely to narrow and bank risk will be reduced.

c. In reality, do you think banks will accept a reduction in profitability, i.e. a lower
return, as a consequence of lower risk due to higher capital adequacy and explain
why/why not?

No, banks are unlikely to accept a reduction in profitability from increased

capital adequacy requirements if there is any action that can be taken to maintain
profitability. This is because bank management has an obligation to maximise
shareholder wealth regardless of the regulatory environment.

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 PBL 1 Solution

d. What action have banks historically taken when faced with higher capital
adequacy requirements and what are the flow on effects to the cost of banking for
everyday Australians?  

Banks historically have not absorbed the opportunity cost of higher capital adequacy
requirements and have instead passed the cost onto customers by increases the price
of loans and/or reducing the interest paid on deposits.

In this way, banks enjoy a lower risk, without sacrificing return. This can only occur
if all the major banks work in unison to pass on the cost.

So, in light of this reality, the flow on effects of safer banks is a higher cost of
banking for everyday Australians.

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 ADI Regulation
It is important to appreciate the impact of bank regulation on the …
1. operation and profitability of banks
2. cost of debt & cost of banking in the economy

Tightening of regulation where banks have to hold more reserves to

strengthen liquidity and capital adequacy (e.g.  CAR &  Liquidity ratios)
 =  risk in banks and safer banks for consumers.
 But  higher costs of debt &  costs of banking

Relaxing of regulation where banks need less reserves that weaken their
liquidity and capital adequacy. (e.g.  CAR &  Liquidity ratios)
 =  risk in banks & less safe banks for consumers.
 But  lower costs of debt &  costs of banking

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 Non-bank
Financial Institutions
Whilst banks are the dominant type of ADI with the top 4
capturing 80% of total ADI assets in 2018, it is important to be
familiar with non-bank financial institutions (NBFIs)
1. Credit unions.
2. Building societies.
3. Finance companies.

Our discussion of NBFIs focus on credit unions and building societies

which are ADIs. Finance companies are not ADIs and tend to be arms
of large conglomerates and multinationals which provide short-term
consumer credit such as store credit, personal, car loans and home
loans. e.g. Latitude Finance.

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 Non-bank
Financial Institutions
A key difference between banks and NBFIs is that most NBFIs
(excluding finance companies) operate under a mutual or customer-
owned structure:
 There are no shareholders, just members. Regulated by APRA.
 Any profits/surplus belong to members but are kept as retained earnings and
not paid out as dividends.
 The surplus represents the major source of capital for NBFIs.
 The objective is not-for-profit lending to provide personal and community-
based financial service.
 As of 2016, NBFIs service over 4.6 mil customers and have over A$85 billion
under management.
PBL2

NBFIs operate primarily in the retail deposit taking and loan market and
market themselves as viable alternatives to commercial banks.
http://www.customerownedbanking.asn.au/

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 PBL2

The objective of this question is to help students classify financial institutions; as

they are required to do in Assignment 2, to identify institutions as:
• Non-“Big 4” Banks
• Non-Bank Financial Institutions
• Credit Unions, Building Society and Mutual Banks (customer-owned institutions)

Look here:
https://www.apra.gov.au/register-authorised-deposit-taking-institutions
https://www.infochoice.com.au/financial-providers/
https://www.rba.gov.au/fin-stability/fin-inst/main-types-of-financial-institutions.html
https://cdn.canstar.com.au/wp-content/uploads/2019/06/Customer-Owned-Bank-Crystal-Report-2019.pdf

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 PBL2 Solution

The objective of this question is to help students classify financial institutions; as

they are required to do in Assignment 2, to identify institutions as:
• Non-“Big 4” Banks
• Non-Bank Financial Institutions
• Credit Unions, Building Society and Mutual Banks (customer-owned institutions)

Look here:
https://www.apra.gov.au/register-authorised-deposit-taking-institutions
https://www.infochoice.com.au/financial-providers/
https://www.rba.gov.au/fin-stability/fin-inst/main-types-of-financial-institutions.html
https://cdn.canstar.com.au/wp-content/uploads/2019/06/Customer-Owned-Bank-Crystal-Report-2019.pdf

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 The Royal Banking Commission

What is a Royal Commission?:

 A public investigation by the Federal government, carried out nation-
wide, usually reserved for the most serious national issues that affect
government policy and legislation.

What is the Royal Banking Commission?:

 Commenced in 14 Dec 2017, to investigate misconduct in the
Banking, Superannuation and Financial Services Industry.
 Severe punishments in place for breaches in lending laws and
misconduct.
 All financial advisors to be registered/subject to a central body.
 Stricter practices on releasing investment and loan products.
PBL3

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 PBL 3

Why should we care about the Royal Banking Commission?

What impact would it likely have on consumers and cost of debt in the
economy?

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 PBL 3 Solution

Why should we care about the Royal Banking Commission?

What impact would it likely have on consumers and cost of debt in the
economy?

• The RBC has already and will continue to result in tighter regulation on
the risk taking of banks.
• This will mean a higher cost of funds.
• Banks are unlikely to absorb the higher costs and will pass these on to
customers in the form of lower interest rates on deposits and higher
interest rates on loans
• This will increase the overall cost of debt in the economy and discourage
consumer from borrowing money.
• The result is with higher banking costs but a safer banking sector

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 Summary

1.Commercial Bank Profitability

Net Interest Margin as Performance Measure
Fees and Premiums as Income Stream
2.Commercial Bank Risk
Credit Risk from Loan Products and Measurement
Interest Rate/Liquidity Risk and Public Perception
3.Regulation
Liquidity and Operations Regulation
Capital Adequacy and the Impact of Regulation

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