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Chapter 2Thefinancialservicesindustry:depositoryinstitutions

Chapteroutline

Banks

Size,structure and composition of the industry

Balancesheet and trends

Bankperformance

Creditunions and building societies

Size,structure and composition of the industry

Balancesheet, performance and trends

Theregulation of Australian depository institutions

Thekey legislation

Theregulatory agencies

Australianprudential supervision framework

Overviewoftheregulation of depository institutions

Learningobjectives

2.1LearnthedifferenttypesofdepositoryinstitutionsinAustraliaandhowtheycompeteinthesamemarketandfacesimilarrisks.

2.2Gainanunderstandingofthemajoractivitiesofbanksandtheindustrystructure.

2.3Gainaninsightintothebalancesheetofbanksandthetrendsinassets,liabilitiesandcapital.

2.4Appreciatethekeyperformanceratiosofbanksandthetrendsinbankperformance.

2.5Learnthehistoryoftheindustrycomprisingcreditunionsandbuildingsocietiesandthestructureoftheirindustry.

2.6Gainanunderstandingofthechangingshapeofthemarketforcreditunionsandbuildingsocietiesandhowtheyhaveperformed.

2.7AppreciatetheregulatoryframeworkgoverningtheactivitiesofAustraliandepositoryinstitutionsandthekeyregulatoryagencies.

2.8Understandthekeyareasofregulationandthereasonswhytheseareasaretargetedforregulation.

Overview ofchapter

ThischapterprovidesanoverviewofthemajoractivitiesofAustralia'sbanks,buildingsocietiesandcreditunions.ItdescribestheapproachtoregulationoffinancialinstitutionsandthevariousagenciesthatregulateAustraliandepositoryinstitutions.DIsrelyheavilyonretaildepositstofundtheiractivities,althoughwholesaleborrowingandoffshorefundingareincreasinglyimportantsourcesoffunds,particularlyforthemajorbanks.Historically,bankshaveofferedafullrangeofservicestobothretailandcorporatecustomers andAustralia'smajorbanksconcentratemuchoftheireffortintheprovisionofbankingandinvestmentbankingservicestobusinesses.Buildingsocietiesandcreditunions,ontheotherhand,focusonretailbusiness,withloanportfoliosdominatedbyresidentialmortgagelending.Thesedifferencesarebeingerodedduetocompetitiveforces,regulation andchangingfinancialandbusinesstechnology.

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Answerstoend-of-chapterquestions

Questionsandproblems

1Howhavetherisksandproductssoldbythefinancialservicesindustrychangedsince1950?LO 2.1

Thefinancialservicesindustrytodayisverydifferentfromthatin1950.In1950,thefinancialinstitutions(FIs) weremorespecialised,eachofferingadistinctsetofproducts/services.Today,however,theactivitiesandproductsofthevariousFItypesaremoreblurred,withmanyoverlappingfunctionsandrisks.TherisksfacedbymodernFIsarebecomingincreasinglysimilarbecauseofthis.

2Describethestructureofthebankingindustryanddiscussthereasonsforanychanges.LO 2.2

Sincethe1980sthenumberofbankshasincreasedfrom13in1985to63in2012.Moreover,therearemanyforeignbanks(eithersubsidiariesorbranches),whichmakeup48ofthetotalnumberofbanks.However,whilethenumberofbankshasgrown,therehasbeenconsiderableconsolidationoftheindustryoverthe30yearsto2012.Despitethis,theindustryishighlyconcentrated.Reasonsforthechangesaremanyandincludethefollowing.Manybuildingsocietiesgainedbankinglicencesandmostofthese—plusothersmallerbanks—havebeentakenoverbythelargerbanks.Thefourmajorbankshold77 per centofallbankassetsand79 per centoftotalbankloans(asatJanuary2012).Whiletherewasintensecompetitionforbanksduringthe1990sandearly2000sfrombuildingsocieties,creditunionsandothermortgageoriginators—particularlyintheresidentialhousingloanmarket—thecompetitiondiminishedthroughtheglobal financial crisis (GFC).ThemainreasonforthiswasthatastheGFChadbeencausedbythefailureofappropriateriskassessmentofmanymortgagedbackedsecuritisation(MBS)programs,accesstosecuritisationmarketsessentiallyclosedafter2008.AsmanyofthesmallerAustraliandepository institutions (DIs)includingbuildingsocietiesusedsecuritisationforfundingtheirincreasingassetbase,theylostcompetitivenessasthissourceoffundsdriedup.DespitegovernmentsupportfortheMBSmarket andthesameregulationsforallDIs,bankswereperceivedassaferinstitutions andtheyincreasedtheirmarketshareofhousingmortgages.Moreover,theybankswerealsoabletocaptureahigherproportionofdepositsasAustralianhouseholdsbecamemorecautiousandincreasedsavings.

3WhatarethemajorsourcesoffundsforbanksinAustralia?WhatarethemajorusesoffundsforbanksinAustralia?LO 2.3

Sourcesoffunds:

  • localdeposits
  • localwholesalefunding(interbankfunds)
  • internationalwholesalefunding
  • equity(andothercapitalcomponents).

Usesoffunds:

  • loansandadvances:

–homemortgages

–commercialloans

–bankacceptedbills

–commercialbills

–promissorynotes

–corporatebondsanddebentures

  • interbanklending
  • securitiesincluding:

–governmentsecurities

–otherbanksecurities

–corporatebonds

–securitisedassets

  • foreigncurrencyandforeigncurrencyassets
  • cashanddepositswiththe RBA.

4ContrasttheactivitiesofthefourmajorAustralianbankswiththoseoftheregionalbanks.LO 2.2, 2.3

Thefourmajorbankscovermostfinancialservicesincludingretailbanking,commercialbanking,investmentbanking,lifeandgeneralinsurance,andfundsmanagement.Regionalbankstendtooperateintheretailmarketonly—consumerandsmallbusinessmarket.

Thefourmajorbankshaveanationalfocusandofferbankingatcorporateandretaillevels,notonlythroughoutAustraliabutalsothroughsmalloperationsoverseas.Manyoftheregionalbankswerebuildingsocietiesthat convertedtobanksandthustendedtoconducttheiractivitieswithintheconfinesoftheregionorstatewheretheyhadtraditionallyoperated.Morerecentlytheregionalbankshavestartedtoexpandacrossstateborders,movingawayfromtheirtraditionalmarkets.Owingtotheirorigins,theassetsoftheregionalbankshavebeenpredominantlyinresidentialhousingloans.

Thelargebankshaveenhancedtheirmarginsbyofferingafullrangeofservicestoretail,smallandlargecorporatecustomers,andthroughinternationaldiversification.Owingtotheirsize,globalpresenceandreputation,theycanaccessfundsmorecheaplythantheregionalbanksandcanoftenofferfundstotheircustomersataslightpremiumbecauseoftheadditionalservicesprovided.Thelargebanksalsohavegreateraccesstotheinternationalmarketsforfundingbecauseoftheirsizeandconsequentreputation—whichisoftenakeyfactorintheEuro-marketsforexample.

5Whydidbanknetinterestmarginfallfrom2000to2011?Whywasn'tbankROEaffected?LO 2.4

Australianbanknetinterestmarginshavebeenfallingsincethe1980sduetoderegulationofthefinancialmarkets andnewtechnologiesaswellasregulatorychangeandthefocusonimprovementsinqualitycapital.However,theirreturnonequityhasremainedatalong-termaverageof16 per cent.Totalbankreturnsaremadeupofinterestincomeandfeeincome,andfeeincomehasrepresentedonequarterofbankoperatingincomesince2004.WiththeintroductionoftheFinancialClaimsScheme(governmentdepositguarantee)andthehighercapitalrequiredunderBaselIII,itcouldbeexpectedthatROEwill fallafter2013whenthefirstpartsofBaselIIIcomesintoeffect.

6WhywasthestructureofAustralianbanks' liabilitiesin2008foundtobeaweakness?Whathavethebanksdonetochangethis?LO 2.3

Atrendinthestructureofbankliabilitieswasanincreasedrelianceonoffshorewholesalefunding.In2008andthecollapseofLehmanBrothers,creditmarketsessentiallyfroze,asdidaccesstoglobalfundingmarkets.Asnearly25percentofbankfundingcamefromoffshorelenders,Australianbanksneededtoattractmorestabletypesofliabilities,suchasdomesticdeposits.Thegovernmentintroducedanumberofmeasurestoassistthebanking(DI)industry,includingtheFinancialClaimsSchemeandinvestmentinlocalmortgagebackedsecurities.PriortotheGFCmuchofthefundingforMBShadcomefrominternationalinvestors.

7Whatisdrivingthebanks' changingcapitalbase andinparticulartheemphasisoncommonequity?LO 2.3

Banksareimprovingthequalityoftheircapitalfortwomainreasons:

  • bankregulationsrequireit—andemphasiscommonequityandincreasedcapitaladequacyratiosforTier1capital,asthelowerqualityformsofregulatorycapitalwerenoteffectiveinabsorbingthemanybanklossesduringtheGFC
  • forglobalcompetitivereasons,bankshaverecognisedthatthereisaneedtostrengthentheircapitalbase,knowingthatmanylargebanksfailedduringtheGFC.

8Describethefactorsinfluencingthedeclineinthenumberofbuildingsocieties?LO 2.5

Buildingsocietieswereoriginallysetuptopoolsmalldepositsfromindividualsandhouseholdsinordertofinancemortgagelending.ResidentialhomeownershipwashighlydesiredbyAustraliansandasitwasdifficulttoobtainhomefinancefrombanksintheregulatedenvironment,buildingsocietieswereabletofillthebreachandthrived.Withderegulationofbanksandthegrowthofthesecuritisedmortgagemarket,thevalueoftheintermediationfunctionperformedbybuildingsocietiesandcreditunions(funnellingsmallsavingsintohomemortgagelendingorshortertermlending)waserodedbycompetition.Deregulationofthefinancialindustryfreedthebanks' capacitytoextendhomeloanstoindividuals,whichresultedinincreasedcompetitionfromthebankingsector,makingitmoredifficultforNBFIstosurviveintheirpreviousform.Asaresultmanysmallersocietiesandcreditcooperativeshavemerged,whilelargerbuildingsocietiesconvertedtobanks,allowingthemtooffermoreservices(althoughmorerecentlybuildingsocietieshavebeenabletoexpandtherangeofservicesonoffer)andgivingtheminstantaccesstoclearinghousefunds.Thisconversionfrombuildingsocietystatustobankstatusresultedinanoveralllossinmarketshareforbuildingsocieties.

9Whatarethesimilaritiesanddifferencesbetweenthethreemajorgroupsofauthoriseddeposit-takinginstitutionsinAustralia?LO 2.1, 2.2, 2.6

Thetwotypesofnon-bankDIsinAustraliaarebuildingsocietiesandcreditunions.Generally,bothbeganlifeascooperativeorganisations,regulatedunderstateorterritorylegislation(buildingsocietiesincreasinglynowhaveissuedsharecapital).However,withregulatoryrestructureinthelate1990s,botharenowregulatedinthesamewayasthebanks—byAPRA.Creditunionstendtoprovideretailfinanceandtheirmembersareusuallylinkedbyacommonbondsuchasanemployerorprofession,whichisnotthecasewithbuildingsocieties.Whilecreditunionshavemovedintolongertermlendingandspecificallyintohousingloans,buildingsocietieshavealwaysfocusedonlongertermlending.Now,thedifferencebetweenthetwogroupsinlendingmaturityisnowfarmoreblurredthanwhenoriginallyestablished.

BanksarethethirdtypeofDIinAustralia andarefarlargerthanbuildingsocietiesorcreditunions.Banksalsooperateinafarbroaderrangeoffinancialservicesthaneitherbuildingsocietiesorcreditunions,astheycanleveragetheirsizeanddistributionnetworkseffectively.Theyoperateinretail,commercial,investmentbankingaswellasinsuranceandfundsmanagement.AllAustraliandepositoryinstitutionsareregulatedbyAPRAinthesameway.

10WhatistheAustralianPrudentialRegulationFrameworkandwhatdoesitaimtodo?LO 2.7

TheregulationandsupervisionofAustralianFIsisguidedbyAPRA'sAustralianPrudentialSupervisionFramework,developedin2003–4.TheFrameworkrequirestheidentificationofFIrisksandthenprovidesforsupervisoryactionbyAPRAtokeeptheFI'srisksatalevelthatAPRAdeemsappropriate.Sinceitsintroduction,theFrameworkhasevolvedtoincorporatenewrisks,changingenvironmentsandchanginginternationalstandards.ThescopeofAPRA'ssupervisoryframeworkisbroad andcoversallactivities,supportingprocedures,processes,systemsandguidelinesthatarenecessarytoformriskassessmentsandsupervisionstrategies.TherearefivepartsofAPRA'sFrameworkforprudentialsupervision:supervisionoutcomesandresponses;entityriskassessment;supervisoryactivities;supportingmaterialandinfrastructure;andqualityassurancewithintheframework.

11Howhastheregulationofbuildingsocietiesandcreditunionschangedsince1999?LO2.8

Regulationofbankinterestratesandexchangeratesweredismantledinthe1980s,leavingbanksfreetodetermineproductprices.Atthesametimetheregulatoryapproachchangedfromcontrolbankactivitiestoprudentialsupervision.Responsibilityforprudentialmanagementlieswiththebanks' management,whileRBA'srolewastoensureitiscarriedouteffectively.AtthattimebuildingsocietiesandcreditunionswereregulatedbytheAustralianFinancialInstitutionsCommission(AFIC).In1998,regulationofthefinancialservicesindustrywasrestructured andtheAustralianPrudentialRegulatoryAuthority(APRA)wasestablishedtosupervisetheactivitiesofalldepositoryinstitutionspreviouslycoveredbytheRBAandAFIC.From1999,theregulationofbanks,creditunionsandbuildingsocietieswasexactlythesameandtheresponsibilityofAPRA.

12WhatisthekeyfocusofDIregulation?LO 2.8

TheregulationofDIscoversanumberofareas,butprincipally,thefocusisoncapital,liquidityandcreditriskmanagement.Theobjectiveofregulationistoensurethestabilityofthebankingsystem andtheprotectionofdepositors.

ThefollowingquestionsrefertoAppendix2A.

13Whatisthelikelyrelationshipbetweentheinterestincomeratioandthenon-interestincomeratio?LO 2.4

Interestincomeandnon-interestincomearenotindependent.Forexample,loansgenerateinterestincome andalsonon-interestincome(feesandservicingfeesetc.).Thustherelationshipbetweentheinterestincomeratioandthenon-interestincomeratioislikelytobepositive—that is, theyaremostlikelytomoveinthesamedirection.Thus themoreloanssold,thehighertheloaninterestincome andthehighertheloanfeesandservicingcharges.

14GiventhefollowingbalancesheetandincomestatementforMegaBank,calculate:LO2.3, 2.4

(a)return on equity

(b)return on assets

(c)asset utilisation

(d)equity multiplier

(e)profit margin

(f)interest expense ratio

(g)provision for loan loss ratio

(h)non-interest expense ratio

(i)tax expense ratio.

Megabankbalancesheet($million)
Assets / Liabilitiesandequity
Cashandduefrombank / 9000 / Chequeaccounts / 19000
Investmentsecurities / 23000 / Savingsaccounts / 89000
Repurchaseagreements / 42000 / NegotiableCDs / 28000
Loans / 90000 / Debentures / 19000
FixedAssets / 15000 / Totalliabilities / 155000
OtherAssets / 4000 / Sharecapital / 16000
Retainedearnings / 12000
Totalassets / 183000 / Totalliabilitiesandequity / 183000
Megabank income statement ($million)
Interestonfeesandloans / 9000
Interestoninvestmentsecurities / 4000
interestonrepurchaseagreements / 6000
Interestearnedondeposits / 1000
Totalinterestincome / 20000
interestondeposits / 9000
interestondebentures / 2000
Totalinterestexpense / 11000
Netinterestincome / 9000
Provisionforloanlosses / 2000
Otherincome / 4000
Otherexpenses / 1000
Incomebeforetaxes / 10000
Taxes / 3000
Netincome / 7000
a / return on equity / 25.00%
b / return on assets / 3.83%
c / asset utilisation / 4.92%
d / equity multiplier / 6.54 times
e / profit margin / 53.85%
f / interest expense ratio / 84.62%
g / provision for loan loss ratio / 15.38%
h / non-interest expense ratio / 23.08%
i / tax expense ratio / 23.08%

Notethattotaloperatingincome=netinterestincomeplusotherincome=$13000

15BoldBankhasthefollowingratios:

(a)Profitmargin21 per cent

(b)Assetutilisation11 per cent

(c)Equitymultiplier12times

CalculateBoldBank'sROEandROA. LO 2.3, 2.4

ROA=PMxAU= / 2.31%
ROE=ROAxEM= / 27.72%

Webquestions

16GotoAPRA'swebsiteandfindthelatestinformationonAustralianbank,buildingsocietyandcreditunionassetconcentration.LO 2.6

GototheAPRAwebsite( 'AuthorisedDepositInstitutions',andthenon 'Statistics'.YoucanthengotothevariousstatisticsforeachoftheADIs—that is,ADIQuarterlyPerformanceStatisticsforbanks,buildingsocietiesandcreditunions.Theanswerwilldependonthedateoftheassignment.

17GototheRBAwebsiteandupdatethebalancesheetsshowninthischapterforbanks,buildingsocietiesandcreditunions.LO 2.3, 2.6

GototheRBAwebsiteandgetthelatestdataforTables2.4and2.108.Theanswerwilldependonthedateoftheassignment.Atthewebsite( 'BulletinStatisticalTables'.FindTablesB2andB7andB8anddownloadtherelevantdata.

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