Authorised Deposit-Taking Institutions

Question 1

What is intermediation?

Answer 1

Intermediation or indirect financing is where financial institutions (mostly banks) acquire funds from surplus units, mainly as deposits, and make loans to deficit units

Question 2

What are the benefits of intermediation?

Answer 2

Banks must manage the mismatches between the preferences of depositors and borrowers
They transform:
many small deposit balances into fewer larger loans
short-term deposits into long-term loans
the risks posed by deficit units into risks that are acceptable to depositors
the returns that are acceptable to surplus units into borrowing costs that are acceptable to deficit units

Question 3

What is the maturity mis match faced by banks?

Answer 3

Banks face a maturity mismatch between their assets (mostly long-term loans) and liabilities (mostly short-term deposits or securities)

Question 4

What are the risks associated with the maturity mismatch?

Answer 4

A liquidity risk of not having sufficient funds to satisfy withdrawals

A funding risk of not being able to rollover maturing sources of funds

Question 5

What is net interest income?

Answer 5

Banks earn net interest income: the interest received on bank assets minus the interest paid on bank liabilities
this can also be expressed as a margin (or spread), that is, the difference between the average interest rate earned and the average interest rate paid by banks on their funds
the margin of the major banks has declined over the period 1999 to 2017
bank fees (such as account servicing fees) also form part of the cost of intermediation

Question 6

What are the 5 subgroups of ADI’s

Answer 6

1. Australian-owned banks
2. Foreign subsidiary banks
3. Branches of foreign banks
4. Building societies
5. Credit unions

Question 7

Where do banks source their funding?

Answer 7

1. Domestic retail deposits
2. Securitisation
3. short-term debt securities (mostly negotiable certificates of deposit) issued in wholesale domestic and foreign financial markets
4. long-term securities (bonds) issued domestically or abroad
5. Equity

Question 8

What are the main benefits of retail deposits?

Answer 8

very safe
risk-taking by banks is constrained by APRA’s prudential supervision
deposits up to $250 000 are government guaranteed
liquid – all deposits can be withdrawn by the depositor
pay interest and/or provide non-cash benefits such as payment services

Question 9

What are the types of deposit accounts?

Answer 9

1. transaction accounts
2. saving accounts
3. fixed term accounts

Question 10

What are the characteristics of retail deposits as investments?

Answer 10

Fixed-term and some savings accounts serve an investment purpose
25% of SMSFs assets are bank deposits
‘Defensive’ investments, meaning low risk/return or capital stable
Attitudes to deposits changed as a result of heavy share losses during the GFC
and by the introduction in 2008 of the Australian government guarantee of deposits up to $250,000

Question 11

Why do banks borrow from financial markets?

Answer 11

Banks borrow from financial markets to:
diversify their funding sources beyond deposits
extend the maturity of their liabilities
raise additional funds that can be lent out
Funding decisions will be influenced by the relative cost of funds, the reliability of the funding sources and regulatory requirements

Question 12

Why do banks borrow from financial markets?

Answer 12

Banks borrow from financial markets to:
diversify their funding sources beyond deposits
extend the maturity of their liabilities
raise additional funds that can be lent out
Funding decisions will be influenced by the relative cost of funds, the reliability of the funding sources and regulatory requirements

Question 13

Short term market investing for banks

Answer 13

Short-term securities are usually unsecured promises by the issuer to pay their face value on their maturity date
they do not make interest payments, rather interest is embedded in the security’s face value
The main short-term security issued by banks domestically are negotiable certificates of deposit
The main offshore source is commercial paper, mostly issued in US dollars
Banks have relied less on short-term markets since the GFC, as they have sought to reduce their funding risk

Question 14

What is an NCD?

Answer 14

A wholesale deposit ($5 million or more) that has a fixed term with an agreed interest rate that can be traded in the money market

Question 15

What are the characteristics of an NCD?

Answer 15

An NCD is effectively a promissory note where the bank promises to repay the deposit with interest on the maturity date
The deposits cannot be withdrawn before maturity, but can be traded (i.e. sold) in the money market to provide the depositor with liquidity

Question 16

What is a bond?

Answer 16

A bond is a long-term security where the borrower makes regular interest payments to their holder and pays the bond’s face value on the maturity date

Question 17

What is the characteristics of a bond?

Answer 17

Banks issue bonds domestically and offshore
Bond issues are usually for very large amounts and mostly have terms of four to six years
Most are unsecured, though banks also issuer smaller amounts of covered, hybrid and asset-backed bonds

Question 18

What are bond issues?

Answer 18

Covered bonds - bonds issued by banks that are collateralised by a parcel of bank assets
this improves the bond’s credit rating and so reduces the cost of funds
issued with terms of five or more years, mostly in euros and US dollars that are swapped to AUD
Hybrid bonds – are debt securities that have equity like features, typically a bond that is convertible into equity
banks have increased these issues because they help them meet APRA’s capital requirements

Question 19

What are SMDS or MBS?

Answer 19

Residential mortgage-backed securities (RMDS or MBS)
Issued through securitisation which is the process of assigning the cash flows from illiquid assets (housing loans) to securities (mortgage-backed securities) that are sold to investors
Enables an ADI to sell a large bundle of their existing housing loans
Securitisation is conducted by special purpose vehicles (SPVs) who issue mortgage-backed securities

Question 20

What are the characteristics of equity?

Answer 20

Equity comprises proceeds from the issue of shares and retained earnings, it is considered a permanent source of funds given it does not have to be repaid
Shareholders require higher returns than debtholders, given they face greater risk
the major bank’s return on equity has mostly been around 12–15% over the past decade
Equity strengthens a bank’s financial position, and helps protect debtholders, including depositors, and for this reason APRA enforces minimum capital requirements

Question 21

What are bank securities?

Answer 21

About 20% of bank assets are held as cash and liquid securities (i.e. can be quickly sold for a fair price)
these include money-market securities, government bonds, notes and coins, ES funds and
loans to the overnight market
Purposes:
as a store of liquidity, meaning
to help manage their cash outflows
to trade in markets
To earn income on low risk/return
investments

Question 22

What is the nature of housing loans?

Answer 22

As of June 2017,
Loans to owner-occupiers (to help households to purchase their own home) were 65% of housing loans,
most have a reducible structure (meaning the loan is repaid over its term), just over 20% are interest-only
can have a range of optional features such as redraw facilities and mortgage offset accounts
The remaining 35% are investment loans (to help an investor purchase a property to rent)
over 60% of these are interest-only

Question 23

What are interest only loans?

Answer 23

The borrower’s regular payments cover only the interest due, and so do not reduce the principal borrowed
the borrower may intend to rollover the loan at its maturity, or repay it by selling the property
The returns to the investor are the net rental income (after all costs, including interest) and perhaps a capital gain (or loss) from the change in the property’s value
When the property’s net rental income is negative the loss can be offset against other income in a practice known as negative gearing

Question 24

Explain key points in Australias housing loans.

Answer 24

The most widely used indicator of housing interest rates is a lender’s standard variable rate (SVR)
however most borrowers receive discounts which mean they pay less than the SVR
An important indication of lending quality is the proportion of non-performing loans (where borrowers are 90 days or more behind in their payments)
these have been very low for decades in Australia (at less than 1% of loans) even during the GFC
reflecting high lending standards and recourse loans

Question 25

Other household loans

Answer 25

Secured
personal loans such as a car loan
overdrafts – allows borrowers to overdraw an account up to a certain limit, usually with a floating interest rate and secured by a mortgage over property
margin loans are for financial securities
Unsecured
credit card loans
some personal loans