CH1-The Business of Banking and the Economic Environment

Question 1

What are the three core bank functions?

Answer 1

1) Accepting deposits
2) Granting loans
3) Acting as an agent for payments

Question 2

What are five important roles that banks play in society and the economy?

Answer 2

1) Financial Intermediary - Bridge between savers (surplus of funds) and borrowers (require funds)
2) Money creation - Expand the supply of money through deposit and loan transactions
3) Create financial products/services that benefit customers
4) Mechanisms for transferring money and making payment
5) All of the above contribute to the development of the economy.

Question 3

What are the five chief parties that make up the Australian financial system?

Answer 3

1) Authorised deposit-taking institutions (ADIs)
2) Insurance companies
3) Superannuation funds
4) Financial markets (debt, equity and derivative markets)
5) Payment systems

Question 4

What is financial intermediation?

Answer 4

It is when banks act as an intermediary between entities who have a surplus of funds (depositors) and those who want to borrow funds (borrowers), by pooling funds from depositors. Depositors act as creditors to the bank, in exchange banks pay an interest for these deposits. Borrowers act as debtors and pay a premium to the bank to cover interest and any additional charges for the bank to take on the risk of making the loan.

Question 5

What is retail banking?

Answer 5

Taking of deposits from and lending to individuals through a range of channels.

Question 6

What is investment banking?

Answer 6

Investment banking is a specific division of banking related to the creation of capital for other companies, governments, and other entities.

KEY TAKEAWAYS
- Investment banking deals primarily with the creation of capital for other companies, governments, and other entities.
- Investment banking activities include underwriting new debt and equity securities for all types of corporations, aiding in the sale of securities, and helping to facilitate mergers and acquisitions, reorganizations, and broker trades for both institutions and private investors.
- Investment bankers help corporations, governments, and other groups plan and manage the financial aspects of large projects.

Question 7

What are five functions of investment banking?

Answer 7

1) Debt capital markets - Large entities want to expand and need to finance through a bond issuance that would be managed by an investment bank
2) Underwriting Deals - Investment bank buys the securities then sell to the public or institutions with an appropriate spread/margin
3) Equity Capital Markets - Large entities want to expand and need to finance through an IPO (Initial Public Offering) and therefore a wider pool of investors.
4) Private placements - Large entities offer bonds directly to an institutional investor like an insurance company or retirement fund. Lower regulatory requirements so can be faster.
5) Mergers and acquisitions - Where a company is looking to buy another company

Question 8

Which of the following are different types of commercial banks that operate in Australia?

Answer 8

Investment banks, retail banks, foreign owned banks

Question 9

What Key Economic Indicator is an indicator of Consumption?

Answer 9

Retail Sales

Question 10

What are key areas that macroeconomics considers?

Answer 10

Unemployment, GDP, Inflation, Exports and Imports

Question 11

What is microeconomics?

Answer 11

Microeconomics is the study of decisions made by people and businesses regarding the allocation of resources, and prices at which they trade goods and services. It considers taxes, regulations, and government legislation on supply and demand.

Question 12

What is macroeconomics?

Answer 12

Macroeconomics, on the other hand, studies the behaviour of a country and how its policies impact the economy as a whole. It analyses entire industries and economies, rather than individuals or specific companies, which is why it’s a top-down approach. It tries to answer questions such as “What should the rate of inflation be?” or “What stimulates economic growth?”

Macroeconomics analyzes how an increase or decrease in net exports impacts a nation’s capital account, or how gross domestic product (GDP) is impacted by the unemployment rate.

Question 13

What is the role of financial markets?

Answer 13

Bring together buyers and sellers of financial products in order to trade.

Question 14

Within financial markets there are different types, what are four types?

Answer 14

1) Primary market - New issues of shares or other securities for when companies/governments are seeking funding for a large project.
2) Secondary market - Like a ‘second hand’ market. Existing shares or securities are traded. Examples is the ASX.
3) Exchange traded market - Standardized trading, licensed with business rules on relationships, products and conventions. Examples are equities and derivatives on the ASX.
4) OTC (Over the Counter) - Non-standard and negotiated between parties.

Question 15

What are the major financial market products or asset classes in Australia?

Answer 15

1) Equities
2) Foreign Exchange
3) Interest rate or debt
4) Derivatives - Value of contract derived from an underlying asset/instrument.
5) Commodities

Question 16

Aside from banks what are examples of ADI, Authorised Deposit Taking Institutions?

Answer 16

1) Credit unions are like early building societies, members share a common bond.
2) Building societies, mutual institutions are where customs are members and each member has a vote on how the organization is run

Question 17

What are the differences between banks, building societies and credit unions?

Answer 17

• Banks are listed on the stock market, building societies and credit unions are owned by members
• Banks have access to a broader foreign funding market, others are limited on where they can raise funds
• Banks return dividends to shareholders, BS and CU reinvest back into business

Question 18

What are examples of financial service providers that are non-ADI (Non deposit taking)?

Answer 18

1) Money market corporations assets (excludes those with assets <$50M). Provide loans to large corporations or government. Advisory, corporate finance, capital markets, foreign exchange and investment management.
2) Finance companies assets (excludes those with assets <$50M). Provide loans to households, small - medium businesses.
3) Securitisation vehicles - Issue securities back

Question 19

What are five examples of financial market participants other than banks?

Answer 19

• Insurance companies
• Superannuation and Approved Deposit Funds
• Unit trusts and managed funds
• Cash management trusts
• Trustee companies
• Friendly societies

Question 20

What are trends in the Australian Banking Industry?

Answer 20

FinTech disruptors, Bitcoin, blockchain, AI, Robotics, Big data customer analytics

Question 21

What are two main ways that banks make money?

Answer 21

1) Lending
2) Charging fees - Credit card fees are the largest component of household fees

Question 22

What is a primary cost for financial institutions?

Answer 22

Obtaining funds to lend is a complex as there are many different funding sources each exposed to different market factors

Question 23

In banking risk management what are the three categories?

Answer 23

1) Credit risk - Risk of borrower being unable to repay
2) Liquidity risk - Risk of bank not being able to pay its obligations
3) Interest rate risk - Risk of interest rate changes changing the value of investments

Question 24

What are three key elements to consider when looking at a bank’s financial statements and performance?

Answer 24

1) Liquidity - Ability for bank to meet is expenses, ned to have cash or assets easily convertible to cash to repay depositors and creditors.
2) Solvency - Ability of bank to meet long term financial obligations.
3) Profitability - Ability to generate earnings, usually measured as a ratio of which ROA (Return on Assets) and ROE (Return on Equity) are good metrics.

Question 25

What are two key components of a bank’s balance sheet?

Answer 25

1) Assets made up of interest earning assets, non lending interest earning assets and non-earning assets (premises, equipment)
2) Liabilities made up of interest bearing liability (savings accounts) and equity (share capital and retained earnings)

Question 26

What are two key parts of a bank’s income statement?

Answer 26

1) Revenue
- Net interest income
- Other banking income from fees and commissions
- Funds management income
- Insurance income
2) Expenses
- Operating expenses
- Loan impairment expenses
- Corporate tax expenses

Question 27

An Australian bank’s regulatory capital is comprised of how many tiers?

Answer 27

Two capital tiers:
- Tier 1 are ordinary shares and retained earnings that can absorb losses and maintain normal banking operations.
- Tier 2 funding sources that rank below that of depositors and senior creditors that can absorb losses in the event the banking operations are winding up.

Question 28

Liquidity Coverage Ratio (LCR) requires Australian ADI’s to hold sufficient liquid assets to meet what period of net cash outflows, as projected under an APRA-prescribed stress scenario?

Answer 28

30 days of net cash outflows as projected under an APRA-prescribed stress scenario, prevents banks selecting a best-case scenario over a realistic/worst case scenario.

Question 29

What is liquidity risk?

Answer 29

The potential inability of a bank to meet its payment obligations in a timely and cost-effective manner

Question 30

What are the two main sources of bank funding?
a) Retail deposits
b) Offshore funding
c) Wholesale funding
d) Deposit accounts

Answer 30

a) Retail deposits
c) Wholesale funding

Question 31

Net Stable Funding Ratio requires Australian ADI’s to fund their assets with sufficient stable funding to reduce funding risk over what time period?

Answer 31

One year horizon as prescribed by APRA

Question 32

What is an Expected Loss?

Answer 32

As part of providing credit it is expected there is an appropriate level of loss simply as part of doing business. Therefore successful banks price for that risk and manage by adding it to the cost of borrowing. Expected Loss is the one year loss expectation.

Question 33

In context of “Credit losses and provisions” what are examples of provisions?

Answer 33

• General provisions, aka Management Overlay, to cover special circumstances such as recessions, COVID19 or natural disasters
• Special provisions are associated with impaired customs who are unable to make scheduled prepayments

Question 34

What are Unexpected Losses?

Answer 34

Arise due to incorrect rating of customers, over-concentration and therefore exposure to particular risk (customer type, industry, geographic location, etc). Recessions are also a cause.

Question 35

How is Expected Loss calculated?

Answer 35

EL = EAD x PD x LGD
EAD = Exposure at Default
PD = Probability of Default (Driven by Rating Agencies)
LGD = Loss Given Default

Question 36

What is capital?

Answer 36

Capital acts as a buffer against unexpected losses.

APRA definition:
as the excess of assets (what the institution owns) over its liabilities (what it owes), or

as the amount invested by shareholders or owners of the institution, plus its accumulated retained profits.

Question 37

What is Economic Capital?

Answer 37

Banks use an internal method to determine for itself the appropriate level of capital to operate their business for optimum returns.

Question 38

What is Regulatory Capital?

Answer 38

Minimum capital required by regulators that has overlays to increase buffer in capital amounts. Calculations are according to regulator rules and consistent with international standards such as Bank of International Settlements (BIS).

Question 39

What are the three core banking functions?

Answer 39

1) Accepting deposits
2) Granting loans
3) Facilitating payments

Question 40

What are examples of bank loans?

Answer 40

1) Overdraft - Credit limit attached to a bank account that can be drawn against for an interest charge.
2) Credit Card - Borrowing within a certain limit, repayments monthly or instalments
3) Short to medium term loans - Principal and interest payments 12 months - 5 years.
4) Long term loans - Principal and interest payments up to 30 years.
5) Bills of Exchange and Promissory Notes - Special instrument that is an unconditional, written order. On maturity borrower must pay in full.
6) Equipment Leasing and Hire Purchase - Provide financing for plant, machinery, equipment and vehicles.
7) Trade finance - Assistance through facilitating import/export finance through lending, letters of credit, insurance, etc.

Question 41

What are examples of facilitating payments?

Answer 41

1) Debit cards - Direct transfer between accounts
2) International Money Transfers - Overseas money tansfers
3) eCommerce Merchant Payments - Services to allow business to accept credit card and EFTPOS transactions.
4) EFT
5) Negotiable instruments - Bank drafts, cheques and letters of credit
6) Period payments - Direct debit at intervals
7) Period credits - Direct credits like dividends

Question 42

What is insurance?

Answer 42

Example of “Transfer of risk”. Customer pays the Bank to be the insurer who takes on the risk of meeting the costs in case there is a loss.

Question 43

What are the four stakeholders for banks?

Answer 43

1) Lending customers - Customers who leave the money with the bank
2) Shareholders - Owners of a right to receive a dividend contribution.
3) Borrowing customers - Loans
4) Employees - Banking is a service business, personnel is 40-50% of the expenses.

Question 44

In investment banking what is underwriting spread?

Answer 44

When an investment bank helps a company sell its bonds, it will purchase these securities, add a markup or margin that compensates for the risk they take on.

Question 45

What is a Chinese wall? An why is it important in investment banking?

Answer 45

A Chinese wall is an information barrier to ring fence the exchange of information that could lead to conflict of interest.

Question 46

As part of a bank acting as intermediary what does maturity transformation mean?

Answer 46

When a bank takes short term liabilities (deposits) and transforms them into longer term assets (such as loans).

Question 47

When was The Better Banking Program launched and what were its key initiatives?

Answer 47

January 2017.
- Independent review of banking remuneration
- Problem resolution
- Dispute resolution
- Whistleblower protection
- Poor conduct moving around the industry
- Independent review of Code of Banking Practice.

Question 48

What are Capital Adequacy Requirements?

Answer 48

Ability for a bank to withstand losses without becoming insolvent. This is usually defined as a ratio between Tier 1 and Tier 2 capital against the risk weighted assets (banks loans). Risk weighting varies depending on the loan taker, governments are 0% and individuals are at 100%. Companies sit in between depending on their credit rating.

Question 49

What are the different Capital Adequacy Requirements under Basel 2 and Basel 3?

Answer 49

Basel 2 = 8%. Basel 3 = 10.5%

Question 50

In financial markets what is a Price Maker versus a Price Taker?

Answer 50

Price Makers are banks, brokers and non-bank financial institutions what act as intermediaries. Price Takers are other participants who are the end consumers.

Question 51

In Macroeconomics what are four examples of key economic indicators?

Answer 51

1) Unemployment
2) GDP
3) Inflation
4) import/export

Question 52

What is fiscal policy and its impact? Give examples of fiscal policy.

Answer 52

Government activities that impact purchase power and spending patterns of households and businesses impacting the economy.
- Government spending and taxation
- Government revenue and capital sources through taxes and borrowing funds.

Question 53

What is monetary policy and its impact? Give examples of monetary policy.

Answer 53

Reserve Bank of Australia is responsible for Monetary policy. Aim is to maintain price stability, full employment and prosperity through the management of inflation.
- Primary lever is the setting of interest rates

Question 54

Return on Assets is used to monitor a banks?

Answer 54

Profitability