Topic 6 - Managing Liabilites

Question 1

APRA classifies deposits into four main categories

Answer 1

1. Current deposits
2. Fixed deposits
3. Certificates of deposit
4. Other deposits

Question 2

Current deposits

Answer 2

This includes interest-bearing accounts (usually held by individuals) and non-interest-bearing accounts (typically held by companies)
These have declined in importance due to: 
Higher interest rates, which increase the opportunity cost of holding cash in current accounts 
Better cash management by customers 
Better returns from other investments

Question 3

Fixed deposits

Answer 3

This comprises deposits with a fixed maturity date, and also includes deposits where a notice period is required for withdrawal

Question 4

Certificates of Deposit

Answer 4

These are fixed-term deposits that are documented by a certificate specifying the maturity date and interest rate
They are usually negotiable securities with face values in excess of $100,000, and are often used by companies to invest surplus cash
Banks have actively promoted CDs because of their advantages in liquidity risk management

Question 5

Other deposits

Answer 5

All other deposits are grouped together into this category, which includes: 
Savings accounts –statement accounts, passbook accounts and online accounts with no minimum balance requirements and no cheque facility Investment savings accounts –similar to savings accounts but with higher interest and a minimum balance requirement
Cash management accounts –similar to investment savings accounts (with higher interest, and a minimum balance requirement) but with rates linked to money market rates 
Pensioner deeming accounts –savings accounts available to pensioners which earn the “deeming” rate used by the Federal government as part of its income test to determine eligibility for social security payments

Question 6

NON-DEPOSIT FUNDING The main categories are:

Answer 6

1. Other borrowings
2. Bill acceptance facilities
3. Other Australian dollar liabilities
4. Foreign currency liabilities

Question 7

Other borrowings

Answer 7

This includes all other borrowed funds, other than deposits, denominated in Australian dollars, including: Loans from domestic and foreign banks 
Debt instruments, such as debentures, issued by the banks

Question 8

Bill acceptance facilities

Answer 8

If a bank becomes the “acceptor” of a bank bill, the bank is liable (initially) for repayment of the face value of the debt on maturity
The resulting liability is included in this category of liabilities, and the offsetting claim against the borrower is recorded as an asset

Question 9

Other Australian dollar liabilities

Answer 9

All other Australian dollar liabilities (i.e. other than deposits, borrowings and those arising from bill acceptances) are grouped together, including: Provisions for anticipated losses or other expenses (other than provisions for doubtful debts) 
Accounts payable and prepayments received 
Gold bullion borrowings repayable in physical gold Deferred tax liabilities 
Unpresentedcheques drawn by a bank against itself

Question 10

Foreign currency liabilitie

Answer 10

This category includes all liabilities denominated in foreign currencies It includes: 
Loans from overseas banks denominated in the bank’s currency or a third currency 
Foreign bonds (bonds issued off-shore in the currency of the country in which they are issued)

Question 11

WHY MEASURE THE COST OF FUNDS?

Answer 11

There are three main reason to measure the cost of funds
One reason might be assessment of past performance, whilst others are linked to decision-making about the future, including: 
Determining the lowest cost sources of funds in order to maximum profitability 
Determining the required return on earning assets (including the pricing of loans) in order to generate sufficient returns and profitability

Question 12

The marginal cost of funds differs from historical average cost in a number of ways:

Answer 12

It estimates the cost of acquiring new sources of funding, in order to make decisions about the future 
It includes not only the interest cost but all other costs associated with acquiring additional funds (e.g. marketing and administrative costs) 
It includes shareholders’ equity, because that is an alternative source of funding along with liabilities

Question 13

pooled marginal cost of fundsis an appropriate method when

Answer 13

If: new funding is to come from a variety of sources (likely to be the case), and the purpose of measuring the cost of funds is to set the required return on new earning assets (a process often referred to as loan pricing)

Question 14

Risks associated with raising funds relate to the four main risk areas previously discussed:

Answer 14

Liquidity risk 
Interest rate risk
Credit risk 
Capital risk

Question 15

LIQUIDITY RISK

Answer 15

The liquidity risk faced by an ADI is related to the probability of depositors wanting to withdraw their funds

Question 16

INTEREST RATE RISK

Answer 16

Interest rate risk arises from a mismatch between the interest rate sensitivity of assets and liabilities, and hence the sensitivity of the new funding sources to interest rate changes is a factor in this equation

Question 17

Credit risk

Answer 17

Credit risk is a function of the likelihood of borrowers defaulting, but funding choices can still have credit risk implications

Question 18

CAPITAL RISK

Answer 18

In theory, debt is a cheaper source of funding than equity, and using more can increase returns

Question 19

Various strategies can be used to attract deposit funding, including:

Answer 19

Developing new and innovative products to meet the needs of customers and hence attract deposits 
Market segmentation –developing products targeted to particular market segments (e.g. pensioners) 
Product differentiation –using advertising, brand names and slogans to differentiate from competitors 
Convenient systems for service delivery (e.g. ATMs) 
Establishing a link between whether a customer holds deposits and the ADI’s willingness to lend

Question 20

The ease with which an ADI can attract nondeposit liabilities is largely related to the interest rate that it offers to investors, but other factors may exist:

Answer 20

Repurchase agreements will depend on the ADI having sufficient suitable assets that can be sold under a repurchase agreement 
Capital market funding may be easier if the ADI has a proven track record in these markets 
Foreign funding sources are facilitated by overseas branches or foreign links

Question 21

OutlinethemajorcategoriesofdepositsraisedbyAustralianbanks.Commentontheir relative importance as a source of bank funding and explain why there have been substantialchangesinthemixofdepositsoverthelast20years.

Answer 21

Therearefourmaincategoriesofdeposits,theyare:

(a) currentdeposits(notbearinginterest),at5%oftotaldepositsthesearenowtheleast importantcategory,clearlythelackofinterestearningsencouragescustomerstolookfor otherdepositproducts.
(b) current deposits (bearing interest), these constitute about 21% of deposits, their attractionsincludetheinterestearned,accesstothechequepaymentsystem,andthe addedliquidityifanoverdraftfacilityisalsoattached.
(c) fixeddeposits,thesearethelargestsinglecategorymakingup40%ofdeposits.Theseare averysafeinvestmentofferingrelativelyhighinterestrates.
(d) certificatesofdeposit,thesecomprise16%ofdeposits,theyareimportanttobanksas theyprovideflexibleaccesstoshort‐termmarketfunding. Overthelasttwentyyearscurrentnotbearinginterestdepositshavelostimportance,fixed depositshaveremainedrelativelystable,whiletheothershavegainedinimportance.Themainfactorsdrivingthishavebeenderegulation,theincreasedcompetitivenessamongdeposit takinginstitutionsandtheexpansionofcapitalmarkets

Question 22

Outlinethemajorcategoriesofnon‐depositliabilitiesraisedbyAustralianbanks.Why havethesegrownsubstantiallyinrelativeimportance?

Answer 22

Themajorcategoriesofnon‐depositliabilitiesareotherborrowingsincludingissuesofterm subordinateddebt,billacceptanceliabilities,otherAustraliandollarliabilities,andforeign currencyliabilities.
Relativetodeposits,non‐depositliabilitieshavebecomeamoreimportantsourceofbank funding. Reasons for this include the globalisation of financial markets and the internationalisation of Australian banking which have encouraged access to foreign currencyliabilities,deeperAustraliancapitalmarketswhichhaveencouragedtermsubordinateddebt, andtheincreasingcompetitionfordepositfundsparticularlyfromthesuperannuationand managedfundsindustries,thishassloweddepositgrowth.

Question 23

WhyshouldanADIbeinterestedinmeasuringitscostoffunds?

Answer 23

Abankneedstomeasureitscostoffundsinorderto: 
assessitspastfundingcostsaspartofitsplanningprocess 
assessthelowestcostsourceoffundsformeetingcurrentneeds 
pricenewloanstotakeaccountofthecostoffunds

Question 24

Distinguishbetweenthehistoricalaveragecostoffundsandthemarginalcostoffunds.

Answer 24

Thehistoricalaveragecostoffundsisbasedonthecostofraisinginterestbearingfundsinthepast.Itiscalculatedbydividingthedollarinterestcostbythetotalnon‐capitalfundsraised.
Themarginalcostoffundsisthecostofraisingadditionalfunds.Itmaybecalculatedfora specificsourceoffunds,forapooledsourceoffundsoritmaybeestimatedusingtheweighted averageprojectedcostoffunds.

Question 25

HowmightthetypesoffundsanADIattractsaffect: (a)itsliquidityrisk? (b)itsinterest‐raterisk?

Answer 25

Liquidity risk is the risk that an ADI will have insufficient funds available to pay out on withdrawalsandnewlending.Differentsourcesoffundswillbeassociatedwithdifferentlevels ofwithdrawalrisk,thatis,itwillbemoredifficulttopredictthewithdrawalpatternsofsome fundingsourcesascomparedtoothers.Forexample,wholesaledepositstendtobelessstable thanretaildeposits.
Interest‐rateriskistheriskthatunexpectedchangesininterestrateswillaffectthecashflows ofthebusinessand/orthevaluesofexistingfinancialinstruments.Interest- rateriskforanADI’snetinterestincomeisminimisedifratesensitiveassetsarefinancedbyratesensitiveliabilities, soifabankchoosestofundratesensitiveassetswithfixedrateliabilitiesthiswilltendto increasethelevelofinterestraterisk.

Question 26

ExplainwhyanADIneedstoimplementdifferentstrategiestoattractdifferenttypesof funds.Illustrateyouranswerwithexamples.

Answer 26

AnADIneedstoimplementdifferentstrategiestoattractdifferenttypesoffundsbecause suppliersoffundsresponddifferently.Forexample,toattractretaildepositstheADImay improvethelevelofserviceofferedtodepositorsandimprovethephysicalfeaturesofthebranchorATM.Alternatively,toattractcapitalmarketfundsthestrategymustbebasedona competitiverateofreturntogetherwithasoundcreditratingandreputationinthemarket.

Question 27

WhyisitimportantforanADItodiversifyitsliabilityfundingsources?

Answer 27

Sourcesofliabilityfundingvaryintermsofthesuppliers,thematuritiesandotherfeaturesof thefundinginstrument.Fundingsourcesmaybeselectedonthebasisofcostminimisationand riskmanagement,butitisalsoimportanttoensurethatthereisadiversityoffundingsources. Adangerofrelyingveryheavilyononesourceoffundsisthataparticularsourceoffundsmay suddenlybecomemorecostlyorlessavailable.
Inaddition,retaildepositstendtobeinterest inelasticsoduringperiodsofrisinginterestratesitcanbebeneficialforabanktohavealargeproportionofretaildeposits.Ontheotherhand, duringperiodsoffallinginterestratesmoneymarketfundstendtocostless.
Unfortunatelyitisdifficulttoswitchquicklybetweenfundingsources.Consequently,itis advisableforabanktohaveamixoffundingsources.