Unit 3: A Bank's Financials

Question 1

What are the two main ways that banks make money?

Answer 1

1. Lending money
2. Charging fees

Question 2

How do banks make money by lending money?

Answer 2

They lend money at higher rates than they pay for deposits. The difference is the spread, or the net interest income. When net interest income is divided by the bank’s earning assets, it is the net interest margin.

Question 3

Banks make money through lending money. What is the net interest income?

Answer 3

The spread between the rate they charge to borrowers and the amount they pay to savers.

Question 4

What item represents the largest component of fee income received from the household sector?

Answer 4

Credit cards, followed by housing loan fees.

Question 5

What represents the largest component of fee income from businesses?

Answer 5

Loans, followed by fees for merchant services.

Question 6

What is the primary cost for financial institutions?

Answer 6

Obtaining the funds used to lend to households and businesses.

Question 7

What are 5 things that influence the price that banks pay for their funds?

Answer 7

1. Credit ratings
2. Investor confidence
3. Inflation expectations
4. Global economic environment
5. Official cash rate

Question 8

As part of their role as intermediaries, banks take on the risk of being unable to satisfy cash flow needs. Why is this?

Answer 8

This is largely because they offer short term liabilities (such as deposits) and transform them into longer term assets (such as loans).

This is known as maturity transformation.

Question 9

What is maturity transformation?

Answer 9

The practice by financial institutions of borrowing money on shorter timeframes than they lend money out i.e., when banks offer short term liabilities and transform them into long term assets.

Question 10

What are the 3 risk categories associated with maturity transformation?

Answer 10

1. Credit risk (borrowers failing to make payment)
2. Liquidity risk (bank inability to meet payment obligations in a timely and cost-effective manner)
3. Interest rate risk (risk of interest rate movement having adverse effect on value of investment)

Question 11

What are 3 key elements to consider when looking at a bank’s financial statements?

Answer 11

1. Liquidity
2. Solvency
3. Profitability

Question 12

In terms of a bank’s financial statements, how is liquidity determined?

Answer 12

Comparing a bank’s ability to meet all its expected expenses, such as funding loans or making payment on debt, using only liquid assets.

Question 13

In terms of a bank’s financial statements, when do liquidity problems arise?

Answer 13

When a bank does not hold sufficient cash (or assets that can easily be converted into cash) on their balance sheet to repay depositors and other creditors.

Question 14

In terms of a bank’s financial statements, what is solvency?

Answer 14

The ability of a bank to meet its long-term financial obligation. Solvency is essential to staying in business as it indicates a company’s ability to continue operations into the foreseeable future.

Question 15

In terms of a bank’s financial statements, what is profitability?

Answer 15

The ability to generate earnings compared to expenses and other relevant costs incurred during a specific period of time.

Question 16

In terms of a bank’s financial statements, what are 3 popular metrics used in financial analysis?

Answer 16

1. Profit margin
2. ROA
3. ROE

Question 17

In terms of a bank’s financial statements, how are assets broken down?

Answer 17

1. Interest earning assets
2. Non-lending interest earning assets
3. Non-earning assets

Question 18

In terms of a bank’s financial statements, what are some examples of interest earning assets?

Answer 18

Loans (home, consumer, corporate, etc.), cash

Question 19

In terms of a bank’s financial statements, what are some examples of non-earning assets?

Answer 19

Premises (e.g., branches/offices); equipment (e.g., computers, furniture, vehicles).

Question 20

In terms of a bank’s financial statements, what are the most common liabilities?

Answer 20

Interest bearing liabilities, such as all kinds of deposits, and debt issues

Question 21

In terms of a bank’s financial statements, what are two kinds of equity?

Answer 21

1. Share capital
2. Retained earnings

Question 22

What is the accounting equation?

Answer 22

Assets = Liability + Equity

Question 23

In terms of a bank’s income statements, what are the main forms of revenue?

Answer 23

1. Net interest income
2. Other banking income
3. Funds management income
4. Insurance income

Question 24

In terms of a bank’s income statements, what is net interest income?

Answer 24

Difference between asset pricing and funding costs.

Question 25

In terms of a bank’s income statements, what are the main forms of expenses?

Answer 25

1. Operating expenses
2. Loan impairment expenses
3. Corporate tax expense

Question 26

In its simplest form, what does a bank’s capital represent?

Answer 26

Its ability to withstand losses without becoming insolvent, and managing risk.

Question 27

Who makes and enforces the rules which govern the capital adequacy requirements of Australian banks?

Answer 27

APRA

Question 28

Why do APRA make and enforce rules governing capital adequacy requirements of Australian banks?

Answer 28

To ensure they meet their financial promises to depositors, policyholders, and fund members within a stable, efficient, and competitive financial system.

Question 29

In terms of capital adequacy requirements, what does Tier 1 capital include?

Answer 29

1. Ordinary shares
2. Retained earnings
3. Can include types of preference shares and convertible securities

Question 30

What are retainined earnings?

Answer 30

Profits not dispersed to shareholders

Question 31

In terms of capital adequacy requirements, what does Tier 2 capital include?

Answer 31

Funding sources that rank below a bank’s depositors and other senior creditors, i.e., subordinated debt

Question 32

In terms of capital adequacy requirements, what does Tier 2 capital (subordinated debt) provide to depositors?

Answer 32

Provides an additional layer of loss protection after a bank’s Tier 1 capital is exhausted.

Question 33

After the global financial crisis, as part of its post-crisis response, what did the Basel Committee on Banking Supervision (BCBS) develop?

Answer 33

They developed the Basel III international bank liquidity framework.

Question 34

Why was the aim of the Basel III international bank liquidity framework?

Answer 34

To improve banks’ resilience to future liquidity shocks.

Question 35

Under the Basel III international bank liquidity framework, there are global quantitative requirements that banks are required to disclose. What are 2 of these?

Answer 35

1. Liquidity Coverage Ratio (LCR)
2. Net Stable Funding Ratio (NSFR)

Question 36

What does Liquidity Coverage Ratio (LCR) require?

Answer 36

Requires Australian ADIs to hold sufficient liquid assets to meet 30-day net cash outflows projected under an APRA-prescribed stress scenario.

Question 37

What does the Net Stable Funding Ratio (NSFR) require?

Answer 37

Requires Australian ADIs to fund their assets with sufficient stable funding to reduce funding risk over a one-year horizon as prescribed by APRA.

Question 38

Banks may require credit quality metrics in their annual reports. Please explain the following metric: Funding cost vs cash rate

Answer 38

Measures deposit and wholesale funding costs by comparing the interest on lending and other assets with the RBA cash rate

Question 39

Banks may require credit quality metrics in their annual reports. Please explain the following metric: Risk Weighted Assets (RWA)

Answer 39

Used to determine the minimum amount of capital that must be held by banks and other institutions to reduce the risk of insolvency.

Question 40

Banks may require credit quality metrics in their annual reports. Please explain the following metric: High Quality Liquid Assets (HQLA)

Answer 40

Includes:
- Cash
- Government securities
- Semi-government securities

Question 41

Banks may require credit quality metrics in their annual reports. Please explain the following metric: Credit Risk Estimates (CRE)

Answer 41

Regulatory estimates of long run Probability of Defaul (PD), downturn Loss Given Default (LGD), and Exposure at Default (EAD).