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Commercial Bank Management HEAD OFFICE: 50 Waterloo Road NORTH RYDE NSW 2113 Tel: (02) 9936 6444 Fax: (02) 9888 2287 For all sales inquiries please ring 1800 650 522 NEW ZEALAND Brooker's Auckland SINGAPORE AND MALAYSIA Thomson Information (SE Asia) CANADA Carswell Ontario UNITED KINGDOM Sweet & Maxwell Ltd London HONG KONG Bloomsbury Books USA Gaunt Inc Holmes Beach, Florida Commercial Bank Management by R D DE LUCIA BComm (Hons), MComm (UNSW), AAIB (Snr) Head of Business Financing Products, Commonwealth Bank of Australia and J PETERS BComm (Hons), MComm (UNSW), AASA, CPA, AAIB (Snr) Finance Director, Kimberley Securities Ltd FOURTH EDITION with a Foreword by G J THOMPSON Deputy Governor, Reserve Bank of Australia; Chief Executive (Designated), Australian Prudential Regulation Authority and an Appendix of Questions and Answers by KEVIN MSHANAHAN BComm, Dip Ed, AAUQ, FASA, CPA, FAIB LBC INFORMATION SERVICES 1998 Published in Sydney by LBC Information Services 50 Waterloo Road, North Ryde, NSW, 2113 First edition 1987 Second edition 1990 Third edition 1993 Fourth edition 1998 National Library of Australia Cataloguing-in-Publication entry De Lucia, R D (Raymond Damien). Commercial bank management. 4th ed. Includes index. ISBN 0455 21555 3. 1. Bank management—Australia. 2. Banks and banking— Australia. I. Peters, John, 1957-. II. Title. 332.12068 © Thomson Professional Information Asia Pacific Ltd t/as LBC Information Services 1998 This publication is copyright. Other than for the purposes of and subject to the conditions prescribed under the Copyright Act, no part of it may in any form or by any means (electronic, mechanical, microcopying, photocopying, recording or otherwise) be reproduced, stored in a retrieval system or transmitted without prior written permission. Inquiries should be addressed to the publishers. Designed and edited by Tricia Dearborn Typeset in Times Roman, 10 on 12 point, by Mercier Typesetters Pty Ltd, Granville, NSW Printed by Ligare Pty Ltd, Riverwood, NSW Foreword G J THOMPSON Deputy Governor, Reserve Bank of Australia, Chief Executive (Designate), Australian Prudential Regulation Authority This book provides, in clear and accessible terms, a comprehensive exposition of the environment in which Australia's banks and other financial institutions operate today. And it reviews the main forces which continue to make for evolution in that environment—technological change as it affects product delivery and risk management techniques, competition from new players and the ebb and flow of official regulation. One of the greatest challenges for educators, and their students, in the field of financial studies is to keep them up to date with a rapidly changing landscape. The authors here have done an admirable job of dealing with very current developments, such as capital requirements for banks' market risks and the real-time gross settlement system for high-value payments—both of which become effective in 1998. They also examine recent advances in the management of credit risk and loan pricing. And there is a brief account of the major changes in regulatory arrangements which will flow from the Wallis Committee's report—the formation of the Australian Prudential Regulation Authority, the increased responsibility of the Reserve Bank for payments system regulation and the expanded role of the Australian Securities Commission in consumer protection. I am sure this new edition of a well-established text will be welcomed by both teachers and students. 24 March 1998 v Preface In this book, the authors discuss some major issues facing banks' managements. The work is largely based on the theme that management's role is to minimise banking risk (whether it be funding, operational, credit, interest rate and/or foreign exchange risk), while at the same time ensuring that the bank takes advantage of any opportunities. In this fourth edition, all chapters have been revised and expanded or updated. Throughout the book, reference is made to the recent Wallis Inquiry into the Australian Financial System and its implications for various elements of the banking system. Chapters 4 and 5 have been rewritten to explain the capital adequacy requirements set by the Reserve Bank of Australia (based on the Basle Convention) in relation to market risk. The authors wish to thank David Ferris and Brett Plummer, who were previous contributors to this book. Most of all, however, the authors extend our love and thanks to Kerry and Samantha, as well as our families whose support and patience enabled us to endure the countless hours of research and revision. In appreciation of their support and love we dedicate this book. The authors, of course, accept full responsibility for any errors or omissions. However, they do wish to point out that, as the financial markets are dynamic, elements within the text may become outmoded within a short period of time. R D DE LUCIA J PETERS Sydney May, 1998 vii Table of Contents Foreword Preface List of Figures and Tables 1 Introduction The changing face of the Australian financial system 2 The Nature of Commercial Banking Commercial banking functions Commercial banks and other financial organisations Banking structures Appendix 2A: Financial mathematics 3 Liquidity Management Money formation and the flow of funds Factors affecting interest rates Bank liquidity management Deposit raising strategies 4 Bank Capital Function of bank capital Definition of bank capital Types of bank risk Capital adequacy and prudential supervision Appendix 4A: Evaluation of banks 5 Credit and Foreign Exchange Risk Management Introduction Credit risk analysis Credit risk management Page v vii xi 1 1 16 16 36 53 65 75 75 94 102 111 120 120 122 126 130 168 173 173 174 195 ix x TABLE OF CONTENTS Credit risk diversification Credit default swaps Derivative transactions and deemed credit risk The management of banks' foreign exchange risk Appendix 5A: Lending against the registered equitable mortgage/registered debenture mortgage (R/E/M) Appendix 5B: International currency abbreviations 6 Interest Rate Risk Background Defining interest rate risk Measuring interest rate risk Managing interest rate risk A philosophy of risk management Appendix 6A: The impact of yield curve shifts on bank portfolios 7 The Pricing of Bank Lending Products Factors influencing the price of loan products Pricing loan products The impact of prudential guidelines on loan pricing decisions Conclusion Appendix 7A: Impact of holding prime assets and non-callable deposits on product pricing Appendix 7B: Impact of capital adequacy guidelines on the required return on assets Appendix 7�: Should the price decision be based on average or marginal costs? 8 Other Bank Management Functions Strategic planning Personnel policies Electronic banking Auditing and control Appendix of Questions and Answers References and Further Reading Index Page 197 199 202 206 230 239 241 241 243 245 262 281 284 288 289 290 301 307 308 310 313 315 315 319 323 330 335 363 369 List of Figures and Tables Fig 1.1 Proposed regulatory framework Fig 2.1 Consumption patterns in an economy with capital markets 2.2 Relative returns from investment in real assets 2.3 Consumption patterns from an economy with real asset and capital markets 2.4 Circular flow of funds 2.5 Mortgage securitisation structure 2.6 Share of customer wallet Fig 3.1 Payments flow with a fixed exchange rate 3.2 Payments flow with a floating exchange rate 3.3 Circular flow of goods and services 3.4 Risk/return profile 3.5 The yield curve 3.6 Yield curves for securities of varying credit risk Fig 5.1 Credit default swap 5.2 Amortisation effect of a derivative transaction with intervening cash flows 5.3 Diffusion effect of a derivative transaction 5.4 Potential exposure effect of a derivative transaction with intervening cash flows 5.5 Matrix for lending against a floating charge Fig 6.1 Asset/liability mismatch 6.2 Diagrammatic representation of the variance model 6.3 Bank's versus market's yield curve 6.4 Standard interest rate swap diagram Fig 7.1 The concept of maturity transformation 7.2 Industry pricing policy Fig 8.1 EFTPOS system linkage arrangements 11 19 20 21 25 52 56 79 80 92 99 100 100 201 204 205 205 231 248 252 264 274 291 313 328 xi xii LIST OF FIGURES A N D TABLES Table 2.1 Alternative forms of payment in the Australian financial system (percentage of total transactions) 2.2 Value of payment instruments (percentage of total payments) 2.3 Total assets of financial institutions (percentage share as at 30 June) 2.4 Australian Bank asset growth 2.5 Major bank branch/agency representation—Australia 2.6 Earnings performance of the major banks Table 3.1 Reserve Bank loans, advances and bills discounted 3.2 Composition of Government security sales to the non-official sector—1995/96 3.3 Changes in monetary aggregates ($m) 3.4 Growth of monetary aggregates 3.5 Quarterly movements in Commonwealth Government Budget transactions ($m) 3.6 The savings ratio (%) 3.7 Projected cheque clearances and liquidity cover for ABC Bank—$m 3.8 Comparison of retail and professional deposit rates as at June 1997 3.9 Cost of variable vs fixed rate deposits 3.10 Interest burden to banks of holding PAR 7 NCD assets... Table 4.1 Characteristics of bank risk 4.2 Off-balance sheet commitments to total assets as at 30 September 1997 4.3 Example of capital ratio calculations 4.4 Major bank failures 4.5 Calculation of credit equivalents for off-balance sheet items 4.6 Calculation of credit equivalents for market related contracts 4.7 Worksheet for calculating capital charge for interest rate related instruments 4.8 Tier 1 ratio—sensitivity analysis 4.9 Major banks—market shares (%) 4.10 Loan provisions and impaired loans—major Australian banks 1997 financial year 29 170 31 37 38 59 62 83 86 87 88 91 95 110 112 113 115 126 129 131 134 145 145 158 165 169 LIST OF FIGURES AND TABLES xiii 4.11 Return (after abnormals) on average total assets—major Australian banks 4.12 Tier 1 and Tier 2 capital ratios Table 5.1 Industry gearing ratios: 1986-1991 5.2 Industry current ratios: 1986-1991 5.3 Industry ebit ratios: 1986-1991 5.4 Industry pre-tax profit ratios: 1986-1991 5.5 Industry debtors' turnover ratios: 1986-1991 5.6 Industry creditors' turnover: 1986-1991 5.7 Industry stock turnover ratios: 1986-1991 5.8 Industry interest cover ratios: 1986-1991 5.9 Quick method of assessing servicing capacity 5.10 Total lending commitments classified by industry 5.11 Total market turnover in foreign exchange 5.12 Currency composition of foreign exchange turnover in Australia 5.13 Industry weighted average foreign exchange exposure (hours) 5.14 Daily AUD settlements by system 5.15 Market rates on day 1 5.16 Covering an exchange exposure Table 6.1 Variance model in practice—ABC Bank 6.2 Sensitivity analysis of duration and convexity deviation.. Table 7.1 Impact of LACF and MACF pricing policies on loan products 7.2 Bank deposit balances 7.3 Impact of risk weightings on required returns 7.4 Industry pricing data 170 171 177 179 180 182 183 184 185 187 188 199 214 215 220 221 222 224 251 285 294 296 305 314
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