FINS1612 Lecture Notes - Lecture 2: Contingent Liability, Cheque, Interest Rate Risk
Monday, 13 March 2017
Capital Markets & Institution
Banks
-Main Activities of Commercial Banking:
•Asset Management - restrict growth in lending to level of funds available in
depositor base
-Practiced under heavy regulation (only lend out what is available)
•Liability Management - actively managing sources of funds (liabilities) in order to
meet future loan demand (assets)
-Borrow directly from domestic & international capital markets to manage liability
base
-Major banks have high credit ratings - can borrow substantial amounts
•Off-Balance Sheet Business - transactions that represent a contingent liability; not
recorded on balance sheet
-Sources of Funds:
•Sources of funds appear on the balance sheet either as liabilities that the bank will
repay, or as equity funds provided by shareholders
•Current Account Deposits:
-Liquid funds held in a cheque account; cheques drawn to purchase goods &
services (may be interest, or non-interest bearing)
-Cheque instructs bank to pay specified sum to payee shown in cheque
-Banks use cheque accounts as operating accounts
•Call or Demand Deposits: (savings-type accounts; low risk, low interest returns)
-Funds held in a savings account that can be withdrawn on demand
-Account fees may be charged - stable accounts
•Term Deposits:
-Funds lodged in an account for a predetermined period at a specified fixed
interest rate (typically one month to five years maturity)
-Higher interest rate compensates loss of liquidity
•Negotiable Certificates of Deposit:
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Monday, 13 March 2017
-Short-term discount security issued by a bank & sold into money market
-Bank pays bearer face value of CD at maturity (no interest payments)
-CD’s are negotiable securities - can easily be sold into a deep & liquid secondary
market
•Bill Acceptance Liabilities:
-Short-term money-market discount security; face value repayable at maturity
-Acceptance - bank puts its name on a bill issued by a third party; accepts
primary liability to repay the face value of the bill at maturity
-Commitment by bank, on behalf of bill issuer, to pay face value of a bank-
accepted bill to bill holder at maturity
•Debt Liabilities:
-Longer term debt instruments issued directly into local capital markets
-Bonds pay regular interest to holder; principal repaid at maturity
-Debentures - form of security attached to corporate bond; fixed/ floating charge
over assets of issuer (usually collateralised floating charge)
•Collateralised floating charge: if borrower defaults, lender will take possession
of borrower’s assets
-Unsecured note - corporate bond issued without any form of security attached
•Foreign Currency Liabilities:
-Debt instruments issued into international capital markets that are denominated in
another currency
-Euromarkets - debt markets where instruments are issued into another country
but not denominated in the currency of that country
•Loan Capital & Shareholders’ Equity:
-Loan Capital - sources of funds that have the characteristics of both debt & equity
-E.g. subordinated notes (hybrid securities) - holder paid after all other creditors
(exc. ordinary shareholders)
-Main type of equity issued is ordinary shares - important source of long-term
funding
-Uses of Funds:
•Personal & Housing Finance:
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Monday, 13 March 2017
-Largest use of banks’ funds
-Largest form of bank lending is for owner-occupied housing
-Housing finance - provision of long-term funds to enable the purchase of
residential property; bank registers mortgage over property as security
•Mortgage - form of security whereby a lender registers an interest over the title
of a property
-Mortgage originators - specialist mortgage lenders that typically refinance their
lending through securitisation
•Securitisation - non-liquid assets are sold into a trust; trustee issues new
securities; cash flows from interest & principal (housing loans) used to repay
principal on new securities issued
-Typical housing loans require amortised loan instalments:
•Regular & equal instalments that comprise the current interest payment due,
plus repayment of the loan principal outstanding
-Investment property finance - funding enabling borrower to purchase property to
rent or lease to a third party
-Personal overdraft facilities - allow individual to put account into debit up to
agreed limit (expected to be brought to credit when individual receives income)
-Credit card - card facility providing access to funds through electronic distribution
systems (ATMs, EFTPOS) - predetermined credit limit
•Typically high interest rates on used credit (transaction & other fees may apply)
•Commercial Lending:
-Bank assets invested in business sector & lending to other financial institutions
-Main type of loan is fixed term loan; maturity of 3-7 years
-Interest rate may be variable & set to reference interest rate
•Benchmark interest rate published daily & used for pricing variable-rate loans
•E.g. Bank bill swap rate (BBSW) - average midpoint of banks’ bid & offer rates
in the bank bill secondary market
-Overdraft: Arrangement with bank allowing business to place operating account
into debit up to agreed limit (manage mismatches in timing of cash flows)
-Commercial Bills: Bill of exchange issued direst to raise finance for a business; a
discount security; may be sold into money market
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Document Summary
Main activities of commercial banking: asset management - restrict growth in lending to level of funds available in depositor base. Practiced under heavy regulation (only lend out what is available: liability management - actively managing sources of funds (liabilities) in order to meet future loan demand (assets) Borrow directly from domestic & international capital markets to manage liability base. Major banks have high credit ratings - can borrow substantial amounts: off-balance sheet business - transactions that represent a contingent liability; not recorded on balance sheet. Sources of funds: sources of funds appear on the balance sheet either as liabilities that the bank will repay, or as equity funds provided by shareholders, current account deposits: Liquid funds held in a cheque account; cheques drawn to purchase goods & services (may be interest, or non-interest bearing) Cheque instructs bank to pay speci ed sum to payee shown in cheque.