Banking and Financial Intermediation
Department of Applied Finance
2024-07-31
DIs (banks, interchangeably) are financial institutions chartered to take deposits from the public and grant loans simultaneously. They are necessary in an economy achieving efficient allocation of financial resources.
However, we also note that
Therefore, bank failures have significant negative externality. As a result, banks are heavily regulated.
What types of regulations are needed or in place for banks?
Economic theories generally view competition as improving social welfare. But it is not necessarily true for the banking sector.
Before GFC, the banking regulations primarily focused on prudential regulations concerning the risks of individual banks.
Post-GFC, the banking regulations have expanded to include macroprudential regulations.
A bank has a banking book and a trading book, two different ways to categorize financial assets and liabilities, each governed by different management strategies and regulatory standards.1
The most simplified balance sheet of a bank:
| Assets | Liabilities and Equity |
|---|---|
| Loans | Deposits |
| Other assets | Other liabilities |
| Equity |
Figure 2: Excerpt of CBA’s 2023 balance sheet - assets
Loans are often in the banking book and reported based on amortised book value.
Major risks due to uncertainties in:
Bonds, derivatives, investment securities, …
For example, a bond’s price is given by
P=T∑t=1C(1+r)t+F(1+r)T(1)
where C is coupon payment, F face value, T maturity, and r interest rate.
Risks due to uncertainties in:
viewof maturity4 = Inputs.range(
[1, 30],
{value: 15, step: 1, label: "Maturity (years):"}
)
viewof couponRate4 = Inputs.range(
[0.01, 0.2],
{value: 0.05, step: 0.01, label:"Coupon rate:"}
)
d = {
const f = 100;
let c, m;
c = couponRate4;
m = maturity4;
function pv(c, f, t, r) {
return c * (1 - (1+r)**(-t)) / r + f / (1+r)**(t)
}
const prices = {"YTM": [], "Price": []};
let coupon = f * c;
for (let ytm = 0.01; ytm < 20; ytm++) {
let price = pv(coupon, f, m, ytm/100);
prices["YTM"].push(ytm);
prices["Price"].push(price);
}
return prices;
}
data4 = transpose(d)
Plot.plot({
caption: "Assume $100 bond, annual coupons paid in arrears and effective annual discount rate.",
x: {padding: 0.4, label: "YTM (%)"},
grid: true,
marks: [
Plot.ruleY([0, 100]),
Plot.ruleX([0]),
Plot.lineY(data4, {x: "YTM", y: "Price", stroke: "blue"}),
]
})Many are on the trading book.
Figure 3: Excerpt of CBA’s 2023 balance sheet - liabilities
Deposits are the most important funding source of banks - 60% for Australian banks.
Risks involved:
Debts are also an important funding source of banks.
Risks involved:
Equity, assets value minus liabilities.
Many other risks:
Note
See how NAB discusses risk factors, p89 of its annual report 2023.
Bank failure occurs when a bank is unable to meet its obligations to its depositors or other creditors and either goes bankrupt or must be taken over by a financial regulatory body to avoid bankruptcy.
Figure 5: Bank failures in the US
SVB’s failure in March 2023 is the largest failure since GFC.
In this course, we will examine bank risks one by one in a three-step framework:
Failure of banks has significant negative externality.
Broadly, banking regulations can be classified into two aspects:
The two aspects are not mutually exclusive, but complementary.
The Bank for International Settlements (BIS) established in 1930 is the principal centre for international central bank cooperation.
The Council of Financial Regulators (CFR) coordinates main financial regulatory agencies in Australia, including:1
Figure 6: Evolution of the RBA
RBA is the central bank of Australia.
The role and functions of the RBA explained by the Governor Michele Bullock [Video].
APRA, established in 1998, is an independent statutory authority that supervises institutions across banking, insurance and superannuation, and is accountable to the Australian Parliament.
APRA’s primary functions and objectives include:
ASIC is Australia’s corporate, markets, and financial services regulator.
The Department of the Treasury (Treasury) also plays a role in the formulation and implementation of banking regulations in Australia.
Some important ones include:
Some important ones include:
Some important ones include:
AFIN8003 Banking and Financial Intermediation
