TFS Mod 3

Introduction to Intermediation and Authorised Deposit-taking Institutions

• Intermediation, or indirect financing, is the process where financial institutions, primarily banks, acquire funds from surplus units and provide them to deficit units.
• Surplus units generally provide funds in the form of deposits, while deficit units receive these funds as loans.
• In Australia, only Authorised Deposit-taking Institutions (ADIs) are legally allowed to conduct banking business.
• The term "banks" is commonly used to refer to all ADIs, which includes entities like credit unions and building societies.

Benefits of Intermediation

• Banks act as intermediaries to manage significant mismatches between the preferences of depositors (surplus units) and borrowers (deficit units).
• Banks perform four primary transformations:
  • Denomination Transformation: They transform many small deposit balances into a smaller number of larger loans.
  • Maturity Transformation: They convert short-term deposits into long-term loans.
  • Risk Transformation: They transform the high risks associated with lending directly to deficit units into risk levels that are acceptable to individual depositors.
  • Return Transformation: They bridge the gap between the returns acceptable to surplus units and the borrowing costs acceptable to deficit units.

Maturity Mismatch and Bank Risks

• A bank balance sheet typically exhibits a maturity mismatch where assets (loans) are long-term and liabilities (deposits and securities) are short-term.
• This mismatch creates two specific risks for banks:
  • Liquidity Risk: The risk of having insufficient liquid funds to satisfy withdrawal demands from depositors.
  • Funding Risk: The risk of being unable to roll over (renew) maturing sources of funds in financial markets.

Net Interest Income and Margins

• Net Interest Income is defined as the interest received on bank assets minus the interest paid on bank liabilities.
• This income is often expressed as a margin or spread, representing the difference between the average interest rate earned on funds and the average interest rate paid for those funds.
• Data indicating the net interest margin for major banks shows a general decline from $1999$ to $2022$.
• By approximately $2023$, the domestic half-yearly net interest margin for major banks hovered around $2.0\%$.
• Cost of intermediation includes not only interest spreads but also bank fees, such as account servicing fees.

Structure of Australia’s Banking System

• The Australian Prudential Regulation Authority (APRA) categorises ADIs into five subgroups:
  • Australian-owned ADIs: This includes the "big four" financial conglomerates (ANZ, Westpac, Commonwealth Bank, and NAB) as well as others like Macquarie Bank.
  • Foreign Subsidiary Banks: These provide retail banking services and include names such as ING, HSBC, and Rabobank.
  • Branches of Foreign Banks: These focus on providing investment banking services for business clients, with examples including BNP Paribas and Deutsche Bank.
  • Restricted ADIs: Entities providing limited services, such as Avenue Bank.
  • Providers of Purchased Payment Facilities: Specialized entities such as PayPal.

Bank Profits and Performance Metrics

• Profitability is measured by the return on shareholders' equity after tax and minority interests.
• Major banks have historically maintained a return on equity around $12\%$ to $15\%$ over the past decade.
• Major banks generally show higher and more stable profitability compared to foreign-owned or other Australian-owned banks.
• Net profit after tax for major banks fluctuates based on economic conditions, with significant charges for bad and doubtful debts impacting the bottom line. For instance, bad debt charges for major banks were notably high around the $2008$ period.

Sources of Bank Funding

• Banks fund their assets through a combination of Equity and Liabilities.
• Primary sources include:
  • Retail Deposits: These are now the largest source, providing approximately $60\%$ of bank funding as of mid-$2022$.
  • Financial Markets: Comprising approximately $28\%$ of funding (mid-$2022$), including short-term and long-term debt.
  • Short-term Debt: Includes Negotiable Certificates of Deposit (NCDs) and Commercial Paper.
  • Long-term Debt: Primarily Bonds.
  • Securitisation: Selling bundles of loans as securities.
  • Equity: Shares and retained earnings.
• Historical Shift: Prior to the Global Financial Crisis (GFC), banks relied more heavily on financial markets. Post-GFC, banks shifted toward domestic retail deposits as they are considered more reliable.

Characteristics of Retail Deposits

• Safety: Highly secure due to APRA’s prudential supervision. Deposits up to $250\,000$ are protected by the Australian government guarantee.
• Liquidity: Deposits are liquid and can be withdrawn by the customer.
• Returns: They provide interest and payment services.
• Investment Role: Fixed-term and savings accounts are used for investment; $25\%$ of Self-Managed Superannuation Fund (SMSF) assets are held in bank deposits. They are viewed as "defensive" investments due to low risk and capital stability.

Short-term and Long-term Debt Markets

• Short-term Debt (< $1$ year):
  • Usually unsecured promises to pay face value at maturity.
  • Interest is embedded in the face value (discount securities) rather than through separate interest payments.
  • Negotiable Certificates of Deposit (NCDs): Domestic wholesale deposits ($5$ million or more) with fixed terms and interest rates that can be traded in the money market.
  • Commercial Paper: Predominantly issued offshore in US dollars.
• Long-term Debt:
  • Bonds: Securities where the bank pays regular interest and returns the face value at maturity. Typically issued in large amounts with terms of $4$ to $6$ years.
  • Bonds can be unsecured (most common), covered, hybrid, or asset-backed.

Securitisation and RMBS

• Securitisation is the process of assigning cash flows from illiquid assets, like housing loans, to Residential Mortgage-Backed Securities (RMBS) which are sold to investors.
• This process allows ADIs to sell large bundles of existing housing loans to free up capital.
• Special Purpose Vehicles (SPVs) are used to conduct the securitisation and issue the securities. Investors in the MBS receive most of the repayments made by the original borrowers.

Bank Equity and Capital Requirements

• Equity consists of proceeds from share issues and retained earnings.
• It is a permanent source of funds that does not require repayment.
• Because shareholders face greater risk, they require higher returns than debtholders.
• Equity serves to strengthen the bank's financial position and protect depositors; consequently, APRA enforces minimum capital requirements.

Uses of Funds: Bank Assets

• Bank assets are categorised as Securities, Housing Loans, and Other Loans (Household and Business).
• Securities:
  • Approximately $20\%$ of bank assets are held in cash and liquid securities.
  • Components include money-market securities, government bonds, notes and coins, Exchange Settlement (ES) funds, and loans to the overnight market.
  • Purpose: Store of liquidity for cash outflows, trading in markets, and earning income on low-risk investments.

Housing Loans

• As of June $2022$, the distribution of housing loans was:
  • Owner-occupier Loans: $65\%$ of total housing loans. Usually follow a reducible structure (principal repaid over the term) and may include features like redraw facilities and mortgage offset accounts.
  • Investment Loans: $34\%$ of total housing loans. These help investors buy property to rent out.
• Interest-only Loans: Monthly payments cover only the interest. The principal is either repaid by selling the property or by rolling over the loan. These accounted for $13.9\%$ of total loans in $2021$, but represented $19\%$ of new loan commitments.
• Negative Gearing: Occurs when the net rental income (after costs and interest) is negative; this loss can be offset against other income for tax purposes.

Lending Standards and Quality

• APRA Prudent Lending Standards include:
  • Assessment of loan servicing capacity (e.g., net surplus income).
  • Verification of income and living expenses.
  • Security arrangements (mortgages over property).
  • Oversight of third-party agents and brokers.
  • Pricing that reflects costs and risks.
  • Management plans for distressed loans and stress-testing of portfolios.
• Lending Indicators:
  • Standard Variable Rate (SVR): The benchmark indicator, though most borrowers receive discounts.
  • Non-performing Loans: Loans where borrowers are $90$ days or more behind on payments. In Australia, this rate has remained below $1\%$ for decades, including during the GFC.
  • Loan-to-Value Ratio (LVR): The majority of outstanding loans have an LVR of $80\%$ or less, protecting banks against property value declines.

Other Loan Categories

• Household Loans:
  • Secured: Personal loans (e.g., car loans), overdrafts (secured by property mortgage, floating rate), and margin loans (for financial securities).
  • Unsecured: Credit cards and some personal loans.
• Business Loans:
  • Small Business: Generally standardised and secured by property mortgages.
  • Large-value Loans: Customised case-by-case. Interest rates include a reference rate plus a margin based on credit risk. Include covenants and mortgages.
  • Common Structures: Term loans (up to $10$ years, fixed or floating) or Revolving Credit Facilities.
  • Other Facilities: Syndicated loans (provided by a group of banks), Standby facilities (approval to borrow if needed), and Leasing (paying for the use of an asset).