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Tutorial 4 Solutions

Identify the main categories of ADIs and briefly describe their main activities and
relative sizes
APRA divides Australias ADIs into five categories:
Australian-owned banks: these are divided into the major banks (WBC, NAB, CB,
ANZ), and others (such as regional banks and Macquarie Bank).
Foreign subsidiary banks: can participate in both retail and wholesale banking
business.
Branches of foreign banks: cannot accept retail deposits and are providers of
wholesale banking services.
Building societies: thrifts, meaning they specialise in retail banking.
Credit unions: also thrifts; often owned by its members and formed by employee
groups or by communities.
Of the banks, the majors (and their subsidiaries) have 76% of resident banking assets and
other domestic banks 9% so Australian owned banks total 85%. Branches of subsidiary banks
hold around 11% of banking assets and foreign subsidiary banks 4%. Building societies and
credit unions are not included in these statistics (as they are not banks) but their combined
assets are small and would total around 3% of bank assets.
(http://www.apra.gov.au/Insight/upload/Insight_Issue_2_2010_all_r.pdf)

Describe the major uses of funds by the banking system and explain the purposes of its
holdings of securities
The main uses of funds by banks are loans (particularly housing loans) and liquid assets.
These assets include notes and coins, ES funds, loans to the overnight market, and money and
bond market securities. The reasons for holding securities are (i) as a store of liquidity, (ii) as
an inventory of securities to trade and (iii) as investments.

Suppose you took out a $280 000 housing loan at 7.2% per annum over 25 years with
monthly payments. Calculate the amount you still owe the bank after having made your
regular payments over the past six years
The regular payment is calculated as follows:

1
$280,000
= = $2,014.85
0.072 2512
1 (1 + 12 )
( 0.072 )
12
The amount owing after six years of payments is calculated as follows (note that after six
years there are (25x12) (6x12) = 228 repayments remaining):
0.072 228
1 (1 + 12 )
= $2,014.85 ( ) = $249,956.05
0.072
12

Explain how banks securitise parcels of their housing loan


Banks securitise large parcels of existing loans by selling them to a special purpose vehicle
(SPV), which buys them with proceeds from the issue of mortgage-backed securities (MBS).
Therefore the loans become the property of the investors in the securities, and repayments
(less fees to the ADI selling the assets and the SPV) flow through to these investors. The
bank receives cash from the sale of the loans. It is important for the bank that the
securitisation of the loans completely shifts their credit risk to the investors in the MBS.

Extract 3, Question 33
Initial proceeds
$60
1 = = $59,024,876.69
90
1 + (0.058 + 0.009)
365
First rollover
$60
2 = = $59,032,036.34
90
1 + (0.0575 + 0.009)
365
Interest payment = 60m - $59,032,036.34 = $967,963.66
Second rollover
$60
3 = = $59,039,197.71
90
1 + (0.057 + 0.009)
365

Interest payment = 60m - $59,039,197.71 = $960,802.29

Third rollover

2
$60
4 = = $59,046,360.83
90
1 + (0.0565 + 0.009)
365
Interest payment = 60m - $59,046,360.83 = $953,639.17

Redemption payment: $60m

Define liquidity risk and explain why ADIs are subject to this risk
Liquidity risk refers to the possibility that an ADI is not able to meet its financial obligations
when they fall due. ADIs are exposed to this risk because of the maturity mismatch between
their assets and liabilities. A large proportion of deposits could be withdrawn immediately
whereas a large proportion of an ADIs assets are housing loans on which the funds are
repaid gradually over many years and thus an ADI could not raise the funds required to repay
depositors if they all (or even many) decided to withdraw their funds at the same time.

Explain how ADIs manage their liquidity risk.


ADIs manage their liquidity risk by holding liquid assets including cash, ES funds, deposits
in the inter-bank market and securities that could be sold to raise additional liquidity. They
also establish diversified sources of funds (such as the majors offshore borrowing programs).
ADIs permit customers to repay loans early and assist borrowers to raise funds from financial
markets as an alternative to lending them the funds. They are also able to borrow ES funds
from the RBA.

Write a concise essay on credit risk and how it should be managed through prudent
lending practices.
Credit risk is the possibility of loss due to a borrowers default. When a borrower is in arrears
the loan is impaired. This means the lender is not receiving the loans scheduled interest
income and the lender would have to judge whether the borrower is able to make up the
missed payments. Once the lender has judged that the loan is in default and has taken over the
secured assets, the lender will decide whether to sell the asset and the proceeds would
determine the extent of the loss given default.

ADIs manage their credit risk by first deciding on what loans to make. When making small-
value retail loans they seek to optimise the collection of data from the applicant given the

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costs involved. When making large business loans they can afford to spend more on
gathering information relevant to the applicant. To optimise such lending they attempt to
develop long-term relationships (say through attracting depositors who later borrow from the
ADI) that provide the ADI with knowledge of the loan applicant. ADIs will set an upper limit
on the risk they take with their loans and seek to diversify their lending to business. They will
also ensure that their lending rates are sufficient to allow them to make provisions for losses.

Define market and interest rate risks and explain how they arise for ADIs
Market risk arises from adverse movements in market variables that cause losses. Banks have
a relatively low exposure to market risk since most of their assets (i.e. loans) are not traded
and so are not exposed to market risk. Their exposures arise from their holdings of securities
and foreign exchange. Interest rate movements are a specialised form of market risk. Banks
are exposed to interest-rate risk in several ways, for example when they fund a fixed-rate loan
with floating-rate funds and when the timing of the change in floating rate loans differs from
the change in the rate on liabilities. Banks generally hedge these exposures.

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