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Financial Regulation and Financial Institutions - Coggle Diagram
Financial Regulation and Financial Institutions
Financial Regulation
APRA
-
Australian Prudential Regulation Authority
---
APRA is resposible for prudential supervision of financial institutions including banks, credit unions, building societies, insurance and superannuation companies.
PBL-1:
Define Capital adequcay and explain how it maintains public confidence in banks
Capital adequacy
is where banks cannot lend out all of their capital as investments. At least 8% of risk-weighted assets must be held in reserve to absorb loan losses and this helps maintain public and depositor confidence that minor loan losses will not cause the bank to fail.
E.g
-if a bank has $100 of capital( which all comes from deposits) and lends all $100 out as loans, if a borrower does not pay back $10, the bank will not be able to repay depositors when they ask for their money back as it has lost $10 of their money. If a bank cannot repay depositors, it will collapse, the public will lose confidence in the bank and will withdraw all their money from the bank.
Why it is important for APRA to regulate ADs do not take excessive risk ?
To maintain investors confidence
Limit Contagion(Bank Run)
To prevent bank failures from spreading to other banks;
Protect the stability of the financial system.
What does APRA do?
A) The development, implementation and supervision of prudential regulation
B) Monitoring regulated entities to ensure they are complying with relevant legislation and prudential policies.
C) Advising the government on the development of regulation and legislation affecting regulated institutions and the financial markets in which they operate.
Prudential Regulation means rules to limit the risk taking of banks
Why fiance industry is most heavily regulated?
This is why the finance industry is the most heavily regulated in Australia. In no other industry, would failure threaten the well being of the entire economy.
Thus, risk-taking by banks is closely monitored by APRA and banks cannot invest all of their capital, at least 8% of assets must be kept in reserve to absorb loan losses; Bank losses on loans ≠ Bank failure.
Failure of any bank has the threat of spreading further to other ADIs. This has the potential to disrupt the entire payments system and the whole economy. E.g. excessive risk-taking and the subsequent failure of key financial institutions in the US brought about the GFC.
ASIC-Australian Securities & Investments Commision
As the regulator for IPOs
,
ASIC directly influences the cost of an IPO through the number and extent of regulations that listing companies need to comply to.
PBL-2
:
ASIC decides to cut the disclosure requirements in the preparation of IPO prospectus. The desired effect is to lower the average listing cost from 6-10% of capital raised to 4-8%.
What
impact
would this reduction in regulation have on the flow of funds, ignoring other considerations?
Answer:
Increase the flow of funds as transaction cost of raising capital is lower.While the answer is straight forward, a consideration (which we were asked to ignore in the question) is a lower level of protection and information available to the share buyers.If the IPO goes poorly, share investors lose money and they blame lower regulatory standards for not disclosing enough about the company, then the market could face a loss of confidence in the system which discourages the growth in flow of funds.
What does ASIC do ?
A) Regulating financial markets
B) Regulating financial instruments, securities, futures and corporations.
C) Consumer protection in superannuation, insurance, deposit-taking and credit.
D) Act to enforce and give effect to the law
E) Receive, process and store information that given to ASIC.
F) Make information about companies and other bodies available to the public as soon as possible
ASIC Priorities (优先级）
C) Facilitate international capital flows and international enforcement.
D) Manage the domestic and international implications of the global financial turmoil.
B) Build confidence in the integrity of Austrlia's capital markets.
E) Lift operational effectiveness and services level for all ASIC shareholders
A) Assist and protect retail investors and consumers in the financial economy.
F) Improve services and reduce costs by using new technologies and process.
Why regulate ?
Over-Regulation
inhibits the
efficient
flow of funds.
E.g. The banking system of Australia in the 1970s and 80s was highly regulated. Banks were not free to compete as they had interest rate ceilings imposed on their deposit taking and loan products.
Under-Regulation
also inhibits the
efficient
flow of funds.
Without sufficient rules and parameters to operate by, the financial market will experience wide scale fraud, corruption and distortion. Market participants who possess sufficient market influence will abuse the system for their own benefit at the expense of other stakeholders.
Why we need financial regulation
Provide fairness to all stakeholders (deficit, surplus, intermediaries)
Provide a minimum level of disclosure (information) among partipating parties.
Rules and a system of operation that govern the financial activity.
Promote confidence and the greater participation of the financial system.
RBA:Reserve Bank of Australia-Australia's central bank.
The RBA is responsible for
monetary policy,
the payments system and
the stability of the entire financial system.
It plays a prime role in
determing the cost of debt capital(KD)
in the economy.
What does RBA do ?
(3) Overseeing the payments system through the Payments System Board (PSB)
(4) Acting as the government's banker
(2) Issuing Australian currency notes
(5) Issuing and providing the market for treasury securties.
(1) Determination and implementation of monetary policy. ----PLUS : The RBA sets monetary policy
independently
of government directions and instructions
(6) Managing financial system liquidity and the government's holding of foreign exchange.
Official Cash Rate:
A benchmark interest rate(基准利率) of the economy.The overnight interest rate at which Australian banks borrow and lend to one another(澳大利亚银行间借贷的隔夜利率）. It is a
primary source of funds
and daily bank liquidity( other sources of bank funds include
retail deposits
and
overseas borrowings from money and capital markets.)
The RBA cash rate drives around 65% of bank funding. This sets a
benchmark cost of debt
in the economy.
RBA increases the official cash rate
----When the economy weakens, the RBA can lower the cash rate, which lowers the cost of debt, stimulating consumption and investment.
This is called expansionary monetary policy.
Banks
:warning: will likely
increase the interest rates on their products
( Both loans and deposits). The reason is that the cost of an important source of bank funding
has increased.
Then banks will pass this higher cost to customers-Lending becomes more expensive-
The cost of debt will increase
in the economy.
Consumer
and business will
borrow less
due to the high cost of debt.
Lower consumption investment
contracting the supply of money. This
dampens
the economy activity and growth.
RBA decreases the official cash rate
----When the economy overheats, the RBA can increase the cash rate, which increases the cost of debt, dampening consumption and investment.
This is called contractionary monetary policy
.
Banks
will likely
decrease the interest rates on their products
( Both loans and deposits). The reason is that the cost of an important source of bank funding
has decreased.
Then Banks will pass this cost saving on to customers in the competition for market share.--Lending becomes more expensive---
The cost of debt will decrease in the economy.
Consumers
and businesses will
borrow more due to the low cost of debt.
Higher consumption&investment, expanding the supply of money.
This stimulates the economy activity and growth.
Inflation
-the change in the prices of good & service in the economy: To know a economy weak or overheat, Banks are able to figure it out by inflation.
TIPS:
Inflation is neither good nor bad.It is the indicator of economic health.
Demand goods and services
increases
=
Price and inflation increases
When inflation goes up , this indicates that consumption and investment are growing, usually because workers are earning more money and so, can pay more for and demand more goods and services.
Demand goods and services
decreases=Price and inflation decreases
When inflation goes down, this indicates that consumption and investment are declining, usually because workers are earning less money, can afford less and so demand fewer goods and services.
A
medium-term goal
of the RBA is to maintain inflation with a target band of
2%-3%
Real Rate of Return= Nominal Return - Inflation Rate
RBA Payment System
1) It promotes the efficiency and stability of the Australian currency(AUD) and the payments system.
2)It provides the facilities for the settlement of transactions
3) It acts as the banker to the Australian government.
Financial Institution
Roles of financial institutions
: Financial institutions provide intermediation and the system of payments in the domestic and global economy; allowing safe and efficient…
Dissemination and distribution of payroll
Payments of large sums of money without need for physical cash
Cheque&Bank draft deposit and clearing
Electronic transfers & payments. E.g. EFTPOS, BPAY, Credit & Debit Cards.
Denomination exchange
Currency exchange & International payments across borders
Storage and management of money for individuals and institutions allowing consumption and trade.
Trade credit, e.g. Letters of Credit, Overdrafts, Bank Accepted Bills
Types of Financial Institutions
Main Regulator : APRA
Authorized Deposit-taking institutions
(ADI)
Commerical Banks
Building Societies
Credit Unions
Insurers & Fund Managers
General&Life insurance Companies
Superannuation Funds
Friendly. Societies
Main Regulator: ASIC
Non-ADI Financial Institutions
Investment/Merchant Banks
Finance Companies
Securities
Public Unit & Cash Management
Bank Risk :
Bank risk can be defined as uncertainty arising from cash flows of the banks assets and liabilities.
It is important to know the
primary risks
that commercial banks face
Interest rate risk
arises from unforeseen changes in the interest rate margin due to volatility in asset earnings and cost of funds. Measured by IRM
Liquidity risk
the possibility of not being able to meet required payments to depositors and creditors. Measured using the liquidity gap; difference cash inflow and outflows.
Credit risk
arises from the possibility of default in the bank loan book; causing a loss of a portion or all of loan principal and interest earnings. Measured by default rate.
Other relevant risks discussed in your self-study reading were…
Operational risk
Market risk (measured through VAR)
APRA Regulation:
As discussed in Topic 6, bank failure has the most wide spread repercussions upon the economy and so banking experiences the most extensive regulation of all industries. This regulation deeply affects the management and profitability of banks.
Two important areas
of bank regulation aim to minimise bank failure …
Liquidity Regulation
Liquidity refers to the availability of sufficient funds to meet day-to-day requirements. A common example is being able to meet on-demand withdrawal of deposits at branches and ATMs. Liquidity management aims to ensure that banks have sufficient funds to meet their obligations
APRA mandates that smaller banks must maintain a minimum liquidity requirement of 9% of their total liabilities as liquid assets. An example of liquid assets is cash stored in bank branches and in ATMs. Large banks do not have any mandated minimum liquidity requirement and can set their own, flexible % of total liabilities held as liquid assets.
The Management of Bank Liquidity involves:
Asset management:
maintaining sufficient cash and non-cash assets that can be quickly converted to cash.
Liability management:
Acquiring liquidity quickly and easily through debt while ensuring diversification in creditor obligations.
Capital Regulation
Bank capital performs several important roles:
(2) It provides a financial cushion or buffer against asset losses
(3) It helps maintain investor and public confidence
(1) It serves as a source of funds for asset investment/expansion
(4) It provides some protection to depositors.
Tips : Credit Regulation
Bank pool together low credit risk deposits and lend it out as higher risk loans. This creates credit risk when a borrower defaults on a loan and the ban loses the capital lent out. The bank manages this risk by ensuring that adequate capital is held in reserve, and not all sources of funds are lent out, to absorb such loses and to repay depositors their capital when they withdraw their funds.
APRA is the primary regulator for ADIs and applies
both domestic and international capital adequacy
.
CAR: The ratio of Capital to risk-adjusted assets must be at least 8%
Impact of CAR
When CAR goes up!!!
Banks will have to hold more capital in reserve, so will have less capital to lend out and invest.
Capital held in reserve earns a poorer return than when invested in high interest earning loans.
IR (interest received) will down, IRM will down as will bank profitability.
Banks are likely to increasses the interest cost of their loans to offset the fall in profitability.
This will increase cost of debt, makes banking more expensive and decreases the flow of funds.
When CAR goes down !!!
Banks will have to hold less capital in reserve, so will have more capital to lend out and invest.
Capital invested in high interest earning loans earns a better return than held in reserve.
IR (interest received) will goes up, IRM will goes up as will bank profitability.
Banks are likely to decrease the interest cost of their loans to compete for market share
This decreases cost of debt, makes banking cheaper and increases the flow of funds.
Why Capital Adequacy Regulation is important ?
If banks lend out all their capital, in the event a borrwoer defaults and does not repay part or all of the loan, the bank suffers a loss. As banks obtain their money to lend from depositors , other creditors and shareholders, a loan loss means these capital providers to withdraw their funds in mass, resulting in the collapse of the bank. Such a situation is called a run on banks. Regulators wish to aviod this as such can result in a lossof faith and collapse of the entire financial system.
ADI Regulations
It is important to appreciate the impact of bank regulation on the …
Tightening of regulation where banks have to hold more reserves to strengthen liquidity and capital adequacy (e.g. up CAR & upLiquidity ratios)
= down risk in banks and safer banks for consumers.
But up higher costs of debt & higher costs of banking
Relaxing of regulation where banks need less reserves that weaken their liquidity and capital adequacy. (e.g. lower CAR & lower Liquidity ratios)
= higher risk in banks & less safe banks for consumers.
But lower costs of debt & lower costs of banking
Non-Bank Financial Institutions
Whilst banks are the dominant type of ADI with the top 4 capturing 80% of total ADI assets in 2018, it is important to be familiar with non-bank financial institutions (NBFIs)
Building societies.
Finance companies.
Our discussion of NBFIs focus on credit unions and building societies which are ADIs.
Finance companies are not ADIs
and tend to be arms of large conglomerates and multinationals which provide short-term consumer credit such as store credit, personal, car loans and home loans. e.g. Latitude Finance.
Credit unions.
A key difference between banks and NBFIs is that most NBFIs (excluding finance companies) operate under a mutual or customer-owned structure:
The surplus represents the major source of capital for NBFIs.
The objective is not-for-profit lending to provide personal and community-based financial service.
Any profits/surplus belong to members but are kept as retained earnings and not paid out as dividends.
As of 2016, NBFIs service over 4.6 mil customers and have over A$85 billion under management.
There are no shareholders, just members. Regulated by APRA.
NBFIs operate primarily in the retail deposit taking and loan market and market themselves as viable alternatives to commercial banks.