This individual assessment task is designed to test a student’s achievement of objectives 1-6. The total mark is 30 marks (weight: 20% of total assessment). Word limit: 2,000 words (±10%), excluding references and appendices.
The 2008 global financial crisis was partly caused by banks’ failure in liability management (or funding management).
a. Contrast between deposit and non-deposit liability sources by highlighting differences in their funding costs as well as other non-cost implications (for instance, risks, market factors, etc.). Your discussion should be supported by real-life examples. (Guide: 1000 words, 16 marks)
b. Comment on the relative importance of different liability items on a specific Australian bank balance sheet. (Guide: 300 words, 6 marks)
c. Download Orbis data for four (4) Australian commercial banks during 2012-2016 with regard to their liability mix and construct two (2) graphs that illustrate the trends in their liability mix over these years. Each graph is a line chart containing four (4) lines for the chosen banks. Based on these graphs, comment on differences between banks (peer analysis) as well as changes over time (trend analysis). (Guide: 500 words, 8 marks)
Note: Approximately 200 words are recommended for introduction and conclusion together. Subheadings should be used to separate parts a, b and c.
Suggested data source for part c: Orbis Bank Focus (access via Monash library database website, under the “Banking and Finance” tab).
Bank’s Liability Management
The uncertainty in the nature of bank in terms of cash flow, the cost of funding, the return on investment, requires banks to put great emphasis on its management of assets and liabilities. Typically, a bank has to make trade-off between its risk, return, and liquidity(Kusy and Ziemba, 1986). The financial intermediation theory argues that one of the essential role of banks is to create liquidity and to establish financial stability and banks achieve these goals by deposits and non-deposit funding.
Part a Differences between deposit funding and non-deposit funding
Traditionally, banks reply on deposit accounts to sell to individuals, business, and government. Examples of non-deposit funding sources include current deposits, fixed deposits, certificates of deposits, and others. The customer relationship doctrine states that the top priority of banks is to lend loans to profitable clients. If the deposit is insufficient to cover the new loans, the low cost source of funds will be borrowed to satisfy the needs of clients. In the 1960s, the customer relationship doctrine of banks has been developed into the liability management theory in banking. If the deposit volume is not adequate to satisfy all the loans that these individuals and organizations want to take out, banks might seek non-deposit source of funding in the capital and market for period s of time. In other words, banks can buy funds to meet the credit requirement of the profitable clients. Examples of non-deposit funding sources include liabilities due to clearing houses and financial institution, bill acceptances, repurchase agreements, commercial papers, and subordinated debts and other long-term borrowings. There are four basic different between the banks’ deposit funding and non-deposit funding.
The relative cost of funds
In general, non-deposit source of funding is more expensive transaction deposit and time deposit. Transaction deposits often have an interest rate close or equal to zero while time deposit pays higher interest rate, which depends on the time span of the deposits. At the same time, the interest rate for non-deposit funds are normally higher than that of the time deposit. The higher non-deposit funding leads to higher loan interest rates as well.
In addition, besides interest costs, non-interest cost might also be incurred if banks want access to the funds, including costs associated with transactions, facilities, and staff time. The chart following is the absolute cost at which banks issue new unsecured wholesale debt, which is above the risk-free benchmarks (Cameron Deans and Stewart, 2012). Compared with the interest rate of term deposit at the same period in 2012, the National Australia Bank has term deposit rate for one year at 5.00% p.a, with Australian New Zealand Bank (ANZ) the same interest rate, Commonwealth Bank of Australia at 4.25% p.a., and Citi Bank at 2.90% p.a (Finder.com, 2017).
Chart the absolute cost of issuing new unsecured wholesale debt
The terms of the funding
Most of the non-deposit source of funding is more short term oriented instead of long term oriented. Lending institutions regard the non-deposit funding market as a major source for short term capital in order to meet the loan obligation or the handle unexpected emergencies for cash. The deposit can be made for different lengthy of time, ranging for one month to several years. On the other hand, due to the nature of non-deposit funding, a large proportion of non-deposit funding is made for relatively short period of time. Liability management of banks puts heavy emphasis on short term loans, especially the overnight loans and intraday loans. In fact, the majority of Eurodollar will mature within six months and some are overnight. Commercial paper also includes short term notes, with will mature in three or four days or in nine months (Rose and Hudgins, 2005). Negotiable CDs and Fed funds is also for a short period of time. The table below is the composition of the Australian bank liabilities in June 2010. It can be seen that from this table, the long term loans and placement is 0.7% of the total liabilities whereas the short term loans and placement accounts for 3.5% of the total liabilities(Cameron Deans and Stewart, 2012).
Table Australian bank liabilities: June 2010
The flexibility of funding
Compared with deposit funding, non-deposit findings offer more options and choices for funding as sources, including Federal Funds Market, repurchase agreements, Borrowing from the Federal Reserve Bank, the Federal Home Loan Bank, the Eurocurrency deposit market, and Commercial Paper Market, and so on (Adrian and Shin, 2009). The different types of funding allow banks to choose the most suitable funding sources to satisfy their need for funding based on cost, timing, risks, and other factors. In other words, the borrower can decide the amount to borrow, the terms of the funding, and the sources of funding. On the other hand, when deposit funding is used, it is the depositor rather that the banks who are making the decision as how long the term should be and the amount of the borrowings (Gorton and Metrick, 2012). For the chart above, it can be identified that Australian bank has non-deposit funding sources in many forms, such as bonds, commercial paper, long term or short term loans, and bill acceptance. Short term loans can help the bank achieve its short term needs for cash and long term loans will satisfy its needs for funding in the long run.
The associated risks of funding
While deposit funding is associated with the interest rate risk, the non-deposit sources of funding is associate with both interest risks and credibility availability risks. The demand and supply in the open capital and money market will determine the interest rate. The shorter term of the loan, the market interest rate will be more volatile. For example, the Fed funds loan, which is overnight, is most volatile among all non-deposit funding sources. Besides, the credibility availability risks should also be considered in liability management of banks. If the overall credit condition is weak, lending institution might have limited funds to loan to the customers and only loyal and sound customers will be granted for credits. In some other situations, the institution might increase the interest rate that makes non-deposit funding difficult (Rose and Hudgins, 2005). In period of weak economic situation, for example the commercial paper market and the negotiate CD market will be sensitive to the credibility availability risks. For example, during the financial crisis in 2007, as banks were dependent on non-deposit findings and they were highly interconnected to other banks, the wholesale providers could not support all the banks in terms of economic downturn and resulted in failure of the whole financial system (López-Espinosa et al., 2012).
Part b Relative importance of different liability items
The specific Australian bank chosen for balance sheet item analysis is Australia and New Zealand Banking Group Ltd. The following table is the summary of the liabilities extracted from the annual report in 2016 (ANZ, 2016). It can be noticed that the company has liabilities as funding sources such as deposit and other borrowings, debt issuance, and subordinated debts. Compared with deposit and other borrowings, debt issuance and subordinated debts is nearly 17% of the total funding sources. As a result, it can be concluded that the company maintains a relatively high deposit and borrowing ratio while has relatively low debt ratio, which might indicate the sound and health condition of the bank.
Table the component of deposit and other borrowings of ANZ
Data Source Annual report 2016 ANZ
A closer look at the components of the deposit and other borrowings reveals that the non-deposit funding sources, namely, Securities sold under repurchase agreements, borrowing corporation debt, and Commercial Paper only consist a small portion of the total item. Among all non deposit sources of funding, however, the debt issuance, subordinated debt, and commercial papers has the largest portions. Meanwhile, the debt issuance plays the most important roles in the funding from non deposit sources, followed by subordinated debts as a source of funding. In addition, the term deposit and On demand and short term deposits consist a large portion of the overall item. Based on the annual report, the customer deposit makes up of more than 65% of the total funding excluding derivatives. It can be concluded that ANZ has relatively well managed its liquidity and has relatively less reliance on non deposit funding.
Table the component of the funding sources of ANZ
Data Source Annual report 2016 ANZ
Provide two (2) graphs to illustrate banks’ liability mix and conduct trend analysis and peer analysis for each graph.
Part c – Construct 2 graphs. Based on the graphs, comment on differences between banks (peer analysis) as well as changes over time (trend analysis).
Adrian, T. & Shin, H. S. 2009. Money, liquidity, and monetary policy.
ANZ 2016. Annual Report.
Cameron Deans & Stewart, C. 2012. Banks' Funding Costs and Lending Rates [Online]. Available: http://www.rba.gov.au/publications/bulletin/2012/mar/5.html [Accessed September 04 2017].
Finder.com. 2017. Historical term deposit interest rates – what was the average? [Online]. Available: https://www.finder.com.au/historical-term-deposit-rates [Accessed September 09 2017].
Gorton, G. & Metrick, A. 2012. Securitized banking and the run on repo. Journal of Financial economics,104,425-451.
Kusy, M. I. & Ziemba, W. T. 1986. A bank asset and liability management model. Operations research,34,356-376.
López-Espinosa, G., Moreno, A., Rubia, A. & Valderrama, L. 2012. Short-term wholesale funding and systemic risk: A global CoVaR approach. Journal of Banking & Finance,36,3150-3162.
Rose, P. S. & Hudgins, S. C. 2005. Bank Management and Financial Services, McGraw-Hill/Irwin.