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ECON335-Economics Of Financial Institutions

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Questions:

1.Discuss the changes in the funding composition of banks in Australia, taking into account the global financial crisis (2008-2009) as a reference point. Also, explain the risks posed by banks’ reliance on short-term wholesale funding.

2.Through reading the following articles, and conducting some independent research on this matter, discuss the problems Chinese banks are facing and the role the People’s Bank of China plays in creating, as well as solving, these problems.

3.What are the Fed’s stress tests? Discuss the conditions under which they were born, and the future prospect of these tests.
 
 

Answer:

1.In Australia, banking sector has changed its funding composition over the years through altering funding costs and rates of lending. This situation can be analysed precisely in the context of global financial crisis, as this has adversely affected funding composition and costs of banks in Australia. The flow-on effects have affected lending rates as well as net interest margins of these banks. The overall costs of funding of Australian banks increased significantly compare to their cash rates since 2007 indicating higher deposit cost along with debt of long-term wholesale and their dynamic funding mix (Reserve Bank of Australia. 2018). Lending rates of Australian banks have increased to a noticeable level compare to the cash rate as well. The lending rates for some significant banks have increased by large extend and this in turn has helped banks to compensate their higher costs of funding based on their net interest margins during 2009. In Australia, operations of banks have various funding bases while deposits are considered as chief source of funding along with short-term and long-term debt of wholesale. For different banks, this funding mix varies though some major banks have comparatively larger deposit funding share while the entire banking system depends chiefly on securitisation by small amount. Regional banks, on the contrary, possess larger deposits and consequently generate securitisation by large amount and fewer use of offshore funding (Saghi-Zedek and Tarazi 2015). On the contrary, foreign banks have comparatively lower deposits but more amount of funding from both domestic market of capital and offshore.

 

Figure 1: Australian banks’ funding composition between 2006 and 2010

Source: (Reserve Bank of Australia. 2018)

The above figure has represented funding composition of Australian banks for four years starting from 2006.  From this figure, it can be said that domestic deposits, long-term deposits and equity have increased over the year while short-term debt and securitisation have decreased during this period. During short-term, funding composition of domestic deposit has decreased while short-term debt increased. To calculate funding share, deposits of all Australian banks are considered that increased between 2007 and 2009. Within this period, the long-tem wholesale debt has increased by 6 percentage points to 24 percentages. The regional banks have played important role to increase their deposit funding while deposit of foreign banks have fallen comparatively (Salim, Arjomandi and Seufert 2016). Over these years, the share of deposits related to Australia’s total funding has changed slightly instead of higher interest rates offered that those banks offered for attracting extra deposits.

During financial crisis, bank bill increased above OIS rates and consequently the spread increased at 100 base points 2008. As the debt has short period of maturity, these higher level of spread has driven through funding costs of banks. However, previous risk related to banks bill have reduced and consequently short-term market of capital debt of some important banks have remained around 15 to 20 basis points, which can be referred as more  costly compare to the cash rate expectation of in 2007. For regional banks, the cost of short-term debt has remained comparatively high.

2.The present governor of Reserve bank of Australia has pointed out risks in China’s financial system due to shadow banks or non-bank financial institutions that operate significant role to regulate entire wholesale market. Most of the countries associated with rapid growth of credit have faced financial crisis, which further has brought recession (Bloomberg.com. 2018). China has indentified this problem though responded at a slower rate to recover from this crisis. According to the financial market commentators of China, the country cannot experience any financial crisis, as it has higher amount of savings, government regulations over the financial market and lower level of foreign debt. Higher amount of savings help the country to protect itself from negative impacts of financial crisis though increasing funding of wholesale by shadow banks have generated significant problems.  

Moreover, the economic slowdown of China adversely affects construction and manufacturing sectors though no significant reform has been done for changing this downturn situation. However, some large-scale companies have taken higher amount of loan from some well-known banks like the Bank of Shengjing (Lowyinstitute.org. 2018). However, this flow of loans from regional banks to loss making companies has generated serious risk with the country’s economy indicating a debt explosion since global financial crisis. In addition to this, a connection between local banks and poor regional banks has generated attention among investors like Alexander Campbell and others. Many regional banks have already bankrupted while the government or some leading banks have possessed some other banks as their person piggy banks. These small banks and their activities have generated huge trouble for China’s financial sector to develop further. The official loan-to-deposit ratio of Chinese banks has increased from 65.8 percent to 71.2 percent from mid of 2015 to march of 2018. New deposits in this country increased during 2015 and since then the sector has failed to maintain its lending growth. In 2017, the total amount of new loans of this country was 100.1 percent while during first five months of 2018 this amount becomes 104 percent of new deposits. Since 2015, the People’s Bank of China has increased its lending to commercial banks by large amount (300%) worth $ 1.5 trillion (Financial Review. 2018). In addition to this, the central bank has also forced other banks to change their lending patterns through allowing debt of short-term to expire and rolling it into long-term debt. As a result, long-term and medium-term loan have generated around 85 percent all total new lending of banks. 

 


In this context, policy has been changed large extend as well. In April 2018, a cut in reserve rate was occurred to help banks for repaying their existing loans with PBOC. Moreover, the central bank has stated that it would accept lower-grade assets like collateral and loans to different enterprises by large extend. China tries to reduce its credit by reducing interbank lending and products related to wealth management (Yamaguchi 2018). However, according to the UBS Global Research, due to sharp increase in issuances related to institutional certificates of deposit and consistent assistance of PBOC, the country generated wholesale funding by 1 trillion.

3.Stress test implies an examination concerning about the activities of banks during any difficult situation. The Fed considers hypothetical scenarios like huge unemployment, financial crisis or other conditions of doomsday with the help of which it observes real-life balance sheet of the bank (Gogas, Papadimitriou and Agrapetidou 2018). This further helps the central bank to calculate the amount of money that it could lose. In the United States, banks that have possessed assets worth $ 50 billion or more in terms of their value, are fallen under the criteria of internal stress tests by the Federal Reserve, or own risk management of these banks (Flannery, Hirtle and Kovner 2017). These tests point out some chief risks, for instance, market risk, credit risk and liquidity risk within the financial system of these banks during the crisis period. . In this context, stress tests can help these banks to earn confidence for upcoming situation.  

During global financial crisis, some large-scale banks experienced trouble, as they were not prepared for this phenomenon and this in turn led taxpayers to bail out. As a result, stress tests of bank has been formed after 2007-2009 period, as this crisis led many banks to experience undercapitalisation that the stress tests intended to prevent. Two types of stress tests can be observed for the Fed and for companies, respectively. The Fed applies this test to observe that whether a bank possesses enough capital to sustain during the period of crisis or not. On the contrary, company conducts these tests semi-annually (Christensen, Lopez and Rudebusch 2015). Banks that fallen under this test publish their outcomes, which further help public to understand about the activities of these banks during the crisis period. In addition to this, new regulations are formed for those banks, which cannot pass the test.

The Federal Reserve implies some streamline, where it provides relief to particular small lenders. These annually conducted tests are considered as one of the chief indicators, which measures the amount that capital regulators demand from the bank. On the contrary, lenders complain about the complexity and unpredictability of this regime. Hence, the new U.S president intends to reduce the burden of regulation related to post-crisis on Wall Street. In this context, some proposals have been formed that lawmakers consider remedying different aspects of the regime. Regulators of the new regime can utilise the outcomes related to the annual stress tests for establishing a new buffer of stress capital. This regime will replace the requirements of existing capital indicate that banks do not require to maintain track for two different regimes. However, these will be different for different banks due to their different circumstances. However, for other banks that are considered less important, the new regime will be less based on their capital requirements considering their capital requirement between $ 10 billion and $ 25 billion in total (Avkiran, Ringle and Low 2018). 

 

References:

Avkiran, N.K., Ringle, C.M. and Low, R., 2018. Monitoring transmission of systemic risk: Application of PLS-SEM in financial stress testing. The Journal of Risk, 20, pp.83-115.

Bloomberg.com. 2018. Terms of Service Violation. [online] Available at: https://www.bloomberg.com/view/articles/2018-06-14/china-s-banks-are-still-in-trouble [Accessed 31 Aug. 2018].

Christensen, J.H., Lopez, J.A. and Rudebusch, G.D., 2015. A probability-based stress test of Federal Reserve assets and income. Journal of Monetary Economics, 73, pp.26-43.

Financial Review. 2018. Why some of China's banks have become dangerous . [online] Available at: https://www.afr.com/news/world/why-some-of-chinas-banks-have-become-dangerous-20180730-h13cqr [Accessed 31 Aug. 2018].

Flannery, M., Hirtle, B. and Kovner, A., 2017. Evaluating the information in the federal reserve stress tests. Journal of Financial Intermediation, 29, pp.1-18.

Gogas, P., Papadimitriou, T. and Agrapetidou, A., 2018. Forecasting bank failures and stress testing: A machine learning approach. International Journal of Forecasting, 34(3), pp.440-455.

Lowyinstitute.org. 2018. China’s looming financial crisis. [online] Available at: https://www.lowyinstitute.org/the-interpreter/china-looming-financial-crisis [Accessed 31 Aug. 2018].

Reserve Bank of Australia. 2018. Liquidity, Financial Crises and the Lender of Last Resort – How Much of a Departure is the Sub-prime Crisis? | Conference – 2008 | RBA. [online] Available at: https://www.rba.gov.au/publications/confs/2008/davis.html [Accessed 31 Aug. 2018].

Reserve Bank of Australia. 2018. Recent Developments in Banks' Funding Costs and Lending Rates | Bulletin – March Quarter 2010 | RBA. [online] Available at: https://www.rba.gov.au/publications/bulletin/2010/mar/6.html [Accessed 31 Aug. 2018].

Saghi-Zedek, N. and Tarazi, A., 2015. Excess control rights, financial crisis and bank profitability and risk. Journal of Banking & Finance, 55, pp.361-379.

Salim, R., Arjomandi, A. and Seufert, J.H., 2016. Does corporate governance affect Australian banks' performance?. Journal of International Financial Markets, Institutions and Money, 43, pp.113-125.

Yamaguchi, M., 2018. Are Foreign Banks in China Homogenous?: Classification of their Business Patterns. Journal of Accounting, Business and Finance Research, 3(1), pp.10-17.

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