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BFF2401 Commercial Banking and Finance

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QUESTION 1: Lange et al. (2015)


3. Identify and explain three economic disincentives that probably would dampen the flow
of funds between household savers of funds and corporate users of funds in an economic
world without FIs.
Investors generally are averse to purchasing securities directly because of (a) monitoring costs,
(b) liquidity costs and (c) price risk.

Monitoring the activities of borrowers requires extensive time, expense and

expertise. As a result, households would prefer to leave this activity to others and, by
definition, the resulting lack of monitoring would increase the riskiness of investing in
corporate debt and equity markets. (households need to check/ensure that the
corporations do not waste the funds on unprofitable profitable projects -> such
monitoring expense is too costly => they would prefer transfer this activity to others)
The long-term nature of corporate equity and debt, and the lack of secondary
market in which household can sell their securities => create disincentive for
household to keep their direct finance claims issued by corporation. Specifically, given a
choice by holding cash or holding securities, household investors are more likely to
choose cash for liquidity reasons.
Third, the price risk of transactions (the sale price will be lower than the purchase
price of that asset) on the secondary markets would increase without the information
flows and services generated by high volume.

8. What are agency costs? How do FIs solve the information and related agency costs when
household savers invest directly in securities issued by corporations? What is the free-rider
Agency costs occur when owners or managers take actions that are not in the best interests of
the equity investor or lender. These costs typically result from a failure to adequately monitor
the activities of the borrower. Because the cost is high, individual investors may do an
incomplete job of collecting information and monitoring under the assumption that someone
else is doing these tasks. In this case, the individual becomes a free rider. But if no other lender
performs these tasks, the lender is subject to agency costs as the firm may not satisfy the
covenants in the lending agreement. Because the FI invests the funds of many small savers, the FI
has a greater incentive to collect information and monitor the activities of the borrower.

10. How do FIs alleviate the problem of liquidity risk faced by investors who wish to invest in
the securities of corporations?
Liquidity risk occurs when savers are not able to sell their securities on demand. Banks, for
example, offer deposits that can be withdrawn at any time. Yet the banks make long-term loans or
invest in illiquid assets because they are able to diversify their portfolios and better monitor the
performance of firms that have borrowed or issued securities. Thus individual investors are able
to realise the benefits of investing in primary assets without accepting the liquidity risk of direct

12. How can FIs invest in high-risk assets with funding provided by low-risk liabilities from
Diversification of risk occurs with investments in assets that are not perfectly positively
correlated. One result of extensive diversification is that the average risk of the asset base of an FI
will be less than the average risk of the individual assets in which it has invested. Thus individual
investors realise some of the returns of high-risk assets without accepting the corresponding risk
20. What is denomination intermediation? How do FIs assist in this process?
Refer to textbook page 13.

4. Contrast the activities of the four major Australian banks with those of the regional banks.
Refer to lecture slides 27-28 of topic 1, or textbook pages 40-41, 52.
9. What are the similarities and differences between the three major groups of authorised
deposit-taking institutions in Australia?
The two types of non-bank DIs in Australia are building societies and credit unions. Generally,
both began life as cooperative organisations, regulated under state or territory legislation
(building societies increasingly now have issued share capital). However, with regulatory
restructure in the late 1990s, both are now regulated in the same way as the banksby APRA.
Credit unions tend to provide retail finance and their members are usually linked by a common
bond such as an employer or profession, which is not the case with building societies. While credit
unions have moved into longer term lending and specifically into housing loans, building societies
have always focused on longer term lending. The difference between the two groups in lending
maturity is now far more blurred than when they were originally established.
Banks are far larger than building societies or credit unions. Banks also operate in a far broader
range of financial services than either building societies or credit unions, as they can leverage their
size and distribution networks effectively. They operate in retail, commercial and investment
banking as well as insurance and funds management.

All Australian depository institutions are regulated by APRA in the same way.

QUESTION 2: What does the term cost of funds mean?

Banks fund loans from a variety of debt and equity sources. Banks need to be aware of how much it
costs to come up with funds so they can then price a loan. Generally equity is more expensive than
debt because shareholders require a higher rate of return.

QUESTION 3: Explain the risk /return trade-off from a banks perspective

A bank's long-term goal is to maximise shareholders' wealth by optimizing the risk return trade off.
Shareholders' wealth can be measured directly using share price.

As the bank takes on more risk, it may be able to generate higher future cash flows which
increase share price.
At the same time, more risk subjects the bank to higher potential losses and volatility, and
so shares will be discounted at a higher rate to reflect larger risk premiums, i.e. a
reduction in share price.

The bank's goal is therefore to maximise share price by taking risk up to the point where the
positive impact on share price is exactly offset by the negative impact.

Students should supplement their response with a diagram similar to that on lecture slide 59 of
topic 1.