Off-Balance-Sheet ActivitiesOff-Balance-Sheet Activities

Chapter 13Chapter 13

OBS ActivitiesOBS Activities

invisible to all but best informed investor or invisible to all but best informed investor or regulatorregulator

in accounting terms, OBS activities appear “below in accounting terms, OBS activities appear “below the bottom line”the bottom line”– i.e. usually just as footnotesi.e. usually just as footnotes

in economic terms, OBS activities are contingent in economic terms, OBS activities are contingent assets and liabilities that affect the future, rather assets and liabilities that affect the future, rather than the current, shape of the FI’s balance sheetthan the current, shape of the FI’s balance sheet– have a direct impact on FI’s future profitability and have a direct impact on FI’s future profitability and

solvency performancesolvency performance– efficient management of these OBS items is central to efficient management of these OBS items is central to

controlling overall risk exposure in modern FIcontrolling overall risk exposure in modern FI

OBS ActivitiesOBS Activities

major types of OBS activities for US banksmajor types of OBS activities for US banks– loan commitmentsloan commitments– standby letters of credit and letters of creditstandby letters of credit and letters of credit– futures, forwards, swaps, and optionsfutures, forwards, swaps, and options– when issued securitieswhen issued securities– loans soldloans sold

large thrifts and insurance companies large thrifts and insurance companies engage in most of these alsoengage in most of these also

Loan CommitmentsLoan Commitments

contractual commitment to make a loan up contractual commitment to make a loan up to a stated amount at a given interest rate in to a stated amount at a given interest rate in the futurethe future– most C&I loans today made by firms that use most C&I loans today made by firms that use

prenegotiated lines of credit or loan prenegotiated lines of credit or loan commitments as compared to using spot loans commitments as compared to using spot loans

up-front feeup-front fee– fee charged for making funds available through fee charged for making funds available through

a loan commitmenta loan commitment

Example 1Example 1

BR = interest on loan = 12%BR = interest on loan = 12% m = risk premium = 2%m = risk premium = 2% ff11 = up-front fee on whole commitment = 1/8% = up-front fee on whole commitment = 1/8%

ff22 = back-end fee on unused commitment = ¼% = back-end fee on unused commitment = ¼%

b = compensating balance = 10%b = compensating balance = 10% R = reserve requirements = 10%R = reserve requirements = 10% t = expected (average) takedown rate (0<t<1) on LC = 75%t = expected (average) takedown rate (0<t<1) on LC = 75% Then general formula for the promised return (1+k) is:Then general formula for the promised return (1+k) is:

Loan CommitmentLoan Commitment

What contingent risks are created by loan What contingent risks are created by loan commitment provision?commitment provision?– interest rate riskinterest rate risk– take-down risktake-down risk– credit riskcredit risk– aggregate funding riskaggregate funding risk

Commercial and Standby Letters of Commercial and Standby Letters of CreditCredit

letters of credit – contingent guarantees sold by FI to letters of credit – contingent guarantees sold by FI to underwrite trade or commercial performance of the buyer underwrite trade or commercial performance of the buyer of the guarantyof the guaranty

Standby letters of credit – guarantees issued to cover Standby letters of credit – guarantees issued to cover contingencies that are potentially more severe and less contingencies that are potentially more severe and less predictable than contingencies covered under trade-related predictable than contingencies covered under trade-related or commercial letters of creditor commercial letters of credit

essentially FI is selling insurance against the frequency or essentially FI is selling insurance against the frequency or severity of some particular future occurrenceseverity of some particular future occurrence– like property-casualty insurance, contracts differ as to the severity like property-casualty insurance, contracts differ as to the severity

and frequency of their risk exposuresand frequency of their risk exposures

Forward Purchases and Sales of Forward Purchases and Sales of When Issued SecuritiesWhen Issued Securities

when issued trading – trading in securities when issued trading – trading in securities prior to their actual issueprior to their actual issue– FIs often enter into commitments to buy and sell FIs often enter into commitments to buy and sell

securities before issuesecurities before issue– exposes FIs to contingent interest rate riskexposes FIs to contingent interest rate risk

Loans SoldLoans Sold– no recourseno recourse– recourserecourse