OFF-BALANCE-SHEET BANKING Class # 9. Lecture Outline 2 Purpose: To understand what is reported off of the balance sheet, why items are not reported

OFF-BALANCE-SHEET BANKING

Class # 9

Lecture Outline2

Purpose: To understand what is reported off of the balance sheet, why items are not reported on the balance sheet, and what risks off-balance sheet accounting poses.

Off-Balance-Sheet Accounting Introduction

Off-Balance-Sheet Items Loan commitment agreement Letters of credit Futures, forward contracts, swaps, and options When issued securities Loans sold

More on Loan Sales

3

Off-Balance-SheetAccounting Introduction

How did Citigroup perform in the crisis?4

Can this be Citi’s Balance Sheet?5

Of course not, this is Coca Cola!

Liabilities

Can this be Citi’s Balance Sheet?6

Off-Balance-Sheet (OBS) Assets/Liabilities7

What are off-balance-sheet assets/liabilities? Contingent assets and liabilities that affect the future, rather than

current, shape of an FI’s balance sheet.

Contingent They are not assets/liabilities yet They are promises to issue assets or take on a new liability if an

event occurs

In accounting terms, they usually appear “below the bottom line”, frequently just as footnotes in the financial statements

Off-Balance-Sheet (OBS) Assets/Liabilities (Continued)

8

OBS Asset: A commitment to add an asset (Ex: loan) to the balance sheet

if a contingent event occurs.

OBS Liability: A commitment to add a liability to the balance sheet if a

contingent event occurs.

Examples: Loan Commitment (Asset): Bank commits to give a company a loan in the

future Bank Guarantee (Liability): Bank guarantees against the default of a loan.

The bank assumes responsibility for the loan in the case of default.

Growth in Off-Balance-Sheet Items9

$14.4 Trillion

Reasons for growth in OBS Activities10

Increased volatility, giving rise to demand for risk management by companies

Banks’ scope for tailoring financial instruments

Banks’ interest in saving capital and avoiding reserve requirements

Some government assistance, such as the US government sponsorship of the securitized mortgage market (to allow risks to be diversified where banks were confined to one area)

Position value vs Notional amount

Banks with large OBS exposure in the Crisis11

Lehman Brothers Bear Stearns Merrill Lynch Citigroup CIT Group Freddie Mac Fannie Mae

- Bankrupt

- “Acquired”- “Acquired”

- Bailed out

- Bankrupt (after bailout)

- Conservatorship

Is OBS accounting Bad? Insolvency Risk12

To get a true picture of FI insolvency we need to consider both on and off balance sheet risk

Assets Liabilities and Equity

Market value of Assets 100 Market value of Liabilities 90

Equity 10

100 100

Assets Liabilities and Equity

Market value of assets 100 Market value of Liabilities 90

Market value of contingent claim assets

50 Equity 5

Market Value of contingent claim liabilities

55

150 150

On Balance sheet

On & Off Balance sheet Including off balance sheet activity, reduces the equity piece and brings the bank closer to insolvency

13

TYPES OF OBS INSTRUMENTS

Types of OBS Activities14

Schedule L : In 1983 banks began to submit “Schedule L,” on which they listed notional size and variety of their OBS activities, as a part of their quarterly reports.

FDIC: Schedule L

Non-Schedule L:Settlement riskAffiliate Risk

http://www.fdic.gov/regulations/resources/call

Types of Schedule L OBS Activities for U.S. Banks

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1. Loan commitment agreement

2. Letters of credit

3. Futures, forward contracts, swaps, and options

4. When issued securities

5. Loans sold

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1. Loan Commitment Definition Risks Expected Return

1. Loan Commitment Definition

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Definition – a contractual commitment to make a loan up to a stated amount at a given interest rate in the future.

Most loans to businesses and consumers are structured as lines of credit, in which the borrower may decide at any time during the life of the loan to borrow.

Banks often charge a fee for making funds available (up-front fee) and also for the unused balance of the commitment at the end of the period (back-end fee).

The difference between the amount actually borrowed and the amount committed is not on the balance sheet.

Loan Commitment TermsAmount Length – (term) Fees Parties

Loan Commitment TermsAmount = 200MTerm = 1 year Fees:

12 bps up front fee 8 bps back end fee

1. Loan Commitment Basic Example

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0 m 1m

$30M

2 m

$50M

7 m

$20M

11 m

$70M $30M unused

$240,000 $24,000

Fees = (0.0012)(200M)

= $240,000

Fees = (0.0008)(30M)

= $24,000

12 m

Sample

http://somfin.gmu.edu/~anderson/321/Exhibits/fairchild_loan_commitment.pdf

1. Loan Commitment Risks Exposure

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Interest rate risk

Takedown risk

Aggregate takedown risk

Credit Risk

20

Interest rate risk – look at commercial paper

Negative Margin

1. Loan Commitment Interest Rate Risk

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Interest rate risk – look at the repo rate

Negative Margin


22

Interest rate risk – look at a floating rate (Libor +1%)

Positi

ve M

argin

Have we eliminated interest rate risk?


23

Look at their profits (margin)

Risky Cash Flow – not constant

Super Risky

Is this risk-free??

This is an example of basis risk


24

Aggregate takedown riskWhen the supply of credit is limited (in a crisis), companies tend to takedown their loan commitments simultaneously, which can severely stress banks’ balance sheets

Government Lending Facilities:Government lending facilities during the crisis were basically a general loan commitment to the financial sector. We can see that financials drew down these commitments simultaneously during the crisis

March 2008 – Sept 2009

Imagine what trillions of dollars in loan take downs would do to the financial sector

1. Loan Commitment Aggregate Takedown Risk

25

Take-down risk: The borrower can “take-down” the entire allotment or any fraction at any time over the commitment period. Therefore, there is uncertainty regarding the amount the FI will have to pay out on the commitment at any given time. Back-end fees are intended to reduce this risk. Ex: February, 2002: Tyco Intl. draws down $14.4B in credit lines from banks

after being shut out of the commercial paper market while wrapped up in an accounting scandal.

Credit risk: Credit rating of the borrower may deteriorate over the life of the commitment. FIs will include an adverse material change in conditions clause which

allows it to cancel or reprice the commitment, but this is usually an option of last resort due to legal fees, etc.

1. Loan Commitment Takedown & Credit Risk

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1. Interest rate risk: Fixed rate – funding costs can increase or decrease bank margins Floating rate – Basis risk, the loan commitment reference rate may

not mirror the company’s cost of funding (commercial paper rate)

2. Takedown risk The company can take down any fraction of the loan at any time

3. Aggregate takedown risk Under tight credit conditions many firms will likely simultaneously

takedown loan agreements

4. Credit Risk The credit quality of a company may deteriorate after the loan

commitment is signed - adverse material change in conditions clause

1. Loan Commitment Risk Summary

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Return on a loan commitment

How do you calculate a return?28

Stock:

Dividend Paying Stock:

Bonds:

General:

1

1

t

tt

P

PP

1

1

t

ttt

P

DPP

1

1

t

tt

P

AIPP

CommittedAmount

EarnedAmount

1. Loan Commitment Return

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CommittedAmount

EarnedAmount

Loan Commitment Return

CommittedAmount

EarnedInterestFees

Loan Commitment Return

ExpenceInterestBalanceCompAmountLoan

EarnedInterestFees

.

LCR

Reserve Req.

Bank requires the borrower to hold a fraction of the

loan at the bank – usually in demand deposits

1. Loan Commitment Expected Return Calculation Strategy:

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1. Calculate loan amount & Interest Earned

2. Calculate the fee income

3. Calculate compensating balance

4. Calculate the reserve requirement

5. Calculate the interest expense

31

USbank has issued a one-year loan commitment to Kamble Inc. for $2M with an up-front fee of 25 bps and a back-end fee of 10 bps on the unused portion. USbank Negotiates a 5% compensating balance to be held as non-interest bearing demand deposits. USbank can borrow and lend at 6% (cost of funding). The interest rate on the loan is 10% p.a. compounded annually. The Federal Reserve requires that 8% of demand deposits be held on reserve at the fed. Assume that the up front fee is held in cash.

Calculate the expected return on the loan if Kamble is expected to take down 80% of the loan commitment immediately.

Step #1 Calculate loan amount & interest earnedMMAmountLoan 6.1$)2)(8.0(

Step #2 Calculate fee income 000,5)0025.0)(2($ MFeefrontUp

Realized at t=0 but held in cash MMMEarnedInterest 16.0$6.1)10.01)(6.1(

400$)0010.0)(6.12($ MMFeeendBack

1. Loan Commitment Expected Return Example:

32



Step #3 Calculate the compensating balance 000,80$)05.0)(6.1($ MBalComp

Step #4 Calculate reserve requirements 400,6$)08.0)(000,80($ RR

Held in demand deposits


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Step #5 Calculate interest expense 0%)0)(400,6$000,80($. ExpInterest

Return:Amount Earned =160,000+5,000+400=165,400

Amount Committed =1,600,000 – 80,000 + 6,400 + 0 =1,526,400

%836.10400,526,1$

400,165$Return


34

What if the up-front fee was reinvested?

What if USbank paid 3% on the compensating balance?

What if the compensating balance is held as a CD paying 5%

%8556.10400,526,1$

700,165$Return

%8203.10608,528,1$

400,165$Return

%85.1000,524,1$

400,165$Return


Amount Earned =160,000+5,300+400=165,700

Up-font Fee = ($2M)(0.0025)=(5000)(1.06)1 =5,300

Interest Exp = ($80,000-6,400)(0.03) =$2,208

Amount Committed =1,600,000 – 80,000 + 6,400 + 2,208 =$1,528,608

Interest Exp = ($80,000)(0.05) =$4,000RR= $0.00Amount Committed =1,600,000 – 80,000 +4,000+ 0 =$1,524,00

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Crux Bank has entered into a 2-year loan commitment for $2M with Powell Inc. The loan has a 7% interest rate compounded annually. Crux charges a 30 bps up-front fee and a 20 bps back-end fee on the unused portion. Crux has also negotiated a 10% compensating balance to be held in demand deposits, which pay 4% interest. The Fed’s reserve requirement on demand deposits is 8%. Assume that Crux Bank invests the up-front fee at 8% (their cost of funding). Calculate the expected loan commitment return if Powell is expected to take down $1M immediately and .6M in 15 months.

Solution

http://somfin.gmu.edu/~anderson/321/Exhibits/Loan_commit_sol.pdf

36

Crux Bank has entered into a 2-year loan commitment for $2M with Powell Inc. The loan has a 7% interest rate compounded annually. Crux charges a 30 bps up-front fee and a 20 bps back-end fee on the unused portion. Crux has also negotiated a 10% compensating balance to be held in demand deposits, which pay 4% interest. The Fed’s reserve requirement on demand deposits is 8%. Assume that Crux Bank invests the up-front fee at 8% (their cost of funding). Calculate the expected loan commitment return if Powell is expected to take down $1.2M after 7 months.

What are we not considering?37

1. The bank has funding costs – they would need to pay 10% (for example) on the $1.6M they lend out (not considered)

2. Risk free loan – we have not taken into account the risk that the company will default on their loan.

3. Assume that the loan is repaid at the end of the loan commitment

4. The return is actual a combination of returns on 2 loans over different horizons 2 year and .75 year – we are combining them

Mid Lecture Summary38

Introduction to OBS Accounting What they are and why they are reported off the

balance sheet Growth in OBS activity

Introduction to Schedule L OBS items Loan Commitments

What they are How to calculate the expected return of loan commitment

Lecture Outline39

Off-Balance-Sheet Items Loan commitment agreement Letters of credit Futures, forward contracts, swaps, and options When issued securities Loans sold

More on Loan Sales – good bank bad bank if there is time

40

2. Letters of Credit Commercial Letter of Credit Standby Letter of Credit

2. Letters of Credit: Commercial Letter of Credit (CLC)

41

Definition: A bank’s guarantee (in exchange for a fee) against the default of a firm on its payment for goods that the firm bought from a seller.

42

2. Letters of Credit: CLC Basic Example

Barneys (Applicant) applies for a CLC

Citi (issuer) Accepts the CLC and guarantees Barneys Payment

Armani has an account with Intesa

Intesa accepts the guarantee

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2. Letters of Credit: CLC Basic Example

Citi extends a loan to Barneys OBS asset or liability?

44

Suppose Citi issues a three-month letter of credit on behalf of Barneys, to back a $500,000 purchase order to Armani in Italy. Citi charges an up-front fee of 100 basis points for the letter of credit.

How much up-front fee does the bank earn?

What risk is Citi exposed to from the letter of credit?

Up-front fee earned = $500,000 x 0.0100 = $5,000

Default Risk – The risk that Barneys does not pay

Interest rate risk – if Barneys survives, the rate on the loan may not properly reflect economic conditions or credit risk Recovery Risk – if Barneys files for bankruptcy, Citi may not receive the full value of its claim from the bankruptcy estate

2. Letters of Credit: Example

45

Suppose Citi issues a three-month letter of credit on behalf of Barneys, to back a $500,000 purchase order to Armani in Italy. Citi charges an up-front fee of 100 basis points for the letter of credit.

How could Armani realize its income today if 3m Libor is 1.5%?

2. Letters of Credit: Example

Once Intesa accepts the letter of credit, it becomes a bankers acceptance and can be sold for its discounted value.

38.142,498)015.1(

000,50025.

Value

46

Santander bank in Chile issues a commercial letter of credit on behalf of RioTinto mining for the purchase of $12M in mining equipment from Caterpillar a US manufacture of heavy equipment. The transaction will take place in 10 months. Santander charges RioTinto a 500 bps upfront fee for the letter of credit. 10 month LIBOR is currently 5%.a)Calculate the upfront feeb)How can caterpillar receive payment today – how much will they receive?

47

Definition: are issued to cover contingencies that are potentially more severe and less predictable.

Examples include default guarantees to back issues of commercial paper and performance bond guarantees whereby, for example, a real estate development will be completed in some interval of time. Not surprisingly, property-casualty insurers are also in this business.

Without credit enhancement, many firms would not be able to borrow in the credit market or would have to borrow at a higher funding cost. Firms also get credit enhancement to boost their rating

2. Letters of Credit: Standby Letters of Credit (SLCs)

Same thing as a CLC but guarantees more severe less predictable events

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3. Derivatives Contracts Forwards/Futures Options Swaps

3. Derivative Contracts Definition

49

Options, Futures, Forwards and Swaps

The cash flows from an option future/forward or swap are contingent on the price of an underlying asset.

Derivatives use by FIs Hedging – interest rate risk, price risk, etc. Dealers – FIs make the market for OTC derivatives and

charge transaction costs (J.P. Morgan Chase, Bank of America, and Citigroup)

In 2009 over 1060 banks used derivatives with JP Morgan, Goldman Sachs and Bank of America accounting for 80% of the 201,964 derivatives held

50

Counterparty risk

The risk that counterparties are unable or unwilling to comply with the terms of the contract

Counterparty risk is more of a problem when one counterparty is deeply in the money and the other is deeply out of the money on the contract.

Counterparty risk is more of a problem in the OTC market – contracts are settled at maturity more likely that one counterparty will be deeply indebted to the other

3. Derivative Contracts Risks

51

4. When Issued Securities

4. When Issued Securities Definition & Examples

52

Definition: Agreements to trade a security that has not been issued yet AOL IPO

Treasury Auctions

4. When Issued Securities Definition & Examples

53

Thursday

Federal Reserve announces allotment of T-

Bills to bring to auction

TuesdayFriday

Sell 5,000 T-bills for $860/bond

Treasury Auctions

Auction Results Winning bidders Price Quantities

54

1. Cannot get enough T-bills in the auction to satisfy the when-issued agreement

2. Being obligated to buy T-bills at a higher price than what they promised to sell them for in the when-issued agreement

Cash flow from when issued securities are contingent on some event (the auction results in this case). Therefore, they are held off balance sheet

4. When Issued Securities Risks

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5. Loan Sales With Recourse Without Recourse

5. Loan Sales (with Recourse)56

Sale with recourse: The buyer has the option to sell the loan back at a prearranged price if the borrower’s credit quality deteriorates.

This generates risks for the selling bank, but the bank can sell the loan at a higher price with recourse than without recourse.

Banks that sell loans often continue to service the loan (that is, collect checks), and they receive a servicing fee.

Sale without recourse: Buyer purchases the loan without the option to sell it back.

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Non-Schedule L Risks

Non-Schedule L OBS Risks58

Settlement Risk FIs receive much of their payments by wire transfer CHIPS wire transfer system processes transactions at

the end of the day Bank X can send a fund transfer to Bank Z at 11 AM,

but the cash settlement takes place at the end of the day. If Bank Z promises funds to Bank Y later in the day, but

Bank X fails to deliver its promised funds, Bank Z can be in a serious net funding deficit position.


Affiliate Risk A holding company is a corporation that owns the

shares (usually 25% +) of other corporations Many FIs operate in this capacity

Citigroup is a One Bank Holding Company that owns all of the shares of Citibank

JPMorgan Chase is a multibank holding company that owns many banks nationwide

The failure of one affiliated firm imposes affiliate risk on other banks within the holding company structure for two reasons:


1. Creditors of the failed affiliate may lay claim to the surviving bank’s resources on the grounds that operationally the bank isn’t really a separate entity from its affiliate

Regulators have tried to enforce a source of strength doctrine in recent years for large MBHC failures

The resources of sound banks may be used to support failing banks – courts have generally prevented this from occurring

Lecture Summary61

Off-balance Sheet Accounting What it is Why it is important Growth in OBS activity

Item: Loan Commitment – return Letters of credit

Commercial Standby

Derivatives contracts When-Issued Securities Loan Sales

62

MORE ON LOAN SALES

63

Types of Loan Sales Contracts

Participations

Limited control rights – syndicate members purchase a piece of the loan but the lead arranger maintains the loan rights.

Dual risk exposure – if the lead arranger fails, the participation may become a secured claim rather than a loan sale

Monitoring Costs – syndicate members rely on the lead arranger to monitor

Participations

Lead Arranger JP Morgan

64

Types of Loan Sales Contracts

Appointments

All rights transferred on sale of loan Currently form the bulk of the market (90% +)

Lead Arranger JP Morgan

Bad Loans

Good Bank – Bad Bank65

The bank instantly looks better after selling bad loans

Bank is tasked with selling crappy loans Why would anyone want this job? What stops management from just

giving these loans away

Management compensation is tied to the bank’s equity value

SPV

off–balance – sheet

Good Bank – Bad Bank

Example: Mellon Bank Creates Grant Street National Bank (GSNB)

Mellon wrote-down the face value of $941 M in real estate loans and sold them to GSNB for $577 M.

GSNB was an SPV funded by bond issues and common /preferred stock

Managers of the bad bank GSNB were given equity (jr. preferred stock). This was an incentive mechanism to maximize value in liquidating the loans purchased from Mellon (i.e. doing better than $577 M)

66

Good Bank – Bad Bank

Why loan sales at the bad banks are value enhancing:

1. Bad bank enables bad loans to be worked out by loan workout specialists

2. Good bank’s reputation and access to deposit and funding markets are improved when bad loans are gone

3. Bad bank does not have short-term deposits, so it can follow an optimal strategy for bad assets – it isn’t concerned about liquidity

4. Contracts for managers are created to maximize incentives to generate good value

5. The structure reduces information asymmetries about the value of the good bank’s assets, increasing attractiveness to risk-averse investors

67

Why do Banks Sell Loans?

Credit and liquidity risk management If sold without recourse, removed from balance sheet.

Fee income Capital costs

Meet capital requirements by reducing assets. Reduce reserve requirements

68

Lecture Summary69

Off-Balance-Sheet Accounting Introduction

Off-Balance-Sheet Items Loan commitment agreement (Return) Letters of credit Futures, forward contracts, swaps, and options When issued securities Loans sold

More on Loan Sales – good bank bad bank

Documents

OFF-BALANCE-SHEET BANKING Class # 9. Lecture Outline 2 Purpose: To understand what is reported off of the balance sheet, why items are not reported