OffBalance Sheet Activities

1
Off-Balance Sheet Activities

• Financial guarantees
• Standby letters of credit
• Bank loan commitments
• Note issuance facilities
• Derivatives
• Currency and interest rate swaps
• Over-the-counter options, futures, and forwards
• Other off-balance sheet activities
• U.S. banks and international expansion

2
Off-balance sheet activities

• Market risk
• Wild gyrations in interest rates in the 1980s.
• Turmoil in emerging markets in the 1990s.
• Periodic volatility in global financial markets.
• Off-balance sheet activities to deal with market
  risk.
• Commitments based on a contingent claim -- an
  obligation by a bank to provide funds (lend funds
  or buy securities) if a contingency is realized.
• Two broad categories financial guarantees and
  derivative instruments.
• Transforming deposit/lending institutions into
  risk management institutions.
• Tremendous growth of off-balance sheet activities
  of large banks.

3
Financial guarantees

• The bank stands behind an obligation of a third
  party. A loan guarantee is a common example.
• Standby letters of credit
• SLCs obligate the bank to pay the beneficiary if
  the account party defaults on a financial
  obligation or performance contract.
• Equivalent to an over-the-counter put option
  written by the bank (i.e., the firm can put the
  credit obligation back to the bank).
• Financial SLCs Backup lines of credit on bonds,
  notes, and commercial paper serve as guarantee.
• Performance SLCs Completion of construction
  contracts guaranteed.
• SLCs are considered loans. They may be
  collateralized.
• Need to diversify, limit credit risk, and
  increase capital to manage risks.
• Liquidity risk (or funding risk), capital risk,
  interest rate risk, and legal risk are inherent
  in these instruments.
• Material adverse change (MAC) clause that enables
  bank to withdraw its commitment if the risk of
  the SLC changes substantially.

4
Financial guarantees

• Bank loan commitments
• Promise by a bank to a customer to make a future
  loan under certain conditions. Most commercial
  and industrial loans are made under some form of
  guarantee (informal or formal).
• Line of credit -- Informal commitment of a bank
  to lend funds to a client firm.
• Revolving line of credit -- Formal agreement by a
  bank to lend funds on demand to a client firm
  under the terms of the contract. MAC clauses may
  be used to protect the bank from changing firm
  risk. Protect firms from availability and markup
  (or premium) risks of credit. Bank is exposed to
  interest rate risk.
• Funding risk -- Risk that many borrowers will
  take down commitments at the same time and
  thereby strain bank liquidity. Also known as
  quantity risk. Most likely to occur during
  periods of tight credit. Some commitments are
  irrevocable (i.e., unconditional and binding).

5
Note issuance facilities

• NIFs are medium-term (2-7 years) agreements in
  which a bank guarantees the sale of a firms
  short-term debt securities at or below
  pre-determined interest rates.
• The bank will step in a timely fashion to buy the
  securities of the firm. Other terms for similar
  financial guarantees are revolving underwriting
  facilities (RUFs) and standby note issuance
  facilities (SNIFs). Banks that use CDs might
  seek a Roly-Poly CD facility. Nonbank borrowers
  might issue short-term debt securities called
  Euronotes (denominated in dollars but sold
  outside of the U.S.).
• Contingent risks to banks here as underwriters
  (i.e., arrangers if a single bank or tender panel
  if a group of banks) are credit risk and funding
  risk.

6
Derivatives

• Swaps, options, futures, forward contracts, and
  securitized assets.
• Most derivatives activities are reported on the
  balance sheet but some are off-balance sheet
  (i.e., those with positive values are assets and
  those with negative values are counted as
  liabilities).
• Two derivatives markets (1) privately traded
  OTC market, and (2) organized exchanges (CBOT,
  CME, CBOE, and other countries).
• Swaps are heavily used in the OTC market. Large
  banks dominate this market.
• Regulators (including the Commodity Futures
  Commission, SEC, Federal Reserve, OCC, and FDIC)
  are very concerned with derivative exposures of
  banks (e.g., liquidity, fraud, human risks).

7
(No Transcript)
8
Currency and interest rate swaps

• Swaps
• Agreement between two counterparties to exchange
  cash flows based upon some notional principal
  amount of money, maturity, and interest rates.
• Plain vanilla interest rate swap is an exchange
  of interest payments, where one party has fixed
  interest payments and the other party has
  variable interest payments. No actual transfer
  of principal, only interest payments on debt
  contracts. Useful in managing interest rate gap
  problems in banks and nonbank firms.
• Three types of interest rate swaps
• (1) Coupon swaps -- fixed and floating coupon
  payments.
• (2) Basis swaps -- two different floating rates
  of interest.
• (3) Cross-currency swaps (or currency swaps) --
  swaps involving three counterparties with
  different currencies on fixed and floating rate
  debts. A plain deal currency swap involves equal
  interest payments but different currencies.

9
(No Transcript)
10
Risks associated with swaps

• Price risk
• Interest rate changes can cause the gap position
  of a bank or firm to change. Thus, the swaps
  effectiveness can change.
• Counterparty interest
• The other party may not want to exchange the same
  amount of cash flows.
• Disputes between counterparties
• International Swap Dealers Association (ISDA)
  offers an advisory service to members.
• Market valuation
• In 1999 the Financial Accounting Standards Board
  (FASB) required all derivatives, including swaps,
  to be stated at fair market value. Thus, they
  can affect a banks or firms financial condition.

11
OTC Options, Futures, and Forwards

• OTC options
• Nonstandardized contracts, unlike exchange-traded
  options.
• No clearinghouse to act as a safety net.
• Floor-ceiling agreements
• Ceiling agreements (caps) -- Sets the max
  interest rate on a loan to protect the customer
  from interest rate risk. The bank pays the firm
  the interest above this ceiling. As such, the
  bank is the writer of a call option in interest
  rates (or, alternatively stated, a put option in
  prices).
• Floor agreements -- Sets a min lending interest
  rate on a loan to protect the bank. The bank is
  a buyer of a put option in interest rates in this
  case (or, alternatively stated, a call option in
  prices).
• Interest rate collar -- Combines a cap and floor
  agreement to set max and min interest rate limits
  on a loan.
• Credit risk derivatives
• Credit option -- For example, an investor buys an
  option that pays the loss in bond value due to an
  agency rating downgrade on a bond.
• Total return swap -- For example, bank A swaps
  payments on a risky loan portfolio for a cash
  flow stream tied to LIBOR plus some compensation
  for the credit risk premium that it has given up
  (i.e., credit risk transfer).

12
OTC Options, Futures, and Forwards

• Forward rate agreements (FRAs)
• OTC interest rate futures contract for bonds or
  other financial asset.
• Not traded on organized exchanges as financial
  futures contracts are.
• Tailored to meet needs of parties involved.
• Not marked to market daily, so little liquidity
  risk, as in the case of futures contracts.
• Synthetic loans
• Use interest rate futures and options to create
  synthetic loans and securities.
• Suppose a firm believes interest rates will fall
  in the near future. As such, it borrows 30
  million for 120 days on a floating rate basis
  (repriced every 30 days at the CD rate plus 4
  percentage points). However, the bank would
  prefer to make a fixed rate loan in this interest
  rate environment. To convert the variable rate
  loan to a fixed rate loan, the bank could buy
  T-bill futures. If interest rates fall, and
  T-bill prices rise, the gain on the futures
  position would offset the lower interest earnings
  on the cash loan position.

13
OTC Options, Futures, and Forwards

• Securitization
• Home loans, auto loans, credit-card receivables,
  computer leases, mobile home loans, and small
  business loans. Recent securitization of
  commercial and industrial loans (collateralized
  loan obligations or CLOs) and commercial
  mortgage-backed securities or CMBSs).
• Banks transfer loan risks into the financial
  marketplace. Reduce credit risks, gap risk,
  improve diversification, and provide stable,
  low-risk service revenues.
• Earn service revenues in roles of loan
  originator, loan packager, and loan service
  company.
• Securitized assets are counted as off-balance
  sheet items only if they have been transferred
  with recourse (i.e., the bank is still exposed to
  risk associated with the underlying asset). For
  example, securitized home loans are not
  off-balance sheet assets. However, securitized
  credit card loans can still expose the bank to
  credit risk if credit payments fall below some
  predetermined level.

14
Other off-balance sheet activities

• Loan sales
• Banks can sell loans to a third party as a source
  of funds. For a fee the selling bank often
  continues to service the loan payment and handle
  other responsibilities of the loan.
• With or without recourse sales (where recourse
  means the selling bank retains some of the credit
  risk).
• Allows banks to make loans without relying on
  deposits and converts traditional lending to a
  quasi-securities business.
• On the other hand, other buying institutions
  become more like banks.
• Trade finance
• Some international aspects of trade finance are
  off-balance sheet.
• Commercial letters of credit -- a letter of
  credit (LOC) issued by a bank is a guarantee that
  the banks customer will pay a contractural debt.
  Banks bear credit risk and documentary risk
  (i.e., complexity of international commerce).

15
Other off-balance sheet activities

• Trade finance
• Acceptance participations
• Bankers acceptances are contingent liabilities
  that do not appear on the balance sheet.
• Some foreign exchange trading and hedging
  activities are off-balance sheet.
• Advisory and management services that earn
  service fees.
• Cash management
• Lock box services (post office boxes to collect
  customer revenues) earn fee income.
• Networking
• Linkages between firms based on comparative
  advantages, otherwise known as a strategic
  alliance. For example, a bank may refer a
  customer to a brokerage firm and earn part of the
  customer fee. Also, placement of branch offices
  in supermarkets and other retail stores.