fnan 321 off balance sheet banking

commercial letter of credit (CLC)

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 ( armani/barneys)

obs liability

a commitment to add a liability to the balance sheet if a contingent event occurs

obs asset

a commitment to add an asset (ex; loan) to the balance sheet if a contingent event occurs

loan commitment

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

under tight credit conditions many firms will likely simultaneously takedown loan agreements

aggregate takedown risk

when issued security

agreements to trade a security that has not been issued yet; IPO and treasury auctions

returns!

amount earned/amount committed

the difference between amount actually borrowed and the amount committed is

not on the balance sheet!

loan commitment does not consider

- bank's funding cost - risk free loans (no default accounted for) - assumes the loan is repaid at the end - the return is actually a combination of returns on 2 loans over different horizons, this combines them

loan commitment expected return calculation strategy

- calc. loan amount and interst earned - calc fee income - calc compensating balance - calc reserve reqs. - cal interest expense

when issued security risk

- cannot get enough t-bills in the auction to satisfy the when-issued agreement - 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 (auction results) therefore, they are OBS

loan commitment risks

- interest rate risk - takedown risk - aggregate takedown risk - credit risk

types of schedule L obs activities for us banks

- loan commitment agreement - letters of credit - futures, forward contracts, swaps, and options - when issued securities - loans sold

adverse material change in conditions clause

FIs include this to allow it to cancel or reprice the commitment, but this is usualy an option of last resort due to legal fees

letters of credit are considered

OBS liabilties

loan committment (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

most banks with large obs exposure in the crisis

bankrupt, acquired, bailed out, conservatorship

up-front fee

banks charge a fee for making funds available

back-end fee

banks charge a fee for the unused balance of the commitment at the end of the period

interest rate - floating rate

basis risk, the loan commitment reference rate may not mirror the company's cost of funding (commercial paper rate)

in accounting terms, off b/s items usually appear

below the bottom line as just footnotes in the financial statements

loan sale without recourse

buyer purchases the loan without the option to sell it back

two kinds of letters of credit

commercial letter of credit standby letter of credit

off-balance sheet assets/liabilities

contingent assets and liabilities that affect the future, rather than current, shape of and FI's balance sheet

what risk is more of a problem in the OTC market?

counterparty risk - contracts are settled at maturity more likely that one counterparty will be deeply indebted to the other

credit risk

credit rating of the borrower may deteriorate over the life of the commitment

the credit quality of a company may deteriorate after the loan commitment is signed - adverse material change in conditions clause

credit risk

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

derivative contracts

government lending facilties

during the crisis were basically a general loan commitment to the financial sector. these financials were drawn down simultaneously during the crisis.

loan commitment return

fees + interest earned/(loan amount - comp balance + interest expense + reserve req)

derivatives contracts

forwards/futures, options, swaps

interest rate - fixed rate

funding costs can increase or decrease bank margins

derivatives use by FIs

hedging - interest rate risk, price risk etc. dealers - FIs make the market for OTC derivatives and charge transaction costs

schedule L

in 1983, banks began to submit___ on which they listed notional size and variety of their obs activites as a part of their quarterly reports

insolvency risk

including off balance sheet activity, reduces the equity piece and brings the bank closer to insolvency

reasons for growth in obs activities

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; sme govt assistance, such as us govt sponsorship of the securitized mortgage markets ( to allow risks to be diveresifed wher banks were confined to one area) position value vs notional amount

standby letters of credit (SLCs)

issued to cover contingencies that are potentially more severe and less predictable; (same thing as a CLC but guarantees more severe and less predictable events)

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

back-end fees are intended to

reduce take-down risk

two types of obs activites

schedule L non-schedule L

nonschedule L

settlement risk affiliate risk

the company can take down any fraction of the loan at any time

takedown risk

takedown 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 times. back-end fees are intended ro reduce this

loan sale with recourse

the buyer has the option to sell the loan back at a prearranged price if the borrower's credit quality deteriorates; 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 serive the loan (collect checks) and receive a servicing fee

counterparty risk

the risk that counterparties are unable or unwilling to comply with the terms of the contract; more of a problem when one counter party is deeply in the money and the other is deeply out of the money on the contract

contingent

they are not assets/liabilities yet they are promises to issue assets or take on a new liability if an event occurs

aggregate takedown risk

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