Off-Balance-Sheet Activities
Chapter Outline
Introduction
Off-Balance-Sheet Activities and FI Solvency
Returns and Risks of Off-Balance-Sheet Activities
∙Loan Commitments
∙Commercial Letters of Credit and Standby Letters of Credit
∙Derivative Contracts: Futures, Forwards, Swaps, and Options
∙Forward Purchases and Sales of When Issued Securities
∙Loans Sold
Nonschedule L Off-Balance-Sheet Risks
∙Settlement Risk
∙Affiliate Risk
The Role of OBS Activities in Reducing Risk
Summary
Solutions for End-of-Chapter Questions and Problems: Chapter Thirteen
1. Classify the following items as either (1) on-balance-sheet assets, (2) on-balance-sheet liabilities, (3) off-balance-sheet assets, (4) off-balance-sheet liabilities, or (5) capital account.
Classification
2.How does one distinguish between an off-balance-sheet asset and an off-balance-sheet liability?
Off-balance-sheet activities or items are contingent claim contracts. An item is classified as an off-balance-sheet asset when the occurrence of the contingent event results in the creation of an on-balance-sheet asset. An example is a loan commitment. If the borrower decides to exercise the right to draw down on the loan, the bank will incur a new asset on its portfolio. Similarly, an item is an off-balance-sheet liability when the contingent event creates an on-balance-sheet liability. An example is a standby letter of credit (LC). In the event that the original payer of the LC defaults, then the bank is liable to pay the amount to the payee, incurring a liability on the right-hand side of its balance sheet.
3.
Assets Liabilities
$220 $20
$240 $240
Net worth = (240-220) + (100-80) = $40 million. The term contingent means an event that may or may not happen. In financial economics, the term is used in conjunction with the result given that some event does occur.
4. notional value?
Contingent assets and liabilities may or may not become on-balance-sheet assets and liabilities in a manner similar to the exercise or non-exercise of an option. In each case the realization of the event is contingent or dependent on the occurrence of some other event. The delta of an option is the sensitivity of an option’s value for a unit change in the price of the underlying security. The notional value represents the amount of value that will be placed in play if the contingent event occurs. The notional value of a contingent asset or liability is the amount of asset or liability that will appear on the balance sheet is the contingent event occurs.
5.
6.
The narrowing of spreads on on-balance-sheet lending in a highly competitive market and large loan losses by commercial banks gave impetus to seek other sources of income in the 1980s. Off-balance-sheet activities represented one avenue. In addition, off-balance-sheet assets and liabilities were not subject to capital requirements or reserve requirements, increasing the effective returns on these activities.
7.
Schedule L is a method for the Federal Reserve to track the types and amounts of off-balance-sheet (OBS) activities of commercial banks. Most of the OBS mentioned in this chapter are reported in Schedule L on the quarterly call reports, although items associated with settlement risk and affiliate risk are not reported.
The following information from Table 13-5 reflects the most significant OBS items in terms of notional value:
OBS Item Rate (%)
Commitments to lend
Future and forward contracts on interest rates
Written option contracts on interest rates
Purchased option contracts on interest rates
Commitments to buy foreign exchange
Notional value of all outstanding interest rate swaps
Total OBS
Total assets (on-balance-sheet items)
Clearly the off balance sheet items have grown at a much faster rate than the on-balance-sheet items for U.S. commercial banks. Further, the dollar value of the notional OBS items was a multiple of 10.1 times as large as the dollar value of the on-balance-sheet items at the end of 2003.
8.
A loan commitment is an agreement to lend a fixed maximum amount of money to a firm within some given amount of time. The interest rate or rate spread normally is determined at the time of the agreement, as is the length of time that the commitment is open. Because the firm usually triggers the timing of the draw, which may be any portion of the total commitment, the commitment is an option to the borrower. If the loan is not needed, the option or draw will not be exercised. The premium for the commitment may include a fee of some percent times the total commitment and a fee of some percent times the amount of the unused commitment. Of course the borrower must pay interest while any portion of the commitment is in use. The option becomes an on-balance-sheet item for both parties at the point in time that a draw occurs.
9. A FI makes a loan commitment of $2,500,000 with an up-front fee of 50 basis points and a back-end fee of 25 basis points on the unused portion of the loan. The take-down on the loan is 50 percent.
a. What total fees does the FI earn when the loan commitment is negotiated?
3,125
10.
400
Expected rate of return = $165,400/$1,526,400 = 10.836%
k = 1 + [(0.0025) + (0.0010)(1 - 0.80) + (0.10)*0.80]/{0.80 - [0.05(0.80)(1 - 0.08) ]}
k = 1.1082, or k = 10.836 percent.
k = 1 + [(0.0025(1+0.06) + 0.0010(1-0.80) + (0.10)*0.80]/{0.80-[0.05(0.80)(1-0.08)]}
k = 1.1084, or k = 10.8556 percent.
k = 1 + [(0.0025(1 + .06) + 0.0010(1 - 0.80) + (0.10) * 0.80]/ {0.80 - [0.05(0.80)]}
k = 1.1090, or k = 10.90 percent.
k = 1+[(.0025(1+.06)+.0010(1-.80)+0.10(.80)-.05(.05)(.80)]/[.80-.05(.80)(1-.08)]
k = 1.1058, or k = 10.5936 percent.
k = 1 + [(0.0025(1+0.06) + 0.0010(1-0.80) + (0.10-0.055) * 0.80]/[0.80]
k = 1.048563, or k = 4.86 percent.
11.
$8,000
k = 1 + [(0.0050) + (0.0020)(1 - 0.60) + (0.09)*0.60]/{0.60 - [0.10(0.60)(1 - 0.10)]}
k = 1.1095, or k = 10.95 percent.
1 by (1.07) will provide the same answer.
12. How is an FI exposed to interest rate risk when it makes loan commitments? In what way can an FI control for this risk? How does basis risk affect the implementation of the control for interest rate risk?
When a bank makes a fixed-rate loan commitment, it faces the likelihood that interest rates may increase during the intervening period. This reduces its net interest income if the borrower decides to take down the loan. The bank can partially offset this loan by making variable rate loan commitments. However, this still does not protect it against basis risk, that is, if lending rates and the cost of funds of the bank do not increase proportionately.
13.
A bank is exposed to credit risk, because the credit quality of a borrower could decline during the intervening period of the loan commitment. When a bank makes a loan commitment, it is obligated to deliver the loan. Although most loan commitments today contain a clause releasing a bank from its obligations in the event of a significant decline in credit quality, the bank may not be inclined to use it for fear of reputation concerns. Interest rate risk is related to credit risk because default risks are much higher during periods of increasing interest rates. When interest rates rise, firms have to generate higher rates of return. Thus, banks making loan commitments are subject to both risks in periods of rising interest rates.
14.
A bank is exposed to takedown risk because not all loan commitments are fully taken down. As a result, a bank has to forecast its funding requirements in order not to keep funds at levels that are too high or too low. Maintaining low levels of funds may result in paying more to obtain funds on short notice. Maintaining high levels of funds may result in lower earnings.
Additionally, banks are exposed to aggregate funding risk, i.e., all customers may choose to take down their loan commitments during a similar period, such as when interest rates are rising or credit availability is low. This could cause a severe liquidity problem.
These two risks are related because takedowns usually occur when interest rates are rising. If all customers decide to increase their takedowns, it could put a severe strain on the bank. Similarly, when interest rates are falling, customers are likely to find cheaper financing elsewhere. Thus, FIs should take into account the interdependence of these two events when forecasting future funding need.
15.
These risk elements all can have adverse effects on the solvency of a bank. While they need not occur simultaneously, there is a fairly high degree of correlation between them. For example, if rates rise, funding will become shorter, takedowns will likely increase, credit quality of borrowers will become lower, and the value of the typical FI will shrink.
16.
Like most insurance contracts, a letter of credit is like a guarantee. It essentially gives the holder the right to receive payment from the FI in the event that the original purchaser of the product defaults on the payment. Like the seller of any guarantee, the FI is obligated to pay the guarantee holder at the holder’s request.
17.
18.
Standby letters of credit usually are written for contingency situations that are less predictable and that have more severe consequences than the LCs written for standard commercial trade relationships. Often SLCs are used as performance guarantees for projects over extended periods of time, or they are used in the issuance of financial securities such as municipal bonds or commercial paper. Banks and property-casualty insurance companies are the primary issuers of SLCs.
19.
2219.18
1000.00
$2219.18
$ 219.18
20.
Credit risk occurs because of the potential for the counterparty to default on payment obligations, a situation that would require the FI to replace the contract at the current market prices and rates. OTC contracts typically are non-standardized or unique contracts that do not have external guarantees from an organized exchange. Defaults on these contracts usually will occur when the FI stands to gain and the counterparty stands to lose, i.e., when the contract is hedging the risk exactly as the FI hoped. Thus default risk is higher when the volatility of the underlying asset is higher.
21.
The purchase or sale of a security before it is issued is called when issued trading. When an FI purchases T-bills on behalf of a customer prior to the actual weekly auctioning of securities, it incurs the risk of underpricing the security. On the day the T-bills are allotted, it is possible that because of high demand, the prices may be much higher than what the FI has forecasted. It then may be forced to purchase them at higher prices which means lower interest rates.
22.
When FIs sell loans without recourse, the buyers of the loans accept the risk of non-repayment by the borrower. In other words, the loans are completely off the books of the FI. In the case of loans sold with recourse, FIs are still legally responsible for the payment of the loans to the seller in the event the borrower defaults. Banks are willing to sell such loans because they obtain better prices and also because it allows them to remove the assets from their balance sheets. FIs are more likely to sell such loans with recourse if the borrower of the loan is of good credit standing. When interest rates increase, there is a higher likelihood of loan defaults and a higher probability that the FI will have to buy back some of the loans. This may be the case even for sales of loans without recourse because banks are reluctant not to take back loans for reputation concerns.
23.
This is an example of settlement risk. If the funds sent by Shakey do not reach the Trust bank in time, then Trust may not have sufficient funds to cover its promised payment to Hope.
24.
Settlement risk occurs when FIs transfer and receive funds from other banks through the FedWire system or CHIPS (Clearing House Interbank Payment System). Since all settlements are netted out at the end of the day, FIs can engage in overdrafts during the day. This means that if a bank defaults during the middle of the day, several banks may be caught short-ended because they may not receive their scheduled payments. This may also cause their payments made to other banks to be denied. The risks of such intra-day overdrafts can be solved by real-time transfers, which should be introduced in the near future.
25.
A one-bank holding company (OBHC) is a holding company that has among its several subsidiaries only one bank. In contrast, a multibank holding company (MBHC) owns several banks. The principle of corporate separateness ensures that the affiliates are all structured as separate entities so that the failure of one will not have a negative impact on either the holding company or the other affiliates. This is accomplished by ensuring that each affiliate is run as a separate entity with its own financial resources and capital.
26.
First, creditors of the failed affiliate may claim that it is not a truly separate firm under the “estoppel argument” because they could not distinguish between affiliates of the holding company with similar names. Secondly, regulators themselves have tried to challenge the principle of corporate separateness by asking the holding company or the other banks of the multibank holding company to bail out the failed unit. Although not yet approved by the courts, a future favorable ruling could undermine the separateness of the affiliates.
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