Off-Balance-Sheet Activities Chapter 13

OBS Activities  invisible to all but best informed investor or regulator  in accounting terms, OBS activities appear “below the bottom line” –i.e. usually just as footnotes  in economic terms, OBS activities are contingent assets and liabilities that affect the future, rather than the current, shape of the FI’s balance sheet –have a direct impact on FI’s future profitability and solvency performance –efficient management of these OBS items is central to controlling overall risk exposure in modern FI

OBS Activities  major types of OBS activities for US banks –loan commitments –standby letters of credit and letters of credit –futures, forwards, swaps, and options –when issued securities –loans sold  large thrifts and insurance companies engage in most of these also

Loan Commitments  contractual commitment to make a loan up to a stated amount at a given interest rate in the future –most C&I loans today made by firms that use prenegotiated lines of credit or loan commitments as compared to using spot loans  up-front fee –fee charged for making funds available through a loan commitment

Example 1  BR = interest on loan = 12%  m = risk premium = 2%  f 1 = up-front fee on whole commitment = 1/8%  f 2 = back-end fee on unused commitment = ¼%  b = compensating balance = 10%  R = reserve requirements = 10%  t = expected (average) takedown rate (0<t<1) on LC = 75%  Then general formula for the promised return (1+k) is:

Loan Commitment  What contingent risks are created by loan commitment provision? –interest rate risk –take-down risk –credit risk –aggregate funding risk

Commercial and Standby Letters of Credit  letters of credit – contingent guarantees sold by FI to underwrite trade or commercial performance of the buyer of the guaranty  Standby letters of credit – guarantees issued to cover contingencies that are potentially more severe and less predictable than contingencies covered under trade-related or commercial letters of credit  essentially FI is selling insurance against the frequency or severity of some particular future occurrence –like property-casualty insurance, contracts differ as to the severity and frequency of their risk exposures

Forward Purchases and Sales of When Issued Securities  when issued trading – trading in securities prior to their actual issue –FIs often enter into commitments to buy and sell securities before issue –exposes FIs to contingent interest rate risk  Loans Sold –no recourse –recourse