1. Off-Balance-Sheet Banking
Class # 9

2. Lecture Outline
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. Accounting Introduction
Off-Balance-Sheet
Accounting Introduction

4. How did Citigroup perform in the crisis?

5. Can this be Citi’s Balance Sheet?
Of course not, this is Coca Cola!
Liabilities

6. Can this be Citi’s Balance Sheet?

7. Off-Balance-Sheet (OBS) Assets/Liabilities
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

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

9. Growth in Off-Balance-Sheet Items
$14.4 Trillion

10. 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
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

11. Banks with large OBS exposure in the Crisis
Lehman Brothers
Bear Stearns
Merrill Lynch
Citigroup
CIT Group
Freddie Mac
Fannie Mae
- Bankrupt
- “Acquired”
- “Acquired”
- Bailed out
- Bankrupt (after bailout)
- Conservatorship

12. Is OBS accounting Bad? Insolvency Risk
To get a true picture of FI insolvency we need to consider both on and off balance sheet risk
On Balance sheet
Assets
Liabilities and Equity
Market value of Assets
100
Market value of Liabilities 90
Equity 10
Including off balance sheet activity, reduces the equity piece and brings the bank closer to insolvency
On & Off Balance sheet
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

13. TYPES OF OBS INSTRUMENTS

14. Types of OBS Activities
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 risk
Affiliate Risk

15. Types of Schedule L OBS Activities for U.S. Banks
Loan commitment agreement
Letters of credit
Futures, forward contracts, swaps, and options
When issued securities
Loans sold

16. 1. Loan Commitment
Definition
Risks
Expected Return

17. 1. Loan Commitment Definition
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.

18. 1. Loan Commitment Basic Example
Sample
Loan Commitment Terms
Amount = 200M
Term = 1 year
Fees:
12 bps up front fee
8 bps back end fee
Loan Commitment Terms
Amount
Length – (term)
Fees
Parties
Fees = (0.0012)(200M)
= $240,000
Fees = (0.0008)(30M)
= $24,000 1m
$30M
2 m
$50M
7 m
$20M
11 m
$70M
$30M unused
0 m
12 m
$240,000
$24,000

19. 1. Loan Commitment Risks Exposure
Interest rate risk
Takedown risk
Aggregate takedown risk
Credit Risk

20. 1. Loan Commitment Interest Rate Risk
Interest rate risk – look at commercial paper
Negative Margin

21. 1. Loan Commitment Interest Rate Risk
Interest rate risk – look at the repo rate
Negative Margin

22. 1. Loan Commitment Interest Rate Risk
Interest rate risk – look at a floating rate (Libor +1%)
Have we eliminated interest rate risk?
Positive Margin

23. 1. Loan Commitment Interest Rate Risk
Look at their profits (margin)
Super Risky
Is this risk-free??
Risky Cash Flow – not constant
This is an example of basis risk

24. 1. Loan Commitment 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
March 2008 – Sept 2009
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
Imagine what trillions of dollars in loan take downs would do to the financial sector

25. 1. Loan Commitment Takedown & Credit Risk
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.

26. 1. Loan Commitment Risk Summary
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)
Takedown risk
The company can take down any fraction of the loan at any time
Aggregate takedown risk
Under tight credit conditions many firms will likely simultaneously takedown loan agreements
Credit Risk
The credit quality of a company may deteriorate after the loan commitment is signed - adverse material change in conditions clause

27. Return on a loan commitment

28. How do you calculate a return?
Stock:
Dividend Paying Stock:
Bonds:
General:

29. 1. Loan Commitment Return
Bank requires the borrower to hold a fraction of the loan at the bank – usually in demand deposits
Loan Commitment Return
Loan Commitment Return
LCR
Reserve Req.

30. 1. Loan Commitment Expected Return Calculation Strategy:
Calculate loan amount & Interest Earned
Calculate the fee income
Calculate compensating balance
Calculate the reserve requirement
Calculate the interest expense

31. 1. Loan Commitment Expected Return Example:
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 earned
Realized at t=0 but held in cash
Step #2 Calculate fee income

32. 1. Loan Commitment Expected Return Example:
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 #3 Calculate the compensating balance
Held in demand deposits
Step #4 Calculate reserve requirements

33. 1. Loan Commitment Expected Return Example:
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 #5 Calculate interest expense
Return:
Amount Earned =160,000+5, =165,400
Amount Committed =1,600,000 – 80, , =1,526,400
Return

34. 1. Loan Commitment Expected Return Example:
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%
Up-font Fee = ($2M)(0.0025)=(5000)(1.06)1 =5,300
Return
Amount Earned =160,000+5, =165,700
Interest Exp = ($80,000-6,400)(0.03) =$2,208
Amount Committed =1,600,000 – 80, , ,208 =$1,528,608
Return
Interest Exp = ($80,000)(0.05) =$4,000
RR= $0.00
Return
Amount Committed =1,600,000 – 80,000 +4, =$1,524,00

35. 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

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.

37. What are we not considering?
The bank has funding costs – they would need to pay 10% (for example) on the $1.6M they lend out (not considered)
Risk free loan – we have not taken into account the risk that the company will default on their loan.
Assume that the loan is repaid at the end of the loan commitment
The return is actual a combination of returns on 2 loans over different horizons 2 year and .75 year – we are combining them

38. Mid Lecture Summary 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

39. Lecture Outline 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

41. 2. Letters of Credit: Commercial Letter of Credit (CLC)
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
Armani has an account with Intesa
Citi (issuer) Accepts the CLC and guarantees Barneys Payment
Barneys (Applicant) applies for a CLC
Intesa accepts the guarantee

43. 2. Letters of Credit: CLC Basic Example
Citi extends a loan to Barneys
OBS asset or liability?
Letters of credit are considered OBS liabilities

44. 2. Letters of Credit: Example
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 = $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

45. 2. Letters of Credit: Example
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%?
Once Intesa accepts the letter of credit, it becomes a bankers acceptance and can be sold for its discounted 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%.
Calculate the upfront fee
How can caterpillar receive payment today – how much will they receive?

47. 2. Letters of Credit: Standby Letters of Credit (SLCs)
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
Same thing as a CLC but guarantees more severe less predictable events

48. 3. Derivatives Contracts
Forwards/Futures
Options
Swaps

49. 3. Derivative Contracts Definition
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. 3. Derivative Contracts Risks
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

51. 4. When Issued Securities

52. 4. When Issued Securities Definition & Examples
Definition: Agreements to trade a security that has not been issued yet
AOL IPO
Treasury Auctions

53. 4. When Issued Securities Definition & Examples
Treasury Auctions
Sell 5,000 T-bills for $860/bond
Federal Reserve announces allotment of T-Bills to bring to auction
Auction Results
Winning bidders
Price
Quantities
Thursday
Friday
Tuesday

54. 4. When Issued Securities Risks
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 (the auction results in this case). Therefore, they are held off balance sheet

55. 5. Loan Sales
With Recourse
Without Recourse

56. 5. Loan Sales (with Recourse)
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.

57. Non-Schedule L Risks

58. Non-Schedule L OBS Risks
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.

59. Non-Schedule L OBS Risks
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:

60. Non-Schedule L OBS Risks
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

61. Lecture Summary Off-balance Sheet Accounting Item:
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
Dual risk exposure- 1. exposed to the risk that the borrower defaults 2. exposed to the risk that the lead arranger defaults

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

65. Good Bank – Bad Bank Bad Loans SPV off–balance – sheet
Bank is tasked with selling crappy loans
Why would anyone want this job?
The bank instantly looks better after selling bad loans
What stops management from just giving these loans away
Management compensation is tied to the bank’s equity value

66. 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)

67. Good Bank – Bad Bank
Why loan sales at the bad banks are value enhancing:
Bad bank enables bad loans to be worked out by loan workout specialists
Good bank’s reputation and access to deposit and funding markets are improved when bad loans are gone
Bad bank does not have short-term deposits, so it can follow an optimal strategy for bad assets – it isn’t concerned about liquidity
Contracts for managers are created to maximize incentives to generate good value
The structure reduces information asymmetries about the value of the good bank’s assets, increasing attractiveness to risk-averse investors

68. 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

69. Lecture Summary 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