Off-Balance Sheet Activities
• Financial guarantees
– Standby letters of credit
– Bank loan commitments
– Note issuance facilities
• Derivatives
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Currency and interest rate swaps
Over-the-counter options, futures, and forwards
Other off-balance sheet activities
U.S. banks and international expansion
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.
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.
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).
Note issuance facilities
• NIFs are medium-term (2-7 years) agreements in which a bank
guarantees the sale of a firm’s 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.
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).
Counting the Risks in Derivatives
The Federal Reserve, Comptroller of the Currency, and FDIC have cited seven key categories of risk associated with derivatives.
1. Counterparty credit risk is the risk that a counterparty in a financial transaction will default, resulting in a financial
loss to the other party. Credit exposure is not measured by the notational amount of the contract but by the cost of
replacing its cash flows in the market. In an interest rate swap, for example, the present value of expected cash flows on
the underlying instruments would need to be calculated.
2. Price, or market, risk is the risk that the market price of the derivative security will change. This risk is closely related
to the price risk of the underlying instrument. Most banks break overall price risk into components, including interest
rate risk, exchange rate risk, commodity price risk, and others.
3. Settlement risk occurs when one party in a financial transaction pays out funds to the other party before it receives its
own cash or assets. Thus, settlement risk is linked to credit risk.
4. Liquidity risk is the risk that a couterparty will default and a liquidity shortfall will occur due to losses.
5. Operating risk is an often-overlooked area of commercial bank risk that can arise due to:
 Inadequate internal controls -- the complexity of some derivatives, human error, and fraud are all sources of risk that
demand internal monitoring and control by management.
 Valuation risk -- the valuation of many derivatives rely on fairly sophisticated mathematical models that are highly
dependent on assumptions about market conditions, which together can make valuation a difficult task.
 Regulatory risk -- as already mentioned, regulators are scrutinizing OTC derivatives due to their explosive growth, and
this attention could draw changes in accounting procedures, capital adequacy, restrictions on activities, and other
banking practices.
6. Legal risk -- the OTC market for derivatives is private in nature, fast developing, and innovative in security design, all
of which means that disputes within this new market will require a period of legal cases to clearly establish the rights
and obligations of all participants. The International Swap Dealers Association has established some rules in
cooperation with most large industrialized countries, but the differences in national bankruptcy laws raises legal
concerns about the risks in international deals.
7. Aggregation risk comes about from the complex interconnections that can occur in derivatives deals which involve a
number of markets and instruments. It becomes difficult to assess the risks to individual parties or groups of parties in
such transactions.
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.
Example of a Swap
Assume firms A and B engage in a coupon interest rate swap based on a notional amount of $10 million. The swap agreement has
a maturity of 7 years, and the payment frequency is semiannually. This is a classic plain vanilla swap between two banks.
Bank A is the fixed rate counterparty--the one that pays the fixed rate of interest (as it has fixed rate assets and variable rate
liabilities to gap); and bank B is the floating rate counterparty (as it has variable rate assets and fixed rate assets to gap)--the one
that pays the floating rate of interest. The fixed rate payer (bank A) pays bank B 12% on the notional amount of debt. Similarly,
the floating rate payer (bank B) pays bank A's cost of its floating rate liabilities.
Let's examine the impact of this transaction on bank A for the first 6 months. The relevant interest rates that we will use in
our simplified calculation are:
6-month LIBOR
10.0%
Bank A's fixed rate payment
12.0
Bank A's variable rate liabilities
9.0
Based on these rates, we can determine the net fixed rate cost of finds to bank A in the following manner.
Fixed rate payments made by bank A
12.0%
Floating rate payment received
-10.0
Interest paid on floating rate liabilities
+9.0
Net fixed cost
11.0%
In terms of dollar amounts, Bank A will make the first semiannual fixed rate payment of $600,000 ($10 million x 0.12/2)
to Bank B, pay $450,000 ($10 million x 0.09/2) on its floating rate liabilities, and receive a floating rate payment of $506,778
from Bank B. The floating rate payment is based on 181 days and a 360-day year.
First interest period
(1-1 to 6-30)
Number of days
181
6-month LIBOR
10.0%
Principal amount
$10 million
Payment = Principal x LIBOR x Number of days = $10 million x 0.10 x 181 = $506, 777.78
Days in year
360
Bank A's net fixed cost for the first six months expressed in dollar terms is:
Fixed rate payment
Floating rate liabilities
Floating rate payment received
$600,000
+450,000
-506,778
$543,222
Risks associated with swaps
• Price risk:
– Interest rate changes can cause the gap position of a bank or firm
to change. Thus, the swap’s 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 bank’s or firm’s financial condition.
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).
OTC Options, Futures, and Forwards
• Forward rate agreements (FRAs):
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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.
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.
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 bank’s customer will pay a contractural debt. Banks
bear credit risk and documentary risk (i.e., complexity of international
commerce).
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.