B ANK 501 ASSET AND LIABILITY MANAGEMENT

BANK 501ASSET AND LIABILITY MANAGEMENT OFF-BALANCE SHEET ACTIVITIES WEEK 5 Saunders and Cornett (2006) Chp. 13

Introduction • Off-balance-sheet (OBS) activities can involve risks that add to an FIs overall risk exposure. On the other hand, OBS can be used to hedge or reduce the interest rate, credit and foreign exchange risk of FIs. That is, OBS activities have both risk increasing and risk reducing attributes.

This chapter examines the various OBS activities of FIs. We first discus the effect of OBS activities on an FIs risk exposure, return performance and solvency. We then describe the different types of OBS activities and the risk associated with each.

OBS Activities and FI Solvency • One of the most important choices facing an FI manager is the relative scale of an FIs on and off balance sheet activities. • In economic terms, off-balance-sheet items are contingent assets and liabilities that affect the future,rather than the current shape of the balance sheet. As such, they have a direct impact on the FIs future profitability and solvency performance.

OBS Assets and OBS Liabilities • An item or activity is an off-balance sheet asset if when a contingent event occurs the item or activity moves onto the asset side of the balance sheet. • An item or activity is an off-balance sheet liability if, when the contingent event occurs, the item or activity moves onto the liability side of the balance sheet.

For example, FIs sell various performance guarantees, especially guarantees that their customer will not default on their financial and other obligations. Letters of credit, and standby letters of credit are such obligations. Should a customer default occur, the FIs contingent liability (its guaranty) becomes an actual liability and it moves onto the liability side of the balance sheet.

How can we measure the risk ofOBS activities and their impact on the FIs value • Because many OBS items involve option features the most common methodology has been to apply contingent claims/option pricing theory models of finance • One relatively simple way to estimate the value of an OBS position in options is by calculating the delta of an option.

Delta of an Option: The change in the value of an option for a small unit change in the price of the underlying security. change in the option’ price d = change in price of underlying security • The delta of an option lies between 0 and 1. • Notional value of an OBS item is its face value.

Example: Suppose a FI has bought call options on bonds (i.e. It has an OBS asset) with a face value of 100 million dollars and the delta is calculated at 0.25 . • The delta equivalent, or contingent asset value = delta X face value of option 0.25 X 100 million = 25 million • If the FI sold options, they would be valued as a contingent liability.

Loan commitments and letters of credit are also off-balance sheet activities that have option features. • Holder of a loan commitment or credit line who decides to draw on the credit line is exercising an option to borrow. When the buyer of a guaranty defaults, this buyer is exercising a default option.

The true picture of FIs economic solvency considers the market value of both its visible on balance sheet as well as OBS activities. In other words, the FI manager should value contingent or future assets and liability claims as well as current assets and liabilities.

Example: E = (A-L) +(CA-CL) E = (100 - 90) + (50 - 55) E = 5 Since the market value of contingent liabilities exceeds the market value of contingent assets by 5 , this difference is an additional obligation, or claim, on the net worth of the FI.

EXAMPLE Assets Liabilities Market value of assets 100 Market value of liabilities 90 Net worth (E) 10 ____ _____ 100 100 Assets Liabilities Market value of assets 100 Market value of liabilities 90 Net worth 5 Mkt. Val. Of cotg. Assets 50 Mkt. Val. Cont. Liabilities 55 ____ ______ 150 150

Loan Commitments • Most commercial and industrial loans are made to firms that take down (or borrow against) pre-negotiated lines of credit or loan commitments rather than borrow spot loans. • Loan Commitment Agreement is a contractual commitment by an FI to loan to a firm a certain maximum amount (say, 10$ million) at given interest rate terms (say, 12%). The loan commitment agreement also defines the length of time over which the borrower has the option to take down this loan.

Up-Front Fee: In return for making this loan commitment, the FI may charge an up-front fee, the fee charged for making funds available through a loan commitment.(eg.1/8 % of the commitment size). • In addition, the FI must stand ready to supply the full $10 million at any time over the commitment period. • The borrower has a valuable option to take down any amount beween $0 and $10 million . • Back-End Fee: The fee imposed on the unused component of a loan commitment.

Up-front fee Back-end fee of 1/4 % Of 1/8 % on whole line on unused portion 0 1 year $10 million commitment 1 If borrower takes down only $8,000in funds over the year and the fee on unused commitments is ¼ % , the FI will generate additional revenue of ¼ percent times $2 million, or $5,000. Note that only when the borrower actually draws on the commitment do the loans made under the commitment appear on the balance sheet. Nevertheless, the FI must stand ready to make the full $10 million in loans on any day within the one year commitment period that is at time 0, a new contingent claim on the resources of the FI was created.

Contingent Risks that are created by loan commitment Provision • Interest Rate Risk • Takedown Risk • Credit Risk • Aggregate Funding Risk

Loan commitments and interest rate risk • If fixed rate commitment, the bank is exposed to interest rate risk • If floating rate commitment, there is still exposure to basis risk. • Basis Risk: The variable spread between a lending rate and a borrowing rate (deposit rate) or between any two interest rates or prices. • Take-down risk: Uncertainty of timing of take-downs exposes bank to risk. Back-end fees are intended to reduce this risk.

Credit Risk: Credit rating of the borrower may deteriorate over life of the commitment • Agreegate Funding Risk: During a credit crunch, bank may find it difficult to meet all of the commitments. Empirical studies have confirmed that banks making more loan commitments have lower on-balance sheet portfolio risk characteristics than those with relatively low levels of commitments.

Commercial Letters of Credit and Standby Letters of Credit • In selling commercial letters of credit(LCs)and standby letters of credit (SLCs) for fees, FIs add to their contingent future liabilities. Commercial Letters of Credit: LCs are widely used in both domestic and international trade, but they are particularly important for foreign purchases. For example, if the credit worthiness of the importer of a good is unknown to seller, then the seller may ask a LCs from the importer.

Example (LC) Orders $10 m of machinery US IMPORTER GERMAN EXPORTER Machinery shipped 10 m LC issued US FI

Standby Letters of Credit (SLCs): Standby letters of credit perform an insurance function similar to that of commercial and trade letters of credit. However, the structure and type of risks covered are different. FIs may issue SLCs to cover contingencies include performance bond guarantees whereby an FI may guarantee that a real estate development will be completed in some interval of time.

Derivative Contracts: Futures, Forwards, Swaps and Options • Contingent credit risk is likely to be present when FIs expand their positions in forwards, futures, swaps and option contracts. This risk relates to the fact that the counterparty to one of these contracts may default on payment obligations, leaving the FI unhedged and having to replace the contract at today’s interest rates, prices, or exchange rates.

Forward contracts leave the bank heavily exposed to risk of default by counterparties. This is because forward contracts are non-standard contracts entered into bilaterally by negotiating parties such as two FIs and all cash flows are required to be paid at one time (on contract maturity. Thus, they are essentially over the counter (OTC) arrangements with no external guarantees should one or the other party default on the contract.

Futures contracts are standardized contracts guaranteed by organized exchanges such as the New York Futures Exchange (NYFE), a part of the New York Board of Trade (NYBOT). If a counterparty defaults on a futures contract, the exchange assumes the defaulting party’s position and the payment obligations. Therefore futures are essentially default risk free (unless the financial markets collapses).

Option contracts can also be purchased or sold by an FI, trading either over the counter (OTC) or bought /sold on organized exchanges. If the options are traded on exchanges, such as bond options, they are virtually default risk free.

Forward Purchases and Sales of When Issued Securities Very often banks and other FIs, especially investment banks enter into commitments to buy and sell securities before issue. This is called when issued (EI) trading. Good examples of WI commitments are those taken on with new T-bills in the week prior to the announcement of T-bill auction results. These OBS commitments can expose an FI to future or contingent interest rate risk.

Loans Sold: When an outside party buys a loan with absolutely no recourse to the seller of the loan, should the loan eventually go bad, loan sales have no OBS contingent liability implications for FIs . Specifically, no recourse means that if the loan the FI sells goes bad, the buyer of the loan must bear the full risk of loss. In particular, the buyer cannot put the bad loan back to the seller or originating bank.

OBS activities or not always risk increasing activities. • In many cases they are hedging activities designed to mitigate exposure to interest rate risk, foreign exchange risk, etc. • OBS activities are frequently a source of fee income, especially for the largest most creditworthy banks.

B ANK 501 ASSET AND LIABILITY MANAGEMENT