Off-Balance Sheet Activities

1. Off-Balance Sheet Activities • Financial guarantees • Standby letters of credit • Bank loan commitments • Note issuance facilities • Derivatives • Currency and interest rate swaps • Over-the-counter options, futures, and forwards • Other off-balance sheet activities • U.S. banks and international expansion

2. 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.

3. 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.

4. 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).

5. 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.

6. 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).

8. 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.

10. 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.

11. 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).

12. OTC Options, Futures, and Forwards • Forward rate agreements (FRAs): • 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.

13. 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.

14. 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).

15. 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.