off-balance-sheet banking class # 9. lecture outline 2 purpose: to understand what is reported off...
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OFF-BALANCE-SHEET BANKING
Class # 9
Lecture Outline2
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
Off-Balance-SheetAccounting Introduction
How did Citigroup perform in the crisis?4
Can this be Citi’s Balance Sheet?5
Of course not, this is Coca Cola!
Liabilities
Can this be Citi’s Balance Sheet?6
Off-Balance-Sheet (OBS) Assets/Liabilities7
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
Off-Balance-Sheet (OBS) Assets/Liabilities (Continued)
8
OBS Asset: 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.
Growth in Off-Balance-Sheet Items9
$14.4 Trillion
Reasons for growth in OBS Activities10
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
Banks with large OBS exposure in the Crisis11
Lehman Brothers Bear Stearns Merrill Lynch Citigroup CIT Group Freddie Mac Fannie Mae
- Bankrupt
- “Acquired”- “Acquired”
- Bailed out
- Bankrupt (after bailout)
- Conservatorship
Is OBS accounting Bad? Insolvency Risk12
To get a true picture of FI insolvency we need to consider both on and off balance sheet risk
Assets Liabilities and Equity
Market value of Assets 100 Market value of Liabilities 90
Equity 10
100 100
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
150 150
On Balance sheet
On & Off Balance sheet Including off balance sheet activity, reduces the equity piece and brings the bank closer to insolvency
13
TYPES OF OBS INSTRUMENTS
Types of OBS Activities14
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 riskAffiliate Risk
Types of Schedule L OBS Activities for U.S. Banks
15
1. Loan commitment agreement
2. Letters of credit
3. Futures, forward contracts, swaps, and options
4. When issued securities
5. Loans sold
16
1. Loan Commitment Definition Risks Expected Return
1. Loan Commitment Definition
17
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.
Loan Commitment TermsAmount Length – (term) Fees Parties
Loan Commitment TermsAmount = 200MTerm = 1 year Fees:
12 bps up front fee 8 bps back end fee
1. Loan Commitment Basic Example
18
0 m 1m
$30M
2 m
$50M
7 m
$20M
11 m
$70M $30M unused
$240,000 $24,000
Fees = (0.0012)(200M)
= $240,000
Fees = (0.0008)(30M)
= $24,000
12 m
Sample
1. Loan Commitment Risks Exposure
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Interest rate risk
Takedown risk
Aggregate takedown risk
Credit Risk
20
Interest rate risk – look at commercial paper
Negative Margin
1. Loan Commitment Interest Rate Risk
21
Interest rate risk – look at the repo rate
Negative Margin
1. Loan Commitment Interest Rate Risk
22
Interest rate risk – look at a floating rate (Libor +1%)
Positi
ve M
argin
Have we eliminated interest rate risk?
1. Loan Commitment Interest Rate Risk
23
Look at their profits (margin)
Risky Cash Flow – not constant
Super Risky
Is this risk-free??
This is an example of basis risk
1. Loan Commitment Interest Rate Risk
24
Aggregate takedown riskWhen the supply of credit is limited (in a crisis), companies tend to takedown their loan commitments simultaneously, which can severely stress banks’ balance sheets
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
March 2008 – Sept 2009
Imagine what trillions of dollars in loan take downs would do to the financial sector
1. Loan Commitment Aggregate Takedown Risk
25
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.
1. Loan Commitment Takedown & Credit Risk
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1. 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)
2. Takedown risk The company can take down any fraction of the loan at any time
3. Aggregate takedown risk Under tight credit conditions many firms will likely simultaneously
takedown loan agreements
4. Credit Risk The credit quality of a company may deteriorate after the loan
commitment is signed - adverse material change in conditions clause
1. Loan Commitment Risk Summary
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Return on a loan commitment
How do you calculate a return?28
Stock:
Dividend Paying Stock:
Bonds:
General:
1
1
t
tt
P
PP
1
1
t
ttt
P
DPP
1
1
t
tt
P
AIPP
CommittedAmount
EarnedAmount
1. Loan Commitment Return
29
CommittedAmount
EarnedAmount
Loan Commitment Return
CommittedAmount
EarnedInterestFees
Loan Commitment Return
ExpenceInterestBalanceCompAmountLoan
EarnedInterestFees
.
LCR
Reserve Req.
Bank requires the borrower to hold a fraction of the
loan at the bank – usually in demand deposits
1. Loan Commitment Expected Return Calculation Strategy:
30
1. Calculate loan amount & Interest Earned
2. Calculate the fee income
3. Calculate compensating balance
4. Calculate the reserve requirement
5. Calculate the interest expense
31
USbank has issued a one-year loan commitment to Kamble Inc. for $2M with an up-front fee of 25 bps and a back-end fee of 10 bps on the unused portion. USbank Negotiates a 5% compensating balance to be held as non-interest bearing demand deposits. USbank can borrow and lend at 6% (cost of funding). The interest rate on the loan is 10% p.a. compounded annually. The Federal Reserve requires that 8% of demand deposits be held on reserve at the fed. Assume that the up front fee is held in cash.
Calculate the expected return on the loan if Kamble is expected to take down 80% of the loan commitment immediately.
Step #1 Calculate loan amount & interest earnedMMAmountLoan 6.1$)2)(8.0(
Step #2 Calculate fee income 000,5)0025.0)(2($ MFeefrontUp
Realized at t=0 but held in cash MMMEarnedInterest 16.0$6.1)10.01)(6.1(
400$)0010.0)(6.12($ MMFeeendBack
1. Loan Commitment Expected Return Example:
32
USbank has issued a one-year loan commitment to Kamble Inc. for $2M with an up-front fee of 25 bps and a back-end fee of 10 bps on the unused portion. USbank Negotiates a 5% compensating balance to be held as non-interest bearing demand deposits. USbank can borrow and lend at 6% (cost of funding). The interest rate on the loan is 10% p.a. compounded annually. The Federal Reserve requires that 8% of demand deposits be held on reserve at the fed. Assume that the up front fee is held in cash.
Calculate the expected return on the loan if Kamble is expected to take down 80% of the loan commitment immediately.
Step #3 Calculate the compensating balance 000,80$)05.0)(6.1($ MBalComp
Step #4 Calculate reserve requirements 400,6$)08.0)(000,80($ RR
Held in demand deposits
1. Loan Commitment Expected Return Example:
33
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 0%)0)(400,6$000,80($. ExpInterest
Return:Amount Earned =160,000+5,000+400=165,400
Amount Committed =1,600,000 – 80,000 + 6,400 + 0 =1,526,400
%836.10400,526,1$
400,165$Return
1. Loan Commitment Expected Return Example:
34
What if the up-front fee was reinvested?
What if USbank paid 3% on the compensating balance?
What if the compensating balance is held as a CD paying 5%
%8556.10400,526,1$
700,165$Return
%8203.10608,528,1$
400,165$Return
%85.1000,524,1$
400,165$Return
1. Loan Commitment Expected Return Example:
Amount Earned =160,000+5,300+400=165,700
Up-font Fee = ($2M)(0.0025)=(5000)(1.06)1 =5,300
Interest Exp = ($80,000-6,400)(0.03) =$2,208
Amount Committed =1,600,000 – 80,000 + 6,400 + 2,208 =$1,528,608
Interest Exp = ($80,000)(0.05) =$4,000RR= $0.00Amount Committed =1,600,000 – 80,000 +4,000+ 0 =$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.
What are we not considering?37
1. The bank has funding costs – they would need to pay 10% (for example) on the $1.6M they lend out (not considered)
2. Risk free loan – we have not taken into account the risk that the company will default on their loan.
3. Assume that the loan is repaid at the end of the loan commitment
4. The return is actual a combination of returns on 2 loans over different horizons 2 year and .75 year – we are combining them
Mid Lecture Summary38
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
Lecture Outline39
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
2. Letters of Credit: Commercial Letter of Credit (CLC)
41
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
Barneys (Applicant) applies for a CLC
Citi (issuer) Accepts the CLC and guarantees Barneys Payment
Armani has an account with Intesa
Intesa accepts the guarantee
43
2. Letters of Credit: CLC Basic Example
Citi extends a loan to Barneys OBS asset or liability?
44
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 0.0100 = $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
2. Letters of Credit: Example
45
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%?
2. Letters of Credit: Example
Once Intesa accepts the letter of credit, it becomes a bankers acceptance and can be sold for its discounted value.
38.142,498)015.1(
000,50025.
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%.a)Calculate the upfront feeb)How can caterpillar receive payment today – how much will they receive?
47
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
2. Letters of Credit: Standby Letters of Credit (SLCs)
Same thing as a CLC but guarantees more severe less predictable events
48
3. Derivatives Contracts Forwards/Futures Options Swaps
3. Derivative Contracts Definition
49
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
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
3. Derivative Contracts Risks
51
4. When Issued Securities
4. When Issued Securities Definition & Examples
52
Definition: Agreements to trade a security that has not been issued yet AOL IPO
Treasury Auctions
4. When Issued Securities Definition & Examples
53
Thursday
Federal Reserve announces allotment of T-
Bills to bring to auction
TuesdayFriday
Sell 5,000 T-bills for $860/bond
Treasury Auctions
Auction Results Winning bidders Price Quantities
54
1. Cannot get enough T-bills in the auction to satisfy the when-issued agreement
2. 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
4. When Issued Securities Risks
55
5. Loan Sales With Recourse Without Recourse
5. Loan Sales (with Recourse)56
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
Non-Schedule L OBS Risks58
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.
Non-Schedule L OBS Risks59
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:
Non-Schedule L OBS Risks60
1. 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
Lecture Summary61
Off-balance Sheet Accounting 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
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
Bad Loans
Good Bank – Bad Bank65
The bank instantly looks better after selling bad loans
Bank is tasked with selling crappy loans Why would anyone want this job? What stops management from just
giving these loans away
Management compensation is tied to the bank’s equity value
SPV
off–balance – sheet
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)
66
Good Bank – Bad Bank
Why loan sales at the bad banks are value enhancing:
1. Bad bank enables bad loans to be worked out by loan workout specialists
2. Good bank’s reputation and access to deposit and funding markets are improved when bad loans are gone
3. Bad bank does not have short-term deposits, so it can follow an optimal strategy for bad assets – it isn’t concerned about liquidity
4. Contracts for managers are created to maximize incentives to generate good value
5. The structure reduces information asymmetries about the value of the good bank’s assets, increasing attractiveness to risk-averse investors
67
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
68
Lecture Summary69
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