BNFN 501 ASSET AND LIABILITY MANAGEMENT

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BNFN 501- ASSET AND LIABILITY MANAGEMENT

• OFF-BALANCE SHEET ACTIVITIES
• WEEK 7
• Saunders and Cornett (2003)
• Chp. 13

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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.

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• 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.

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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.

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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.

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• 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.

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How can we measure the risk of OBS 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.

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• 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.

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• 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.

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• 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.

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• 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.

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• 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.

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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

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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.

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• 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.

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• 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.

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Contingent Risks that are created by loan
commitment Provision

• Interest Rate Risk
• Takedown Risk
• Credit Risk
• Aggregate Funding Risk

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• 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.

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• 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.
• Emprical 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.

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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.

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

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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 todays interest
  rates, prices, or exchange rates.

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• 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.

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• 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 partys position and the
  payment obligations. Therefore futures are
  essentially default risk free (unless the
  financial markets collapses).

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• 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.

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• 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.

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• 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.

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• 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.