Professional Documents
Culture Documents
Financial guarantees
Standby letters of credit
Bank loan commitments
Note issuance facilities
Derivatives
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).
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).
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
Counterparty interest:
The other party may not want to exchange the same amount of cash
flows.
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 banks or firms financial condition.
OTC options:
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.
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 banks customer will pay a contractural debt. Banks bear
credit risk and documentary risk (i.e., complexity of international commerce).
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.