• BEO2000 Financial Institutions & Monetary Theory
• Lecture 8: Commercial Banks: Off-Balance Sheet Activities and Performance
• Primary Sources:
• Kidwell et al. 2014, Ch. 14, pp. 562-568.
• Beets , S. 2004, The use of derivatives to manage interest rate risk in commercial banks,
pp. 60-63.
• Learning Outcomes
• With respect to learning outcomes, you should be able to:
• a. Explain the various off-balance sheet activities of commercial banks;
• b. Identify the main derivative securities used by commercial banks;
• c. Examine commercial bank performance and profitability.
• Off-Balance-Sheet (OBS) Activities
• OBS transactions are a significant part of a bank’s business.
– OBS items generate fee income for the bank but also increases bank risk.
– OBS items are contingent assets or liabilities.
– Contingent asset: A possible asset that may arise because of a gain that is
contingent on future events that are not under an entity's control.
– Contingent liability: A potential liability that may occur, depending on the outcome
of an uncertain future event.
– OBS activities are notionally more than 7 times the total value of assets held by the
banks.
• Off-Balance-Sheet (OBS) Activities
• Banks’ major OBS activities include, but are not limited to:
– Loan commitments,
– Letters of credit (LOC),
– Securitisation, and
– Derivative securities contracts.
i. Typically used to hedge their asset-liability risk exposures in an attempt to
protect an FI's net worth from adverse events.
• OBS Activities: Loan Commitments
• Formal promises by a bank to lend money according to certain terms outlined in the
commitment.
– Bank assures borrower funds will be there when needed.
, – Consumers familiar with available credit on credit cards.
– Three main types of loan commitments between business borrowers and
commercial banks:
i. Line of credit: Moral obligation on a short-term basis (< 1 year).
ii. Term loan: A formal legal agreement where bank will lend a customer a
certain dollar amount for a period exceeding a year.
iii. Revolving credit: A formal legal agreement where bank agrees to lend up to
a certain limit for a period exceeding a year.
iv. Exposure to funding risk which can strain bank liquidity
• OBS Activities: Letters Of Credit (LOC)
– Letter of credit sets up the conditions to be met in order for payment to occur.
Commercial LOC (trade finance):
• The bank guarantees payment for goods in a commercial transaction (e.g. client non-
performance).
• Credit risk is transferred to the buyer's bank at issuance of a documentary credit.
Standby LOC (direct credit substitute):
• An undertaking by a bank to support the financial obligations of a client to a third
party.
• The bank acts as guarantor on behalf of a client for a fee.
• Bank is required to make a payment only if the client defaults on a payment
to a third party, or fails to meet contractual obligations.
• OBS Activities: Securitisation
• Originating bank provides house loans to customers.
• Pool of mortgages divided into tranches based on their homogeneity with respect to
maturity and type of loan.
• Tranches are officially rated for their risk level (AAA, etc.).
• Risk rating helps determine the value of the security.
• Tranches are then transferred to a trust (i.e., special purpose vehicle).
• OBS Activities: Securitisation
• A special purpose vehicle (SPV), a stand-alone legal entity, purchases these assets
and then issue securities.
• SPV used to transfer ownership of assets from originating bank.
• Securities are backed by the pools of assets.
• The SPV issue the debt securities to an underwriter in exchange for cash.
• Lecture 8: Commercial Banks: Off-Balance Sheet Activities and Performance
• Primary Sources:
• Kidwell et al. 2014, Ch. 14, pp. 562-568.
• Beets , S. 2004, The use of derivatives to manage interest rate risk in commercial banks,
pp. 60-63.
• Learning Outcomes
• With respect to learning outcomes, you should be able to:
• a. Explain the various off-balance sheet activities of commercial banks;
• b. Identify the main derivative securities used by commercial banks;
• c. Examine commercial bank performance and profitability.
• Off-Balance-Sheet (OBS) Activities
• OBS transactions are a significant part of a bank’s business.
– OBS items generate fee income for the bank but also increases bank risk.
– OBS items are contingent assets or liabilities.
– Contingent asset: A possible asset that may arise because of a gain that is
contingent on future events that are not under an entity's control.
– Contingent liability: A potential liability that may occur, depending on the outcome
of an uncertain future event.
– OBS activities are notionally more than 7 times the total value of assets held by the
banks.
• Off-Balance-Sheet (OBS) Activities
• Banks’ major OBS activities include, but are not limited to:
– Loan commitments,
– Letters of credit (LOC),
– Securitisation, and
– Derivative securities contracts.
i. Typically used to hedge their asset-liability risk exposures in an attempt to
protect an FI's net worth from adverse events.
• OBS Activities: Loan Commitments
• Formal promises by a bank to lend money according to certain terms outlined in the
commitment.
– Bank assures borrower funds will be there when needed.
, – Consumers familiar with available credit on credit cards.
– Three main types of loan commitments between business borrowers and
commercial banks:
i. Line of credit: Moral obligation on a short-term basis (< 1 year).
ii. Term loan: A formal legal agreement where bank will lend a customer a
certain dollar amount for a period exceeding a year.
iii. Revolving credit: A formal legal agreement where bank agrees to lend up to
a certain limit for a period exceeding a year.
iv. Exposure to funding risk which can strain bank liquidity
• OBS Activities: Letters Of Credit (LOC)
– Letter of credit sets up the conditions to be met in order for payment to occur.
Commercial LOC (trade finance):
• The bank guarantees payment for goods in a commercial transaction (e.g. client non-
performance).
• Credit risk is transferred to the buyer's bank at issuance of a documentary credit.
Standby LOC (direct credit substitute):
• An undertaking by a bank to support the financial obligations of a client to a third
party.
• The bank acts as guarantor on behalf of a client for a fee.
• Bank is required to make a payment only if the client defaults on a payment
to a third party, or fails to meet contractual obligations.
• OBS Activities: Securitisation
• Originating bank provides house loans to customers.
• Pool of mortgages divided into tranches based on their homogeneity with respect to
maturity and type of loan.
• Tranches are officially rated for their risk level (AAA, etc.).
• Risk rating helps determine the value of the security.
• Tranches are then transferred to a trust (i.e., special purpose vehicle).
• OBS Activities: Securitisation
• A special purpose vehicle (SPV), a stand-alone legal entity, purchases these assets
and then issue securities.
• SPV used to transfer ownership of assets from originating bank.
• Securities are backed by the pools of assets.
• The SPV issue the debt securities to an underwriter in exchange for cash.
