Thefocusofthepreviousdiscussionhasbeenonthebalancesheet—specifically,theacquisitionanduses offundsbythecommercialbanks.Suchanemphasisunderstatestheroleofamodernbank.Itwasnoted atthebeginningofthechapterthatbanksundertakeasubstantialvolumeofbusinessthat,byitsnature, isnotrecordedasanassetorliabilityonthebalancesheet.Suchoff-balance-sheettransactionsrepresent animportantsourceofincomeforthebanks,andaremostimportantinthefinanciallifeofbusinesses andgovernments.
Themaintypesofoff-balance-sheetbusinessconductedbycommercialbankscanbedividedinto fourmajorcategories:
• directcreditsubstitutes
• trade-andperformance-relateditems
• commitments
• foreignexchangecontracts,interestratecontractsandothermarket-rate-relatedcontracts.
LEARNING OBJECTIVE 2.4
Outline the nature and importance of banks’ off-balance-
sheet business, including direct credit substitutes, trade- and performance-related items, commitments and market-rate-related contracts.
R EFLECTION POINTS
• The major business of commercial banks is the provision of loans to customers.
• Personal finance includes housing loans, term loans and credit card facilities.
• Housing finance is the provision of loans to purchase residential property. As security, the bank will register a mortgage over the property.
• Loan repayments may be amortised; that is, each loan instalment includes both interest and principal repayments.
• A bank may securitise part of its loan portfolio; that is, sell a group of loans into a trust in order to raise additional funds for new lending.
• Commercial lending is loans provided to the business sector, including overdrafts, term loans and mortgage finance.
• Loans may have a fixed interest rate, or a variable interest rate based on a reference rate such as the BBSW.
• Businesses establish overdraft facilities that allow a firm to put its operating account into debit up to an agreed limit. This fluctuating facility allows a business to manage the timing of its cash flows.
• Banks are providers of lease finance, whereby the bank purchases an asset that is leased to a customer.
• Banks mainly lend to government by purchasing government securities. These securities allow banks to invest surplus funds and manage interest rate risk and maturity risk in the asset portfolio.
• Banks also accumulate other assets such as physical infrastructure, for example, branches, and electronic information and product delivery systems.
somebankshavesoldaproportionoftheirbranchpremisesandenteredintolease-backarrangements.
Othershaveoutsourcedtheircomputercentreoperationstospecialistproviders.
Youcantestyourunderstandingofthesourcesandusesoffundsbycommercialbanksbyexamining thebalancesheetofamajorbank.Thenotestotheaccountsrevealthedetailsofthevarioussources andusesoffunds.Bankspublishtheirfinancialstatementsontheirwebsites;forexample:
• AustraliaandNewZealandBankGroupLimitedatwww.anz.com.au
• CommonwealthBankofAustraliaLimitedatwww.commbank.com.au
• NationalAustraliaBankLimitedatwww.nab.com.au
• WestpacBankingCorporationatwww.westpac.com.au
Directcreditsubstitutesandtrade-andperformance-relateditemsgenerallyinvolvethebankin supportingorguaranteeingtheobligationofaclienttoathirdparty.Normallythebankwillmakea paymenttothatthirdpartyonlyifaspecifiedeventoccurs.Commitmentsrelatetoabank’scontractual obligationstocustomersthatareyettobecompleted.Finally,market-rate-relatedcontractsinvolvethe useofderivativeproductstomanagefinancialriskexposuresofthebankanditscustomers.
Thelargecommercialbanksalsoprovideawiderangeofadvisoryservicestobusinessandgovernment.
Theseadvisoryservicesincluderiskmanagementadviceandportfoliorestructuringadvice.Muchmore detailisprovidedonthesetypesofadvisoryservicesinChapter3,Section3.1.2(‘Off-balance-sheetbusiness’).
2.4.1 DIRECT CREDIT SUBSTITUTES
Direct credit substitutesareprovidedbyacommercialbanktosupportaclient’sfinancialobligations.
Inthissituation,thebankdoesnotprovidethefinancefromitsownbalancesheet.Thedirectcredit substituteeffectivelyensuresthattheclientisabletoraisefundsdirectfromthemarkets.
Forexample,thedirectcreditsubstitutemaytaketheformofastand-byletterofcredit.Thisis anundertakingbyabanktomakepaymenttoaspecifiedthirdpartyifthebank’sclientfailstomeet itsfinancialobligationtothatparty.Withthebankundertakinginplace,theclientisabletoissue securitiesandraisefundsdirectlyinthemarkets,sincethelenderisassuredthatamountsduewillbe repaidbyeithertheborrowerorthebankthatissuedtheletterofcredit.
Otherexamplesofdirectcreditsubstitutesincludeguarantees,indemnitiesandlettersofcomfort issuedbyabankthathavetheeffectofguaranteeingthefinancialobligationsofaclient.Forexample,a bank’sclient,whensubmittingtenderdocumentsforamajorconstructionproject,mayneedtoprovide, withthetenderdocuments,aformalassurancethatithasthefinancialcapacitytocompletetheproject.
Itwouldbeexpectedthatiftheclientwinsthetender,thebankwillprovidefinancefortheproject.
2.4.2 TRADE- AND PERFORMANCE-RELATED ITEMS
Trade- and performance-related itemsarealsoguaranteesmadebyabankonbehalfofitsclient,butin thiscasetheyaremadetosupportaclient’snon-financialcontractualobligations.
Theobligationsmayincludetrade-relatedundertakingsorcontractualagreementstoprovidegoods orservices.Inthesecircumstances,thebankprovidesaguaranteeonbehalfofitsclientthatitwill makeapaymenttothethirdpartysubjecttothetermsofthespecificcommercialcontract.
Examplesoftrade-andperformance-relateditemsinclude:
• Documentary letters of credit (DLCs).Thesearewhereabanksubstitutesitscreditstandingforthat of its client. The bank, on behalf of its client, will authorise payment to a named party against deliverybythatpartyofashipmentofgoods(evidencedinspecifieddocuments).Forexample,an exporterofgoodswillusuallyrequiretheimporterofthegoodstoarrangeforitsbanktoprovidea documentaryletterofcredittotheexporter’sbank.Oncetheimportedgoodsarriveinthecountry, theassociateddocumentsareinspectedandpaymentismadebetweenthebanksimmediately.The DLCwillbeirrevocable;thatis,itcannotbecancelled.
• Performance guarantees.Thesearewhereabankagreestoprovidefinancialcompensationtoathird partyifaclientdoesnotcompletethetermsandconditionsofacontract.Forexample,aclientmay bedeemedtohavefailedtocompletethetermsofacontractifinferiorcomponentsareusedina majorcomputersystemupgrade.
2.4.3 COMMITMENTS
Commitmentsinvolveabankinanundertakingtoadvancefundstoaclient,tounderwritedebtand equityissuesortopurchaseassetsatsomefuturedate.
Direct credit substitute an undertaking provided by a bank to support the financial obligations of a client
Trade- and
performance-related item
an undertaking provided by a bank to a third party promising payment under the terms of a specified commercial contract
Commitments the contractual financial obligations of a bank that are yet to be completed or delivered
Examplesofcommitmentsinclude:
• Outright forward purchase agreements.Thesearewhereabankcontractstobuyaspecifiedasset, suchasforeigncurrency,fromitsclientatanagreedexchangerateonaspecifieddate.
• Repurchase agreements.Abanksellsassets,suchasgovernmentsecurities,ontheunderstanding thatthebankwillrepurchasethemataspecifieddate.
• Underwriting facilities.Abankguaranteesaclientthat,subjecttoarangeofconditions,itwillcover anyshortfallinfundsreceivedfromaprimarymarketissueofdebtorequitysecurities.
• Loans approved but not yet drawn down.Forexample,abankhasagreedtoprovideaborrowerwith aloanatafuturedateuponcompletionoftheloandocumentation.
• Credit card limit approvals that have not been used by card holders.Forexample,abankmayauthorise acreditcardlimitof$4000foraclient.Iftheclientuses$1000oftheavailablecredit,thenthat amountwillappearonthebalancesheetasanasset(loan),andtheremaining$3000creditremains asanoff-balance-sheetcommitment.
2.4.4 FOREIGN EXCHANGE CONTRACTS, INTEREST RATE CONTRACTS AND OTHER MARKET-RATE-RELATED CONTRACTS
Foreignexchange,interestrateandothermarket-rate-related contractsprincipallyinvolvetheuseof derivativeproducts—thatis,futures,options,swapsandforwardcontracts.
Theseinstrumentsareprimarilydesignedtofacilitatehedgingagainstrisk;forexample,theeffects ofmovementsinexchangerates,interestrates,equitypricesandcommodityprices.Derivativecontracts arealsoboughtandsoldbytradersinanattempttomakeprofitsfrommovementsincontractprices.
DetailsofeachoftheseinstrumentsandtheiruseforriskmanagementareprovidedinParts5and6.
Examplesofforeignexchange,interestrateandothermarket-rate-relatedcontractsinclude:
• Forward exchange contracts.Abankcontractstobuyorsellatafuturedateaspecifiedamountofa foreigncurrencyatanexchangeratethatissettoday.
• Currency swap.Abankexchangesaprincipalamountandongoingassociatedinterestpaymentsthat aredenominatedinaforeigncurrency.
• Forward rate agreements.Acompensationagreementbetweenabankandclientbasedonanotional principalamount.Onepartycompensatestheotherpartyifinterestratesmoveaboveorbelowan agreedinterestrate.
• Interest rate futures contracts.Theseareexchange-tradedagreementstobuyorsellaspecificsecurity ataspecificpriceatapredeterminedfuturedate.
• Interest rate options contracts.Theseprovidetheright,butnottheobligation,tobuyorsellaspecified financialinstrumentatanagreeddateandprice.
• Equity contracts. These include futures and options contracts based on specified stock prices or stockindices.Thesecontractslockintheequitypricetodaythatwillapplyataspecifiedfuturedate.
2.4.5 VOLUME OF OFF-BALANCE-SHEET BUSINESS
Therearetwooutstandingfeaturesofthebanks’off-balance-sheetbusiness.Thefirstisthemagnitude ofthenotionalfacevalueoftheoff-balance-sheetcontractswrittenbybanks.Thiswillvarybetween countries,butanexaminationofthevolumeofoff-balance-sheetbusinesswithintheAustralianmarket givesagoodindicationofthesizeofthemarkets.
In Australia, the face value of banks’ off-balance-sheet business as at December 2017 stood at
$37341981(million)whilethetotalvalueofbanks’assetsstoodat$4125764(million).Thatis,the
Market-rate-related contracts derivative products;
allow management of exposures to interest rate, foreign exchange, equity and commodity price risks
Hedging implementing strategies
to protect against an identified risk exposure
notionalvalueofoff-balance-sheetbusinessisninetimesthevalueoftotalassetsheldbythebanks.
AsdescribedinPart6,thenotionalvalueofmanyderivativeproductsissignificantlygreaterthanthe actualassociatedcashflows.Comparingthenotionalvalueofderivativeswiththevalueofbalance- sheetassetsdoesoverstatetherelationship.
Thesecondcharacteristicoftheoff-balance-sheetbusinessisthatitismainlymarket-rate-related contracts.Thenotionalvaluesofthevarioustypesofoff-balance-sheetbusinessareshowninTable2.1.
R EFLECTION POINTS
• Direct credit substitutes are provided by a bank to support a customer’s financial obligations to a third party (e.g. a letter of comfort written by the bank confirming that a customer has sufficient funding in place to proceed with a project).
• Trade- and performance-related items are guarantees given by a bank to support a customer’s obligations; for example, a bank will execute a documentary letter guaranteeing that it will pay for the importation of goods on behalf of its customer.
• Commitments are yet-to-be-completed financial agreements made by a bank to its customers (e.g.
the approval to provide a loan in the future to purchase a house, or a credit limit on a credit card).
• Foreign exchange, interest rate and other market-rate-related contracts are typically derivative contracts, such as futures, forwards, options and swaps, used to manage risk exposures.
• The notional value of the off-balance-sheet business of banks is much greater than the value of balance-sheet assets.
The nature and size of market-rate-related contracts, combined with the volatility and speed at whichcontractsarere-pricedinthemarket,hasresultedinanumberofextraordinarylossesbeing incurred by both financial institutions and their clients. The threat to the stability of domestic and globalfinancialsystemsthatmayresultfromlargelossesinthederivativesmarketshasbeenthesubject ofmuchdiscussionbyregulatorsandprudentialsupervisors.
Onehigh-profileexample(whichhassincebeendepictedinthemovieRogue Trader)wasthelossof
$1.5billionbytheUKbankBaringBrothersplc.Speculationonpricemovementsofderivativecontracts ontheSingaporeandOsakaexchangesbyoneofitstraders,NickLeeson,broughtabouttheloss,which resultedintheeventualfailureofthebank.Ofcourse,duringtheGFCanumberofinstitutions,including Lehman Brothers and Bear Stearns, collapsed as the direct or indirect result of excessive trading in mortgage-relatedderivatives.Intheend,itistheresponsibilityofeachbanktoensurethatitestablishes anddocumentsobjectives,policiesandproceduresinrelationtoitsuseofderivativeproducts.
Table 2.1 Bank off-balance-sheet business, Australia, as at December 2017
Off-balance-sheet business type Notional amount ($ millions)
Direct credit substitutes 46 806
Trade- and performance-related items 66 945
Commitments 1 232 076
Interest rate contracts 27 356 300
Foreign exchange contracts 8 305 871
Credit derivatives 42 312
Other 291 667
Total 37 341 981
SOURCE: © Australian Prudential Regulation Authority 2018