Learning Objectives
- What are off-balance-sheet activities and why do bankers engage
in them?
To protect themselves against interest rate increases, banks
go off road, engaging in activities that do not appear on their
balance sheets.This is not to say that these activities are
not accounted for. It isn’t illegal or even slimy. These activities
will appear on revenue statements, cash flow analyses, etc. They do
not, however, appear on the balance sheet, on the list of the
bank’s assets and liabilities.Banks charge customers all sorts
of fees, and not just the little ones that they sometimes slap on
retail checking depositors. They also charge fees for loan
guarantees, backup lines of credit, and foreign exchange
transactions. Banks also now sell some of their loans to investors.
Banks usually make about .15 percent when they sell a loan, which
can be thought of as their fee for originating the loan, for, in
other words, finding and screening the borrower. So, for example, a
bank might discount the $100,000 note of XYZ Corp. for 1 year at 8
percent. We know from the present value formula that on the day it
is made, said loan is worth PV = FV/(1 + i) = 100,000/1.08
= $92,592.59. The bank might sell it for 100,000/1.0785 =
$92,721.37 and pocket the difference. Such activities are not
without risks, however. Loan guarantees can become very costly if
the guaranteed party defaults. Similarly, banks often sell loans
with a guarantee or stipulation that they will buy them back if the
borrower defaults. (If they didn’t do so, as noted above, investors
would not pay much for them because they would fear adverse
selection, that is, the bank pawning off their worse loans on
unsuspecting third parties.) Although loans and fees can help keep
up bank revenues and profits in the face of rising interest rates,
they do not absolve the bank of the necessity of carefully managing
its credit risks.
Banks (and other financial intermediaries) also take
off-balance-sheet positions in derivatives markets, including
futures and interest rate swaps. They sometimes use derivatives
to hedge their risks; that is, they try to earn income should the
bank’s main business suffer a decline if, say, interest rates
rise. For example, bankers sell futures contracts on U.S.
Treasuries at the Chicago Board of Trade. If interest rates
increase, the price of bonds, we know, will decrease. The bank can
then effectively buy bonds in the open market at less than the
contract price, make good on the contract, and pocket the
difference, helping to offset the damage the interest rate increase
will cause the bank’s balance sheet.
Bankers can also hedge their bank’s interest rate risk by
engaging in interest rate swaps. A bank might agree to pay a
finance company a fixed 6 percent on a $100 million notational
principal (or $6 million) every year for ten years in exchange for
the finance company’s promise to pay to the bank a market rate like
the federal funds rate or London Interbank Offering Rate (LIBOR)
plus 3 percent. If the market rate increases from 3 percent (which
initially would entail a wash because 6 fixed = 3 LIBOR plus 3
contractual) to 5 percent, the finance company will pay the net due
to the bank, (3 + 5 = 8 − 6 = 2% on $100 million =) $2 million,
which the bank can use to cover the damage to its balance sheet
brought about by the higher rates. If interest rates later fall to
2 percent, the bank will have to start paying the finance company
(6 − [3 + 2] = 1% on $100 million) $1 million per year but will
well be able to afford it.
Banks and other financial intermediaries also sometimes
speculate in derivatives and the foreign exchange markets, hoping
to make a big killing. Of course, with the potential for high
returns comes high levels of risk. Several hoary banks have gone
bankrupt because they assumed too much off-balance-sheet risk. In
some cases, the failures were due to the principal-agent problem:
rogue traders bet their jobs, and their banks, and lost. In other
cases, traders were mere scapegoats, instructed to behave as they
did by the bank’s managers or owners. In either case, it is
difficult to have much sympathy for the bankers, who were either
deliberate risk-takers or incompetent. There are some very basic
internal controls that can prevent traders from risking too much of
the capital of the banks they trade for, as well as techniques,
called value at riskwww.gloriamundi.org and stress
testing,financial-dictionary.thefreedictionary.com/Stress+Testing
that allow bankers to assess their bank’s derivative risk
exposure.
KEY TAKEAWAYS
- Off-balance-sheet activities like fees, loan sales, and
derivatives trading help banks to manage their interest rate risk
by providing them with income that is not based on assets (and
hence is off the balance sheet).
- Derivatives trading can be used to hedge or reduce interest
rate risks but can also be used by risky bankers or rogue traders
to increase risk to the point of endangering a bank’s capital
cushion and hence its economic existence.