BUS307 Topic 6 - Topic 6 Of Balance Sheet Banking I Loan Commitments BUS307 Commercial Banking DEFINITIONS Of-Balance-Sheet(OBS activities are

BUS307 Topic 6 - Topic 6 Of Balance Sheet Banking I Loan...

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Topic 6 Off Balance Sheet Banking I: Loan Commitments BUS307 Commercial Banking
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DEFINITIONS Off-Balance-Sheet (OBS) activities are contingent assets and liabilities that may affect the future characteristics of a FI’s balance sheet. These can be classified into: OBS Asset: on the occurrence of a contingent event the OBS activity moves into the asset side of the balance sheet. OBS Liability: on the occurrence of a contingent event the OBS activity moves into the liability side of the balance sheet. In addition they can be classified into option-like and non- option-like contingent claims.
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DEFINITIONS (Continued) Greenbaum and Thakor present the following categorization: OFF-BALANCE-SHEET ITEMS ITEM CLASSIFICATION ITEM Option-like Contingent Claim Loan Commitments Guarantees Options Standby Letters of Credit Non-option like Contingent Claim Interest Rate Swaps Foreign Currency Transactions Futures and Forward Contract
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LOAN COMMITMENTS Definition: a promise to lend up to a pre-specified amount to a pre-specified customer at pre-specified terms. Alternately, LC can be considered as a pre- negotiated line of credit. Need to consider: commitment fee or up-front fee; usage fee or back-end fee (on unused component); servicing fee (on borrowed amount); and compensating balance requirements.
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CONTINGENT RISKS IN LOAN COMMITMENT interest rate risk - lending at low margins; take-down risk or liquidity risk – market-wide or bank-specific decline in liquidity ; credit risk - high and volatile interest rates may reduce the economic value of cash flows and borrowers may invest in riskier investments (asset substitution); and aggregate funding risk.
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EXPLANATIONS FOR THE EXISTENCE OF LOAN COMMITMENTS SUPPLY-SIDE EXPLANATIONS: regulatory taxes; [avoidance of Negotiable Certificates of Deposit (NCDs), liquidity, and capital requirements] contractual discretion and reputation - material adverse clause (MAC) financial and reputational capital; and demand forecasting.
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