standby letters of credit Guarantees issued to cover contingencies that are

Standby letters of credit guarantees issued to cover

This preview shows page 19 - 22 out of 50 pages.

standby letters of credit Guarantees issued to cover contingencies that are potentially more severe and less predictable than contingencies covered under trade-related or commercial letters of credit. 1. Loan commitments 2. Commercial letters of credit 3. Standby letters of credit Notional Amounts for Derivatives 5. Forwards and futures 6. Options 7. Interest rate swaps
Image of page 19
option to take down this loan. In return for making this loan commitment, the bank may charge an up- front fee (or facility fee) of, say, 1/8 percent of the commitment size, or $12,500 in this example. In addition, the bank must stand ready to supply the full $10 million at any time over the commitment period— for example, one year. Meanwhile, the borrower has a valuable option to take down any amount between $0 and $10 million over the commitment period. The bank may also charge the borrower a back-end fee (or commitment fee) on any unused commitment balances at the end of the period. In this example, if the borrower takes down only $8 million over the year and the fee on unused commitments is 1/4 percent, the bank generates additional revenue of 1/4 percent times $2 million, or $5,000. Note that only when the borrower actually draws on the commitment do the loans made under the commitment appear on the balance sheet. Thus, only when the $8 million loan is taken down exactly halfway through the one-year commitment period (i.e., six months later) does the balance sheet show the creation of a new $8 million loan. We illustrate the transaction in Figure 13-2. When the $10 million commitment is made at time 0, nothing shows on the balance sheet. Nevertheless, the bank must stand ready to supply the full $10 million in loans on any day withiri the one-year commitment period—at time 0 a new contingent claim on the resources of the bank was created. At time 6 months, when the $8 million is drawn down, the balance sheet will reflect this as an $8 million loan. Commercial Letters of Credit and Standby Letters of Credit. In selling commercial letters of credit (LCs—item 2 in Table 13-2) and standby letters of credit (SLCs— item 3) for fees, depository institutions add to their contingent future liabilities. Both LCs and SLCs are essentially guarantees to underwrite performance that a depository institution sells to the buyers of the guarantees (such as a corporation). In economic terms, the depository institution that sells LCs and SLCs is selling insurance against the frequency or severity of some particular future event occurring. Further, similar to the different lines of insurance sold by property-casualty insurers, LC and SLC con- tracts differ as to the severity and frequency of their risk exposures. We look next at the risk exposure from engaging in LC and SLC activities off the balance sheet.
Image of page 20
Part 3 Depository Institutions Figure 13-2 Loan Commitment Transaction 0 6 Months 1 Year Loan Commitment Take Down $8m. Loan Commitment Agreement Begins of Loan Commitment; Period Ends and Is Off Balance Sheet; Loans Increase by $8m. Removed Off Balance No Change Made On On Balance Sheet; $2m. Sheet; No Change Balance Sheet.
Image of page 21
Image of page 22

You've reached the end of your free preview.

Want to read all 50 pages?

  • Left Quote Icon

    Student Picture

  • Left Quote Icon

    Student Picture

  • Left Quote Icon

    Student Picture