Standby letters of credit guarantees issued to cover

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

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.

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.