standby letters of creditGuarantees 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 commitments2.Commercial letters ofcredit3.Standby letters of creditNotional Amounts for Derivatives5.Forwards and futures6.Options7.Interest rate swaps
option to take downthis loan. In return formakingthisloancommitment, the bankmay charge an up-front fee (or facilityfee) of, say, 1/8percentofthecommitment size, or$12,500inthisexample. In addition,the bank must standready to supply thefull $10 million at anytimeoverthecommitment period—for example, one year.Meanwhile,theborrowerhasavaluable option to takedown any amountbetween $0 and $10millionoverthecommitmentperiod.The bank may alsocharge the borrower aback-endfee(orcommitment fee) onanyunusedcommitment balancesat the endof theperiod. In this example,if the borrower takesdown only $8 millionover the year and thefeeonunusedcommitments is 1/4percent,thebankgeneratesadditionalrevenue of 1/4 percenttimes $2 million, or$5,000.Note that onlywhen the borroweractually draws on thecommitment do theloans made under thecommitment appear onthe balance sheet.Thus, only when the$8 million loan istaken down exactlyhalfway through theone-year commitmentperiod (i.e., six monthslater) does the balancesheet show the creationof a new $8 millionloan. We illustrate thetransaction in Figure13-2. When the $10 million commitment is made at time 0, nothing shows on thebalance sheet. Nevertheless, the bank must stand ready to supply the full $10 million inloans on any day withiri the one-year commitment period—at time 0 a new contingentclaim on the resources of the bank was created. At time 6 months, when the $8 millionis drawn down, the balance sheet will reflect this as an $8 million loan.Commercial Letters of Credit and Standby Letters of Credit. In selling commercialletters 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. BothLCs and SLCs are essentially guarantees to underwrite performance that a depositoryinstitution sells to the buyers of the guarantees (such as a corporation). In economicterms, the depository institution that sells LCs and SLCs is selling insurance againstthe frequency or severity of some particular future event occurring. Further, similar tothe 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 therisk exposure from engaging in LC and SLC activities off the balance sheet.
Part 3 Depository Institutions Figure 13-2 Loan Commitment Transaction06 Months1 YearLoan CommitmentTake Down $8m.Loan CommitmentAgreement Beginsof Loan Commitment;Period Ends and IsOff Balance Sheet;Loans Increase by $8m.Removed Off BalanceNo Change Made OnOn Balance Sheet; $2m.Sheet; No ChangeBalance Sheet.