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Chapter 14 Liquidity risk Answers to end-of-chapter questions Questions and problems 1 How does the degree of liquidity risk differ for different types of financial institutions? Depository institutions are the FIs most exposed to liquidity risk. Managed funds, pension funds, superannuation funds and property-casualty insurance companies are the least exposed. In the middle are life insurance companies. 2 What are the two reasons why liquidity risk arises? How does liquidity risk arising from the liability side of the balance sheet differ from liquidity risk arising from the asset side of the balance sheet? What is meant by ‘fire-sale prices’? Liquidity risk occurs because of situations that develop from economic and financial transactions that are reflected on either the asset side of the balance sheet or the liability side of the balance sheet of an FI. Asset-side risk arises from transactions that result in a transfer of cash to some other asset, such as the exercise of a loan commitment or a line of credit. Liability-side risk arises from transactions whereby a creditor, depositor or other claim holder demands cash in exchange for the claim. The withdrawal of funds from a bank is an example of such a transaction. A fire-sale price refers to the price of an asset that is less than the normal market price because of the need or desire to sell the asset immediately under conditions of financial distress. 3 What are core deposits? What role do core deposits play in predicting the probability distribution of net deposit drains? Core deposits are those deposits that will stay with the bank over an extended period of time. These deposits are relatively stable sources of funds and consist mainly of demand, savings, and retail time deposits. Because of their stability, a higher level of core deposits will increase the predictability of forecasting net deposit drains from the bank. 4 The probability distribution of the net deposit drain of a DI has been estimated to have a mean of 2 per cent and a standard deviation of 1 per cent. Is this DI increasing or decreasing in size? Explain. This bank is decreasing in size because less core deposits are being added to the bank than are being withdrawn. On average, the rate of decrease of deposits is 2 per cent. If the distribution is normal, we can state with 95 per cent confidence that the rate of decrease of deposits will be between 0 per cent and 4 per cent (plus or minus two standard deviations). 5 How is a DI’s distribution pattern of net deposit drains affected by the following? (a) A long weekend The entire distribution shifts to the right (an increase in the expected amount of withdrawals) as individuals spend more. Moreover, the standard deviation decreases as the distribution narrows. (b) The summer holidays The entire distribution shifts to the right (an increase in the expected amount of withdrawals) as individuals spend more. Moreover, the standard deviation decreases as the distribution narrows. (c) A severe economic recession The entire distribution shifts to the left and may have a negative mean value as withdrawals average more than deposits. However, as the opportunity cost of holding money declines, some depositors may increase their net deposits. The impact will be to widen the distribution. (d) Double-digit inflation The entire distribution shifts to the left and may have a negative mean value as withdrawals average more than deposits. Inflation may cause a general flight from money that will cause the distribution to narrow. 6 What are two ways in which a DI can offset the liquidity effects of a net deposit drain of funds? How do the two methods differ? What are the operational benefits and costs of each method? If the bank has a net deposit drain, it needs to either increase its liabilities (by borrowing funds or issuing equity) or reduce its assets. An institution can reduce its assets by drawing down on its cash reserves, selling securities, or calling back (or not renewing) its loans. It can increase liabilities by issuing more federal funds, long-term debt, or new issues of equity. If a bank offsets the drain by increasing liabilities, the size of the firm remains the same. However, if it offsets the drain by reducing its assets, the size of the firm is reduced. If it has a net negative deposit drain, then it needs to follow the opposite strategy. The operational benefit of addressing a net deposit drain is to restore the financial stability and health of the FI. However, this process does not come without costs. On the asset side, liquidating assets may occur only at fire-sale prices that will result in realised losses of value, or asset-mix instability. Further, not renewing loans may result in the loss of profitable relationships that could have negative effects on profitability in the future. On the liability side, entering the borrowed funds market normally requires paying market interest rates that are above those rates that it had been paying on low interest deposits. 7 What are two ways in which an FI can offset the effects of asset-side liquidity risk such as the drawing down of a loan commitment? A DI can use either purchased liquidity management or stored liquidity management. Purchased liquidity management involves borrowing funds in the money/purchased funds market. Stored liquidity management involves selling cash-type assets, such as Treasury bills, or simply reducing excess cash reserves to the minimum level required to meet regulatory imposed reserve requirements. 8 A DI with the following balance sheet (in millions) expects a net deposit drain of $15 million. Assets Liabilities and equity Cash $10 Deposits $68 Loans 50 Equity 7 Securities 15 Total assets $75 Total liabilities and equity $75 Show the DI’s balance sheet if the following conditions occur: (a) The DI purchases liabilities to offset this expected drain. If the bank purchases liabilities, then the new balance sheet is: Cash $10 Deposits $53 Loans $50 Purchased liabilities $15 Securities $15 Equity $ 7 (b) The reserve-asset adjustment method is used to meet the liquidity shortfall. If the bank uses reserve-asset adjustment, a possible balance sheet may be: Loans $50 Deposits $53 Securities $10 Equity $ 7 FIs will most likely use some combination of these two methods. 9 All Star Bank has the following balance sheet (in millions): Assets Liabilities and equity Cash $30 Deposits $110 Loans 90 Borrowed funds 40 Securities 50 Equity 20 Total assets $170 Total liabilities and equity $170 All Star Bank’s largest customer decides to exercise a $15 million loan commitment. How will the new balance sheet appear if All Star uses the following liquidity risk strategies? (a) Stored liquidity management Assets Liabilities and equity Cash $15 Deposits $110 Loans 105 Borrowed funds 40 Securities 50 Equity 20 Total assets $170 Total liabilities and equity $170 When stored liquidity management is used to finance the loan commitment the balance sheet total is unchanged, as in part (a), whereas in part (b) liability management causes the balance sheet total to expand. (b) Purchased liquidity management Assets Liabilities and equity Cash $30 Deposits $110 Loans 105 Borrowed funds 55 Securities 50 Equity 20 Total assets $185 Total liabilities and equity $185 10 A DI has assets of $10 million consisting of $1 million in cash and $9 million in loans. The DI has core deposits of $6 million, subordinated debt of $2 million and equity of $2 million. Increases in interest rates are expected to cause a net drain of $2 million in core deposits over the year. (a) The average cost of deposits is 6 per cent and the average yield on loans is 8 per cent. The DI decides to reduce its loan portfolio to offset this expected decline in deposits. What will be the effect on net interest income and the size of the DI after the implementation of this strategy? Assuming that the decrease in loans is offset by an equal decrease in deposits, the cost of the drain = (0.08 – 0.06) × $2 million = $40 000. The average size of the firm will be $8 million after the drain. (b) If the interest cost of issuing new short-term debt is expected to be 7.5 per cent, what would be the effect on net interest income of offsetting the expected deposit drain with an increase in interest-bearing liabilities? Cost of the drain = (0.075 – 0.06) × $2 million = $30 000. (c) What will be the size of the DI after the drain using this strategy? The average size of the firm will be $10 million after the drain. (d) What dynamic aspects of DI management would further support a strategy of replacing the deposit drain with interest-bearing liabilities? Purchasing interest-bearing liabilities may cost significantly more than the cost rate on deposits that are leaving the bank. However, using interest-bearing deposits protects the bank from decreasing asset size or changing the composition of the asset side of the balance sheet. 11 Define each of the following four measures of liquidity risk. Explain how each measure would be implemented and utilised by a DI. (a) Sources and uses of liquidity This statement identifies the total sources of liquidity as the amount of cash-type assets that can be sold with little price risk and at low cost, the amount of funds the bank can borrow in the money/purchased funds market, and any excess cash reserves over the necessary reserve requirements. The statement also identifies the amount of each category the bank has utilised. The difference is the amount of liquidity available for the bank. This amount can be tracked on a day-to-day basis. (b) Peer group ratio comparisons Banks can easily compare their liquidity with peer group banks by looking at several easy to calculate ratios. High levels of loan to deposit and borrowed funds to total asset ratios will identify reliance on borrowed funds markets, while heavy amounts of loan commitments to assets may reflect a heavy amount of potential liquidity need in the future. (c) Liquidity index The liquidity index measures the amount of potential losses suffered by an FI from a fire-sale of assets compared to a fair market value established under the conditions of normal sale. The lower the index, the less liquidity the FI has on its balance sheet. The index should always be a value between 0 and 1. (d) Financing gap and financing requirement The financing gap can be defined as average loans minus average deposits or, alternatively, as negative liquid assets plus borrowed funds. A negative financing gap implies that the bank must borrow funds or rely on liquid assets to fund the bank. Thus, the financing requirement can be expressed as financing gap plus liquid assets. This relationship implies that some level of loans and core deposits as well as some amount of liquid assets determine the need for the bank to borrow or purchase funds. 12 A DI has $10 million in T-notes, a $5 million line of credit to borrow in the repo market and $5 million in excess cash reserves (above the regulatory reserve requirements). The DI currently has borrowed $6 million in central bank funds and $2 million from the central bank rediscounting facility to meet seasonal demands. (a) What is the DI’s total available (sources of) liquidity? The DI’s available resources for liquidity purposes are $10m + $5m + $5m = $20 million. (b) What is the DI’s current total use of liquidity? The DI’s current use of liquidity is $6m + $2m = $8 million. (c) What is the net liquidity of the DI? The DI’s net liquidity is $12 million. (d) What conclusions can you derive from the result? The net liquidity of $12 million suggests that it can withstand unexpected withdrawals of $12 million without having to reduce its less liquid assets at fire-sale prices. 13 A DI has the following assets in its portfolio: $20 million in cash reserves with the Reserve Bank, $20 million in T-notes and $50 million in mortgage loans. If the assets need to be liquidated at short notice, the DI will receive only 99 per cent of the fair market value of the T-notes and 90 per cent of the fair market value of the mortgage loans. Estimate the liquidity index for these securities using the above information. where wi = weights of the portfolio Pi = fire-sale prices Pi* = fair market value of assets Thus, and assuming that fixed assets will not be disposed on short notice: I = ($20m/$90m)(1.00/1.00) + ($20m/$90m)(0.99/1.00) + ($50m/$90m)(0.90/1.00) = 0.942 14 Conglomerate Corporation has acquired Acme Corporation. To help finance the takeover, Conglomerate will liquidate the overfunded portion of Acme’s pension fund. The face values and current and one-year future liquidation values of the assets that will be liquidated are given below. Liquidation values Asset Face value t = 0 t = 1 BHP shares $10 000 $ 9 900 $10 500 Woolworths bonds 5 000 4 000 4 500 Treasury securities 15 000 13 000 14 000 Calculate the one-year liquidity index for these securities. where wi = weights of the portfolio Pi = fire-sale prices Pi* = fair market value of assets Asset Weights BHP shares $10 000/$30 000 = 0.333 Woolworths bonds $5 000/$30 000 = 0.167 Treasury securities $15 000/$30 000 = 0.5 Thus I = (0.333)(9900/10 500) + (0.167)(400/4500) + (0.5)(13 000/14 000) = 0.927 15 Plain bank has $10 million in cash and equivalents, $30 million in loans, and $15 million in core deposits. (a) Calculate the financing gap. Financing gap = average loans – average deposits = $30 million – $15 million = $15 million. (b) What is the financing requirement? Financing requirement = financing gap + liquid assets = $15 million + $10 million = $25 million. (c) How can the financing gap be used in the day-to-day liquidity management of the bank? A rising financing gap on a daily basis over a period of time may indicate future liquidity problems due to increased deposit withdrawals and/or increased exercise of loan commitments. Sophisticated lenders in the money markets may be concerned about these trends, and they may react by imposing higher risk premiums for borrowed funds or stricter credit limits on the amount of funds lent. 16 How can an FI’s liquidity plan help reduce the effects of liquidity shortages? What are the components of a liquidity plan? A liquidity plan requires forward planning so that an optimal mix of funding can be implemented to reduce costs and unforeseen withdrawals. In general, a plan could incorporate the following: (a) assigning a team that will take charge in the event of a liquidity crisis (b) identifying the account holders that will most likely withdraw funds in the event of a crisis (c) estimating the size of the runoffs and the sources of borrowing to stem the runoffs (d) establishing maximum limits for borrowing by subsidiaries and affiliates, including inter-affiliate loans, and the maximum risk premium to be paid during crisis borrowing (e) specifying the sequencing of asset disposal in the event of a crisis. Planning will ensure an orderly procedure to stem the rush of withdrawals and avert a total breakdown during a crisis. This is very important for firms that rely on deposits or short-term funds as a source of borrowing because of the difficulty in rolling over debt in periods of crisis. 17 What is a bank run? What are some possible withdrawal shocks that could initiate a bank run? What feature of the demand deposit contract provides deposit withdrawal momentum that can result in a bank run? A bank run is an unexpected increase in deposit withdrawals from a bank. Bank runs can be triggered by several economic events including (a) concerns about solvency relative to other banks, (b) failure of related banks, and (c) sudden changes in investor preferences regarding the holding of non-bank financial assets. The first come, first served (full pay or no pay) nature of a demand deposit contract encourages priority positions in any line for payment of deposit accounts. Thus, even though money may not be needed, customers have an incentive to withdraw their funds. 18 The following is the balance sheet of a DI in millions: Assets Liabilities and equity Cash $ 2 Demand deposits $50 Loans 50 Plant and equipment 3 Equity 5 Total $55 Total $55 The asset-liability management committee has estimated that the loans, whose average interest rate is 6 per cent and whose average life is three years, will have to be discounted at 10 per cent if they are to be sold in less than two days. If they can be sold in four days, they will have to be discounted at 8 per cent. If they can be sold later than a week, the DI will receive the full market value. Loans are not amortised; that is, the principal is paid at maturity. (a) What will be the price received by the FI for the loans if they have to be sold in (i) two days and (ii) in four days? Price of loan = PVAn=3,k=10(3) + PVn=3, k=10(50) = $45.03 if sold in two days. Price of loan = PVAn=3,k=8(3) + PVn=3, k=8(50) = $47.42 if sold in four days. (b) In a crisis, if depositors all demand payment on the first day, what amount will they receive? What will they receive if they demand to be paid within the week? Assume no deposit insurance. If depositors demand to withdraw all their money on the first day, the bank will have to dispose of its loans at fire-sale prices of $45.03 million. With its $2 million in cash, it will be able to pay depositors on a first-come basis until $47.03 million has been withdrawn. The rest will have to wait until liquidation to share the remaining proceeds. Similarly, if the run takes place over a five-day period, the bank may have more time to dispose of its assets. This could generate $47.42 million. With its $2 million in cash it would be able to satisfy on a first-come basis withdrawals up to $49.42 million. 19 What government safeguards are in place to reduce liquidity risk for DIs? In Australia, the role of overseeing the Australian financial system stability and the operation of the payments system has been allocated to the Reserve Bank of Australia (RBA), while regulatory requirements for liquidity have been assigned to the Australian Prudential Regulation Authority (APRA). Liquidity regulations require an authorised DI (bank, credit union and building society) to have levels of liquidity that must be sufficient for the ‘going-concern scenario’ and the ‘bank-specific-crisis scenario’. The RBA, similar to other central banks, provides facilities to assist DIs with short-term non-permanent liquidity needs. The ‘rediscount facility’ allows DIs to access funds from the central bank by selling discounted T-notes at a further discount (re-discount) back to the central bank. This access to liquidity comes at the high cost of the re-discount rate. A second liquidity mechanism is the ‘repurchase agreement facility’, which allows DIs to sell T-notes to the central bank to access short-term liquidity, but with a contract that specifies that the DI must purchase the T-notes back (repurchase) at a specified date and price. In addition, from 1 January 2015, the RBA will introduce a secured committed liquidity facility in conjunction with the introduction of the Basel III liquidity reforms being implemented by APRA. The liquidity will provide repurchase arrangements outside of normal RBA open market operations for DIs approved by APRA to use the facility. 20 What are the levels of defence against liquidity risk for a life insurance company? How does liquidity risk for a general insurance company differ from that for a life insurance company? The initial defence is the amount of premium income and returns on the asset portfolio. As additional policies are surrendered, the insurance company may need to sell some relatively liquid assets such as government bonds. In the case of extreme liquidity pressures, the company may need to begin to liquidate less-liquid assets in the portfolio, possibly at distressed prices. General insurance covers short-term contingencies, and thus the assets of general insurers generally are more short term than for life insurance companies, and the policy premium adjustments come at shorter intervals. As a result, although the degree and timing of contingency payout is more uncertain for general insurance companies, the flexibility to deal with liquidity pressures is better. 21 How is the liquidity problem faced by managed funds different from that faced by DIs and insurance companies? How does the liquidity risk of an open-end managed fund compare with that of a closed-end fund? In the case of a liquidity crisis in banks and insurance firms, there are incentives for depositors and policyholders to withdraw their money or cash in their policies as early as possible. Latecomers will be penalised because the financial institution may be out of liquid assets. They will have to wait until the institution sells its assets at fire-sale prices, resulting in a lower payout. In the case of managed funds, the net asset value for all shareholders is lowered or raised as the market value of assets change, so that everybody will receive the same price if they decide to withdraw their funds. Hence, the incentive to engage in a run is minimised. Closed-end funds are traded directly on stock exchanges, and therefore little liquidity risk exists since any fund owner can sell the shares on the exchange. An open-end fund is exposed to more risk since those shares are sold back to the fund, which must provide cash to the seller. 22 A managed fund has the following assets in its portfolio: $40 million in fixed-income securities and $40 million in stocks at current market values. In the event of a liquidity crisis, the fund can sell the assets at 96 per cent of market value if they are disposed of in two days. The fund will receive 98 per cent if the assets are disposed of in four days. Two share/unit holders, A and B, own 5 per cent and 7 per cent of equity (share/units), respectively. Value of fixed-income securities if sold in two days: $40m × 0.96 = $38.4m Value of stocks if sold in two days $40m × 0.96 = $38.4m Total = $76.8m (a) Market uncertainty has caused share/unit holders to sell their share/units back to the fund. What will the two share/unit holders receive if the managed fund must sell all the assets in two days? In four days? Share/unit holder A will receive $76.8 × 0.05 = $3.84 down from the current value of $4.00. Share/unit holder B will receive $76.8m × 0.07 = $5.376m down from the current value of $5.60m. Value of fixed-income securities if sold in four days: $40m × 0.98 = $39.2m Value of stocks if sold in two days: $40m × 0.98 = $39.2m Total = $78.4m Share/unit holder A will receive $78.4m × 0.05 = $3.92m down from the current value of $4.00m. Share/unit holder B will receive $78.4m × 0.07 = $5.488m down from the current value of $5.60m. (b) How does this situation differ from a bank run? How have bank regulators mitigated the problem of bank runs? This differs from a run on a bank in that the claimants of the assets all receive the same amount, as a percentage of their investments. In the case of bank runs, the first to withdraw receive the full amount, leaving the likelihood that some depositors may not receive any money at all. One way of mitigating this problem is for regulators to offer deposit insurance or deposit guarantees such as that provided by the Australian government under the Financial Claims Scheme (FCS) which protects individual deposits up to $250 000. This reduces the incentive for small depositors to engage in runs. APRA also has specified liquidity requirements (see question 19 above). Banks are expected to provide sufficient liquidity to meet a bank-specific crisis, and from 2015 will be required to meet more stringent liquidity reforms. The Australian government does not have a stated ‘too-big-to-fail’ policy; however, it is interesting to speculate on the government response should one of the major Australian banks fail. While no private Australian bank has failed for over one hundred years, the Victorian state government response to a significant building society failure in 1990 is perhaps indicative of what may occur. In that instance, the state government imposed a three-cent per litre petrol tax to help pay depositors out. 23 A managed fund has $1 million in cash and $9 million invested in securities. It currently has 1 million units outstanding. (a) What is the net asset value (NAV) of this fund? NAV = Market value of units/number of units = $10m/1m = $10 per unit (b) Assume that some of the unit holders decide to cash in their units of the fund. How many units at its current NAV can the fund take back without resorting to a sale of assets? At the current NAV, it can absorb up to $1 million, or 100 000 units. (c) As a result of anticipated heavy withdrawals, the fund sells 10 000 shares of BHP stock currently valued at $40 per share. Unfortunately, it receives only $35 per share of the BHP stock. What is the net asset value after the sale? What are the cash assets of the fund after the sale? Its loss by selling 10 000 shares of BHP at $35 instead of $40 = –$5 × 10 000 = –$50 000. New NAV = $9 950 000 /1m = $9.95 Cash = $1 million + $350 000 = $1.35 million and 9.60 million in securities. (d) Assume that after the sale of BHP shares, 100 000 fund units are sold back to the fund. What is the current NAV? Is there a need to sell more securities to meet this redemption? If 100 000 units are redeemed, it needs to pay $9.95 × 100 000 = 995 000. Its NAV will remain the same, that is, $8 955 000/900 000 = $9.95. No, it does not need to sell any extra securities since it has $1.35 million in cash. Web question 24 Go to the Reserve Bank of Australia’s website and update Table 14.1 from Statistics Tables B02 and B03 (Banks assets and liabilities). Comment on any changes in balance sheet structure as it relates to liquidity risk. Note the differences when using total assets and liabilities and only resident assets and liabilities as shown in Table 14.1. The answer will depend on the date of the assignment. The website is www.rba.gov.au. Go to the RBA home page and click on ‘statistics’. Click on ‘search for statistics’. Type ‘bank assets’ in the search box and find ‘banks–assets–B2’ and download. Repeat and type ‘bank liabilities’ in the search box and find ‘banks–liabilities–B3’ and download. Chapter 15 Liability and liquidity management Answers to end-of-chapter questions Questions and problems 1 What are the benefits and costs to an FI of holding large amounts of liquid assets? Why are Treasury securities considered good examples of liquid assets? A major benefit to an FI of holding a large amount of liquid assets is that it can offset any unexpected and large withdrawals without reverting to asset sales or emergency funding. If assets have to be sold at short notice, FIs may not be able to obtain a fair market value. It is more prudent to anticipate withdrawals and keep liquid assets to meet the demand. On the other hand, liquid assets provide lower yields, so the opportunity cost for holding a large amount of liquid assets is high. FIs taking conservative positions by holding large amounts of liquid assets will therefore have lower profits. 2 How is an FI’s liability and liquidity risk management problem related to the maturity of its assets relative to its liabilities? For most FIs, the maturity of assets is greater than the maturity of liabilities. As the difference in the average maturity between the assets and liabilities increases, liquidity risk increases. In the event that liabilities begin to leave the FI or are not reinvested by investors at maturity, the FI may need to liquidate some of its assets at fire-sale prices. These prices would tend to deviate further from their market value as the maturity of the assets increases. Thus, the FI may sustain larger losses. 3 Consider the assets (in millions) of two banks, A and B. Both banks are funded by $120 million in deposits and $20 million in equity. Which bank has the stronger liquidity position? Which bank probably has a higher profit? Bank A assets $ Bank B assets $ Cash 10 Cash 20 Treasury securities 40 Consumer loans 30 Commercial loans 90 Commercial loans 90 Total assets 140 Total assets 140 Bank A is more liquid because it has more liquid assets than Bank B, although it has less cash. Bank B probably earns a higher profit because the return on consumer loans should be greater than the return on Treasury securities. However, comparing the loan portfolios is difficult because it is impossible to evaluate the credit risk contained in each portfolio. 4 What concerns motivate regulators to require DIs to hold minimum amounts of liquid assets? Regulators prefer DIs to hold more liquid assets because this ensures that they are able to withstand unexpected and sudden withdrawals. In addition, regulators are able to conduct monetary policy by influencing the money supply through liquid assets held by DIs. Finally, reserves held at the RBA specifically, and central banks more generally, by financial institutions also are a source of funds to regulators, since they pay little interest on these deposits. 5 How do liquid asset reserve requirements enhance the implementation of monetary policy? How are reserve requirements a tax on DIs? In the case of DIs, reserve requirements on demand deposits allow regulators to increase or decrease the money supply in an economy. The reserve requirement against deposits limits the ability of DIs to expand lending activity. Further, reserves represent a form of tax that regulators can impose on DIs. By raising the reserve requirements, regulators cause DIs to transfer more balances into non-earning assets. This tax effect is even larger in cases where inflation is stronger. 6 Rank these financial assets according to their liquidity: cash, corporate bonds, ASX-traded stocks, and T-notes. The liquidity ranking from most liquid to least liquid would be cash, T-notes, ASX-traded stocks, and corporate bonds. 7 Outline the main features of exchange settlement accounts and identify the safety valves used by the RBA to assist DIs to maintain their exchange settlement accounts. Exchange settlement accounts are clearing accounts that each bank holds with the Reserve Bank of Australia to allow settlement of payments as they arise. All interbank payments are made through ESAs. ESAs pay interest at 25 basis points below RBA target cash rate. ESAs are not allowed to be overdrawn and must be in credit at all times. Transactions require the use of ‘same-day’ funds, that is, cleared funds.Banks must actively manage their liquidity positions to ensure they have access to adequate same-day funds. There are three liquidity facilities provided by the RBA to assist DI maintenance of their ES accounts: (1) the ‘intra-day repurchase agreement facility’, (2) the ‘overnight repurchase agreement’ facility and (3) a ‘committed liquidity facility’, will be introduced in conjunction with the Basel III liquidity reforms on 1 January 2015. 8 Discuss the risks and returns associated with using liability management to meet liquidity needs. Suppose the manager of a DI’s liquid assets portfolio anticipates that interest rates will rise over the next few years. How might this manager structure the liquid assets portfolio to take advantage of this situation? To take advantage of rising interest rates in the future the DI manager restructures the portfolio in favour of short-term securities. As rates rise, the maturing securities can be reinvested at higher yields, resulting in an overall higher return on the liquid assets portfolio. When the manager believes rates have risen to their maximum level, the portfolio should then be restructured in favour of long-term fixed-rate securities in order to maximise coupons and provide for potential capital gains under falling market rates. What factors should the manager take into consideration before implementing any strategies you have recommended in part (a)? There are a number of factors that the manager should take into consideration before implementing this strategy. First, the manager should determine an appropriate planning horizon for the active management of the portfolio. Specifically, is the manager seeking to pick short-term swings in yields or long-term trends in yields? For instance, over a four-year period bond yields may be rising in general, but over the short term there is likely to be variability in yields—indeed, yields may rise and fall over the course of a week or month. If the planning horizon is short term in focus, the manager needs to balance realised capital gains against the transactions costs incurred in the regular restructuring of the portfolio. Second, a portfolio weighted too heavily in short- or long-term securities loses potential diversification benefits. To consider the situation in (a), a portfolio comprising entirely short-term securities could take significant losses if rate expectations prove incorrect and interest rates fall. Thus, the manager should seek an appropriate balance between improving the return on the portfolio and avoiding excessive speculation on interest rate movements. 9 How can liquidity and interest rate risk management objectives conflict in a DI? Where possible, provide examples. Are these conflicts resolvable? Explain. Liquidity risk and interest rate risk are usually closely linked in a DI. For example, a DI that runs a positive or negative duration gap to take advantage of expected interest rate movements may suffer an increase in liquidity risk if the gamble proves wrong and, as a result of losses on the interest rate mismatch, there is an increase in withdrawals by depositors. Alternatively, a DI that acts to immunise the value of equity against interest rate risk may find that this has created potential liquidity problems in terms of an imbalance between cash inflows and outflows as the maturities of assets and liabilities are mismatched to achieve a zero duration gap. Similarly, a DI that issues long-term fixed-rate paper to secure funds and reduce liquidity risk may find that this impacts adversely on the interest rate risk position of the DI if the DI has a zero or negative duration gap before the funds are issued, or if managers expect falling interest rates in the short term. To resolve these conflicts DI managers need to be aware of the interactive nature of interest rate and liquidity risks (as well as other balance sheet risks) when formulating risk management strategies. For example, if the goals of matched asset/liability maturities and a zero duration gap are incompatible, managers need to amend these goals or set in place secondary strategies to deal with any risks that may be increased. Here such a strategy might be to increase standby credit arrangements with other DIs to deal with potential cash imbalances arising from the policy of equity immunisation against interest rate risk. 10 Calculate the average implicit interest rate on the following non-interest-bearing accounts: (a) A $1 million account with average management costs of $150 000 and fees earned of $35 000. The average implicit interest rate is determined by the following formula: IIR = DI’s average management costs per account per annum minus average fees per account per annum divided by average size of the account times 100 to convert to a percentage. $150 000 – $35 000/$1 000 000 × 100 = 11.50 per cent (b) A $150 000 account with average management costs of $25 000 and fees earned of $5000. $25 000 – $5000/150 000 × 100 = 13.33 per cent A$1000 account with average management costs of $1000 and fees earned of $750. $1000 – $750/$1000 = 25 per cent Which account is least costly for the DI that carries these accounts? The $1 million account is the least costly for the DI. 11 Suppose a bank wishes to raise $20 million in deposits to cover lending projections for the next quarter. It can raise the funds through fixed-term deposits at an interest rate of 6 per cent or variable-rate savings accounts at an interest rate of 4 per cent. The bank currently has $100 million in savings accounts and is paying an interest rate of 3 per cent on the savings portfolio. (a) Which option should the bank use to raise the required funds? Why? The bank should use the funding source that is the cheapest to the bank (assuming profit considerations override duration gap and other risk considerations). Although the interest rate on savings accounts is lower, this is not necessarily the best funding source because interest rates on these accounts are variable, meaning the interest rate on all savings accounts will be increased. This implies that the bank will be paying a higher interest rate than is commercially warranted on $100 million in accounts. If the bank raises funds by using fixed-term deposits, its interest expense will rise by $1.2 million ($20 million × 6 per cent). If the bank raises savings deposits, its interest expense will rise by $1.8 million ($120 million × 4 per cent) – ($100 million × 3 per cent). Thus, the bank should finance its lending by raising new term deposits at 6 per cent. Calculate the relative cost benefit of your recommendation in part (a). The relative cost benefit is $600 000. 12 What is the relationship between funding cost and funding or withdrawal risk? Liabilities that have a low cost often have the highest risk of withdrawal. Thus, a DI that chooses to attract low cost deposits may have high withdrawal risk. 13 An FI has estimated the following annual costs for its demand deposits: management cost per account = $140, average account size = $1500, average number of cheques processed per account per month = 75, cost of clearing a cheque = $0.10, fees charged to customer per cheque = $0.05 and average fee charged per customer per month = $8. (a) What is the implicit interest cost of demand deposits for the FI? Cost of clearing cheques = $0.10 × 75 × 12 = $90 Cost of managing each account = $140 Per cheque fee per account = $0.05 × 75 × 12 = –$45 Fee received per account = $8 × 12 = –$96 Total cost per account = $89 The average (imputed) interest cost of demand deposits = $89/1500 = 5.93 per cent. (b) If the FI has to keep an average of 8 per cent of demand deposits as required reserves with the RBA paying no interest, what is the implicit interest cost of demand deposits for the FI? If the bank has to keep 8 per cent as reserves, its use of funds is limited to 0.92 × $1500 per account or $1380. The average (imputed) interest cost = $89/$1380 = 6.45 per cent. (c) What should be the per-cheque fee charged to customers to reduce the implicit interest costs to 3 per cent? Ignore the reserve requirements. For an average imputed interest cost of 3 per cent, the total cost per account = 1500 × 0.03 = $45. This means that the total cost per account should be decreased by $44 ($89 – $45) and the per-cheque fee charged to customers should be increased to $89 ($45 + $44). Thus, the fee per-cheque should be raised to $89/(75 × 12) = $0.0989 per cheque. 14 A cheque account requires a minimum balance of $750 for interest to be earned at an annual rate of 4 per cent. An account holder has maintained an average balance of $500 for the first six months and $1000 for the remaining six months. The account holder writes an average of 60 cheques per month and pays $0.02 per cheque, although it costs the bank $0.05 to clear a cheque. (a) What average return does the account holder earn on the cheque account? Gross interest return = explicit interest return + implicit interest return Interest earned by account holder ($500 × 0.00 × 6/12) + ($1000 × 0.04 × 6/12) = $20 Implicit fee earned on cheques ($0.05 – $0.02) × 60 × 12 = $21.60 Average deposit maintained during the year (6/12 × 500) + (6/12 × 1000) = $750 Average interest earned = $41.60/750 = 5.55 per cent (b) What is the average return if the bank lowers the minimum balance to $400? If the minimum balance requirement is lowered to $400, the account holder earns an extra $500 × 0.04 × 6/12 = $10 in interest. The average interest earned = $51.60/750 = 6.88 per cent. (c) What is the average return if the bank pays interest only on the amount in excess of $400? Assume that the minimum required balance is $400. If the bank only pays interest on balances in excess of $400, the explicit interest earned = ($100 × 0.04 × 6/12) + ($600 × 0.04 × 6/12) = $2 + $12 = $14. The implicit fee earned on cheques = $21.60, and the average interest earned = $35.60/$750 = 4.75 per cent (d) How much should the bank increase its cheque fee to the account holder to ensure that the average interest it pays on this account is 5 per cent? Assume that the minimum required balance is $750. Interest earned (both explicit and implicit) = $750 × 0.05 = $37.50. Fees to be earned through cheque clearing = $37.50 – $20 = $17.50. Fee subsidy per cheque = 17.50/(60 × 12) = $0.0243. So, the bank should charge $0.05 – $0.0243 = $0.0257 per cheque. 15 How is the withdrawal risk different for interbank funds and repurchase agreements? Withdrawal risk is lower for repurchase agreements (repos) because they are collateralised, usually by government securities. Since repos are collateralised, they require a lower risk premium but they require time to process because of the need to post collateral. In every other respect, the transaction of a REPOS is similar to interbank funds. 16 How does the cash balance, or liquidity, of an FI determine the types of repurchase agreement into which it will enter? If the FI has surplus cash, it would buy securities with the understanding that the seller would repurchase them later. In this case the repurchase agreement is an asset for the firm that bought the securities. If an FI is low on cash, it would sell securities for cash with the understanding that it would repurchase the securities later. Here the repo is a liability. 17 Briefly explain the approach taken to liquidity management by APRA in its role as prudential supervisor of DIs. Regulators are interested in making sure that banks carry an adequate quantity of liquidity, as opposed to the least cost amount. Adequacy is judged by evaluating a number of factors, including the amount of liquid assets held, lending and investment commitments of the bank, sources and stability of deposits, interest sensitivity of assets and liabilities, and ability to cope with changes in business conditions. APRA expects the following procedures to be adopted as part of a liquidity management plan: maturity mismatch limits adequate liquid holdings diversification of liabilities access to wholesale markets foreign currency and other markets intra-group liquidity use of assets industry liquidity support schemes. The introduction of Basel III liquidity reforms commencing on 1 January 2015 will require a new set of liquidity requirements of all DIs, and are being introduced to strengthen liquidity rules with the key aim of promoting a more resilient banking sector. This is in line with other countries, with the objective of strengthening the resilience of the global banking sector. APRA’s approach follows the BIS proposals with minor modifications. 18 What is a contagious run? What are some of the potentially serious adverse social welfare effects of a contagious run? Do all types of FIs face the same risk of contagious runs? A contagious run is an unjustified panic condition in which liability holders withdraw funds from an FI without first determining whether the institution is at risk. This action usually occurs at a time that a similar run is occurring at a different institution that is at risk. The contagious run may have an adverse effect on the level of savings that may affect wealth transfers, the supply of credit, and control of the money supply. Depository institutions and insurance companies face the most serious risk of contagious runs. 19 How do deposit insurance and deposit guarantees help mitigate the problem of bank runs and what schemes are available in Australia to protect DI deposits? Bank runs are costly to society since they create liquidity problems and can have a contagion effect. Because of the first-come, first-served nature of deposit liabilities, DI depositors have incentives to run on the DI if they are concerned about solvency. As a result of the external cost of runs on the safety and soundness of the entire banking system, governments have put into place safety nets using deposit insurance/guarantees to remove the incentives to undertake DI runs. The primary pieces of this safety net are the Financial Claims Scheme which guarantees deposits of Australian dollar deposits in authorised DIs up to $250 000 per depositor per institution. Deposit insurance and other guarantee programs provide assurance that funds are safe even in cases when the FI is in financial distress. Web questions 20 Look up the website of National Australia Bank (www.nab.com.au) or another large bank and click on ‘Shareholder Centre’. Click ‘Annual reports’, and select the latest annual report (also downloadable in a PDF form). Scroll through to see what the bank has to say about its liquidity position in its annual report. Also look at the section on the bank’s security portfolio. What type of securities does it hold? Do you see any different trends versus previous years? Examine the bank’s liabilities. Have there been any changes in the bank’s liability structure? The answer will depend on the date of the assignment. As websites change periodically, you will find that the instructions on how to locate an annual report can change. The answer will depend on the particular year/s selected. We would expect changes in the holdings of liquid assets from 2012 through to 2015 in the lead-up to the implementation of the Basel III liquidity reforms, as banks prepare for that implementation. (a) Liquidity Position: • In the annual report, the bank usually provides information on its liquidity position, including its liquidity ratios, funding sources, and liquidity risk management practices. • The bank may discuss its liquidity reserves, such as cash and liquid assets, to meet short-term obligations and regulatory requirements. • Look for sections or discussions related to liquidity management, liquidity risk assessment, and the bank's strategies for maintaining adequate liquidity levels. (b) Security Portfolio: • The annual report typically contains information on the bank's security portfolio, which may include various types of securities such as government bonds, corporate bonds, mortgage-backed securities, and other fixed-income instruments. • The bank may provide details on the composition of its security holdings, including the types of securities, their credit ratings, maturity profiles, and market values. • Look for sections or discussions related to the bank's investment portfolio, asset allocation strategies, and any changes or trends observed in the security holdings compared to previous years. (c) Liabilities: • The bank's liabilities section in the annual report typically covers its funding sources, capital structure, and debt obligations. • Look for information on the composition of the bank's liabilities, including deposits, borrowings, debt securities, and other obligations. • The bank may discuss any changes in its liability structure, such as shifts in funding mix, changes in deposit composition, or adjustments in debt issuance strategies. • Pay attention to discussions on the bank's funding costs, interest rate sensitivity, and funding diversification efforts. To access this information, you can visit the National Australia Bank's website (www.nab.com.au), navigate to the Shareholder Centre, and locate the section on Annual Reports. From there, you can select the latest annual report available for download in PDF format. Then, you can search within the document or browse through relevant sections to find information on liquidity position, security portfolio, and liabilities. 21 Go to the website for the Reserve Bank of Australia and find the latest list of ‘eligible securities’ that an Australian DI can use for any repo transaction with the RBA. Also note any conditions of use for the securities (www.rba.gov.au/mkt-operations/tech-notes/eligible-securities.html). Also, find the list of margins for each security type (www.rba.gov.au/mkt-operations/tech-notes/margins.html) and discuss why some securities require higher margins than others. To find the latest list of eligible securities for repo transactions with the RBA and any conditions of use, you can visit the RBA's website and navigate to the Market Operations section. From there, you can look for technical notes or guidelines related to eligible securities for repo transactions. The URL provided seems to be a valid link to the RBA's website, so you can use it to access the relevant information. Once you've found the list of eligible securities, you can also explore the section on margins for each security type. Margins for repo transactions typically vary based on factors such as the credit quality, liquidity, and market volatility of the underlying securities. Securities with higher credit risk or lower liquidity may require higher margins to mitigate the risk of default or loss in the event of a market downturn. Some reasons why some securities require higher margins than others include: 1. Credit Risk: Securities issued by entities with lower credit ratings or higher default probabilities may require higher margins to compensate for the increased risk of default. 2. Liquidity: Securities that are less liquid or have thinner trading markets may require higher margins to account for the potential difficulty of selling the securities quickly in the event of a margin call. 3. Market Volatility: Securities with higher price volatility or sensitivity to market fluctuations may require higher margins to cushion against potential losses due to adverse price movements. 4. Haircuts: Certain types of securities may be subject to haircuts, which are predetermined deductions from the market value of the securities to determine the collateral value for repo transactions. Haircuts reflect the perceived riskiness and market liquidity of the securities. By understanding these factors, central banks like the RBA can establish margin requirements that align with the risk profiles of different types of eligible securities and ensure the stability and effectiveness of repo market operations. Chapter 16 Off-balance-sheet activities Answers to end-of-chapter questions Questions and problems 1 Classify the following items as (1) on-balance-sheet assets, (2) on-balance-sheet liabilities, (3) off-balance-sheet assets, (4) off-balance-sheet liabilities or (5) capital account. Classification Loan commitments 3 Loan loss reserves 5 Letter of credit 2 Bankers’ acceptance (BA) 2 Rediscounted bankers’ acceptance 2 Loan sales without recourse none of the above. Loan sales with recourse 2 Forward contracts to purchase 3 Forward contracts to sell 4 Swaps 4 (for liability swaps) Loan participations 1 Securities borrowed 3 Securities lent 4 Loss adjustment expense account (General insurers) 2 Net policy reserves 2 How does one distinguish between an OBS asset and an OBS liability? Off-balance-sheet activities or items are contingent claim contracts. An item is classified as an off-balance-sheet asset when the occurrence of the contingent event results in the creation of an on-balance-sheet asset. An example is a loan commitment. If the borrower decides to exercise the right to draw down on the loan, the FI will incur a new asset on its portfolio. Similarly, an item is an off-balance-sheet liability when the contingent event creates an on-balance-sheet liability. An example is a standby letter of credit (SLC). In the event that the original payer of the SLC defaults, then the FI is liable to pay the amount to the payee, incurring a liability on the right-hand side of its balance sheet. 3 Contingent Bank has the following balance sheet in market value terms (in millions of dollars): Assets $ Liabilities and equity $ Cash 20 Deposits 220 Mortgages 220 Equity 20 Total assets 240 Total liabilities and equity 240 In addition, the bank has contingent assets with $100 million market value and contingent liabilities with $80 million market value. What is the true stockholder net worth? What does the term ‘contingent’ mean? Net worth = ($240m – $220m) + ($100m – $80m) = $40 million. The term contingent means an event that may or may not happen. In financial economics, the term is used in conjunction with the result given that some event does occur. 4 Why are contingent assets and liabilities like options? What is meant by the delta of an option? What is meant by the term ‘notional value’? Contingent assets and liabilities may or may not become on-balance-sheet assets and liabilities in a manner similar to the exercise or non-exercise of an option. In each case the realisation of the event is contingent or dependent on the occurrence of some other event. The delta of an option is the sensitivity of an option’s value for a unit change in the price of the underlying security. The notional value represents the amount of value that will be placed in play if the contingent event occurs. The notional value of a contingent asset or liability is the amount of asset or liability that will appear on the balance sheet if the contingent event occurs. 5 An FI has purchased options on bonds with a notional value of $500 million and has sold options on bonds with a notional value of $400 million. The purchased options have a delta of 0.25 and the sold options have a delta of 0.30. What is (a) the contingent asset value of this position, (b) the contingent liability value of this position, and (c) the contingent market value of net worth? (a) The contingent asset value is $500 million × 0.25 = $125 million. (b) The contingent liability value is $400 million × 0.30 = $120 million. (c) The contingent market value of net worth is $125 million – $120 million = $5 million. 6 What factors explain the growth of FI OBS activities from the 1980s up to the early 2000s? The narrowing of spreads on on-balance-sheet lending in a highly competitive market gave impetus to seek other sources of income in the 1980s, and off-balance-sheet activities represented one avenue. In addition, during the 1980s, off-balance-sheet assets and liabilities were not subject to capital requirements or reserve requirements, increasing the effective returns on these activities. In the 1990s and early 2000s, increased revenue from trading activities was a major reason for the increase in OBS activities. For the first time, OBS activities fell in Australia in 2009 with the fallout from the GFC. However, OBS activities quickly recovered in 2010. 7 What are the characteristics of a loan commitment that an FI may make to a customer? In what manner and to whom is the commitment an option? What are the various possible pieces of the option premium? When does the option or commitment become an on-balance-sheet item for the FI and the borrower? A loan commitment is an agreement to lend a fixed maximum amount of money to a firm within some given amount of time. The interest rate or rate spread normally is determined at the time of the agreement, as is the length of time that the commitment is open. Because the borrower usually triggers the timing of the draw, which may be any portion of the total commitment, the commitment is an option to the borrower. If the loan is not needed, the option or draw will not be exercised. The premium for the commitment may include a fee of some per cent times the total commitment and a fee of some per cent times the amount of the unused commitment. Of course, the borrower must pay interest while any portion of the commitment is in use. The option becomes an on-balance-sheet item for both parties at the point in time that a draw occurs. 8 An FI makes a loan commitment of $2.5 million with an upfront fee of 50 basis points and a back-end fee of 25 basis points on the unused portion of the loan. The drawdown on the loan is 50 per cent and drawdown occurs at the beginning of the year. (a) What total fees does the FI earn when the loan commitment is negotiated? Upfront fee = $2 500 000 × 0.0050 = $12 500 (b) What are the total fees earned by the FI at the end of the year, that is, in future value terms? Assume the cost of capital for the FI is 6 per cent. Note that adjustment has not been made for the fact that the upfront fee is usually collected at the beginning of the period. To adjust, a common treatment is to find the future value for this fee by multiplying by bank’s cost of capital. Thus, $2 500 000 × 0.0050 × (1 + 0.06) = $13 250, and the total fees are: Upfront fee = $2 500 000 × 0.0050 (1.06) = $13 250 Back-end fee = $2 500 000 × 0.0025 × 0.50 = 3125 Total = $16 375 9 An FI has issued a one-year loan commitment of $2 million for an upfront fee of 25 basis points. The back-end fee on the unused portion of the commitment is 10 basis points. The FI requires a compensating balance of 5 per cent as demand deposits. The FI’s cost of funds is 6 per cent, the interest rate on the loan is 10 per cent, and reserve requirements on demand deposits are 8 per cent. The customer is expected to draw down 80 per cent of the commitment at the beginning of the year. (a) What is the expected return on the loan without taking future values into consideration? Upfront fees = 0.0025 × $2 000 000 = $ 5 000 Interest income = 0.10 × $2 000 000(.80) = 160 000 Back-end fee = 0.0010 × $2 000 000(1 – 0.80) = 400 Total = $165 400 Funds committed = $2 000 000(0.80) – $80 000 (compensating balances = $2 000 000 × 0.80 × 0.05) + $6400 (reserve requirements on demand deposits = $80 000 × 0.08) = $1 526 400. Expected rate of return = $165 400/$1 526 400 = 10.836 per cent or, Using the formula: 1+k = 1 + [(0.0025) + (0.0010)(1 – 0.80) + 0.10(0.80)]/{0.80 – [0.05(0.80)(1 – 0.08) ]} 1+k = 1.10836, or k = 10.836 per cent. (b) What is the expected return using future values? That is, the net fee and interest income are evaluated at the end of the year when the loan is due. The only difference is that the upfront fee is estimated at year-end, that is, $5000 × 1.06 = $5300. Thus, expected return = $165 700/$1 526 400 = 10.8556 per cent. Using the formula: 1+k = 1 + [(0.0025(1 + 0.06) + 0.0010(1 – 0.80) + 0.10(0.80)]/{0.80 – [0.05(0.80)(1 – 0.08)]} => 1+k = 1.108556, or k = 10.8556 per cent. (c) How is the expected return in part (b) affected if the reserve requirements on demand deposits are zero? In this case, the amount of funds committed is reduced by the amount normally set for reserves, that is, $6400. Thus, expected return = $165 700/$1 520 000 = 10.90 per cent. Using the formula: 1 + k = 1 + [(0.0025(1 + .06) + 0.0010(1 – 0.80) + 0.10(0.80)]/ {0.80 – [0.05(0.80)]} 1 + k = 1.1090, or k = 10.90 per cent. (d) How is the expected return in part (b) affected if compensating balances are paid a nominal interest rate of 5 per cent? Here, we need to subtract additional payments of interest on reserve requirements from the total fees and interest earned, that is, 0.05 × $80 000 = $4000. Expected return = $161 700/1 526 400 = 10.5936 per cent Using the formula: 1+k = 1+[(.0025(1+ 0.06) + 0.0010(1 – 0.80) + 0.10(0.80) – 0.05(0.05)(0.80)]/[0.80 – 0.05(0.80)(1 – 0.08)] 1 + k = 1.105936, or k = 10.5936 per cent. (e) What is the expected return using future values but with the compensating balance placed in certificates of deposit that have an interest rate of 5.5 per cent and no reserve requirements, rather than in demand deposits? In this case we assume that the compensating balance is placed in certificates of deposits paying 5.5 per cent and with no compensating balance requirement. Thus, revenue in part (b) above is reduced by $80 000 × 0.055 = $4400, and the expected return is $161 300/$1 520 000 = 10.612 per cent. Using the formula: 1 + k = 1 + [(0.0025(1 + 0.06) + 0.0010(1 – 0.80) + 0.10(0.80) – (0.05)(0.8)(0.055)]/{0.80 – [0.05(0.80)]} => 1 + k = 1.10612, or k = 10.612 per cent. 10 Suburb Bank has issued a one-year loan commitment of $10 million for an upfront fee of 50 basis points. The back-end fee on the unused portion of the commitment is 20 basis points. The bank requires a compensating balance of 10 per cent to be placed in demand deposits, has a cost of funds of 7 per cent, will charge an interest rate on the loan of 9 per cent, and must maintain reserve requirements on demand deposits of 10 per cent. The customer is expected to draw down 60 per cent of the commitment at the beginning of the year. (a) What is the expected return on this loan? Upfront fee = 0.0050 × $10 000 000 = $50 000 Interest income = 0.0900 × $10 000 000(0.6) = 540 000 Back-end fee = 0.0020 × $10 000 000(1 – 0.6) = $8 000 Total revenue = $598 000 Funds committed = $10 000 000(0.60) – $600 000 (compensating balance = $10 000 000(0.60)(0.1)) + $60 000 (reserve requirements on demand deposits = $10 000 000(0.60)(0.1)(0.1)) = $5 460 000. Expected rate of return = $598 000/$5 460 000 = 10.95 per cent. Using the formula: 1 + k = 1 + [(0.0050) + (0.0020)(1 – 0.60) + 0.09(0.60)]/{0.60 – [0.10(0.60)(1 – 0.10)]} 1 + k = 1.1095, or k = 10.95 per cent. (b) What is the expected annual return on the loan if the drawdown on the commitment does not occur until the end of six months? In this case the fees remain the same, but the interest revenue will be only half as large, and the average balance outstanding will be only half as large. Thus, revenue will be $598 000 – $270 000 = $328 000, and the funds committed will be $5 460 000/2 = $2 730 000. The expected rate of return on an annual basis is 12.0147 per cent. Note, the return is greater than the return calculated in part (a) because the fees are dollar sensitive, not time sensitive. 11 How is an FI exposed to interest rate risk when it makes loan commitments? In what way can an FI control for this risk? How does basis risk affect the implementation of the control for interest rate risk? When an FI makes a fixed-rate loan commitment, it faces the likelihood that interest rates may increase during the intervening period. This reduces its net interest income if the borrower decides to take down the loan. The FI can partially offset this loan by making variable-rate loan commitments. However, this still does not protect it against basis risk, that is, if lending rates and the cost of funds of the FI do not increase proportionately. 12 How is the FI exposed to credit risk when it makes loan commitments? How is credit risk related to interest rate risk? What control measure is available to an FI for the purpose of protecting against credit risk? What is the realistic opportunity to implement this control feature? An FI is exposed to credit risk because the credit quality of a borrower could decline during the intervening period of the loan commitment. When an FI makes a loan commitment, it is obligated to deliver the loan. Although most loan commitments today contain a clause releasing an FI from its obligations in the event of a significant decline in credit quality, the FI may not be inclined to use it for fear of reputation concerns. Interest rate risk is related to credit risk because default risks are much higher during periods of increasing interest rates. When interest rates rise, firms have to generate higher rates of return. Thus, FIs making loan commitments are subject to both risks in periods of rising interest rates. 13 How is an FI exposed to drawdown risk and aggregate funding risk? How are these two contingent risks related? An FI is exposed to drawdown risk because not all loan commitments are fully taken down. As a result, an FI has to forecast its funding requirements in order not to keep funds at levels that are too high or too low. Maintaining low levels of funds may result in paying more to obtain funds on short notice. Maintaining high levels of funds may result in lower earnings. Additionally, FIs are exposed to aggregate funding risk; that is, all customers may choose to take down their loan commitments during a similar period, such as when interest rates are rising or credit availability is low. This could cause a severe liquidity problem for the FI. These two risks are related because drawdowns usually occur when interest rates are rising or when credit availability is low. If all customers decide to increase their drawdowns, it could put a severe strain on the FI. Similarly, when interest rates are falling or when credit availability is high, customers are likely to find cheaper financing elsewhere. Thus, FIs should take into account the interdependence of these two events when forecasting future funding need. 14 Do the contingent risks of interest rate, drawdown, credit, and aggregate funding tend to increase the insolvency risk of an FI? Why or why not? These risk elements all can have adverse effects on the solvency of an FI. While they need not occur simultaneously, there is a fairly high degree of correlation between them. For example, if rates rise, funding will become shorter, drawdowns will likely increase, credit quality of borrowers will become lower, and the value of the typical FI will shrink. 15 What is a letter of credit? How is a letter of credit like an insurance contract? Like most insurance contracts, a letter of credit is a guarantee. It essentially gives the holder the right to receive payment from the FI in the event that the original purchaser of the product defaults on the payment. Like the seller of any guarantee, the FI is obligated to pay the guarantee holder at the holder’s request. 16 A German bank issues a three-month letter of credit on behalf of its customer in Germany, who is planning to import $100 000 worth of goods from Australia. It charges an upfront fee of 100 basis points. (a) What upfront fee does the bank earn? Upfront fee earned = $100 000 × 0.0100 = $1000 (b) If the Australian exporter decides to discount this letter of credit after it has been accepted by the German bank, how much will the exporter receive, assuming that the interest rate currently is 5 per cent and that 90 days remain before maturity? (Hint: To discount a security, use the time value of money formula.) PV = FV [1 – interest rate × (days to maturity/365)] PV = [1 – (0.05 × 90/365)] × $100 000 = $98 767.12 (c) What risk does the German bank incur by issuing this letter of credit? The German bank faces the risk that the importer may default on its payment and it will be obligated to make the payment at the end of 90 days. In such a case, it will incur an on-balance-sheet liability of $100 000. 17 How do standby letters of credit differ from documentary letters of credit? With what other types of FI products do SLCs compete? What types of FIs can issue SLCs? Standby letters of credit usually are written for contingency situations that are less predictable and that have more severe consequences than the LCs written for standard commercial trade relationships. Often SLCs are used as performance guarantees for projects over extended periods of time, or they are used in the issuance of financial securities such as municipal bonds or commercial paper. Banks and general insurance companies are the primary issuers of SLCs. 18 A corporation is planning to issue $1 million of 270-day commercial paper for an effective yield of 5 per cent. The corporation expects to save 30 basis points on the interest rate by using either an SLC or a loan commitment as collateral for the issue. (a) What are the net savings to the corporation if a bank agrees to provide a 270-day SLC for an upfront fee of 20 basis points (of the face value of the loan commitment) to back the commercial paper issue? Cost of using SLC = – (0.0020) × $1 000 000 = –$2000.00 Savings by using SLC as collateral = (0.0030 × 270)/365 × $1 000 000) = $2219.18 Net savings = $ 219.18 (b) What are the net savings to the corporation if a bank agrees to provide a 270-day loan commitment to back the issue? The bank will charge 10 basis points for an upfront fee and 10 basis points for a back-end fee for any unused portion of the loan. Assume the loan is not needed and that the fees are on the face value of the loan commitment. Upfront fee of loan commitment = – (0.0010) × $1 000 000 = –$1000.00 Back-end fee (assuming no usage) = – (0.0010) × $1 000 000 = –$1000.00 Cost of loan commitment = –$2000.00 Savings by using loan commitments as collateral = (0.0030 × 270)/365 × $1 000 000) = $2219.18 Net savings = $ 219.18 (c) Should the corporation be indifferent to the two alternative collateral methods at the time the commercial paper is issued? Not necessarily. If some of the loan commitment is drawn down, the back-end fee will be less and the savings will be greater. 19 Explain how the use of derivative contracts, such as forwards, futures, swaps and options creates contingent credit risk for an FI. Why do OTC contracts carry more contingent credit risk than do exchange-traded contracts? How is the default risk of OTC contracts related to the time to maturity and the price and rate volatilities of the underlying assets? Credit risk occurs because of the potential for the counterparty to default on payment obligations, a situation that would require the FI to replace the contract at current market prices and rates. OTC contracts typically are non-standardised or unique contracts that do not have external guarantees from an organised exchange. Defaults on these contracts usually will occur when the FI stands to gain and the counterparty stands to lose, that is, when the contract is hedging the risk exactly as the FI hoped. Thus, default risk is higher when the volatility of the underlying asset is higher. 20 What is meant by when-issued trading? Explain how forward purchases of when-issued government Treasury securities can expose FIs to contingent interest rate risk. The purchase or sale of a security before it is issued is called when-issued trading. For example, when an FI purchases Treasury securities on behalf of a customer prior to the actual weekly auctioning of securities, it incurs the risk of under-pricing the security. On the day the Treasury securities are allotted, it is possible that because of high demand, the prices may be much higher than what the FI has forecasted. It then may be forced to purchase the securities at higher prices, which means lower interest rates. 21 Distinguish between loan sales with and without recourse. Why would FIs want to sell loans with recourse? Explain how loan sales can leave FIs exposed to contingent interest rate risks. When FIs sell loans without recourse, the buyers of the loans accept the risk of non-repayment by the borrower. In other words, the loans are completely off the books of the FI. In the case of loans sold with recourse, FIs are still legally responsible for the payment of the loans to the seller in the event the borrower defaults. FIs are willing to sell such loans because they obtain better prices and also because it allows them to remove the assets from their balance sheets. FIs are more likely to sell such loans with recourse if the borrower of the loan is of good credit standing. When interest rates increase, there is a higher likelihood of loan defaults and a higher probability that the FI will have to buy back some of the loans. This may be the case even for sales of loans without recourse because FIs are reluctant not to take back loans for reputation concerns. 22 Defend the statement that although OBS activities expose FIs to several forms of risks, they also can alleviate the risks of FIs. Although an FI is exposed to interest rate, foreign exchange, credit, liquidity and other risks, it also can use these risks to help alleviate its overall risk, if used judiciously. For example, the use of options and futures can reduce the volatility of earnings if hedged with the appropriate amount. Such hedging can be incorporated in an FI’s overall portfolio so that both trading and hedging activities can be pursued independently while still reducing the total exposure of the FI. It is also possible to offset the exposures of on- and off-balance-sheet activities. For example, it is possible that decreases in interest rates could lead to increased exposures for some assets (reinvestment risks), but they could be offset by off-balance-sheet liabilities. Thus, regulation of off-balance-sheet activities should recognise the positive effects of these instruments in helping ameliorate the total exposure of the FI. Web question 23 Go to the RBA website and find from RBA Statistical Table B4 the total amount of unused commitments and letters of credit, and the notional value of interest rate swaps of banks for the most recent period available. The answer will depend on the date of the assignment. At the website, click on ‘statistics’ and then select Table B4. Integrated mini case: calculating income on OBS activities Uluru National Bank has issued the following off-balance-sheet items: • A one-year loan commitment of $1 million with an upfront fee of 40 basis points. The back-end fee on the unused portion of the commitment is 55 basis points. The bank’s base rate on loans is 8 per cent, and loans to this customer carry a risk premium of 2 per cent. The bank requires a compensating balance on this loan of 10 per cent to be placed in demand deposits and must maintain reserve requirements on demand deposits of 8 per cent. The customer is expected to draw down 75 per cent of the commitment at the beginning of the year. • A one-year loan commitment of $500 000 with an upfront fee of 25 basis points. The back-end fee on the unused portion of the commitment is 30 basis points. Loans to this customer carry a risk premium of 2.5 per cent. The bank does not require a compensating balance on this loan. The customer is expected to draw down 90 per cent of the commitment at the beginning of the year. • A three-month commercial letter of credit on behalf of one of its AA-rated customers who is planning to import $400 000 worth of goods from Germany. The bank charges an upfront fee of 75 basis points on commercial letters of credit to AA-rated customers. • A standby letter of credit to one of its A-rated customers who is planning to issue $5 million of 270-day commercial paper for an effective yield of 5 per cent. The corporation expects to save 50 basis points on the interest rate by using the SLC. The bank charges an upfront fee of 40 basis points on SLCs to A-rated customers to back the commercial paper issue. a. What upfront fees does the bank earn on each of these? Upfront fee on $1m loan commitment = 0.0040 × $1 000 000 = $4000 Upfront fees on $500 000 loan commitment = 0.0025 × $500 000 = 1250 Upfront fee on commercial letter of credit = 0.0075 × $400 000 = 3000 Upfront fee on standby letter of credit = 0.0040 × $5 000 000 = 20 000 Total upfront fees $28 250 b. What other income does the bank earn on these OBS activities? $1m loan commitment Interest income = (0.08 + 0.02) × $1 000 000(0.75) = $75 000 Back-end fee = 0.0055 × $1 000 000(1 – 0.75) = 1 375 $500,000 loan commitment Interest income = (0.08 + 0.025) × $500 000(0.9) = $47 250 Back-end fee = 0.0030 × $500 000(1 – 0.9) = 150 No other income is earned on the letters of credit. c. Calculate the returns on each of the off-balance-sheet activities assuming that the takedowns on the loan commitments are at the expected percentage and the customers holding the letters of credit do not default on their obligations. $1m loan commitment Upfront fee = $4000 Interest income = 75 000 Back-end fee = 1375 Total revenue $80 375 Funds committed = $1 000 000(0.75) – $75 000 (compensating balances = $1 000 000 × 0.75 × 0.10) + $6000 (reserve requirements on demand deposits = $75 000 × 0.08) = $681 000. Expected rate of return = $80 375/$681 000 = 11.80% $500 000 loan commitment Upfront fee = $1250 Interest income = 47 250 Back-end fee = 150 Total revenue $48 650 Funds committed = $500 000(0.90) = $450 000. Expected rate of return = $48 650/$450 000 = 10.81% No investment is made by the bank for the guarantees offered through the letters of credit. Thus, the bank invests no funds, yet makes $3000 on the commercial letter of credit and $20 000 on the standby letter of credit. Solution Manual for Financial Institutions Management Anthony Saunders, Marcia Cornett, Patricia McGraw 9780070979796, 9780071051590
