Topic 2: Liquidity Management

The Liquidity Problem

Liquidity management consists of:

1. Estimating funds needs
Deposit flows are affected by interest rates (relative to other
financial instruments).
Loan commitments vary over time.
2. Meeting liquidity needs
Asset management: meeting liquidity needs by using near-cash
assets (money market securities, asset-backed securities).
Liability management: meeting liquidity needs by using outside
sources of discretionary funds (repurchase agreements, certificates
of deposit, other borrowings).
Bank managers need to balance risk and returns.
Excessive asset liquidity is safe, but decreases profits, as low risk asses
offer lower rate of return.
Aggressive liability management can increase profits by putting funds into
higher earning longer term assets, however the bank is exposed to sudden
rises in costs of borrowed funds or unexpected unavailability of funds.
Prudential regulation of the banking industry prevents unexpected bank failures
and liquidity crises that follows.

Estimating liquidity needs

In order to estimate liquidity needs, banks need to forecast the future deposit and
loan activity.
Liquidity management involves considerable subjectivity because of the
uncertainty in forecasting the future.
It is thus prudent to adjust the estimated need upwards to avoid a liquidity
squeeze in the form of a cash shortage that could result in lost lending
opportunities, reduced depositor confidence and regulatory suspicions concerning
safety and soundness.
Sources and uses of funds method:
Bank management evaluates potential future changes in its individual
asset and liability accounts
Loans: the demand for funds in different lending areas is estimated from
past loan histories and future economic projections.
Deposits: are influenced by economic and competitive market conditions.
Influenced by interest rates (monetary policy & international financial
markets) low rates encourage depositors to look for better investments.
Summarised in a sources and uses of funds statement.
Deposit withdrawals are non-discretionary in that they cannot be
controlled by the bank, whereas loans are discretionary.
Basel framework for assessing and managing bank liquidity: (1) measuring
and managing net funding requirements, (2) managing market access, and
(3) contingency planning.
Structure-of-deposits method:
Lists the different types of deposits and assign a probability of withdrawal
to each.
More liquidity required for high-risk unstable deposits.
Core funds: deposits of loyal, local depositors that tend to be stable.

Non-core deposits: tend to be unstable sources of funds, are rice sensitive

and influenced easily by interest rates.
Directs management attention to probable cause of liquidity pressures
(deposit withdrawals).
Ignores other liquidity demands stemming from loans.
Funding-liquidity risk: maintaining sufficient cash to meet investment objectives.
Banks with significant securities portfolios are exposed to liquidity needs
that arise from trading activities.
Market-liquidity risk: volatile financial markets can cause temporary
illiquidity in securities positions in banks (due to freezing markets from
increased spread).

Asset liquidity

Traditional way of meeting cash demands for banks.

Asset management (selling assets (internal sources) money market instruments)
was the dominant method until 1960s, when liability management became an
alternative.
Liability management involves the acquisition of external funds from deposit and
non-deposit sources as liquidity needs arise (from external sources).
Asset liquidity has two roles:
1. Liquid assets serve as an alternative source of funds for the bank the
choice between asset or liability liquidity depends on their relative costs.
2. Acts as a reserve if financial markets lose confidence in bank, borrowed
sources of funds will become inaccessible, and bank will rely on its liquid
assets to maintain operations.
Liability management increases the asset size of the bank and so requires
increases in capital reserves to stay within regulatory guidelines. However,
liquidating money market assets (with no capital requirements) does not change
bank size, and therefore does not initially affect bank capital reserves.
Making loans require capital backing.
Australian banks are required to settle interbank payments through their
Exchange Settlement Accounts (ESA).
ESAs earn a rate that is 25 basis points below the RBA target cash rate.
Bank therefore aim to minimise these low-return funds.
If a bank runs out of ESA funds, it can borrow ESF from other banks, or
through repurchase agreements (repos of securities) from the RBA. Eligible
securities are limited in range, so the banks ensure their stock of liquid
assets includes these securities.
Liquidity needs must be covered by either liquid assets or by borrowing funds.
Money market approach: for assets, banks normally seek to match the
maturities of their assets with specific future liquidity needs. This allows
avoidance of transaction costs and rice risk while maximising interest
revenues.
Assets may be used as collateral for repurchase agreements (only eligible
securities are allowed).
Cyclical monetary policies to restrain strong inflationary pressures can
cause liquidity pressures that force banks to rely more on their internal
liquidity than on their external liquidity. This influences the decision
concerning the choice of liquid assets to hold.
Aggressive liquidity approach: taking advantage of yield curve
relationships if the yield curve is upward sloping, the purchase of longer
term securities would offer higher yields and capital gains if sold before
maturity (capital gains occur because as time passes the securities

maturities shorten, interest rate declines in line with the upward slope of
the yield curve.

Treasury notes
and
Commonwealth
government
bonds
Interbank loans

Loans to money
market dealers
Bank-accepted
bills

Negotiable
certificates of
deposits
Semi-government
securities
Repurchase
agreements
(repos)

Main Money Market Instruments

Issued by the Australian Government.
Treasury notes are short-term discount securities,
Bonds begin as long-term securities but as time passes
their maturities shorten and this generally means that
they become more liquid.
Interbank loans of Exchange Settlement Funds.
Typically overnight, where banks with excess exchange
settlement funds lend to other banks which are
experiencing a shortage.
Overnight loans (must be repaid at 11am the next day).
24 hour money has no set maturity but is redeemable
with 24 hours notice.
Bills of exchange which are accepted by banks, which
means that on the maturity date the accepting bank
prmises to pay the face value of the bill to the holder.
These are discount securities, normally with maturities of
30, 90 or 180 days.
Also includes bank-endorsed bills.
Negotiable instruments issued by baks to raise debt.
These are short term instruments which are liquid in the
money market.
Securities issued by state and territory government
borrowing entities, and thus trade at a slightly higher
yield than commonwealth government securities.
Sale of a bond with an agreement to buy it back at an
agreed price at an agreed future time. Commonwealth
government or semi-government securities are usually

Commercial paper
(promissory
notes)
Other securities

used as collateral.
Effectively a short-term collateralised loan.
Short-term securities issued by companies.
Carry higher credit risks than securities issued by banks
and thus have higher promised yields.
Corporate bonds and mortgage-backed securities.

Liability Liquidity

Liability management: alternative approach is to borrow the funds necessary to

meet loan demands and deposit withdrawals.
Large banks that are active in the money market have an advantage in their
ability to cost-effectively raise funds through the financial markets.
Smaller banks often obtain purchased funds in the money market through their
larger correspondent banks. Since small banks tend to have deposits in excess of
loans, they will deposit excess funds at correspondents in exchange for money
market services.
Correspondent balances serve as an additional source of asset liquidity for
smaller bansk and as an additional source of borrowed liquidity for larger
banks

Managing liability liquidity

The main advantage of liability management is that assets can be shifted from
lower earning money market instruments to higher earning loans and longer term
securities. Greater asset diversification may also be possible.
The main risks include:
Increased interest rate risk: if interest rates increase suddenly, the cost of
funds could rise substantially as borrowed funds come due and must be
rolled over at higher rates of interest.
Increased financial risk: increased variability of EPS due to increased debt
as a proportion of total assets (financial leverage). Bank managers need to
consider the risk preferences of shareholders when using liabilities to meet
liquidity needs.
Capital market risk: occurs due to low interest levels that motivate
investors to transfer deposit funds to the capital market in an attempt to
earn higher rates of return.
Bond carry trade strategy: implemented by borrowing short-term funds and
investing in longer term securities. As long as interest rates do not increase, the
carry trade can earn a positive yield spread. However there is an interest rate risk,
as rising interest rates collapse the positive yield spread and result in capital
losses on the Treasury bonds.
Estimating the availability and cost of external funds is a challenge.
Medium-term notes: debt securities that are continuously offered by a firm, as
opposed to underwritten debt securities sold within a relatively short time period.
Maturities range from 9 months to 30 years. MTNs help avoid price risks in
underwriting that could affect the cost of the debt to the bank. MTNs can be sold
in exact quantities and maturities demanded by investors.

Funds management of liquidity

Management of liquidity is best done by combining asset liquidity and liability

management (funds management).

Funds management involves comparing total liquidity needs with total liquidity
sources.
Funds management must ensure that sources of liquidity are sufficient to meet
liquidity needs, through:
1. The bank may impose maturity mismatch limits and encourage stable
funding sources, which will place a ceiling on liquidity needs
2. Liquidity may be sourced by holding liquid assets which can be readily
sold, but careful planning is required to select a desirable level of these
assets and a diversified mix of appropriate assets
3. The bank should aim for a diversified funding base, which provides the
bank with a further source of liquidity management.
Access to interbank markets, domestic financial markets and foreign currency
markets can enable the bank to reduce its risk by avoiding excessive reliance on
any one counterparty or market.

Liquidity Ratios
Three basic ratio measures of bank liquidity:
1. Simple liquidity ratio: liquid assets over total assets.
2. Loans/deposits
3. Loans/non-deposit liabilities
Another approach to measuring liquidity is to account for changes over time in
both liquidity needs and sources. This approach is better than focusing on one or
the other parts of the liquidity problem because it evaluates liquidity relative to
bank needs.

liquid assetsliabilities period t

Estimated liquidity needs period t

Optimum bank liquidity

Optimality is dynamic in that liquidity conditions change over time. Bank liquidity
must therofre be monitored regularly.
Optimum liquidity is achieved by balancing risks and returns liquidity needs to
be high enough to meet even unexpected changes in liquidity needs and sources,
but not too high due to the opportunity cost of excessive cash invested in nearcash assets that could be invested elsewhere and earn higher rates of return.
Excessive use of liability management could force the bank to use relatively highcost funding if interest rates unexpectedly surge upwards. Banks must balance
the cost of maintaining excessive liquidity and the cost of insufficient liquidity.

Liquidity shortfall: the probability that all liquidity will be used up.

Regulatory view of bank liquidity

The Australian Prudential Regulation Authority (APRA) supervises bank liquidity.

Each bank must:
Have an agreed liquidity management strategy document
Conduct scenario analysis or hold 9% of its liabilities in high quality liquid
assets. Banks must last 5 days during a bank run through plansto access
sufficient liquidity. High quality assets include cash, securities eligible for
repo, bank bills, CDs issued by banks, and deposits with other banks which
are convertible into cash within 2 business days.
Provide quaterly liquidity reports to APRA
There is a difference between operational liquidity and crisis liquidity
management.
Management information systems collect information and forecast operational
and crisis liquidity positions under alternative scenarios in a simulation.
Comprehensive contingency funding plans: outline courses of action in response
to various liquidity problems and define coincident management responsibilities.
They specify people and processes for identifying and responding to crises, set
out procedures for speedy access to alternative funds sources and for determining
priority in customer relationships, and monitor and manage the reaction of the
market.

1. Define the basic liquidity problem facing banking institutions

Banks are under constant liquidity pressures. Since no bank can function without
adequate liquidity, it is one of the most fundamental aspects of bank
management.
Liquidity risk is the risk that a bank will not be able to meet obligations as they fall
due, such as when customers wish to withdraw funds from their deposits or draw
down loans which have been approved.
Although adequate liquidity to avoid a crisis is one dimension of the problem, for
most ongoing banks it is operational liquidity for the bank as a going concern that
is the real challenge. In this respect the central issue that management must
evaluate is the risk and return trade-offs.

2. Describe how banks can estimate their liquidity needs

The sources and uses approach to estimating liquidity needs evaluates the effects
of deposit inflows and outflows and changing loan demands on bank liquidity.

The structure-of-deposits method of estimating liquidity needs focuses on the

stability of deposits as a source of funds. Daily ladders tracking cash inflow and
outflow projected forward are a critical tool in this process.

3. Discuss the resources available to meet bank liquidity needs

Liquidity management involves estimating future expected liquidity needs and

then planning to meet those needs. One approach is to meet these needs by
converting assets to cash, that is, using asset liquidity. This approach requires
banks to hold a reserve of liquid assets.
Liquidity management involves estimating future expected liquidity needs and
then planning to meet those needs. An alternative method of meeting liquidity
needs is to borrow external funds, that is, use liability liquidity.
In practice, most banks use some mix of asset liquidity and liability liquidity.

4. Compare alternative bank management approaches to meeting liquidity

needs

Asset liquidity is a traditional approach, whereas liability management is a more

modern approach. Asset liquidity refers to holding liquid financial assets that may
be quickly converted to cash with little or no capital loss. Use of cash and shortterm financial instruments to meet liquidity needs has minimal effects on the
capital position of the bank, whereas liability management can affect the banks
capital position, which must be sufficient to satisfy regulatory requirements.
Liability management of liquidity enables the bank to shift funds from lower
earningmoney market instruments to higher-earning loans and investment
securities. It also tends to increase the financial flexibility of the bank in dealing
with liquidity needs. If it is cheaper to acquire funds than it is to liquidate assets to
finance new loans, the former should naturally be used, barring the influence of
other factors in the decision. However, this liquidity approach is not without risks.
Debt interest obligations rise as a percentage of total assets, which tends to
increase the banks exposure to interest rate risk, as well as its financial risk
because of increased financial leverage.
Optimally, bank managers must weigh the cost of maintaining excessive liquidity
against the cost of insufficient liquidity in an attempt to minimise the total costs of
liquidity management.
Liability management is easier for big banks with a credit rating (from Moodys or
Standard and Poors, for example) in that they can access funds in the vast
Eurodollar market and then hedge the currency and interest rate risk as it suits
them in the swap market.

5. Identify measures of bank liquidity and their trends over time in the banking
industry

Funds management involves comparing total liquidity needs with total liquidity
sources.
Three basic ratio measures of bank liquidity are (a) simple liquidity ratio, (b)
loans/ deposits and (c) loans/non-deposit liabilities.
Accounting for changes over time in both liquidity needs and sources evaluates
liquidity relative to bank needs. This can be done by dividing liquid assets and
liabilities in period t by estimated liquidity needs in period t.
Optimum liquidity is achieved by balancing risks and returns. The bank must trade
off the cost of maintaining excessive liquidity and the cost of insufficient liquidity.

Explain the regulators concerns with bank liquidity

If a bank has liquidity problems there is a risk that this will have adverse
implications for the banking system, possibly causing a panic and a run on the
banks.
The regulator is concerned to protect depositors and the financial system as a
whole. Consequently, it requires that banks have a liquidity management strategy
in place which effectively covers the liquidity requirements of a bank in the
ordinary course of business the going concern scenario and in the name
crisis scenario.

Topic 3: Off-Balance Sheet Activities

The Expansion of Off-Balance Sheet Activities

Increased global volatility has caused higher variability in profits and an increased
risk of doing business in the financial markets.
In response to increased risk, the need to satisfy customers demands, generate
stable fee income, and increase their capital to asset ratios, banks have
developed new financial services that do not appear on their balance sheets.
There are two categories of off-balance sheet transactions:
1. Market-related: derivative activities (interest rate, forex, equity etc.)
comprise 95% of off-balance sheet activities, although the introduction of
AASB 139 means many of them are now showed on the balance sheet.
2. Non-market related: direct credit substitutes, performance-related
contingencies, etc comprise 5% of off-balance sheet activities.
Over-the-counter (OTC) financial instruments is growing the fastest. These are
customised financial instruments negotiated between two parties, rather than
standardised exchange-traded instruments.
Contingent claim: an obligation by a bank to provide funds (lend funds or buy
securities) if a contingency is realised. Bank has underwritten an obligation of a
third party, and in case of default the bank has an immediate loss. These claims
do not appear on the balance sheet until they are exercised.

Financial Guarantees

Financial guarantee: an undertaking by a bank (guarantor) to stand behind the

current obligation of a third party and to carry out that obligation if the third party
fails to do so eg. Loan guarantee repayment of loan is guaranteed by bank.
Given that the bank has better credit than the borrower, the borrowers debt
obligation is reduced (interest).

Standby Letters of Credit

Standby letters of credit (SLCs): obliges the bank to pay the beneficiary if the
account party defaults on a financial obligation or performance contract. Most do
not become a bank liability, and 1% of the guarantee is charged by the issuing
bank.
Financial SLC: related to a financial commitment.

Performance SLC: non-financial in nature.

Use of SLCs
Commonly used in connection with the issue of debt obligations as backup lines of
credit.
Also used in connection with building contractors obligation to complete a
construction project. If the project is not completed before a certain date, the
bank is required to pay the beneficiary. In this case, the SLC is a substitute for a
surety bond bonds sold by insurance companies to insure against loss, damage
or default (these bonds are a special type of insurance policy and NOT a debt
obligation).
SLCs are used to ensure the delivery of merchandise, the performance of options
or forward contracts, and to back other loans.
If a banks credit rating decreases, the value of the SLCs issued would decline,
and the ability to issue new SLCs will deteriorate.
Risks of SLCs
Because bankers accept only those credits that they are believe are least likely to
default, APRA considers their credit risk minimal, and are classified as direct credit
substitutes.
Many SLCs are backed by deposits and/or collateral to further reduce risk, and
terms are sometimes periodically renegotiated due to changes in risk over time.
When SLCs are activated, banks may record the unreimbursed balance as a
commercial loan.
Banks can manage risk by limiting the amount of SLCs they issue, diversifying
their portfolio of SLCs, and increasing capital.
SLCs subject banks to liquidity (funding) risk and capital risk, since losses can
rapidly accumulate in cases of economic downturn that can cause more than one
borrower to default at the same time.
Interest rate risk is present either from possible changes in their duration gap
or the increased/decreased likelihood of default as interest rate levels
increase/decrease.
SLCs expose banks to an ill-defined legal risk. Most SLCs contain material adverse
change clauses that enable the bank to withdraw its commitment under certain
conditions. This is needed to deter the firm from taking excessive risks and
exploiting the banks guarantee.
Pricing of SLCs
Upfront fees & annual fees, eg. Upfront fee of 1% of outstanding and unused
guarantee, and annual fees 25-150 bp lower than loans of equivalent maturity
and risk.
Annual fees are lower than loan fees because of the lower administrative cost and
other expenses, and also because no funding is required.
Bank Loan Commitments
Loan commitment: a banks promise to a customer to make a future loan or a
guarantee under certain conditions.
Can be formal or informal, however some agreements are not legally binding.
Major benefit is the assurance of funds to the borrower and fees or compensating
balances of equivalent value to the bank.
Drawback is that the bank acquiring a credit exposure in the future because it
may have to make a loan or a guarantee.

Line of Credit
Line of credit: an agreement between a bank and a customer that the bank will
entertain a request for a loan from that customer. Bank will usually make the loan
even if not obliged to do so.
Frequently informal, with no fee for service.
If formal, fee is charged.
Revolving Loan Commitments
Revolving loan commitment: a formal agreement between the bank and a
customer, which obliges the bank to lend funds according to the terms of the
contract.
The contract specifies the terms under which loans will be made, and the
customer pays the bank a commitment fee (facility fee), for the privilege of
borrowing at the future date.
May contain clauses that release the bank from its obligation if there is a
substantial change in the customers financial condition.
Protects the borrower from availability risk and credit risk.
Revolving commitments fix the risk premium, in contrast to a confirmed credit line
that sets the premium at the time funds are drawn down.
Revolving loan commitments are tantamount to options contracts, wherein the
bank must offer a loan at the agreed upon premium.
Because revolving commitments expose the bank to credit risk, the commitment
fee is priced to capture this bank risk.
Funding Risk
Funding (liquidity risk/quantity risk) is the major risk if a large number of
borrowers draw down their loans simultaneously, as the bank may not have
sufficient funds. This is most likely to occur during periods of tight credit.
Because the bank is obliged to make the loans, it may have to raise additional
funds, which is difficult during tight credit, to honour the commitments.
If the bank does not honour the commitment, a customer with a legally binding
commitment could bring legal action against the bank. Such an action could
damage the banks reputation, which could impair its future growth and
profitability.
Certain types of commitments are considered irrevocable (i.e. unconditional and
binding). According to the Bank for International Settlements (BIS 1986), these
include the following:
Asset sale and repurchase agreements an arrangement whereby a bank
sells a loan, security or non-current asset to a third party with a
commitment to repurchase the asset after a certain time, or in the event of
a certain contingency.
Outright forward purchases a commitment to purchase a loan, security
or other asset at a specified future date, typically on prearranged terms.
Bank standby facilities where the bank commits to pay the beneficiary if
the account party defaults on an obligation.
Note issuance facilities which are explained in the next section.
Similarly, certain types of commitments are considered revocable. These
include credit lines and undrawn overdraft facilities.

Note Issuance Facilities

Promissory Notes and Euronotes
Note issuance facility (NIF): medium-term (2 to 7 years) agreements whereby
banks guarantee the sale of a borrowers shortterm, negotiable promissory notes
at or below predetermined interest rates. If a borrower cannot readily obtain
short-term funds in a timely fashion for one reason or another, the bank will step
in and buy the securities.
Other terms for similar financial guarantees are revolving underwriting facilities
(RUFs) and short-term note issuance facilities (SNIFs).
For bank borrowers, the short-term securities are usually certificates of deposit.
For large creditworthy non-bank borrowers, the short-term debt securities may be
euronotes, which are denominated in Australian dollars and sold offshore.
Various other terms used for these types of agreements are RUFs, transferable
RUFs (TRUFs), SNIFs, note purchase facility, multiple component facilities, and
euronote facilities.
Arrangers and Tender Panels
One contingent risk to banks in NIF arises from their roles as underwriters or
arrangers. The NIF can be organised or underwritten by a single bank (the
arranger) or by a group of fifteen or more banks and financial institutions (the
tender panel) that have the right to bid for the short-term notes issued under the
facility.
The advantage of a tender panel is the broader competitive market offered by
many institutions bidding for the securities, rather than having one bidder.
The tender panel provides a means of placing larger dollar amounts of securities
than may be possible for a single arranger.
Maturity transformation: arranger or tender panel assures the borrower access to
short-term funds (e.g. 90 days) over the 57 years covered by the agreement.
Results in increased credit risk for the arranger or tender panel, which may have
to lend the borrower funds if the borrower is unable to sell the short-term
securities at the interest rates (or prices) agreed upon.
The NIFs increase the funding risk of the underwriting banks if they are called on
to make the loans.

Derivatives

Derivatives: financial instruments that are derived from underlying securities, eg.
swaps, options, futures, forwards etc.
Most derivatives are reported on the balance sheet.
Players in the derivative markets:
Counterparties to the derivatives (ultimate end users).
Agents market participants acting on behalf of counterparties, and
earning brokerage fees.
Traders/dealers (including speculators and arbitragers) market
participants who trade for themselves. They buy and resell for a profit by
maintaining a spread between buy and sell price. Important contributor to
market liquidity.

Counting the Risks in Derivatives

Derivatives have more complex risks, including credit, market, funding, market
liquidity, operations and legal risks.

The nature and size of derivative contracts combined with the volatility and speed
of derivative contract repricing means that contracts can result in high levels of
losses if risk is not properly monitored and managed.
Counterparty risk: the risk that a counterparty in a financial transaction will
default, or fail to fully perform its obligations, resulting in a financial loss to the
other party. Credit exposure is measured not by the notional amount of the
contract but by the cost of replacing its cash flows in the market, eg. in an interest
rate swap, the PV of expected cash flows on the underlying instruments.
Market risk is the risk that the market price of the derivative security will
change. This risk is also referred to as the price risk of the underlying instrument.
Most banks break overall market risk into components, including interest rate risk,
exchange rate risk, share price risk, commodity price risk and others.
Liquidity risk involves both funding risk and market-liquidity risk.
Funding risk is the risk of adverse cash flow pressures arising from
derivatives positions.
Market-liquidity risk arises when positions cannot be eliminated quickly, or
offset, as the market reprices.
Operating risk is an often-overlooked area of commercial bank risk that can
arise owing to:
Inadequate internal controls the complexity of some derivatives, human
error and fraud are all sources of risk that demand internal monitoring and
control by management
Valuation risk the valuation of some derivatives relies on sophisticated
mathematical models that are highly dependent on assumptions about
market conditions, which together can make valuation a difficult task.
Marking to market is relatively easy where financial data feeds such as
Reuters, Bloomberg and Telerate can be used to get the latest prices, but
where such pricing is not available, marking to model is the only option
available
Regulatory risk as already mentioned, regulators are scrutinising overthe-counter (OTC) derivatives because of their explosive growth, and this
attention is drawing changes in accounting procedures, capital adequacy,
restrictions on activities, and other banking practices.
Legal risk the OTC market for derivatives is private in nature, fast-developing
and innovative in security design, all of which means that disputes in this new
market will require a period of legal cases to clearly establish the rights and
obligations of all participants. The International Swaps and Derivatives Association
(ISDA) has established some rules in cooperation with most large industrialised
countries, but the differences in national bankruptcy laws raises legal concerns
about the risks in international deals.
Aggregation risk comes about from the complex interconnections that can
occur in derivatives deals which involve a number of markets and instruments. It
is difficult to assess the risks to individual parties or groups of parties in such
transactions. Risk aggregation methods are relatively new and are still evolving.
The largest banks are best able to manage risks, owing to the operational
demands of capital and expertise. There is question whether derivatives are too
risky for banks.
There are two derivatives markets:
1. Privately traded OTC market dominated by banks and large securities firms
that custom-design products for users
2. Organised exchanges that offer standardised contracts and a clearing
house for handling transactions eg. Sydney Futures Exchange, ASX
Derivatives market.

The growth of derivatives and the potential for unknown risks had led regulators
(APRA) to be weary. Whilst most participants are reputable financial institutions,
there is a risk of fraudulent participants and competition driving some large banks
to take precarious positions and expose themselves to sudden liquidity risk.

Currency and Interest Rate Swaps

Swap: an agreement between two counterparties to exchange cash flows, and is

based on some notional principal amount of money, maturity and interest rates.
Counterparties are financial institutions, business concerns, government agencies
and international agencies.
Plain vanilla interest rate swap: counterparties swap their interest payments,
where one party has fixed interest payments and the other has variable interest
payments.
Within swaps, there is no transfer of principal between counterparties (notional)

Types of Swaps
Currency swaps include the exchange of interest payments in different currencies,
as well as the exchange of a principal amount at the start and end of the swap.
Currency swaps are used to hedge interest rate gaps and cash flow risks.
Interest rate swaps involve the exchange of a stream of interest payments over
time. These include:
Coupon swaps: interest payments are based on a fixed rate and a floating
rate.
Basis swaps: interest payments are based on two different floating rates of
interest.
Cross-currency interest rate swap (currency swap): may involve 3
counterparties, with interest payments based on fixed-rate flows in one
currency and interest rate, and the other interest payments based on
floating-rate flows in another currency interest rate.
Plain deal currency swap: between two counterparties with equal
interest payments in different currencies.
Equity swaps: exchanges of cash flows in which one side of the contract is
determined by the returns of an equity index, and the other based on a money
market interest rate. One party will have an exposure to the share market which it
wants to convert into an interest stream, whilst the other will have an exposure to
the money market which it wants to convert to a share market return.
Re-read Managerial issues pg. 440
Risks Associated with Swaps
It is not uncommon for banks to have swap levels that exceed their on-balance
sheet total assets.
Counterparties in swap agreements face:
Credit risk: risk that one fo the parties to the swap arrangement will
default, resulting in a liability to the bank. To reduce credit risk, SLCs can
be used to guarantee payments, or parties may agree to cash-settle the
replacement costs of the swap every 6-12 months.
Market (price) risk: the risk that interest rates or exchange rates may
change and have an adverse effect on one or more of the participants in a
swap agreement. Price risk can be controlled by entering an offsetting
swap, or selling the swap on the secondary market.

A complication of swaps is finding sufficient interest on both sides of the swap. It

may be necessary to use more than two assets or parties to get approximate
matches of interest rate or currency needs.
The International Swaps and Derivatives Association (ISDA) was established in
1985 to promote standardisation and sound business practices in the swap
market. This was established by banks and securities firms to self-regulate.
Changes to accounting rules now requires all trading assets such as derivatives,
including swaps, to be stated at fair market value.

Over-the-Counter Options, Futures and Forwards

Over-the-Counter Options
OTC options meet the needs of investors that arent satisfied by the standardised
options contracts traded on organised exchanges. OTC options are usually written
on OTC instruments such as debt securities and currencies.
Floor and Ceiling Agreements
Interest rate options: off-balance sheet products and services offered by banks to
manage interest costs.
Ceiling agreements (caps): an agreement between a bank and its customer that
specifies the maximum lending rate on a loan, and therefore protects the
customer from interest rate risk.
Read example 14.2
Floor agreements: specify the minimum rate of interest on a loan, and therefore
protects the bank from interest rate risk. If interest rates go below the floor, the
customer pays the bank the difference between the actual rate and the floor rate.
The bank is therefore the buyer of an out-of-the-money put option. Out-of-themoney because the current level of interest rates is above the strike interest rate
cannot be exercised for a profit at present time.

Interest rate collar: an OTC option that combines ceiling and floor.
Credit swap: two banks exchange interest and principal payments on portions of
their loan portfolios. This is a common type of credit derivative. Allows banks to
further diversify their credit risk.

Total return swap: Bank A swaps payments received on a risky loan portfolio for a
cash flow stream from Bank B comprising a benchmark interest rate plus some
negotiated compensation for the credit risk premium it has given up. This
transfers the credit risk from Bank A to Bank B, even though Bank B did not make
the loan.
The key advantage of credit derivatives is that they transfer credit risk without
any sale of the underlying debt contact it allows banks to reduce exposure to
concentrated credit risks and thereby diversify its loan portfolio. This is important
if, for example the bank holds a large concentration of loans in a particular
industry.

Forwards and Futures

Contracts in the spot/cash forex market are for delivery 2 business days after the
deal.
Derivative forex markets trade forwards and futures contracts contracts to buy
or sell currencies at a date greater than 2 business days from today, at an
exchange rate struck today.
Forwards: OTC contracts executed bilaterally between two counterparties.
They are customised to the needs of the counterparties and involve
counterparty risk.
Futures: standardised, anonymous, exchanged-traded contracts, market to
market daily, with protection against defaults provided by the exchange
(through imposition of exchange-clearing margins).
Forwards and futures exist for most major underlying financial instruments, for
interest rates, share prices or commodity prices.
Forward-rate Agreements
Forward-rate agreement (FRA): an OTC interest rate forward contract for bonds or
other financial assets. The buyer and seller agree on some interest rate to be paid
on some notional amount at a specified time in the future.
The major advantage of FRAs over exchange-traded futures contracts is that they
can be tailored to meet the needs of the parties involved, and there are no margin
requirements.
The disadvantage is that counterparty risk is acquired.
Buying an FRA is analogous to buying a call and selling a put, where the forward
price is equal to the exercise price of the options (put-call parity).
Re-read forward rate agreement 2nd paragraph (last).
Synthetic Loans
Interest rate forwards or futures contracts and options can be used to create
synthetic loans and securities.
A can use interest rate futures market to convert a floating-rate loan into a fixed
rate loan, thereby creating a synthetic loan.
Review example 14.3
Unlike forward contracts, futures contracts expose the bank to liquidity risk due to
the fact that their value is marked-to-market daily. Gains or loses on futures
contacts must be settled daily against margin positions, thereby opening up the
possibility of cash demands.

Other Off-Balance-Sheet Activities

Securitisation
Securitisation involves the packaging of similar loans into large pools and the
issue of securities to investors that earn returns based on the payments on the
loans.
The process may take the loans and the related risk completely off the lenders
balance sheet, or it may involve the retention of some risk (in which case the
lending institution will still need to allocate capital against the off-balance sheet
asset).
Loan-backed securities can be collateralised by mortgages (residential and
commercial), motor vehicle loans, credit card receivables, computer leases and
small business loans.
The rapid growth of loan securitisation is changing the nature of the lending
business for smaller financial institutions. Instead of making loans and bearing all
of their associated risks and returns, these institutions are making loans,
securitising them, and selling the securities into the financial marketplace.
In the process they are changing their risk exposures to loans and increasing
service revenues. In regard to service revenues, these institutions can serve
multiple roles in the securitisation process, including loan originator, loan
packager and loan service company.
An excellent example of how securitisation solves risk management problems is
the case of building societies. Because these institutions use short-term retail
deposits and make long-term mortgage loans, they often have a negative dollar
gap that makes them sensitive to interest rate movements. By securitising home
loans and then purchasing mortgage-backed securities with much shorter terms
to maturity, their gap problem can be substantially reduced.
Trade Finance
Most trade finance is on-balance-sheet. However, there are some international
aspects of trade finance that are off-balance-sheet commitments by banks.
Trade finance includes commercial letters of credit which are used to finance
international trade.
A letter of credit (LOC) involves a bank (the issuer) that guarantees the banks
customer (the account party) to pay a contractual debt to a third party (the
beneficiary).
Letters of credit are contingent liabilities because payment does not take
place until the proper documents (i.e. title, invoices) are presented to the
bank.
Payment depends on the banks creditworthiness, not the buyers financial
strength.
LOCs are specific to the period of time involved in the shipment and
storage of goods, result in fee income for banks from the buyer, and
require the buyer to reimburse the bank for payment of goods.
LOCs expose banks to credit risk and documentary risk. Credit risk in this
case differs from a typical loan that is carefully evaluated by a loan officer.
Instead, because LOCs are essentially working capital loans with a fast
turnaround and are offered to otherwise creditworthy buyers, little credit
risk evaluation is made in common practice. Of course, to the extent that
credit review standards are lowered, there is some degree of credit risk, as
some proportion of even sound buyers can experience a deterioration in
their ability to pay at times.

Documentary risk is associated with the complexity of international

commerce, which can become tangled by different countries legal
systems and international legal rules. It is possible for conflicts between
sellers and buyers to spill over to banks involved in their transactions.

.Services for Fees

Advisory and management fees provide a fairly riskless source of bank income.

Cash management
Cash management systems for business concerns are one of the most popular off
balance-sheet service areas offered by banks.
Cash management systems are used to help business concerns collect
remittances and use their bank balances efficiently.
Locked boxes are part of cash management systems. These are post office boxes
where customers remittances are sent by mail and then collected by bankers who
deposit them in a business concerns account (see chapter 16 for further
discussion). Banks receive fees for collecting and processing the funds.
With the exception of the computers used to process the funds and an increase in
cash (from the collected funds), no other specific items on their balance sheets
are directly attributable to cash management systems.
Networking
Networking refers to links among different companies that seek to exploit
comparative advantages in the production and delivery of a product (strategic
alliance).
For example, a bank may use networks to sell insurance, provide managed funds
services, and other services.
Networks permit banks to expand certain specialised services without a major
investment on their part.

Summary
1. Outline the reasons off-balance-sheet activities are expanding rapidly to meet
market demands.
During the 1990s and early 2000s, a dramatic shift occurred in the way
banks do business. In response to increases in financial markets volatility
in the 1980s and 1990s, and the demands of their customers for riskmanagement services, banks adapted by expanding beyond making
traditional loans and gathering deposits to fee-generating activities that do
not appear on their balance sheets.
2. Describe the different types of contingent claims or guarantees offered by banks.
Off-balance-sheet activities include a variety of commitments and
contingent claims that business firms are increasingly demanding.
Financial guarantees are created when a bank commits to stand behind the
obligation of a third party.
Standby letters of credit are guarantees of payment to a beneficiary if the
account party defaults on an obligation.
A loan commitment is a banks promise to make a future loan or
guarantee, under certain conditions.
Note issuance facilities are created when banks guarantee the sale of a
borrowers promissory notes at or below a given interest rate.
3. Discuss the growing derivative securities activity of banks, which is challenging
regulators to control potential risks inherent in this growth market.

Banks are offering various derivative securities services, such as swaps,

options, futures and forward contracts to help customers cope with the
greater volatility that exists in todays financial marketplace.
Derivatives can be used to manage financial risks such as foreign
exchange risk, interest rate risk, commodity price risk and share price risk.
Derivatives can also be combined to provide services such as interest rate
caps, floors and collars.
Although derivatives provide fee income and can be used to manage
banks risk exposures, they also introduce new risks. Indeed, off-balancesheet exposures of some banks exceed recorded assets, and this has
increased regulatory attention to these new risks. The challenge for
bankers is to provide the off-balance-sheet services that customers
demand and, at the same time, control the risk implications of these
services.
4. Identify other off-balance-sheet services that do not involve contingent claims or
derivative securities
Banks also offer off-balance-sheet services that do not involve contingent
claims or derivative securities.
Trade finance is provided through documentary letters of credit.
Fee-based services include cash management services (including locked
box processes and receivables management), and networked (third party
or related party) services, including insurance, managed funds and similar
services.

Topic 4: Evaluating Bank Performance