MONASH

BUSINESS
SCHOOL

Lecture 11
OFF–BALANCE SHEET ACTIVITIES

BFF2401 Commercial banking and finance

LEARNING OBJECTIVES

On completion of this lecture, students should be able to:

1. Discuss the relative importance of off-balance sheet
(OBS) activities for banks
2. Identify the major types of non-market-related OBS
activities, describe their main features, and explain
why banks participate in non-market-related OBS
activities
3. Provide an overview of market-related OBS activities
(derivative instruments) and the three purposes of
bank derivative transactions

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REFERENCE

▪ Lange et al. (2015): Chapter 16

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LECTURE OUTLINE

▪ Definition and the importance of OBS activities (LO1)

▪ Non-market-related OBS activities
▪ Market-related OBS activities (derivatives)

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OBS ACTIVITIES

▪ OBS activities: relate to transactions which, at the time

of their origination, do not appear on a bank’s balance
sheet.
– OBS asset: an item or activity that moves onto the asset side of
the balance sheet when a contingent event occurs
– OBS liability: an item or activity that moves onto the liability
side of the balance sheet when a contingent event occurs

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OBS ACTIVITIES

OBS activities On Balance Sheet Ratio

($ billion) Assets ($ billion) OBS/BS
Dec 1990 1,748.64 347.98 5.03x
Dec 1995 2,223.38 469.44 4.74x
Dec 2000 4,168.30 759.96 5.48x
Dec 2005 9,017.14 1,451.08 6.21x
Dec 2010 14,838.46 2,668.79 5.56x
Dec 2015 31,167.12 3954.28 7.88x
Dec 2016 34,948.24 4167.79 8.39x
Dec 2017 37,187.10 4125.76 9.01x
Dec 2018 38,253.11 4340.40 8.81x

Source: Adapted from RBA Statistical Tables – Tables B1 and B2, accessed May
7, 2019

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MEASURING OBS ACTIVITIES

▪ When measuring an importance of OBS, we typically

use the face value of the transaction.
– For example if a bank buys a futures contract with a face value
of $1m, this would count as $1 million of OBS.
▪ This overstates the bank’s exposure to loss.
▪ An alternative is to look at the “credit equivalent”.
– For example: the futures contract of $1m might have a credit
equivalent of $20,000.

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DERIVATIVES AND OVERSTATING

▪ This problem of overstating affects both derivatives and

non-market related OBS.
▪ But it is much more important for derivatives.

Example: Off-balance sheet business of Australian banks (3/2007)

Gross Credit equivalent

Non-market related OBS $538.2b $141.0b
Derivatives (locally $5752.7b $94.5b
incorporated banks)
$235.5b
Source: APRA Insight Table A3

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OBS AND SHAREHOLDER VALUE

OBS activity is a substantial contributor to shareholder

value.
▪ It affects the level and timing of bank profits.
– Approximately 40% of Australian bank profits come from
non-interest income.
– Earnings and expenses are incurred.
▪ It affects bank risks.
– liquidity risk, credit risk, interest rate risk and operational risk
▪ It is growing in importance.

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DERIVATIVE TRADING LOSSES

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LECTURE OUTLINE

▪ Definition and the importance of OBS activities

▪ Non-market-related OBS activities (LO2)
▪ Market-related OBS activities (derivatives)

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NON – MARKET OBS ACTIVITIES

▪ Loan commitments
▪ Letters of credit (documentary & standby)
▪ Bill endorsements
▪ etc.

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LOAN COMMITMENTS

▪ involve a commitment to lend up to a stated amount at

a given interest rate in the future.
▪ charge upfront fee and back-end fee.
– Upfront fee: the fee charged for making funds available
through a loan commitment
– Back-end fee: the fee imposed on the unused component of
a loan commitment

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LOAN COMMITMENTS AND RISKS

Risks associated with loan commitments:

▪ Interest rate risk
– On fixed-rate loan commitments, banks are exposed to
interest rate risk.
– On floating-rate commitments, there is still exposure to
basis risk.
▪ Draw-down risk
– Uncertainty of timing of draw-downs exposes bank to risk.
– Back-end fees are intended to reduce this risk.

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LOAN COMMITMENTS AND RISKS (cont.)

Risks associated with loan commitments:

▪ Credit risk
– Credit rating of the borrower may deteriorate over the life of the
commitment.
– Addressed through 'adverse material change in conditions'
clause
▪ Aggregate funding risk
– During a credit crunch, bank may find it difficult to meet all of the
commitments.
– Bank may need to adjust its risk profile on the balance sheet in
order to guard against future draw-downs on loan commitments.

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LETTERS OF CREDIT (LCs)

▪ Both documentary LCs and standby LCs are essential

guarantees sold by an FI to underwrite the performance
of the buyer of the guarantees (such as a corporation).
– Documentary letters of credit (LCs)
▪ Contingent guarantees to underwrite a trade or commercial
performance of the buyer of the guarantee
▪ Widely used in both domestic and international trade
– Standby letters of credit (SLCs)
▪ Cover contingencies that are potentially more severe and less
predictable than those covered by documentary LCs.
▪ Not necessarily trade related.
▪ Both expose banks to default risk.

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DOCUMENTARY L/Cs

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STANDBY L/Cs

▪ Insurance function
▪ Structure and type of risks covered different from trade
LCs and documentary LCs
▪ Some examples include:
– Performance bond guarantees
– Default guarantees
▪ SLCs are direct 'competitors' to loan commitments.
▪ SLCs are often issued by general insurers.

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BILL ENDORSEMENTS

▪ When selling a bill of exchange, market practice is for

the seller to endorse the back of the bill.
▪ This means that if the acceptor does not pay the face
value on maturity, those parties that have endorsed the
bill will need to pay.
▪ If the bill is paid on maturity, there is no impact on the
bank. If it is not paid, the endorser may have to do so.

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 CRYSTALLIZATION OF AN OBS ITEM

Crystallization: An OBS item fully or partly becoming an actual asset or

liability.
Example: (1) Becoming a liability:
– Bank endorses bills with face value $1m issued by a customer.
– If the customer defaults then the bank will have to pay the face
value of the bill to the holder at maturity.
– This creates a bank liability valued at $1m.
Today:
▪ Bank’s balance sheet…….. nothing recorded
▪ Off-balance sheet………….. a bill endorsement
▪ Bank earns endorsement fees.
In 6 months’ time:
▪ Bank’s balance sheet…….. liability = $1m

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CRYSTALLIZATION OF AN OBS ITEM

Example: (2) Becoming an asset:

▪ Bank makes a loan commitment – it contracts to lend $1 million for 1
year starting in 6 months’ time.
Today:
▪ Bank’s balance sheet…….. nothing recorded
▪ Off-balance sheet………….. a loan commitment
▪ Bank earns commitment fees.
In 6 months’ time:
▪ Bank’s balance sheet…….. Asset = loan of $1m
▪ Off-balance sheet………….. nothing

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WHY DO BANKS CONDUCT NON-MARKET RELATED OBS ACTIVITIES?

It is because banks earn fees related to the costs and

risks involved (e.g. liquidity risk, credit risk, interest rate
risk and operational risk).

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LECTURE OUTLINE

▪ Definition and the importance of OBS activities

▪ Non-market-related OBS activities
▪ Market-related OBS activities (derivatives) (LO3)

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MARKET – RELATED OBS ACTIVITIES

▪ Derivatives (Market-related OBS transactions)

– Value depends of the market value of the underlying
instrument.
– 90% of total bank OBS activities
▪ Banks can be involved in a whole range of derivatives
products, particularly related to foreign exchange and
commodities.
▪ Risks: primarily price risk, but also credit risk,
liquidity risk, operational risk

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MARKET – RELATED OBS ACTIVITIES

▪ Interest rate derivatives

are the most important
and include:
─ Forward Rate Agreements
─ Swap contracts
─ Futures contracts
─ Options

Source: Central Clearing of OTC

Derivatives in Australia A discussion
paper issued by the Council of
Financial Regulators, June 2011

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(i) FORWARD RATE AGREEMENTS (FRAs)

▪ An FRA is an agreement to make a payment depending

on the change in interest rates.
▪ The FRA defines the amount, timing and direction of
the payment.
▪ Two parties to the FRA are the “buyer” and the “seller”.
─ The buyer pays the fixed FRA rate and receives the floating
market rate.
─ The seller pays the floating market rate and receives the
fixed FRA rate.

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(i) FRAs

An FRA contract defines:

▪ the transaction date (now)
▪ the settlement date
▪ the notional value or face value
▪ the FRA rate
▪ the market rate

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(i) FRA

▪ FRA diagram:
FRA rate = fixed rate
Buyer Seller
Market rate

▪ FRA implications:
─ The buyer of an FRA will gain if market interest rates
rise and lose if market interest rates fall.
─ The seller of an FRA will lose if market interest rates rise
and gain if market interest rates fall.

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(i) FEATURES OF AN FRA

An FRA is characterised as:

▪ An ‘over-the-counter’ product
▪ Generally not longer than two years
▪ Separate from physical transaction
▪ NO exchange of principal
▪ Settlement by compensation (payment of the interest
differential)

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(i) FRA SETTLEMENT

▪ On the settlement date

– If the market rate > the FRA rate, the seller pays the buyer.
– If the market rate < the FRA rate, the buyer pays the seller.
▪ Payments are equal to the interest differential.
▪ Example:
FRA rate = 10%
Buyer Seller
Market rate

– If market rate on the settlement date is 12%, then to settle,

the seller pays the buyer 2%.

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(ii) INTEREST RATE SWAPS

▪ An interest rate swap is an agreement between two

parties to exchange interest payments on specified
dates.
▪ The most common is a swap between fixed interest
payments and floating market interest payments.
▪ Settlement is by payment of the interest differential.
▪ A swap is like a series of FRAs.
– The swap buyer agrees to pay the fixed swap rate and receive
the floating market rate.
– The swap seller agrees to pay the floating market rate and
receive the fixed swap rate.

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(ii) FEATURES OF AN INTEREST RATE SWAP

An interest rate swap can be characterised as:

▪ An ‘over-the-counter’ (OTC) product
▪ Generally a long-term contract (at least 3 years
usually more) with multiple settlement dates
▪ Separate from physical transaction
▪ No exchange of principal
▪ Settlement by compensation (payment of the interest
differential)

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(ii) INTEREST RATE SWAPS
Bank bill rate (BBR)
A SWAP B

12%
fixed 12% BBR + 1.5

A’s lender B’s lender

in the in the
physical physical
market market

▪ A (swap seller) has agreed to pay the floating market rate (BBR) and
receive the fixed ‘swap’ rate.
▪ B (swap buyer) has agreed to pay the fixed rate of 12% and receive
the floating market rate.
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 (ii) IMPLICATIONS OF INTEREST RATE SWAPS

▪ The swap buyer (counterparty B) will gain if market

interest rates rise and lose if market interest rates fall.
▪ The swap seller (counterparty A) will lose if market
interest rates rise and gain if market interest rates fall.

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(iii) FUTURES CONTRACTS

▪ A futures contract is an obligation to buy (or sell) a

specified asset on a specified date at a specified price.
▪ Settlement is either
– by delivery, or
– by taking an equal but opposite position and settling by paying the
difference between the two prices
▪ It is like a forward contract except for being
– a standardised contract - only the price may change
– exchange traded
▪ Example: 90 day bank bill futures contract

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(iii) FUTURES CONTRACTS

Example of trading futures:

– If a bank buys a bond futures contract
– Then when it closes out its position it must sell an equal contract at
the new price.

▪ If interest rates fall, bond prices will rise, and the bank will
sell at a profit.
▪ If interest rates rise, bond prices will fall, and the bank will
sell at a loss.

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(iii) FEATURES OF A FUTURES CONTRACT

▪ An exchange traded product

▪ Generally not longer than two years
▪ Separate from physical transaction
▪ No exchange of principal
▪ Settlement by physical delivery or closing out early by
buying/selling an equal but opposite position

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(iii) IMPLICATIONS OF A FUTURES CONTRACT

▪ The buyer of a bond futures contract will profit if market

interest rates fall and lose if market interest rates rise.
▪ The seller of a bond futures contract will lose if market
interest rates fall and gain if market interest rates rise.
(And so it is opposite to the FRAs)

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(iv) OPTIONS

▪ A call option is the right to buy an asset at a specified

exercise price on or before the exercise date.
▪ A put option is the right to sell an asset at a specified
exercise price on or before the exercise date.
▪ Options can be exchange traded or issued in the ‘over the
counter’ market.

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(iv) OPTIONS ARE DIFFERENT

▪ FRAs, futures and swaps result in gains or losses

depending on the movement in market prices.
▪ Options are different from other derivatives as they
allow the holder to avoid market losses while being
able to benefit from market gains.

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IMPORTANCE OF DERIVATIVES

▪ Derivatives are contracts relating to future

transactions but the transactions have not yet taken
place.
▪ Derivatives affect bank risk and return.
– Revenue and costs from these transactions appear on the
income statement – they impact on profitability.
– These transactions also affect bank risk.
▪ increase risk if there are no offsetting transactions
▪ reduce risk if there are offsetting transactions (hedging)

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WHY DO BANKS USE DERIVATIVES?

Banks use derivatives in order to:

1. augment bank earnings through speculation and
arbitrage (this generally increases bank risk)
2. manage their own risk, that is they hedge or reduce
bank risk
3. earn spread income by providing risk management
products for their customers with minimal impact on
risk
(these points are discussed in subsequent slides)

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1. BANK SPECULATION

▪ Banks augment their earnings through speculation and

arbitrage = (generally) increase bank risk
– Speculation involves forecasting market price changes and
taking a position to profit from this.
– Arbitrage involves finding a product trading in two markets at
different prices – buying in the cheaper market and selling in
the expensive market – thereby making a profit.
▪ In practice this generally involves taking on more risk.

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1. BANK SPECULATION (USING FRAs)

▪ Method:
– If the bank forecasts that interest rates will rise above the FRA
rate quoted by another bank then it could speculate by taking an
FRA position which would gain if interest rates rise.
▪ That is by taking a buyer position.
– If the bank forecasts that interest rates will fall below the quoted
FRA rate then it could speculate by taking an FRA position which
would gain if interest rates fall.
▪ That is by taking a seller position.
Outcome: If the bank is correct it will profit, if the bank is
wrong it will make losses.

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1. BANK SPECULATION (USING FRAs)

Example:
▪ The current FRA rate is 7%.
▪ The bank predicts that future interest rates will rise above
7%.
▪ To speculate – take a buyer position.
▪ Assume FRA contract relates to a security with
– nominal value $500,000
– maturity 180 days (6 months)

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1. BANK SPECULATION (USING FRAs)

FRA rate = 7%
Buyer Seller
(Bank)
Market rate

In six months’ time (on the settlement date):

▪ If market rates have risen to 7.75%, then the market rate on
the settlement date is 7.75% .
▪ And to settle: the seller pays the buyer 0.75%
In this case the speculating bank would make a profit.

(To calculate the actual dollar amount of the payment – use

the bill pricing formula)

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1. BANK SPECULATION

FRA settlement:
Step 1. Calculate price @ 7.75%
500,000 Nominal value = $500,000
1 + 0.0775 × 180/365 Maturity = 180 days

= $𝟒𝟖𝟏, 𝟓𝟗𝟑. 𝟖𝟖
Step 2. Calculate price @ 7.00%
500,000
1 + 0.07 × 180/365 Market rate (7.75%) is
= $𝟒𝟖𝟑, 𝟑𝟏𝟓. 𝟔𝟖 more than FRA rate
(7%), so the seller pays
Step 3. Compensation due the buyer (bank makes
profit of $1,721.8)
= $𝟏, 𝟕𝟐𝟏. 𝟖𝟎

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1. BANK SPECULATION

FRA rate = 7%
Buyer Seller
(Bank)
Market rate

BUT In six months’ time (on the settlement date):

▪ If market rates have fallen to 6%, then the market rate on
the settlement date is 6%.
▪ And to settle: the buyer pays the seller 1%
In this case the speculating bank would make a loss.

(To calculate the actual dollar amount of the payment – use

the bill pricing formula)

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2. BANK HEDGING (USING FRAs)

▪ Banks manage their own risk by hedging bank risk =

reduce bank risk.
– Derivatives provide a hedge in which the change in the
physical market is offset by an opposite change in the
derivative market.
– The bank must find a derivative position with an opposite
exposure to the risk position it wants to hedge.
▪ Method: consider your position in the physical market
and then choose a position in the FRA market which
has an opposite exposure.

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2. BANK HEDGING (USING FRAs)
▪ In the physical market
– A borrower planning to
borrow in the future
▪ gains if interest rates fall
▪ And loses if interest rates
rise
▪ To hedge IR risk: buy an
FRA.
– Because the borrower
loses if interest rates rise
but the FRA buyer gains if
interest rates rise.
– That is he has an opposite
exposure to interest rates.
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▪ In the physical market
– An investor planning to
invest in the future
▪ gains if interest rates rise
▪ And loses if interest rates
fall
▪ To hedge IR risk: sell an
FRA.
– Because the investor loses
if interest rates fall but the
FRA seller gains if interest
rates fall.
– That is he has an opposite
exposure to interest rates.
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2. BANK HEDGING (USING FRAs)

Example:
▪ ABC bank has committed that in 3 months’ time it will
lend $500K for 6 months (180 days).
▪ The bank needs to borrow to finance $500K loan. If
market rates rise the bank’s cost of funds will rise and
the loan would not be profitable.
To summarise: the bank faces interest rate risk.

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2. BANK HEDGING (USING FRAs)

▪ The bank is planning to borrow in the future.

– It will lose if interest rates rise and gain if interest rates fall.
▪ Bank hedges an increased interest rate risk by buying an
FRA.
Quote: 3M v 9M 7.00 (= FRA rate)

Note: The buyer of an FRA will gain if interest rates rise

and lose if interest rates fall.

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2. BANK HEDGING (USING FRAs)

FRA rate = 7%
Buyer Seller
(Bank)
Market rate

In three months’ time: (on the settlement date)

▪ If market rates actually have risen to 7.75%, then the
market rate on the settlement date is 7.75%.
▪ To settle: the seller pays the buyer 0.75%
(To calculate the actual dollar amount of the payment – use
the bill pricing formula – refer to the previous example)

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2. BANK HEDGING (USING FRAs)

▪ Cash settlement on settlement date, here the

seller pays buyer (i.e. the bank) a $ amount worth
0.75%.
▪ When the bank goes to the market to borrow funds to
finance its loan commitment, the bank will have to pay
7.75% (i.e., 0.75% higher than FRA rate).
▪ The profit from the FRA will offset the extra funding cost
and so the bank will make the original spread on the
loan.

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2. BANK HEDGING (USING FRAs)

▪ If the market rate had been lower than 7% (say 6.2%)

then the bank would have had to pay out on the FRA
(the interest differential of 0.8%) but this would have
been offset by the lower cost of borrowing.
▪ The loss from the FRA would be offset by the lower
interest cost - the bank will still make the original
spread on the loan. It does not matter whether interest
rates go up or down.
▪ By entering into the FRA the bank’s interest rate risk
has been reduced because a change in market
interest rates would now have little effect on the
bank’s profitability.

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3. BANK INCOME EARNING

▪ Banks earn spread income by providing risk management

products for their customers.
– By running a matched book, banks minimize risk.
– A matched book has equal buy and sell positions – that is the
face value, the quality, the maturity date, the life of the
instruments are all equal. The only difference is the interest
rate or price.
– For example, the bank
▪ Is the seller for one transaction and the buyer for the matched
transaction.
▪ Is the borrower for one transaction and the lender for the matched
transaction.
▪ Has the short position for one transaction and the long position for
the matched transaction.

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3. BANK INCOME EARNING

Risk:
▪ On a matched book the bank earns the spread
regardless of any changes in the market interest rate.
▪ On a matched book the bank does not incur market and
interest rate risk.
▪ The bank does incur credit risk and operational risk.

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3. BANK INCOME EARNING

Bank runs a matched FRA:

10.5% 10.1%
Buyer Bank Seller

Market rate Market rate

Bank always earns the spread = 10.5% – 10.1% = 0.4%

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LECTURE SUMMARY

▪ Definition and the importance of OBS activities

▪ Non-market-related OBS activities
▪ Market-related OBS activities (derivatives)

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