Issue of bank credit and bank guarantee instruments
Off-Balance Sheet Activities
The issue of bank credit and bank guarantee instruments has been a part of daily banking practice for many decades. The best known of these instruments is the commercial letter of credit, which is widely used, in foreign trade. The commercial letter of credit is a guarantee issued by the buyer’s bank to the seller’s bank. It ensures that if the buyer fails to pay or perform under the terms of the transaction, the buyer’s bank will assume the liability and pay the seller. Because these instruments are considered contingent liabilities of the bank (based on the potential default of the applicant), they are accounted for “off-balance sheet”. A glimpse at the current magnitude of off-balance sheet banking was given in a recent press statement in which Deutsche Bank reported its off-balance sheet business at US$800 Billion in 1993 or roughly 2.4 times its on-balance sheet business. For Swiss and American banks, off-balance sheet operations are 7 to 30 times larger than on balance sheet activities.1 Since the 1930’s and with dramatically increasing frequency during the last fifteen years, the largest western European banks (top European 25) have extended the use of off-balance sheet transactions to include issue and sale of various guaranteed senior bank obligations or credit instruments. These include Medium Term Notes (MTN) and one-year, zero coupon, standby letters of credit or (SLC). The medium term debentures are usually ten year notes carrying a 7.5%+ - coupon. These instruments are backed by the full faith and credit of the issuing bank. Several factors have promoted the growth of off-balance sheet banking activities. First they provide a substantial source of additional capital for the banks. The banks augment their capital by issuing notes and are then able to borrow several times (5 to 10 times depending on the multiplier ratio of the country of domicile) from their central bank at lower interest rates. The higher interest paid on the notes is offset by the low interest rate on the much larger central bank borrowing. Second, fee-based issuance of debentures for third parties provides an increasing source of profits to the banks. In 1993, top German and Swiss banks reported record profits from off-balance sheet business, including fee-based trading which now represents their largest source of earnings.
THE FINANCIAL INSTRUMENTS USED IN THE BANK CREDIT INSTRUMENTS MARKETS
The Federal Reserve uses two financial instruments to control and utilize the amount of USD in circulation internationally. These are Medium Term Bank Debentures, also known as Medium Term Notes (MTN) and Standby Letters of Credit (SLC). The Debenture is normally a medium-term note ranging between five to ten years, carrying a coupon paid annually in arrears. Today’s interest rates are in the 7.5% interest range and twenty-year instruments are also sometimes issued. The SLC is usually a one-year term, zero coupon instrument and is used by the Fed to bring USD back into the Treasury. It is a monetary tool that bids up the price of the USD. When the Fed buys back an SLC, it bids the USD price down. Medium Term Bank Debentures are normally used to raise capital for loans and to assist the development of the world infrastructure projects. The SLC used in the international banking markets is a very different instrument than the typical three-party SLC in the Import/Export market. These SLC’s are two party instruments similar to a one-year corporate note, used primarily to raise funds. Banks issue SLCs on behalf of the Fed and the Fed is the customer on the issuing bank. The Bank operates through the Commitment Holder (defined later in this report) and issues the SLC from the Commitment Holders Contract with the Fed. Once an issue is determined, usually by contract and proof of funds, the issuing bank will exchange the SLC for the funds. Normally, a purchase must be initiated with a pledge of $500,000,000 in tranches of no less than $100,000,000 face value. Under the BIS rules, the issuing bank is then required to convert the “off-balance sheet” item to an “on-balance sheet” equivalent. This is done by writing on-balance sheet the “risk” in the transaction and setting aside the capital reserved against the risk exposed, based on capital requirements. As the risk is very low, and 97-98% of the face value is paid by the Fed to the issuing bank upon maturity, the capital needed to be reserved is also very low, usually 4-5%. As an example, the issuing bank will issue the MTN at 78% of face value, and sell it to the Commitment Holder at 84%. The issuing bank will reserve 5% for margin cost of capitalization and transfer 79% back to the Fed. The Commitment Holder will sell the MTN to the Investor for 86% of face value. The Investor will sell the MTN to the secondary market for 92.5% where the retail market equivalent is 93.5% for U.S. Treasuries at that time. In this way, each transaction is attractive to the next holder in due course and all parties profit. Upon maturity, the Fed under its Commitment Holder Contract will remit 95% of face value plus a 2% fee to the issuing bank and in addition a $5 Million USD reserve is released by the issuing bank back to the Fed. The Fed provides these margins to be competitive against other governments for large deposits of USD, and to attract the USD exactly when they require it. Against these margins, the Fed utilizes the funds against another bank’s guarantee for the term and they are able to maintain the benefits as outlined below. The issuing banks for their small cost, but large fee, receive the benefits as listed below inclusively. Benefits for both that by far outweigh the costs. MTN %of Spread Bank Margin Disc. Issuance Face Earned Fees Fed Price Value Remission Issuing Price 78% 6% 5% 79% 97% Commitment 84% 2% 86% Holder Price Selling Price 86% 6.5% 92.5% Secondary Market Price 92.5% 1.0% 93.5% Retail Market 93.5% 6.5% 100% USD Remitted 95% 2% To Fed at Maturity USD Released 5% By Bank to Fed
The foregoing memorandum is for informational purposes only and should not be construed as an offer to sell nor a solicitation to buy a Bank Credit Instrument trading program nor an offer to sell nor a solicitation to purchase a Bank Credit Instrument. It is highly recommended that the readers rely solely on their own judgment and experience as they utilize any of the ideas contained herein. This memorandum was designed to provide accurate and authoritative information in regard to the subject matter covered. It is presented with the understanding that the author is not engaged in rendering legal, accounting or other professional services. If legal advice or other professional assistance is required the services of a competent professional person should be sought. The above information is given in good faith and has been derived form different sources believed to be accurate and reliable. This page is for information purposes only and does not constitute an offer, or an invitation to receive offers to purchase or sell any security or other financial instrument or to engage in any form of business or dealing in any jurisdiction. AP Venture Capital Ltd. - does not accept any responsibility arising in any way - including by reason of negligence - for errors in, or omissions from, this information. INFORMATION SOURCE: Authentically from WCF - The Strategic Think Tank of Specialist Banking & Management Associates on Capital Management, Private Wealth Management and International Relations Management. Dr. Thomas C. Heynen, Chairman & Executive Director.
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Last modified: Feb 27, 2006 at 10:15:40 PST