Off Balance Sheet Activities

3 Key excerpts on "Off Balance Sheet Activities"

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  eBook - ePub

  Contemporary Financial Intermediation

  • Stuart I. Greenbaum, Anjan V. Thakor(Authors)
  • 2007(Publication Date)
  • Academic Press

    (Publisher)

  Derivative: A financial contract, also called a contingent claim, whose value depends on the values of one or more of the underlying assets or indices of asset values. For example, Treasury-bill futures derive their value from movements in the T-bill rate. Bank regulators and banks themselves refer to derivatives more narrowly as contracts, such as forwards, futures, swaps, and options, whose primary purpose is not to borrow and lend but rather to transfer risks associated with fluctuations in asset and liability values.

  Initial Public Offering: A public stock offering that converts a privately held firm into a publicly held corporation.

  Introduction

  Once negligible in amount, and therefore worthy of no more than passing mention in banking texts, off-balance sheet items of banks now amount to trillions of dollars in the United States. They include contingent claims that represent a variety of exposures across markets and credit risks—standby letters of credit, interest rate and currency swaps, note issuance facilities, options, foreign currencies, fixed- and variable-rate loan commitments, and futures and forward contracts on everything from Treasury bills to gold. Loan commitments are among the largest components of the off-balance sheet items of banks. Also, when added together, off-balance sheet items exceed the total recorded assets of most large banks. This is a little misleading, however, since only some contingent claims impose a (contingent) liability on the bank, and this contingent liability is only a fraction of the nominal amount of its outstanding contingent claims. Nonetheless, these data highlight the enormous importance of off-balance sheet items in the current banking environment. The enormous growth in contingent claims of banks has coincided with an explosion in the growth of exchange-traded contingent claims like options and futures. Figure 8.1 depicts the global growth of exchange-traded options and futures.

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  eBook - ePub

  Efficiency and Productivity Growth

  Modelling in the Financial Services Industry

  • Fotios Pasiouras(Author)
  • 2013(Publication Date)
  • Wiley

    (Publisher)

  Another paper by Clark and Siems (2002) confirms that cost X-efficiency increases upon including OBS activities, but profit X-efficiency does not. Other results revealed that bank size and off-to-on-balance sheet mix of banking activities are not related to cost or profit X-efficiency. Tortosa-Ausina (2003) also reports mixed evidence, with OBS activities improving the cost efficiency of some groups of banks but lessening efficiency among other groups. However, Rao (2005) examines banks in the United Arab Emirates and finds OBS activities tend to reduce bank operating costs. More recently, Pasiouras (2008) finds that OBS items do not have a significant impact on efficiency scores of Greek commercial banks in the period 2000–2004. Finally, numerous efficiency studies (e.g., see Berger and Mester, 1997; Bos and Kolari, 2005; Saunders and Walter, 1994, and others) have incorporated OBS activities in cost and profit efficiency analyses, but their inclusion is peripheral to their main ­purposes. In general, these studies establish that OBS activities should be counted as an output to accurately measure bank efficiency. However, no studies investigate potential scale and scope economies of OBS activities themselves. In the forthcoming analyses, we seek to fill this gap in the literature.

  4.2 Off-balance sheet activities of European banks

  OBS activities are comprised of loan commitments, credit risk guarantees (e.g., standby letters of credit, revolving underwriting facilities, and credit derivative swaps), and various derivatives contracts (e.g., swap, futures, forwards, and options contracts). Banks utilize OBS operations to manage on-balance sheet risks as well as provide client hedging risk management services. With respect to on-balance sheet risk management, securitization of home and other loans has allowed banks to create vehicles that move these loans OBS. While the notional value of derivative instruments is held OBS, their fair value is carried on the balance sheet. OBS activities generate revenues but have little or no effect on total assets (see Ronen, Anthony, and Sondhi, 1990). Consequently, OBS can boost profit ratios greater than traditional on-balance sheet activities per unit of labor. Since little or no investment in assets is required, operating costs are reduced per unit aggregate output. Hence, there are practical reasons to believe that OBS cost and profit efficiencies exist.

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  Capital Structure Decisions

  Evaluating Risk and Uncertainty

  • Yamini Agarwal(Author)
  • 2013(Publication Date)
  • Wiley

    (Publisher)

  Chapter Six

  Role of Off–Balance Sheet Capital

  OFF–BALANCE SHEET ITEMS ARE strategic capital investments that hedge risk and provide capital support to a firm. Capital is primarily necessary for the operations of the firm; it provides a risk cushion, and it incentivises future expectations. Through its operations, a firm generates several contingent claims to support the need for operational, risk, and signaling capital. Such contingent claims do not directly support the firm’s operations, but they provide strategic value to a firm’s ROE and ROA by reducing the burden of balance sheet liabilities. Instruments of off–balance sheet capital have earned themselves a bad name, with the mismanagement of such capital by Enron, Barring Banks, and others. It is undeniable that such capital adds strategic value by securing value-added risk, if and only if it is managed properly

  Most off–balance sheet items are recognised with insurance covers and derivative products, as mentioned in the previous chapter. Such instruments support only the passive and value-added risk of a firm. Off–balance sheet capital is beyond the use of such instruments. It uses contingent claims on financial contracts to support investments in fixed assets, provides for working capital, supplies risk-management tools for selective exposures, and also offers incentive schemes for a firm’s management and signaling capital. Innovations of leasing, hire purchase, factoring, revolving credits, derivatives, insurance covers, warrants, convertibles, and employee stock options support the capital needs of a firm. There are several informal arrangements in the industry that support and guide capital for different strategic exposures that are known and unknown to the financial academic world. We cover a few well-known strategic financial contracts in this chapter.

  Cash outlays and obligations are important considerations for a firm. Given the limited access and scarcity of cash and capital flow for both large and small firms, judicious evaluation of various alternatives becomes essential. Capital allocation demands that firms estimate the cost of blocking funds into fixed assets, current assets, or other hedges. Similarly, a firm would need to build up stakeholders’ expectations about, and confidence in, the firm and its future earnings. Firms that constantly struggle to obtain a good-quality cash flow cannot block investment in fixed assets and current assets or seek claims that may increase the probability of default. Capital investments in fixed assets can be reduced by using financial contracts such as leasing and factoring that provide for the economic use of an asset without having to own it. Similarly, capital that is blocked in current assets, such as receivables, can be easily converted into cash, using factoring and securitisation. In the same vein, instead of keeping ideal resources to hedge the selective risks of currency volatility, interest rates, or earnings, a firm may choose to chip out a small amount of capital as premiums to purchase instruments such as insurance covers or derivatives. Creditors, government bodies, investors, and other parties constantly evaluate the equity stakes of a firm before making their investments. A firm can create a positive impact on its probability of default by using debt-to-equity conversion instruments, such as convertibles; by using option contracts, such as warrants; or by linking investment plans with ownership through employee stock option schemes. We discuss a few options in this chapter.

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