Data Warehousing and Business Intelligence

16 June 2013

Off Balance Sheet Items

Filed under: Business Knowledge,Finance,Investment Banking — Vincent Rainardi @ 8:02 am

What are off balance sheet items in investment banking? This short article tries to answer this question. In a finance data warehouse for investment banking, we have to know what are off B/S items because we have to report on it.

Balance Sheet and Profit & Loss

In finance or accounting we have five account types: asset, liability, equity, revenue and cost. The first 3 are balance sheet accounts (B/S), the last 2 are profit & loss accounts (P&L). Asset is a debit account (Dr), whereas liability and equity are credit account (Cr). Revenue is Cr, cost is Dr.

In banking the examples are:

  • Assets: balances at central banks, trading portfolio assets, loans to banks, loans to customers, repurchase agreements, debt securities, equity shares, derivatives, property, settlement balances
  • Liabilities: banks deposits, customer deposits, repurchase agreements, short positions, debt securities, trading portfolio liabilities, derivatives
  • Revenues: net interest income, fees and commissions, income from trading activities, other operating income
  • Costs: staff costs, indirect costs

Off-Balance Sheet (Off B/S)

Off balance sheet items consists of 2 things: guarantees, derivatives and managed assets.

Guarantees are basically: if the client can’t pay, we pay (“we” as in: “the bank”). And we get paid a fee for this. There are various form, the most popular ones are standby letter of credit and loan guarantee.

  • Letter of Credit (L/C) is basically: we pay the seller, regardless the buyer pays us or not. And we get paid a fee for this (from the buyer). L/C is used for payment in a international trade, i.e. a buyer buy something from a seller in another country.
    Standby L/C (SLC) is not L/C. L/C is a form of payment. SLC is a form of guarantee. There are two kinds of SLC:
    1. Performance SLC: we guarantee a construction contract. If the contractor failed to build it in time and in satisfactory quality, we pay.
    2. Financial SLC: we guarantee a company paying money. If they can’t pay, we pay. Example: insurance company paying claims, hedge fund can’t settle the end of day trade balance (lack of cash flow), company can’t pay employee’s salary.
  • Loan guarantee is basically if the obligor can’t pay, we pay. Example: an SME can’t secure funding from a bank (3y FT loan) due to shortfall of security i.e. insufficient collateral. We guarantee the SME will be able to meet their obligation (make the payment everytime it’s due). For a fee of course, from the SME.

There’s also another type of guarantees: note issuance facilities (NIF). When a company issues notes (debt securities), and they can’t sell it, we buy it. Usually we do this in syndication. This is off B/S because the guarantee is only a contigency, so it doesn’t go into B/S. When we have to buy the debt securities, at that time we put it on B/S. Similar to NIF is revolving underwriting facilities (RUF).

Off B/S derivatives covers 5 areas: FX derivatives, interest rate derivatives, credit derivatives, equity derivatives and commodity derivatives.

  • FX derivatives include forward FX contracts (buying or selling FX in the future at a rate agreed today), FX swaps (exchange of interest rates between fix interest rate and floating interest rate, in different currencies), FX options (right to buy or sell FX at a rate agreed today, both OTC and Exchange Traded)
  • Interest rate derivatives include IR swaps (exchange of IR between fix and floating in the same currency), forward rate agreement (like IR swap but starting in the future), OTC options (bought and sold), exchange traded future and options, and IR derivatives cleared by central counterparty (CCP).
    Note: in CCP trade, the OTC contract is replaced by 2 contracts: 1 between the buyer and CCP, and 1 between the seller and CCP. This is to reduce counterparty risk. Example of CCP for IR swap is SwapClear.
  • Credit derivatives include both OTC swaps and the ones cleared by CCP, and both single name and index. Credit derivatives consists of Credit Default Swaps, Credit Linked Note, Collateraized Debt Obligation, Constant Proportion Debt Obligation.
  • Equity derivatives include both equity and stock index. OTC equity options (incl. warrants), equity swaps and forwards, OTC derivatives, and exchange traded equity futures and options.
  • Commodity derivatives include OTC commodity options, commodity swaps and forwards, OTC derivatives, and exchange traded equity futures and options.

Managed assets are client assets, which we manage as a fund manager or asset management firm. We invest the client’s money into equities, cash and bonds, with or without using derivatives. Of course it belong to the clients hence it’s off balance sheet, but the bank has liability to report it.

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