This is “Off the Balance Sheet”, section 9.6 from the book Finance, Banking, and Money (v. 1.1).
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To protect themselves against interest rate increases, banks go off road, engaging in activities that do not appear on their balance sheets.This is not to say that these activities are not accounted for. It isn’t illegal or even slimy. These activities will appear on revenue statements, cash flow analyses, etc. They do not, however, appear on the balance sheet, on the list of the bank’s assets and liabilities.Banks charge customers all sorts of fees, and not just the little ones that they sometimes slap on retail checking depositors. They also charge fees for loan guarantees, backup lines of credit, and foreign exchange transactions. Banks also now sell some of their loans to investors. Banks usually make about .15 percent when they sell a loan, which can be thought of as their fee for originating the loan, for, in other words, finding and screening the borrower. So, for example, a bank might discount the $100,000 note of XYZ Corp. for 1 year at 8 percent. We know from the present value formula that on the day it is made, said loan is worth PV = FV/(1 + i) = 100,000/1.08 = $92,592.59. The bank might sell it for 100,000/1.0785 = $92,721.37 and pocket the difference. Such activities are not without risks, however. Loan guarantees can become very costly if the guaranteed party defaults. Similarly, banks often sell loans with a guarantee or stipulation that they will buy them back if the borrower defaults. (If they didn’t do so, as noted above, investors would not pay much for them because they would fear adverse selection, that is, the bank pawning off their worse loans on unsuspecting third parties.) Although loans and fees can help keep up bank revenues and profits in the face of rising interest rates, they do not absolve the bank of the necessity of carefully managing its credit risks.
Banks (and other financial intermediaries) also take off-balance-sheet positions in derivatives markets, including futures and interest rate swaps. They sometimes use derivatives to hedge their risks; that is, they try to earn income should the bank’s main business suffer a decline if, say, interest rates rise. For example, bankers sell futures contracts on U.S. Treasuries at the Chicago Board of Trade. If interest rates increase, the price of bonds, we know, will decrease. The bank can then effectively buy bonds in the open market at less than the contract price, make good on the contract, and pocket the difference, helping to offset the damage the interest rate increase will cause the bank’s balance sheet.
Bankers can also hedge their bank’s interest rate risk by engaging in interest rate swaps. A bank might agree to pay a finance company a fixed 6 percent on a $100 million notational principle (or $6 million) every year for ten years in exchange for the finance company’s promise to pay to the bank a market rate like the federal funds rate or London Interbank Offering Rate (LIBOR) plus 3 percent. If the market rate increases from 3 percent (which initially would entail a wash because 6 fixed = 3 LIBOR plus 3 contractual) to 5 percent, the finance company will pay the net due to the bank, (3 + 5 = 8 − 6 = 2% on $100 million =) $2 million, which the bank can use to cover the damage to its balance sheet brought about by the higher rates. If interest rates later fall to 2 percent, the bank will have to start paying the finance company (6 − [3 + 2] = 1% on $100 million) $1 million per year but will well be able to afford it.
Banks and other financial intermediaries also sometimes speculate in derivatives and the foreign exchange markets, hoping to make a big killing. Of course, with the potential for high returns comes high levels of risk. Several hoary banks have gone bankrupt because they assumed too much off-balance-sheet risk. In some cases, the failures were due to the principal-agent problem: rogue traders bet their jobs, and their banks, and lost. In other cases, traders were mere scapegoats, instructed to behave as they did by the bank’s managers or owners. In either case, it is difficult to have much sympathy for the bankers, who were either deliberate risk-takers or incompetent. There are some very basic internal controls that can prevent traders from risking too much of the capital of the banks they trade for, as well as techniques, called value at riskhttp://www.gloriamundi.org/ and stress testing,http://financial-dictionary.thefreedictionary.com/Stress+Testing that allow bankers to assess their bank’s derivative risk exposure.