Prime Bank Letters of Credit, Guarantees, Bank Obligation instruments and derivatives, etc.
Letters of Credit are issued in a manner recognized by the Bank for International Settlements (B.I.S.) and the International Chamber of Commerce (I.C.C.), and are subject to the Uniform Rules of Collection for Documentary Credits (ICC 500, Paris 1993) as it relates to Prime Bank instruments.
This type of instrument is normally called a Documentary Letter of Credit (”DLC”) and is always trade or transaction related, with an underlying sale of goods or services between the applicant (Buyer) and the beneficiary (Seller).
During the evolution of trade related Letters of Credit a number of institutions issued Standby Letters of Credit (”SLC’s”). These credit instruments are effectively a surety or guarantee that if the applicant (Buyer) fails to pay or perform under the terms of a transaction, the bank will take over the liability and pay the beneficiary (Seller).
In the United States, banks are prohibited by regulation from providing formal guarantees on behalf of clients and instead offer these instruments as the functional equivalent of a guarantee.
A conventional Standby Letter of Credit (CSCL) is an irrevocable obligation in the form of a Letter of Credit issued by a bank on behalf of its Customer. It is used where the bank’s customer may be unable to meet the terms and conditions of its contractual agreement with a third party (as stipulated in the terms of the CSLC) and assumes liability on behalf of its customer. A CSCL can be primary (direct draw on the bank) or secondary (available in the event of default by the customer to pay the underlying obligation). [Extracts from “Recent Innovations in International Banking – April 1986” prepared by a study group established by the Central Banks of the Group of Ten Countries and published by the Bank for International Settlements].
Such Standby Letters of Credit are effectively contingent liabilities based upon the potential formal default or technical default of the applicant, and they are thus held “off balance sheet” as far as the bank’s accounting practices are concerned. This arrangement is acceptable under the current rules laid down by all Regulators (such as the Bank of England and the Federal Reserve) under rules for Standby Letters of Credit
During the period when SLC’s were being evolved, the banks, and their customers, began to see the potential profitable situation created by such “off balance sheet” positioning. In absolute terms the issuing of a Standby Letter of Credit when attributed as a “contingent” liability and, as such held “off balance sheet” is therefore an unregulated position.
Due to constraints imposed on the banks by Regulatory bodies, and Government controls, the use of these “off balance sheet” items as financial tools has increased. They effectively adjust the capital asset ratios of banks, and are seen to be a method of staying within regulation guidelines, yet achieving desired capital situations as well.
At the request of Central Bank Governors, of “the Group of Ten countries”, a study Group was established in early 1985 to examine these recent innovations in the conduct of international banking.
The Study Group carried out extensive discussions with the international commercial and investment banks that are most active in the field of new financial instruments. The purpose was both to improve Central bank knowledge of the instruments and their market, as the situation existed in the second half of 1985. It was also to provide a foundation for considering the implications for the stability and functioning of international financial institutions. How they affected monetary policy, banking financial reporting and statistical reporting of international financial transactions.
Alongside this work the Basle Supervisors’ Committee undertook a study of the relevant aspects of banking innovations. They produced a report on the management of Banks’ “off balance sheet” exposures and the supervisory implications. This was published by the Committee in March 1986.
The growth of these credit instruments can be attributed generally to the same factors affecting the trend towards securitisation, with two additional influences. Firstly, Bankers have been attracted to the off-balance sheet business because of increasing constraints imposed on their balance sheets. This has been notably by regulatory pressure to improve capital ratios.
Off balance sheet transactions offer a simple way to improve the rate of return earned on assets. Secondly, for similar reasons, Banks have sought ways to hedge interest rate risk without inflating balance sheets, as occurs using the established interbank market. [Extracts from “Recent Innovations in International Banking – April 1986” prepared by a study group established by the Central Banks of the Group of Ten Countries and published by the Bank for International Settlements.]
Why should such an instrument be issued?
To understand the logic behind the mechanics of the operation it is necessary to look at the way in which a Bank usually works. The bank’s credit rating and status is judged by the “size” of the bank and its capital/asset ratio. The Bank lists its real assets and its cash position, including deposits, securities, etc., against its loans, debts and other liabilities, showing a ratio of liquidity. Each jurisdiction in the world banking system has different minimum capital adequacy requirements and, depending on the status of the individual bank, the ratio over assets which a bank may effectively lend. This ratio can be as high as 20 times the minimum capital requirement
In simple terms, for every US$100 held in asset/capital, the bank may lend or obligate at least US$1,000 to other clients or institutions against cash on hand. The money placed on deposit by the bank’s customers is dealt with in a different manner to the actual cash reserves or assets of the bank. If the bank disposes of any asset, the resultant capital is able to be “leveraged” using the bank’s multiplier ratio, based on minimum capital adequacy requirements.
Thus a bank receives an indication from a client that the client wishes to obtain from his bank a one year obligation instrument in favour of a nominated beneficiary. It will be at zero interest, and is effectively unsecured by any existing asset of the bank. Once issued therefore, the credit instrument is based solely on the “full faith and credit worthiness of the bank”. The Bank will quote its customer a price for such an instrument to be issued with interest paid in advance.
Obviously, the format of any Credit Instrument must be one which is acceptable to a beneficiary in most jurisdictions, be freely transferable, and able to be settled at maturity in simple terms, without restrictions other than maturity conditions.
The ideal Instrument is the Letter of Credit or Standby Letter of Credit. It is a time payment Instrument, due usually on or after one year and one day from the date of issue, and normally valid for a period of fifteen days after the date of maturity.
Standby Letters of Credit can serve as substitutes for simple or first demand guarantees. In practice, the Standby Letter of Credit functions almost identically to a first demand guarantee. The beneficiary’s claim is made payable on demand without independent evidence of its validity. The Instruments are security devices and can be issued for transactions not directly involving the sale goods, although they may be “for financial services”. [Extract from “Standby Letters of Credit : Does the Risk Outweigh the Benefits?” published in the 1988 Columbia Business Law Review].
The Instruments are “issued” with standard texts for “ten million US Dollar denominations face value”, signed and sealed by duly authorised bank officers. The question is “what is the piece of paper worth”? It is completely unsecured by any tangible or real asset. In reality it merely has a “perceived value of say US$10 million” payable in 366 (367 in a leap year) days time, based upon the “full faith and credit of the Bank”. Everything depends on the credit worthiness of the Issuing Bank.
Will the Bank honour its obligation when the bank note or credit is presented? This will depend entirely upon the credit worthiness and hence reputation of the Issuing Bank. Thus the “belief is” that the Instrument value is US$10 million in 366 (367) days time, and the “Client” must negotiate a price, or discount, acceptable to his Bank to cause it to “issue” the credit.
To arrive at an issue price one has to determine the accounting ramifications of the transaction value to the issuing Bank. The liability is US$10 million payable “next year and one day”. It is important to note that the reason for one year and one day period is to take the liability into the “next” financial year, no matter when the credit is issued. Thus the liability is held “off balance sheet” and is technically therefore a contingent liability because it is not based upon any assets. However, the Bank will receive cash immediately from its Client for the Issue and this cash will be classified as a capital asset. This capital asset is in turn subject to the ratio multiplier, referred to above, as laid down by its Regulator, (say 10 to 20 times).
The Issuing Bank may ask, for instance, 86% of the face value from its client to create the issue. This will provide US$8.6 million cash on hand, against a forward liability of US$10 million in one year and one days time. The actual contingent liability is therefore US$1.4 million. The cash received from the Client, US$8.6 million, may then be lent 10 to 20 times this amount under the Bank’s capital adequacy rules. Thus US$8.6 million is able to be lent (this time on the Bank’s Balance Sheet) against normal securities, such as real estate, shares etc.
If the lending interest rate is 8% simple per annum, and the loan is short-term, say one year, to coincide with the liability, then the income and return (without taking into account the principle sums loaned) from interest alone is equal to (@ multiplier of 10) US$6.88 million.
In this example at the end of the year the credit is due for payment against cash on hand and interest received. In other words, US$8.6 million plus US$6.88 million, to a total of US$15.48 million less the US$10 million committed liability which will show a gross profit of US$5.48 million (or 47%) plus the full value of the loan amounts.
The return to the Issuing Bank after issuing the credit is well in excess of the given discount to the Client, and the Bank is placed in this profitable position without any risk whatsoever. Also the Bank achieves a much greater asset yield than by more conventional Banking means.
There is, however, a much greater underlying reason, when an overview of the complete Banking supply system is taken. One which is powerfully indicated by all the evidence.
The Federal Reserve Bank is not a Federal Government entity or body. It is, in fact, a private institution. It may well operate in a quasi-government manner but it is absolutely under the control of private individuals.
If one assumes that the money supply requirements for a specific period indicates a need to print say US$100 million of new issue currency, then the U.S. Treasury is required to issue the same. The impact of the release of “New Dollars” in terms of increased inflation and depressed market effect is material.
If, however, the U.S. Treasury operating privately through the Federal Reserve Bank is asked to forward “sell” those Dollars for “cash” the amount of “new” Dollars required is reduced by whatever amount is clawed back by such a sale.
Suppose the Federal Reserve Bank “contracts” with a major World Bank to “issue” Dollar denominated one year paper in the amount of US$100 million and “offers” this paper through a secure network of Clients. The “offer” may be made at a discount of say 80% of face value. The cash clawed back to the U.S. Treasury would be US$80 million against a paper dollar credit of same amount to the Issuing Bank.
For the privilege of pursuing this transaction the Issuing Bank would take a US$100 million liability position against a contingent future maturity date for the reasons set out above.
The U.S. Treasury thus receives US$80 million in cash clawed back in from circulation and needs only to print US$20 million to meet its forecast obligation to the money supply. Thus 20% of the original amount has a much reduced impact on the system. Of course, if the amount “issued” is greater than the money supply requirement, the U.S.
Treasury achieves a reduction in the amount in circulation, which in turn allows lower interest rates to be maintained and/or controlled.
The long-term position is not affected as the Issuing Bank in question takes on the liability, not the U.S. Government. The paper Dollar credit is classed as “cash” for the purpose of capital adequacy and is physically “printed” as such.
The market issue and sale of all such bank credit instruments is controlled by supply and demand. All U.S. Dollar denominated paper is thus “issued” with the control of and “blessing of” the Federal Reserve Bank.
To achieve this, the Federal Reserve Bank, it appears, enters into an understanding between the U.S. Treasury and top World Banks (excluding state operated banks, American banks, with the exception of Morgan Guaranty, Third World Banks and all other banks which have a capital/credit problem). The current list totals some 62 banks, mostly European.
Each bank agrees to allow the Federal Reserve Bank to allocate, on its behalf, a specific amount of U.S. Dollar denominated paper. The details are kept confidential, they are not published and no evidence is in the public domain. However, the result is that a specific volume of Dollar denominated paper is from time to time available and the Federal Reserve Bank can release it on demand.
This amount of bank obligation paper is “pooled” to provide a total position each year, and it is from this “Federal Pool” that supply contracts can be issued by the participating Banks. Various interbank documents, including GNMA transfer documents, contain the relevant “Pool Number”.
Although the market place and issue of these Instruments is “unregulated”, the Banks are effectively controlled by the B.I.S. and maintain self-imposed rules. Otherwise the whole system would be subject to possible manipulation and abuse by a Bank, or group of Banks, who could enter into a form of “insider trading”, detrimental to the whole Banking system.
The rules are very simple, cash payment is required at all times for all Instruments ordered. This business is strictly cash driven. The non-regulatory position of these Instruments create a major problem for all regulated entities. How can a high denomination unregulated item be handled by a regulated body?
It appears the main reason for the highly confidential nature of the processing of these credit Instruments is that it is perceived as a sophisticated form of financial engineering, which makes “normal” accounting principles a complete mockery. It exposes the banking system to the charge of conducting massive unregulated business which, for the most part, is off Balance Sheet with all its implications.
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