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Banking & Finance
AN EIGHTH DISTRICT PERSPECTIVE
FALL 1988

Standby Letters of Credit and Capital
Requirements
During the 1980s, the trend toward more stringent capital
adequacy standards in bank regulation has constrained asset
growth at many of our nation’s banks. In other words, banks
have attempted to increase their capital-to-asset ratios by
restricting the growth of assets listed on their balance sheets.
At the same time, however, standby letters of credit (SLCs)
and other “off-balance sheet” transactions have experienced
tremendous growth. Regulators are concerned that offbalance sheet exposure may increase capital risk even as
banks strengthen their capital-to-asset ratios. From a
regulatory perspective, the general improvement in capital
adequacy positions serves to reduce default risk and to protect
the deposit insurance fund. However, default risk and the
liability of the deposit insurance system also depend on the
degree of asset risk assumed by banks. To the extent that
asset risk has increased in recent years, the effects of the
higher capital levels may have been offset.
This article looks at one example of off-balance sheet
banking, standby letters of credit, and explains how these
transactions will be accounted for under the new risk-based
capital guidelines.

Standby Letters of Credit
A standby letter of credit is a contractual arrangement
involving three parties. The bank, as issuer of the letter of
credit, guarantees that the bank’s customer will meet an
underlying contractual obligation to the beneficiary. The SLC
underwrites the beneficiary’s risk of loss should the account
party fail to repay a debt obligation.
When an SLC is used to back a debt obligation, the bank
assumes the default or credit risk of the loans
to its customer, and a third party funds the
loan. By issuing an SLC, many of the
services associated with commercial lending,
such as credit risk evaluation, are separated
from the actual funding of the loan. Through
this separation, a bank can earn fee income
w ithout having to put an asset or
corresponding liability on its balance sheet.




A Growing Market
As indicated in the table on the following page, the
nationwide SLC market has grown rapidly over the last
several years, from less than $50 billion at year-end 1980
to more than $160 billion in June of this year. At the 36 largest
banks in the nation, those with assets more than $10 billion,
SLCs now exceed $124 billion. Across the nation, more than
2,000 banks had SLCs outstanding as of mid-year, a notable
increase from the 177 banks in December 1980.
A similar pattern of growth for SLCs has occurred at banks
in the Eighth District. SLCs outstanding as of June 1988
totaled approximately $1.5 billion, slightly less than 10 times
the dollar volume reported in December 1980. In addition,
the number of District banks participating in the SLC market
has expanded from seven at year-end 1980 to 160 in June
of this year.
One reason for the growth in SLCs is that these
instruments provide a way for a bank to increase its effective
leverage. Currently, banks must hold a fixed amount of
capital against all booked assets. One way for a bank to avoid
this requirement is by issuing a contingent liability such as
an SLC, which is not categorized as an asset and, therefore,
not subject to capital requirements. Thus, the presence of
these unbooked liabilities effectively increases capital
leverage, creating an incentive for banks to shift toward the
fee income generated by SLCs and other off-balance sheet
activities that do not absorb capital.
Another explanation for the growth in this market is that
SLCs permit banks to separate the credit risk from the
interest-rate risk associated with a loan. The bank can
underw rite the credit risk while the
beneficiary bears the risk of any change in
the value of the loan caused by interest rate
movements.

Capital Adequacy
Currently, bank regulators place only
limited restrictions on banks’ SLC activities.
They require that banks treat SLCs as loans

FALL 1988

FEDERAL RESERVE BANK OF ST. LOUIS

Standby Letters of Credit
(billions of dollars outstanding)
June 1988

December 1980

$1 6 5 .8 (2294)1
2.1 (1376)
4.5 (478)
3 5 .0 (309)
124.1
(36)

$ 4 2 .6 (177)

United States
A il banks
$100-$300 m illio n 2
$300 m illion-$1 b illio n
$1 -$ 1 0 b illio n
> $ 1 0 billio n

0.0
0 .2 (19)
7.1 (134)
35 .3 (18)

Eighth District
A ll banks
$100-$300 m illio n
$300 m illion-$1 b illio n
$1-$10 b illio n

1.5
0.1
0.2
1.2

(160)
(113)
(30)
(13)

0.2

(7)

0.0
0.0
0 .2

(7)

1The number in parenthesis represents the number of reporting banks.
2Size categories based on asset size.
SOURCE: FDIC Quarterly Reports of Condition and Income for Insured
Commercial Banks, June 1988 and December 1980

for the purposes of evaluating credit quality and calculating
loan concentration ratios. However, because of the inherent
riskiness of SLCs as well as the greater potential for capital
leverage with SLCs than with loans, some form of capital
regulation is needed in order to protect the assets of the
federal deposit insurance fund.
The Federal Reserve Board has proposed that its current
capital regulation be supplemented by risk-based capital
guidelines that would take into account the relative riskiness
of certain off-balance sheet items. The basic purpose of the
new guidelines is to require more bank capital against riskier
assets. Therefore, the focus on risk-based standards reflects
the concern that simple minimum standards for capital
adequacy have not kept pace with possible increases in asset
risk.
The guidelines chart a bank’s risk profile by establishing
a relationship between assets and five general categories of
risk, to be weighted at 0, 10, 25, 50 or 100 percent. Each
asset is assigned a category depending on its credit risk.
Assets in the highest risk category receive a 100 percent
weight, meaning they count fully as assets when calculating
the risk-adjusted capital ratio. Many of the usual bank assets
fall within this group, including commercial and industrial
loans, residential real estate loans and consumer loans. Offbalance sheet assets are included in the guidelines on a
“credit equivalent” basis; that is, the face amount of the item
is multiplied by a conversion factor to arrive at a balance

sheet equivalent amount. The guidelines apply a 100 percent
conversion factor to financial guarantees that are effectively
a direct extension of credit to the customer, as with standby
letters of credit.
After the conversion amount is determined, that amount
is multiplied by the asset risk variable to determine capital
risk. Under the new risk-based capital guidelines for offbalance sheet items, the same risk weight is assigned to most
SLCs as to loans. For example, an off-balance sheet standby
letter of credit to support a shopping center development
has a conversion rate of 100 percent because it is a credit
substitute. The risk capital assessment on such a loan on
the balance sheet is also 100 percent; therefore, the entire
balance is considered a risk asset. The risk asset ratio is
determined by aggregating the risk-weighted asset and offbalance sheet amounts and dividing the total capital by the
amount of risk assets.
In order to comply with the new risk-based requirements,
a bank with a large portfolio of SLCs might be required either
to raise additional capital or to reduce leverage by changing
the composition of its asset and off-balance sheet portfolios.
The advantage of these guidelines is that they reduce banks’
incentive to issue SLCs merely as a means of increasing
effective leverage and circumventing capital regulation.
—Lynn M. Barry

This is the final issue of Banking & Finance - An
Eighth District Perspective. The Bank’s three
quarterly regional publications will be merged into one
regional publication, Pieces of Eight - An Economic
Perspective on the Eighth District. Our goal is to
increase the usefulness of the Bank’s analyses of
economic activity in the Eighth District. The new
format will allow greater flexibility in covering topics
and providing data. Pieces of Eight will debut
February 1989 and will be published quarterly. Current
subscribers of our regional publications will
automatically receive the new publication.

Banking & Finance—An Eighth District Perspective is a quarterly summary of banking and finance conditions in the area
served by the Federal Reserve Bank of St. Louis. Single subscriptions are available free of charge by writing: Research and
Public Information Department, Federal Reserve Bank of St. Louis, P.O. Box 442, St. Louis, Missouri 63166. Views expressed
are not necessarily official positions of the Federal Reserve System.




FALL 1988

FEDERAL RESERVE BANK OF ST. LOUIS

EIGHTH DISTRICT BANKING DATA
LARGE WEEKLY REPORTING BANKS *
1
Rates of Change
Level

Current
Quarter

Current
Year

111/1988
($ millions)

11/1988111/1988

111/1987111/1988

Same Periods
Previous Year
111/1986111/1987

11/1987111/1987

S e le c te d A s s e ts & L ia b ilitie s
$ 2 0 ,8 5 8
7 ,1 4 7
4 ,3 7 4
6 ,058
913
2 ,364

T otal Loans & Leases
C o m m e rc ia l Loans
C o n s u m e r Loans
R eal E sta te Loans
Loans to F in a n cia l In stitu tio n s
A ll O th e r Loans
T o ta l S e c u ritie s
U.S. T re a s u ry & A g e n c y S e cu ritie s
O th e r S e c u ritie s
T otal D ep o sits
N o n -T ra n sa ctio n B a la n ce s
MMDAs
$ 1 0 0 ,0 0 0 C D s
D em and D ep o sits
O th e r T ra n s a c tio n B a la n c e s 2

2 .8 %
-2 .4
9.1
27.5
-5 2 .5
-1 0 .0

9 .7 %
8.6
15.8
24.7
-2 1 .3
-9 .2

2 .6 %
7.7
-1 5 .8
12.3
32.5
-6 .8

6 .2 %
11.2
-9 .1
16.0
3.8
3.0

4 ,9 8 0
3,5 3 9
1,440

-1 3 .9
-1 7 .6
-3 .9

6.9
10.6
-1 .4

-2 .1
-1 .1
-4 .3

13.6
29.0
-9 .9

23,881
15,318
2,7 1 8
4 ,8 2 6
5 ,9 3 8
2,6 2 4

2.8
6.3
-5 .0
-0 .6
-1 .9
-5 .9

5.7
9.0
-0 .8
7.4

1.3
10.4
-2 1 .6
38.1
-1 6 .7
1.9

7.3
8.2
2.9
19.0
0.4
22.3

-1 .9
5.8

EIGHTH DISTRICT INTEREST RATES 3

September 1988
NOW s
MMDAs
T im e C D S
92 — 182 days
1 — 2 1/2 years
2 1/2 ye a rs and ove r

August 1988

July 1988

September 1987

5 .0 8 %
5.50

5 .0 9 %
5.50

5 .0 8 %
5 .4 3

5 .0 4 %
5 .3 8

7.06
7.50
7.95

6.96
7.52
7.92

6 .7 3
7 .2 7

6.3 6
7.0 3
7.59

7 .7 6

All data are not seasonally adjusted.
1 A sample of commercial banks with total assets greater than $750 million. Historical data have been revised to incorporate adjustment factors
that offset the cumulative effects of mergers and other changes involving weekly reporting banks during 1986. These adjustment factors, which are
computed each year, are used to construct a consistent time series for which year-to-year growth rates can be calculated. Adjustment factors are available
upon request from the Statistics Section of the Research and Public Information Department. Rates of change are compounded annual rates.
2 Includes NOW, ATS and accounts permitting telephone or pre-authorized transfers.
3 Average interest rates paid on new deposits by a sample of Eighth District commercial banks.




3

QUARTERLY BANK PERFORMANCE RATIOS
Eighth District
11/88
A n n u a lize d R eturn on A ve ra g e
A ssets
< $ 1 0 0 million1
$100 — $300 million
$300 million — $1 billion
$1 billion — $10 billion
> $ 1 0 billion

1.06%
1.04
1.05
.84
N.A.

11/87
1.00%
.97
.97
.45
N.A.

United S ta tes
11/86
1.09%
1.03
.89
1.02
N.A.

11/88
.72%
.85
.68
.69
.64

11/87
.65%
.78
.58
.46
-2 .0 3

11/86
.76%
.92
.81
.76
.46

A n n u a lize d R etu rn on A ve ra g e
E q u ity
< $ 1 0 0 million
$100 — $300 million
$300 million — $1 billion
$1 billion — $10 billion
> $ 1 0 billion

11.62
12.65
13.24
12.74
N.A.

11.27
12.08
12.36
6.94
N.A.

12.31
12.90
11.69
15.19
N.A.

8.17
10.92
9.83
10.88
14.03

7.53
10.25
8.08
7.35
- 4 8 .8 8

8.73
12.14
11.46
11.95
9.06

Lo a n s as P erc e n t of D e p osits
< $ 1 0 0 million
$100 — $300 million
$300 million — $1 billion
$1 billion — $10 billion
> $ 1 0 billion

57.40
66.21
71.01
86.34
N.A.

55.62
64.65
67.89
83.47
N.A.

55.17
62.64
68.60
79.54
N.A.

59.93
66.22
75.58
86.24
89.21

58.41
64.98
74.56
83.77
88.12

58.54
64.44
73.02
83.30
89.74

N o n p e rfo rm in g L o a n s as P erce n t
of T o ta l L o a n s 2
< $ 1 0 0 million
$100 — $300 million
$300 million — $1 billion
$1 billion — $10 billion
> $ 1 0 billion

2.01
1.81
1.51
2.27
N.A.

2.52
2.14
2.15
2.43
N.A.

3.00
2.31
2.65
2.02
N.A.

2.50
2.09
2.21
2.21
5.01

3.08
2.49
2.52
2.51
5.59

3.39
2.62
2.49
2.25
3.51

Loan L o s s R e s e rv e s as P erce n t
of T o ta l L o a n s
< $ 1 0 0 million
$100 — $300 million
$300 million — $1 billion
$1 billion — $10 billion
> $ 1 0 billion

1.50
1.35
1.35
1.91
N.A.

1.51
1.38
1.44
1.94
N.A.

1.38
1.30
1.38
1.44
N.A.

1.64
1.51
1.62
1.77
4.17

1.64
1.54
1.67
1.87
4.25

1.48
1.37
1.46
1.54
1.72

N et Lo a n L o s s e s as P erce n t
of To ta l L o a n s 3
< $ 1 0 0 million
$100 — $3 00 million
$300 million — $1 billion
$1 billion — $10 billion
> $ 1 0 billion

.18
.19
.19
.56
N.A.

.30
.31
.33
.30
N.A.

.38
.32
.28
.27
N.A.

.35
.33
.39
.55
.52

.48
.36
.41
.34
.40

.57
.37
.37
.38
.40

1 Size ranges based on bank assets.
2 Includes past due greater than 89 days and nonaccrual.
3 Loan losses are adjusted for recoveries.





Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102