The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
S M
87-4
c
0
1
E
E
o
O
"
D
C
r
s
£
£
O
o.
c
c
0
/
E
<
*
CL
o
Q
(
V
{>
/
V
Q
£
A Series of Occasional Papers in Draft Form Prepared by Members
O N
T H E
R E L A TIONSHIP B E T W E E N
O F
S T A N D B Y
CREDIT A N D
B A N K
LETTERS
CAPITAL
Gary D. Koppenhaver and Roger Stover
m
O
m
7
0
>
70
70
<
m
05
>
Z
*
0
■n
n
X
n
>
o
o
ON THE RELATIONSHIP BETWEEN
STANDBY LETTERS OF CREDIT AND BANK CAPITAL
by
6.
D. Koppenhaver
Senior Economist
Federal Reserve Bank of Chicago
230 S. LaSalle Street
Chicago, Illinois 60690
(312)322-5858
and
Roger Stover
Professor of Finance
Iowa State University
300 Carver Hall
Ames, Iowa 50011
(515)294 8114
April 1987
The authors thank Herbert Baer, Federal Reserve Bank of Chicago, Lawrence
Benveniste, Board of Governors of the Federal Reserve System, Hark Flannery,
University of North Carolina, George Kaufman, Loyola University, and Donald
Mullineaux, University of Kentucky for helpful comments and suggestions. The
authors alone are responsible for any errors. All views expressed here are
those of the authors and are not necessarily those of the Federal Reserve Bank
of Chicago or the Federal Reserve System.
On the Relationship Between
Standby Letters of Credit and Bank Capital
Abstract
A relatively recent trend in commercial banking has been the rapid growth
in the issuance of off balance sheet guarantees.
This paper theoretically
models and empirically estimates the relationship between bank standby letter
of credit activity, a type of guarantee, and primary capital.
To accurately
estimate this relationship, a simultaneous equation model is developed to
capture the feedback effects of standby letter of credit issuance on the
decision to manage intermediary risk though changes in bank capital.
Currently, federal bank regulators are concerned that banks are bolstering
profits by shifting out of liquid assets and secondary reserves and increasing
their issuance of off balance sheet guarantees to generate fee income and
conserve capital.
This paper addresses the appropriateness of risk-based
capital rules, recently proposed as a means of altering the perceived
relationship between standby letter of credit issuance and bank capital.
1
I.
Introduction
A relatively recent trend 1n commercial banking has been the rapid growth
1n guarantor activities that are carried off the balance sheet.
Some of the
largest of these off balance sheet activities, in terms of dollar amounts, are
instruments such as standby letters of credit, loan commitments, and
commercial letters of credit.
From 1973 to 1985, the combined industry-wide
issuance of standby letters of credit in constant 1982 dollars grew at an
annual rate of 24% while total loans grew at a 3% rate (Benveniste and Berger
[1]).
Off balance sheet items are contingent claims that usually generate fee
income for the bank at the time they are initiated but also create credit,
interest rate, and liquidity risks.1
When a bank issues a standby letter of
credit, three parties are involved: the issuing bank, its customer, and the
beneficiary entitled to draw down the credit.
The bank makes an irrevocable
commitment to pay the beneficiary the credit amount when the beneficiary
presents evidence that the bank's customer failed to fulfill the obligations
of an underlying agreement.
A standby letter of credit makes the beneficiary
similar to an uninsured depositor because a claim is owned on the bank's
assets, contingent upon default by the bank's customer.
The contribution of this paper is to theoretically model and empirically
estimate the relationship between bank standby letter of credit activity and
primary capital.
This relationship is important because public policy
concerning bank risk management and the use of off balance sheet items should
be based on a logical understanding of how bank balance sheet and off balance
sheet decisions are related.
Recently, the Federal Reserve has proposed a
risk-based capital standard in which banks must hold a minimum level of
capital against their outstanding standby letters of credit.2
underlying this proposal is:
The assumption
because the current minimum capital standards
2
exclude off balance sheet items, bank capital decisions do not offer a prudent
buffer for an organization's off balance sheet risk exposure.
Federal banking
agencies are concerned that banks are bolstering profits and taking risks by
shifting out of liquid assets and secondary reserves and increasing their off
balance sheet activity.
Currently, the ability to earn non-interest income while avoiding capital
requirements makes standby letters of credit an attractive alternative to
booking balance sheet assets.
Goldberg and Lloyd-Davies [4] found an
inconsistent relationship between capital and letter of credit activity; a
positive relationship existed only for small banks.
In contrast, Koppenhaver
[7] examined why a bank may be in the guarantee market.
He concludes that the
relationship between capital and letter of credit activity is negative but
again, only for small banks.
Finally, Benveniste and Berger [1] estimate that
banks with low capital ratios are more likely to issue standby letters of
credit but, given that they do issue these instruments, capital ratios and
standby letter of credit volume are positively related.
Another viewpoint suggests that a uni-directional relationship may not
fully capture the interaction between standby letters of credit and bank
capital.
On the one hand, the risks of standby letter of credit issuance may
be fully recognized by those banks that issue these guarantees and they
increase their capital position simultaneously.
The bank might raise their
capital position because of an internal assessment of increased credit,
interest rate, or liquidity risk or because of market discipline imposed by
demanders of guarantees.
Since a standby letter of credit is a guarantee of
funds availability issued by the bank for a transaction between the bank's
customer and the letter of credit beneficiary, the bank must be sufficiently
sound to make the guarantee credible.3
A bank with greater equity is
3
perceived as being more sound by the guarantee market, and hence, it can issue
more standby letters of credit.
In this view, capital and standby letters of
credit are then complementary decisions.
On the other hand, the ability to
issue standby letters of credit may depend on other aspects of the bank's
overall safety and soundness besides equity capital, such as asset quality,
liability mix, and absolute size.
A bank will not need to hold as much
capital if it is viewed as sufficiently sound to issue standby letters of
credit.
Thus, the relationship between outstanding standby letters of credit
and capital could be negative.
If this is the true relationship, it runs
contrary to the proposal by the Federal Reserve that banks should hold
additional capital against their standby letters of credit.
This study examines whether or not banks explicitly increase their capital
to reflect the potential risk exposure from standby letter of credit
activity.
To accurately estimate the relationship, a simultaneous equation
model is needed to capture the joint decision process for standby letter of
credit issuance and bank capital.
This paper models the standby letter of
credit and capital decisions in sections II and III, presents the estimation
results in section IV, and addresses the appropriateness of the recently
proposed risk-based capital rule in the conclusion.
II.
Theoretical Model
The model of bank balance sheet and off balance sheet activities developed
here retains the traditional depiction of bank decision-making as a process of
reconciling the goals of profitability, liquidity, and solvency.*
The model
incorporates the latter two goals by assuming i) the bank has access to a
competitive funds market where funds can be purchased or sold in any desired
quantity at a given rate, and ii) bank management makes decisions given a
4
soundness function based on the expected value of
forced liquidation.
the bank in the event of
Management can affect the degree of banksoundness
explicitly through both balance sheet and off balance sheet decisions.
Uncertainty in bank decision-making is introduced through the interest rate at
which funds can be purchased or sold and through the takedowns on outstanding
standby letters of credit.
The model is closely related to Luckett [8]
although risk aversion is introduced, as well as the off balance sheet
decision to issue standby letters of credit.5
Assume the bank has a one period planning horizon.
At the beginning of
the period, bank management must decide on the quantity of equity, K, to hold,
and the quantity of standby letters of credit, S, to issue.
rate on and quantity of earning assets, RL and L,
At this time, the
the rate on
and quantity of
insured retail deposit liabilities, RD and D, and the opportunity cost of
equity, R^, are all known.
Unknown to bank management is the cost
of purchased funds, Ru, and the takedown per dollar of standby
letters of credit issued, e.
These unknown values are revealed at the end of
the period when the bank either borrows or lends (B^O) in the competitive,
uninsured funds market.
The ex post balance sheet constraint can be written
as:
L + es = B + (l-r)D + K,
(1 )
with r equal to the exogenously imposed reserve requirement on retail deposits.
The ex ante decisions (K and S) and the ex post decision (B) are arguments
in a function that reflects the bank's desire to maintain an economically
sound institution (see Mingo and Wolkowitz [12]).
The soundness function
measures the bank's financial strength by weighting the various items in the
bank's balance sheet and calculating the excess of weighted assets over
5
weighted liabilities.
Asset weights are based on credit risk and
marketability; liability weights are based on interest rate sensitivity and
insurance status.
Let the ex ante expected soundness measure be given by:
Ex = y (L + E0S) + aK - BEB - 6(l-r)D,
(2)
with E equal to the expectations operator and a>B,Y,4>0 equal to the
weights known by all members of the financial community.
Therefore, Ex
increases if either an increase in earning assets is funded by an increase in
equity or an increase in equity replaces deposit liabilities; Ex decreases if
the bank increases its leverage at the expense of equity.
The relative
magnitudes of B,y, and 4 are left unspecified because financial and banking
theories are not clear on the effects their respective balance sheet items
have an expected soundness.
To illustrate, recast Equation (2) by
substituting for B from Equation (1).
Ex = (Y-B)[t*E0S] 4 (a+B)K + (B-4)(l-r)D
-
(2‘)
Changes in expected soundness due to a change in the bank's balance sheet are
now relative to an offsetting change in purchased funds.
The earning asset weight, (y-B), may be negative because an increase in
leverage to expand earning assets means that more uninsured depositors have a
claim on bank assets.
funds.
However, this ignores the quality of the bank's uses of
If the quality of bank assets are high, then expected soundness may
increase in spite of the increased leverage.
It could also be argued that
exposing a bank to the increased market discipline associated with purchased
funds increases expected soundness because it offsets the risk-taking
incentives provided by flat-rate deposit insurance.
Similarly, B-4 may be
positive or negative depending on the strength of the market discipline
argument (B<4) versus the argument that a greater reliance an insured retail
6
deposits makes a run on the bank less probable and hence more sound (6>S).
Bank profits, n, at the beginning of the planning horizon are:
n = RL(U-0S) - (Rb *p )B - (Rd +p )D - Rk K * f(ET)S,
with
p
(3)
equal to the flat-rate deposit insurance premium on all balance sheet
liabilities, and f equal to the initial fee income earned upon standby
letter of credit issuance.&
Note that f is a function of the expected
soundness of the bank at the end of the period.
Assume f'(Ex)>0 (f"(Ex)<0),
since the more sound the bank, the greater the likelihood that it can provide
funds to the standby letter of credit beneficiary should the need arise.
All
other things equal, the more sound the bank, the greater the guarantee
market's demand for its standby letters of credit and the greater the fee
income earned.
Therefore, by altering its mix of assets, liabilities, and
equity, the bank can influence the fees earned in the market for standby
letters of credit.
The choice problem facing the bank can be simplified by i) substituting
Equation (1) into Equation (3), and ii) substituting Equation (21) into
Equation (3).
B is determined after o is revealed to equate assets with
liabilities plus equity.
Profits at the start of the period are then a
function of the K and S decisions alone.
n(K,s) = (r l -r b ~p ) ( U 0S)
* [(RB*p)(l-r)-RD-p]D * (Rb +P-Rk )K « f(Et )S.
■
(3')
To close the model, let the unconstrained decisions K and S in Equation
(4) be based on the bank's subjective expectation about future events,
described by the joint cumulative density F(Rb ,o ).
It is assumed that this
joint distribution does not change over the planning period.
The decision
problem is then to select K and S to maximize the expected utility of profits
given F(Rb ,o ).
Maximize
K,S > 0
F.U[n | F(Rb .O)]
(4)
7
where U 1s a risk averse utility function such that U'(n)>0 and U"(n)<0,
and n and E t are defined 1n Equations (3‘) and (21).
Note that E t 1 s
endogenous to the decision problem with weights given by either bank
customers, Industry-wide agreement, or federal banking regulators.
By assuming constant absolute risk aversion and a jointly normal
distribution for the random variables, the objective function 1n expression
(4) can be rewritten 1n a mean-variance expected utility framework.
The
optimal solutions for the ex ante decisions can be shown to be:
K* = [L-(l-r)D] * [(ERb +p -Rk ) * S*[(a-B)f'- U ( R l -p )Co v [RB ,0]
-Cov[RB,RBe]]]}AVar[RB], and
(5)
S* - ((RL-ERB-p)Ee - Co v [RB ,0] * f - \[-U(l-r)D*K*][(RL-p)
Cov[RB ,0] - Cov[RB ,RBe]n/{>Var[(RL-RB-p)93
-(Y-B)Eef'},
where
\
(6)
1s the Index of risk aversion, Var represents variance, and Cov
represents covariance.
Note that Equations (5) and (6) form a system of
simultaneous equations for the solutions K* and S*; once this system 1s
solved, B* 1s determined by the realization of 0.
Holding S* constant, Equation (5) Implies that bank equity Increases with
an Increase 1n the expected rate on purchased funds or required reserves;
equity decreases with an Increase 1n the cost of equity or a decrease 1n the
marginal effect of capital on standby fee Income.
The Impact of a change 1n
S* on equity 1s unknown because the magnitude and sign of the covariance terms
1n the second term on the right hand side of Equation (5) are subject to
empirical Investigation.
Holding K* constant 1n Equation (6), standby letter
of credit Issuance Increases with an Increase 1n the per dollar fee Income
earned and with a decrease 1n the expected rate on purchased funds, provided
8
(J>y * The effect on standby letter of credit issuance due to changes in K* is
ambiguous, again due to the lack of apriori expectations about the covariance
terms.
To gain further insight into the optimal joint decisions facing the bank,
assume RB and e are joint normally distributed.?
E[RB]Cov[RB ,e] + E[o]Var[RB].
f"=0.
If so, then Cov[RB ,RBo] =
Without loss of generality, also assume that
These assumptions can then be used in Equations (5) and (6) to show
that
3K*/3S = t(a4-B)f' - X[(R|_-ERB-p)Cov[RB ,e]-EeVar[RB ]]}/\Var[RB ]
(7)
3S*/3K = ((afB)f' - X[(RL-ERB-p)Cov[RB ,0]-E6Var[RB ]]}/
(\Var[(RL-RB-p)0] - 2(T-B)E0f'}.
(8)
It seems likely that higher market interest rates are associated with more
bank customer defaults and hence, greater letter of credit takedowns by
beneficiaries.
If so, Cov[RB ,o] will be positive.
However, if there is no
relationship between market rates and takedowns (Cov[RB ,0] = 0), then each
decision is still not independent of the other; the decisions are related
through the marginal effects on standby fee income.
Regardless of the sign of the covariance terms in Equations (7) and (8),
the partials will have the same sign as long as B>y.
positive and expectations are such that ERB > Rl -
p,
Assuming Cov[RB ,o] is
then takedowns of
letters of credit result in a loss of expected utility, provided the takedowns
are funded by purchased liabilities.
To guard against this risk, more capital
is desired as S increased (3K*/3S > 0) to decrease the bank's potential
dependence on purchased funds.
But as bank equity is increased and the
potential dependence on purchased funds declines the takedown risk is less and
the bank issues more standby letters of credit (3S*/3K >0).
On the other
hand, if expectations are such that the numerators of Equations (7) and (8)
are negative (ERb < R l - p )♦ then takedowns increase expected utility; less
9
capital 1s needed as a cushion for letter of credit Issuance (3S*/3K < 0) and
standby letters of credit can be substituted for capital 1n maximizing
expected utility (aS*/3K < 0).
The partlals 1n Equations (7) and (8) will have the opposite signs 1f
(T-B)>XVar[(RL-RB-p)6]/2Eef'>0.
That 1s, 1f 1) high quality loans made as a
result of standby takedowns enhance expected bank soundness enough to offset
funding the takedowns with purchased liabilities or 11) Increased exposure to
market discipline enhances expected bank soundness by a large enough
magnitude, then less capital might be desired when more standby letters of
credit are Issued (3K*/3S < 0).
An Increase 1n capital still facilitates the
credibility of the guarantee and the bank will desired to Issue more standbys
(aS*/aK > 0).
The critical level that (y -B) must exceed Increases with bank
risk aversion and the variability of takedowns returns; 1t decreases with
greater expected takedowns.
Equations (5) and (6) demonstrate that bank equity and standby letter of
credit decisions are interrelated in a model of bank behavior under risk
aversion.
The most Important point 1s that ex ante balance sheet and off
balance decisions are linked by the correlation of their respective returns
and the determination of the standby fee schedule.
The relationship between
decisions, however, depends on the weights assigned to balance sheet Items 1n
the function measuring bank quality.
The model also suggests that factors
such as Interest rate risk exposure, required reserves, and measures of
overall bank quality Influence both of these decisions.
The next section of
the paper Introduces a linear simultaneous equation system to Investigate the
empirical relationship between standby letter of credit Issuance and bank
capital.
10
III.
Empirical Model
Based on the previous section, the model Is presented as the following set
of equations.
Standby Letters of
Credit:
S = a-jK + r^X-i
Capital:
+ e|
-
K = &-jS + r2X2
(Nxl) (Nxl) (NxK-j)(K-jxl)
(9)
(Nxl)
* e2
(Nxl) (Nxl) (NxK2)(K2xl)
(10)
(Nxl)
where the predetermined variables are represented by X^. The parameters - a-j,
, r-|, and r2 - are estimated In the model using the sample of banks active
1n the standby letter of credit market.
The purpose of this simultaneous
model 1s to represent the endogenous variables 1n terms of their mutual
Interaction as well as selected exogenous variables.
The sample Includes all
banks with assets 1n excess of $500 million which reported standby letter of
credit activity In the June 1985 Report of Condition and Income.
sample with complete Information 1s 459 banks.®
The final
While standby letters of
credit are Issued by a large number of U.S. banks of all asset sizes (over 50%
of all banks), approximately 96% of the outstanding dollar value was Issued by
banks with assets greater than $500 million at this report date.
variables are normalized by total bank assets.
Almost all
(See Table 1 for variable
definitions.)
Primary capital 1s defined as equity (Including perpetual preferred stock)
and allowance for loan and lease losses less goodwill.
While Marcus [9]
employed a market value measure of capital, this Information Is not easily
available for all banks In the sample.
Primary book capital has been used 1n
previous research and Is employed by the Federal Reserve System.
The standby
letter of credit variable Includes letters originated by the bank less those
which have been conveyed to others through participations.
11
Table 1
Summary Statistics and Definitions of Variables
For Banks with Assets Greater Than $500 million
(N=459)
Variable
Mean
Standard
Deviation
Eouatlon No
CAPITAL
0.0714
0.0179
9, 10
Primary cap1tal/Total assets
STANDBY
0.0285
0.0303
9, 10
Net standbys outstanding/
Total assets
7.418
1.0273
9, 10
Logarithm of total assets/!,000,000
0.3033
0.0854
9, 10
Sum of squared shares of ten loan
categories
GAP
-0.0149
0.0944
9, 10
One year maturity gap/Total assets
BHC
0.9412
0.2356
9, 10
= 1 1f affiliated, = 0 otherwise
FUNDS
0.2435
0.1377
9
RESERVES
0.0404
0.0078
9, 10
Required reserves/Total assets
LLOSS
0.0079
0.0030
9, 10
Loan loss reserves/Total assets
BINDING
0.0588
0.2356
9
FDIC
0.4802
0.2084
10
CR3
0.7437
0.1894
9, 10
CNSTRL
0.0395
0.0421
9
Construction loans/Total assets
MUNI
0.0830
0.0437
9
Municipal loans and securities/
Total assets
CASH
0.1232
0.0682
10
Cash and due/Total assets
USTRSY
0.0786
0.0669
10
U.S. Treasury secur1t1es/Total assets
ROA
0.0041
0.0037
10
Net Income/Total assets
SIZE
INDEX
Source:
Definitions
Short-term borrowings, foreign
deposits, and large CDs/Total assets
= 1 1f CAPITAL < 5.5%, = 0 otherwise
Insured depos1ts/Total assets
Three-firm share of total deposits
1n county
Report of Condition and Income, June 1985.
12
Exogenous variables in the letter of credit equation (Equation (9)) enter
through the fee schedule that banks face in issuing these instruments.
The
logarithm of asset size is expected to relate to letter of credit activity in
two ways:
i) larger banks have the specialized management skills needed to be
an active participant in this market, ii) larger banks can more easily
diversify their asset portfolios which may include contingent guarantees
(Koppenhaver [7] and Marcus [9]).
The direct effect of loan portfolio
diversification is also measured for ten different loan categories.9
Additional variables reflecting the quality of the bank include the
asset-liability maturity gap at one year forward (GAP), whether or not the
bank is affiliated with a holding company (BHC), and reliance on purchased
funds (FUNDS).
For interest rate risk (i.e., the maturity gap), the issue is
whether or not those banks with mismatched balance sheets would also be
willing to incur the additional risk of standby takedowns.
Regulatory variables also affect the willingness of banks to engage in
letter of credit activity.
Those specifically included in Equation (9) are
the level of required reserves (RESERVES), the bank's loan and lease loss
reserves (LLOSS), and a binding capital constraint (BINDING).
Koppenhaver [7]
suggests that the cost of funding assets with reservable deposits and examiner
pressure to allocate balance sheet assets into loan and lease losses may more
than offset the additional risks of issuing standby letters of credit.
Additional variables that are likely to be important in the standby letter
of credit decision include: i) a measure of market concentration (CR3); ii)
the level of construction loans outstanding (CNSTRL), and iii) the level of
municipal loans and securities outstanding (MUNI).
It is hypothesized that
the greater the concentration of a banking market the less likely the bank is
to accommodate customer needs for loan guarantees.19
The construction loan
13
variable is likely to be associated with standby letters of credit because
they are often utilized to back up an obligation to complete a construction
project.
Uses of standbys also include credit enhancement facilities to
municipal borrowers and liquidity backstops that require the bank to buy bonds
put to them.
For Equation (10), the capital ratio equation, the selected exogenous
variables are assumed to affect the capital ratio through the cost of equity
and the marginal effect of capital on the schedule of standby fees (R^ and f 1,
respectively, in Equation (5), above).
The logarithm of asset size appears
because the larger, more diversified banks need less capital for deposit
losses.
ratio.
It is included as a means of monitoring a size effect on the capital
Return on assets (ROA), loan loss reserves, and loan portfolio
diversification are also assumed to affect the judgment of both examiners and,
for large banks, the financial markets regarding the necessary level of
capital.
Because more liquid banks require less capital (Heggestad and Mingo
[5]), a liquidity measure is included in this study and defined as the ratio
of cash and due from banks to total assets (CASH).
The riskiness of the
investment portfolio and the level of secondary reserves is quantified in
Equation (10) by the ratio of U.S. Treasury securities to total assets
(USTRSY).11
The twelve month cumulative gap is included as a measure of
overall interest rate risk assumed by the bank.
Other variables assumed to
affect capital are whether or not the bank is affiliated with a holding
company, required reserves, insured deposit funding, and banking market
concentration. 12
14
IV. Empirical Results
The simultaneity of the relationship between letter of credit activity and
the level of primary capital in commercial banks, as depicted in Section II,
has not been examined in previous research.
When performance measures such as
those used in this study are employed, explicit consideration must be made for
the correlation between the error terms.
The use of ordinary least squares
when such correlation is present can lead to inefficient and possibly biased
estimators.
This study utilizes the three stage least squares procedure to
correct this problem.
Table 2 reports the results of the 3SLS estimation.
The results for the exogenous variables are generally as expected. The
very large banks in the sample are most active in this market as indicated in
the letter of credit equation.
Kim and Stover [6] found similar results in
the industrial development bond market.
The significant holding company
variable suggests that it has a separate positive effect on the credibility of
standby guarantees.
From the model in Section II, the level of standby letter of credit
activity increases with a decrease in the expected rate on purchased funds.
The empirical estimation confirms this as evidenced by the positive
coefficient for GAP, which is likely to reflect interest rate expectations.
The assertion that banks substitute letter of credit commitments for the
booking of balance sheet assets is refuted by our results.
MUNI is significant.
Neither CONSTRL or
Finally, the bank concentration ratio, CR3, indicates
that banks faced with greater competition engage in more letter of credit
activity.
The capital equation indicates that these banks do not tradeoff
traditional banking risks and capital.
Banks with greater asset size and
greater competition exhibited lower capital ratios.
However, no significant
15
Table 2
Three-Stage Least Squares Estimates of
Equations (9) and (10) for
Bank Participants with Assets Greater Than $500 Million
(N=459)
_________Dependent Variable_________
(1)
RHS
Variable
CAPITAL
STANDBY
SIZE
INDEX
GAP
BHC
FUNDS
RESERVES
LLOSS
BINDING
BINDING* FIDC
FDIC
CR3
CNSTRL
MUNI
CASH
USTRSY
ROA
CONSTANT
System R2
"
STANDBY
Coefficient
Std. error
0.6445*
0.0013
0.0152
0.0139
0.0047
0.0092
0.1805
0.4726
0.0077
0.0182
- -
-0.0428*
-0.0329
-0.0139
0.0063
0.0249
0.0238
- -
- -
--0.1192*
__
-0.0245
0.7923*
-0.0167*
-0.0076
-0.0140
-0.0130*
—
0.1419
1.2791*
__
0.1860
0.0025
0.0131
0.0150
0.0038
—
0.1433
0.3262
- -
—
—
—
0.0005
0.0333*
—
-0.0082
0.0253**
0.8912*
0.1419*
0.445
*SlgnlfIcantly different from zero at the 5% level.
**SlgnlfIcantly different from zero at the 10% level.
(2)
CAPITAL
Coefficient
Std. error
0.1911
- -
0.0179*
0.0197
0.0433*
0.0130*
0.0057
-0.3680*
-0.1309
0.0043
-0.0161
"
0.0089
0.0070
—
0.0152
0.0130
0.2535
0.0120
16
relationship exists between interest rate risk (GAP) and capital.
Also, the
coefficient for the level of insured FDIC deposits is insignificant.
The
positive coefficient for USTRSY confirms the results of Marcus [9].
Most importantly, the coefficients of the endogenous variables indicate
that bank capital is recognized in the letter of credit market, while the
level of participation in this market affects the management of the issuing
banks' capital.
This evidence confirms the feedback system suggested by the
model in Section II.
The positive coefficient for CAPITAL in the first column
indicates that the level of standby letter of credit activity is related to
the soundness of the bank as measured by its capital ratio.
A one standard
deviation increase in the mean capital ratio increases the ratio of letter of
credit volume to assets by 0.012.
Despite the importance of the capital
ratio, the capital adequacy guidelines of 5.5% (BINDING) has no significant
effect.
The significant coefficient for the letter of credit volume in the capital
equation implies that these banks do allocate more capital in response to
greater standby letter of credit issuance.
A one standard deviation increase
in the mean ratio of standby letter of credit volume to assets increases the
capital ratio by 0.02.^
This responsiveness may reflect the role of credit
agencies such as Standard and Poors [15] which factors outstanding letter of
credit volume into its analysis of capital adequacy for bank rating.14
V. Conclusion and Implications
Given that a bank may not issue standby letters of credit unless the
guarantee can be made credible to the beneficiary, bank decisions will have an
effect on its participation in this guarantee market.
An identification
problem exists with respect to the impact of a bank's capital policy.
Ceteris
17
paribus, the bank with the higher capital ratio is assumed to be more sound.
However, a well managed portfolio of bank assets and liabilities reduces the
need for capital as a buffer against losses.
If bank management decisions
reflect a sound banking organization, regardless of the effect of equity
capital, this should have a direct effect on the level of standby letters of
credit issued.
The contribution of this study is to examine the relationship
between capital and letter of credit activity as joint decisions made by
management.
The empirical results substantiate the theoretical argument that a
feedback system exists between the letter of credit activity and capital.
The
major result of the simultaneous estimation of these decisions is that a
bank's capital ratio appears to add credibility to the guarantee embodied in
the standby letter of credit.
credit volume.
The capital ratio effected greater letter of
Further, the level of capital reflects this volume of loan
guarantees.
The results have implications for the public policy debate surrounding
bank off balance sheet activities and the risks they embody.
Under proposed
Federal Reserve capital guidelines, outstanding letter of credit volume would
be treated exactly the same as a balance sheet loan.
However, the empirical
results of this study suggest that the large issuing banks are maintaining
sufficient capital, from the regulator's viewpoint, to offset this off balance
sheet activity.
Adoption of the proposed risk-based capital guidelines would
impose a redundant and meaningless constraint on existing large bank capital
policies.
18
Footnotes
contingent claim involves an obligation to lend or provide funds should the
contingency be realized; it does not create a change in the balance sheet
until that time. Wolkowitz et al. [16] provides an overview of these off
balance activities along with descriptive statistics on bank usage up to 1980.
20n January 20, 1986, the Board of Governors of the Federal Reserve System
proposed rules for implementing risk-based capital guidelines. In guidelines,
revised March 6, 1987, supplemental capital ratios are to be calculated that
explicitly include standby and commercial letters of credit, and loan
commitments. Standby letters of credit are either given a weighting of 50% or
100% depending on their reason for issuance. The weights determine the
quantity of each item that are included in risk assets and then compared to
primary capital.
3In an extreme situation, the standby letter of credit will not be made if the
beneficiary is not satisfied. This assumes that the terms of the underlying
contract between the bank customer and the beneficiary are fixed. If not, the
contract terms may change in light of the quality of the guarantee and then
the bank's customer would have an additional interest in obtaining the highest
quality guarantor possible.
4In another theoretical paper on the standby letter of credit decision,
Benveniste and Berger [2] investigate the non-regulatory incentives for
standby issuance in a state-dependent model with risk neutral banks. After an
analysis of arbitrage conditions, standby letters of credit are found to be
more profitable than warehousing balance sheet assets if their are states of
nature in which the bank fails while some of its loans are not in default.
5See also Mingo and Wolkowitz [12]. For justification of expected utility
maximization by banks, see the empirical studies by Edwards [3] and Ratti [14].
^Equation (3) assumes that the return to standby takedowns is the same as a
balance sheet loan. However, since takedowns are caused by bank customer
default, one might argue that the credit risk of a loan resulting from a
takedown is higher than a warehoused loan. Based on a survey of 28 banks in
1978, Lloyd-Davies [Federal Reserve Bulletin. September 1979, pp. 716-719]
finds the loss experience on standby takedowns to be less than on warehoused
loans, in part due to bank customer collateral requirements.
7This assumption is technically inconsistent with previous assumptions but is
made to gain insight into the joint bank decisions. Rates and quantities in
the model cannot be joint normally distributed if profits and rates are joint
normally distributed as implied by the closed-form solution in Fquations (51
and (6).
8This sample represents approximately 92% of all U.S. commercial banks in this
size category filing Reports of Condition and Income in June, 1985.
19
9These loan categories are: loans secured by real estate, loans to depository
institutions, agricultural loans, commercial and industrial loans, acceptances
of other banks, loans to individuals, loans to foreign governments, municipal
loans, other loans, and lease financing receiveables. Given these categories,
the variable INDEX in Table 1 was calculated.
10With the exercise of monopoly power, balance sheet risks can be passed on to
customers through high and variable loan rates and low deposit rates. CR3
proxies the competitiveness of the bank's market, assuming the relevant market
is a county. Admittedly, this is a questionable assumption for money center
and regional banks, but a more accurate measure of competition is not readily
available.
^Marcus [9] found that the coefficient of this ratio was positive and
significant, suggesting that interest rate fluctuations made governments more
risky than loans.
12Exogenous variables were selected with consideration given to previous
research on bank equity decisions. See [5], [9], [10], [11], and [12].
13Two other capital ratios were used as dependent variables in the system
estimation; the ratio of primary capital to total assets plus outstanding
standbys, and the ratio of primary capital less non-interest income to total
assets. These ratios were used to keep the immediate effect of booking fee
income from confusing the capital/standby relationship. The results using
these alternative measures were not significantly different from Table 2.
14It should be noted that in a dispute arising from the collapse of the Penn
Square Bank, Oklahoma City, in 1982, a federal appeals court in Denver ruled
in December 1984 that a standby letter of credit was like an insured deposit.
Although the Supreme Court recently overturned this ruling (Ruling 6 3 , Hay
27, 1986), uncertainty abut the eventual insurance status of standby letters
of credit at the time the data for this study was collected could influence
the estimation results. Given it is often argued that flat-rate deposit
insurance subsidizes bank risk-taking, the positive relationship between
standby letters of credit and bank capital found here is even more noteworthy.
20
References
1. Benveniste, 3. and A. Berger. "An Empirical Analysis of Standby Letters
of Credit." Proceedings of a Conference on Bank Structure and
Competition. Federal Reserve Bank of Chicago, 1986, pp. 387-412.
2. Benveniste, L. and A. Berger. "Substituting Loan Insurance for
Intermediation: The Private and Social Benefits of Standby Letters of
Credit." Research Papers in Banking and Financial Economics #92, Board of
Governors of the Federal Reserve System, October 1986.
3. Edwards, F. "Managerial Objectives in Regulated Industries: Expense
Preference Behavior in Banking." Journal of Political Economy. 85
(February 1977): 147-162.
4. Goldberg, M. and P. Lloyd-Davies. "Standby Letters of Credit: Are Banks
Overextending Themselves?" Journal of Bank Research. 16 (Spring 1985):
28-39.
5. Heggestad, A. and J. Mingo. "Capital Management by Holding Company
Banks." Journal of Business. 48 (October 1975): 500-505.
6. Kim, J. and R. Stover. "The Role of Bank Letters of Credit in Corporate
Tax Exempt Financing." Financial Management. 16 (Spring 1987): 31-37.
7. Koppenhaver, G. "The Effects of Regulation on Bank Participation in the
Guarantee Market." Paper presented at a Conference on Asset
Securitization and Off Balance Sheet Risks of Depository Institutions,
Northwestern University, February 1987.
8. Luckett, D. "Credit Standards and Tight Money."
and Banking. 2 (November 1970): 420-434.
Journal of Money. Credit
9. Marcus, A. "The Bank Capital Decision: A Time Series-Cross Section
Analysis." Journal of Finance. 38 (September 1983): 1217-1232.
10. Mingo, J. "Capital Management and Profitability of Prospective Holding
Company Banks." Journal of Financial and Quantitative Analysis. 10 (June
1975): 191-203.
11. Mingo, J. "Managerial Motives, Market Structure and Performance of Holding
Company Banks." Economic Inquiry. 14 (September 1976): 414 424.
12. Mingo, J. and B. Wolkowitz. "The Effects of Regulation on Bank Balance
Sheet Decisions." Journal of Finance. 32 (December 1977): 1605-1616.
13. Morgan, G. "On the Adequacy of Bank Capital Regulation." Journal of
Financial and Quantitative Analysis. 19 (June 1984): 141-162.
14. Ratti, R. "Bank Attitude Toward Risk, Implicit Rates of Interest, and the
Behavior of an Index of Risk Aversion for Commercial Banks." Quarterly
Journal of Economics. 95 (September 1980): 309-331.
21
15. Standard and Poors and Credit Overview, "Structural Financings-Letters of
Credit," 1983.
16. Wolkowltz, B., P. Lloyd-Davles, B. Gendreau, G. Hanweck, and M. Goldberg.
"Below the Bottom Line: The Use of Contingencies and Commitments by
Commercial Banks." Staff Studies #113, Board of Governors of the Federal
Reserve System, January 1982.
@FedFRASER