R I S K A N A LY S I S A N D M A N AG E M E N T

LECTURE 11
TOPICS:
LOAN SALES
LIQUIDITY & LIABILITY MANAGEMENT
THE BANK LOAN SALES MARKET
• Credit derivatives, like credit swaps, enable financial institutions (FIs) to decrease credit risk without physically
removing assets from their balance sheet.
• Loan sales allow FIs to reduce credit risk completely by removing the loan from the balance sheet. Specifically,
a bank loan sale occurs when a FI originates a loan and sells it either with or without recourse to an outside
buyer.
• Loans sold without recourse are removed from the FI's balance sheet and have no explicit liability if the loan
goes bad. That is, the originator of the loan can take it off the balance sheet after selling the loan. With loans
sold with recourse, credit risk is still present for the originator because the buyer can transfer back ownership to
the originator. Bear the least amount of credit risk for the buyer. Then, the FI retains a contingent credit risk
liability. Most loans are sold without recourse as they are removed from the balance sheet only when the buyer
has no future credit risk claim.
• Loan sales are a primitive form of securitization, creating a secondary market for loans without creating new
securities like pass-throughs, CMOs, and MBBs.
RECOURSE VS. NON-RECOURSE LOAN
PERSPECTIVE
There are two types of debt, recourse and non-recourse.

• Recourse is when the borrower is liable for the entire debt amount, regardless of the collateral or whatever security is offered on the loan.

• Non-recourse debt just means the borrower is not liable. Therefore, the bank’s or other FI’s only security is the collateral itself.

• The only time the difference these types of loans come into play is in the event of foreclosure.

• When the lender forecloses, they liquidate the property or sell it to recoup the money they loaned to the borrower.
ü Let’s say for instance a property is worth $2M and they loaned you $1.5M, then they have enough to cover the money that they loaned out, plus other
expenses and costs.
ü But as we may know, properties may not remain having the same value due to any mismanagement of the property, not having enough money to maintain
the property etc, therefore, the property value has declined to $1M. The difference between what the property is worth, and the loan amount is called the
deficiency.

• NB the deficiency isn’t just the difference between the loan amount and the property’s new value. In addition to the principal the FI is trying to recover, they
are also owed accrued interests, legal fees, and other expenses related to the foreclosure.

• In the example, the deficiency in reality would exceed $500K.

• In the case of a recourse loan, the FI can sue the borrower for recovery of the deficiency. They can go after other assets or other ways to get it into to court to
recover whatever the collateral did not cover. In a non-recourse loan, the lender cannot sue the borrower for the deficiency, the lender has no recourse against
the borrower.
 LOAN SALES EXAMPLE
Table 1 FI Balance Sheet before and after a $20 Million Loan Sale (in millions)

Before Loan Sale After Loan Sale

Panel A of Table 1 shows an FI’s
Assets $ Liabilities/Equity $ Assets $ Liabilities/Equity $ balance sheet before and after a $20
million loan sale without recourse. If
Panel A: Loan Sales Without Recourse
the loan is sold with recourse, under
Cash 10 Deposit 90 Cash 10 Deposits 90 certain conditions the buyer can put the
Loans 90 Equity 10 Loans 70 Equity 10 loan back to the selling FI. Therefore,
New Investments 20 the FI retains a contingent credit risk
liability. Panel B of Table 1 shows the
100 100 100 100 FI’s balance sheet, including the
Panel B: Loan Sale with Recourse contingent liability from the loan sale
Cash 10 Deposit 90 Cash 10 Deposits 90 with recourse held off the balance
Loans 90 Equity 10 Loans 70 Equity 10
sheet. In practice, most loans are sold
without recourse because a loan sale is
New Investments 20
technically removed from the balance
100 100 100 100
sheet only when the buyer has no
future credit risk claim on the FI.
Off-Balance-Sheet 20
(contingent
liability)
TYPES OF LOAN SALES
The U.S. loan sales market comprises three segments: domestic loan sales and trading, emerging-market loan sales, and sovereign risk,
with a focus on domestic loan sales at this point.

• Traditional Short-Term Loan Sales

ü In the traditional short-term segment of the market, FIs sell short-term loans with one to three months maturities, similar to corporate
commercial paper markets in terms of maturity and issue size. Loan sales typically yields 1 to 10 basis points higher than
commercial paper of similar rating.

• Highly Leveraged Transaction (HLT) Loan Sales

ü Virtually all HLT loans have the following characteristics:
§ They are term loans (TLs).
§ They are secured by assets of the borrowing firm (usually given senior secured status).
§ They have a long maturity (often three- to six-year maturities).
§ They have floating rates tied to LIBOR, the prime rate, or a CD rate (normally 200 to 275 basis points above these rates).
§ Classified as non-distressed and distressed ie. HLT borrowers experienced financial distress post-origination, leading to a
distinction between distressed and non-distressed markets.
§ They have strong covenant protection.
TYPES OF LOAN SALES CONTRACTS
Loan sale contracts consist of participations and assignments, with assignments currently accounting for the majority of loan sales trading.
Participations

The unique features of participations in loans are:

• The initial contract between loan seller and borrower remains in place after the sale.

• The loan buyer can exercise only partial control over changes in the loan contract’s terms. The holder can vote only on material
changes to the loan contract, such as the interest rate or collateral backing.

The economic implications of these features suggest that the buyer of loan participation has a double risk exposure: risk exposure to the
borrower and risk exposure to the loan selling FI. If the selling FI fails, an outside party's loan participation may be considered an
unsecured obligation of the FI, rather than a true sale, if there is any implied recourse between the seller and buyer.
Borrower claims against failed selling FI can be set off against loans, reducing outstanding amounts and negatively impacting the buyer's
participation in those loans, resulting in double monitoring costs on the buyer.
TYPES OF LOAN SALES CONTRACTS
Assignments
The key features of an assignment are:

• All rights are transferred on sale, meaning the loan buyer now holds a direct claim on the borrower.

Loan sale by assignment typically involves clear ownership rights, but contractual terms may restrict the seller's sale to specific
institutions, such as those meeting certain net worth/net asset size conditions. This is often required by the FI agent (A FI agent is a FI that
distributes interest and principal payments to lenders in loan syndications with multiple lenders.)

Loan syndications involve multiple banks collaborating to jointly lend to a borrower, often involving relationship banks who retain a
portion of the loan and seek junior participants.
TRENDS IN LOAN SALES
Banks and other FIs have sold loans among themselves for over 100 years. In fact, a large part of
correspondent banking involves small banks making loans that are too big for them to hold on their balance
sheets, for lending concentration, risk, or capital adequacy reasons, and selling parts of these loans to large
banks with whom they have a long-term deposit-lending correspondent relationship. In turn, the large banks
often sell parts of their loans called participations to smaller banks.
Loans in the secondary loan market are syndicated with multiple sponsoring banks. For example, J.P.
Morgan was the leading syndicator in 2011 but retained risk for only $257 billion of these loans, alongside
Bank of America Merrill Lynch, Citigroup, BNP Paribas, and RBS.
THE BUYERS AND THE SELLERS: THE BUYERS
Investment banks and vulture funds are increasingly specialized buyers of distressed loans due to regulatory and strategic reasons.
Investment Banks

Investment banks, like Bank of America Merrill Lynch and Goldman Sachs, are primarily buyers of loans due to (1) analysis of these loans
utilizes investment skills like those used in junk bond trading and (2) investment banks were often closely associated with the distressed
borrower in underwriting the original junk bond/HLT deals.

Vulture Funds

Vulture funds are specialized hedge funds established to invest in distressed loans, often with an agenda that may not include helping the
distressed firm to survive. These investments can be active, especially for those seeking to use the loans purchased for bargaining in a
restructuring deal; this generates restructuring returns that strongly favour the loan purchaser. Alternatively, such loans may be held as
passive investments, such as high-yield securities in a well-diversified portfolio of distressed securities. Many vulture funds are in fact
managed by investment banks.
THE BUYERS AND THE SELLERS: THE BUYERS
For the non-distressed HLT market and the traditional U.S. domestic loan sales market, the five
major buyers:
• Other Domestic Banks
• Foreign Banks
• Insurance Companies and Pension Funds
• Closed- and Open-End Bank Loan Mutual Fund
• Nonfinancial Corporations
THE BUYERS AND THE SELLERS: THE SELLERS
The sellers of domestic loans and HLT loans are:
• Major Money Centre Banks – JP Morgan
• Good Bank–Bad Bank – A possible solution when FIs may run into distress with their bad
assets, the famous Grant Street National Bank. These assets are placed in the bad banks at a
significant discounted price from their initial face value. The bad banks allow FIs to have a
much lighter balance sheet. This is a strategy where banks can unencumber themselves.
• Foreign Banks
• Investment Banks
• The U.S. Government and Its Agencies
WHY BANKS AND OTHER FIs SELL LOANS

FIs sell loans to manage credit risk, diversify assets, and achieve better asset diversification. Economic and regulatory reasons also encourage this practice.

Reserve Requirement

Regulatory requirements, including central bank reserve requirements, are tax-like taxes that increase the cost of funding a bank's loan portfolio. Regulatory taxes,
like reserve requirements, encourage banks to sell loans without external recourse, reducing assets and deposits, and increasing reserves against deposits.

Fee Income

A FI can report fee income from originating and selling loans as current income, while interest earned on direct lending can only be accrued over time. As a result,
originating and quickly selling loans can boost a FI’s reported income under current accounting rules.

Capital Costs

Capital adequacy requirements on FIs can be burdensome if required capital exceeds privately beneficial amounts. Debt is a cheaper source of funds, so struggling
FIs can boost their required capital to assets ratio through loan sales.

Liquidity Risk

In addition to credit risk and interest rate risk, holding loans on the balance sheet increases illiquidity of a FI's assets, exposing them to liquidity squeezes. That is,
whenever liability holders unexpectedly liquidate their claims. To mitigate this, management can sell loans to outside investors, creating a secondary market that
significantly reduces illiquidity of FI loans.
FACTORS AFFECTING LOAN SALES GROWTH

Notwithstanding the value of loan sales as a credit risk management tool, there remain a number of factors that will both spur and deter the
market’s growth and development in future years.

• Factors that may deter the market’s growth.

ü Access to the Commercial Paper Market
ü Customer Relationship Effects
ü Legal Concerns

• There are at least six (6) factors that point to an increasing volume of loan sales in the future:
ü BIS Capital Requirements
ü Market Value Accounting
ü Asset Brokerage and Loan Trading
ü Government Loan Sales
ü Credit Ratings
ü Purchase and Sale of Foreign Bank Loans
LIABILITY AND LIQUIDITY MANAGEMENT

• Depository institutions and life insurance companies face liquidity risk due to their relatively
illiquid assets, which can lead to bank runs when liquid claims are suddenly withdrawn or not
renewed, such as a large portfolio of nonmarketable loans.
• In addition to ensuring that FIs can meet expected and unexpected liability withdrawals, two
additional motives exist for holding liquid assets: monetary policy implementations and
taxation reasons.
• FIs can mitigate liquidity risk by effectively managing their liquid asset positions or portfolio
liability structure, thereby insulate their balance sheets from potential crises.
LIQUID ASSET MANAGEMENT
A liquid asset, such as T-bills, notes, and bonds, can be converted into cash quickly and cost-effectively, without causing significant loss in
principal value. The ultimate liquid asset is, of course, cash.

FIs can reduce liquidity risk by holding large amounts of assets like cash, T-bills, and T-bonds, but typically face a return or interest
earnings penalty. That is, high liquidity assets often offer low returns due to their risk-free nature, while nonliquid assets often lust promise
additional returns or liquidity risk premiums to compensate for instrument's lack of marketability and default risk.
Small liquid assets increase illiquidity risk for financial institutions (FIs), potentially leading to run-off, liability claim payments, or even
insolvency. Regulators often impose minimum liquid asset reserve requirements on financial institutions (FIs) for at least two other reasons
other than to mitigate the negative impact of contagious effects and ensure they can meet expected and unexpected liability withdrawals,
varying in nature and scope. The other two reasons are monetary policy implementation and taxation.
LIQUID ASSET MANAGEMENT
Monetary Policy Implementation Reasons
• Countries often establish minimum liquid asset reserve requirements to enhance monetary policy. Setting a minimum ratio of liquid
reserve assets to deposits, limiting depository institutions' lending capacity and enhancing central bank control over the money supply.

• Depository institutions can reduce their reserve requirement ratio (holding fewer reserves against their transaction accounts (deposits),
allowing them to lend out more of their deposits, thereby increasing credit availability in the economy.

• New loans finance consumption and investment expenditures, returning to depository institutions as deposits. These deposits are used
by DIs to create additional loans, and a decrease in reserve requirement multiplies the supply of DI deposits and money supply,
ensuring a stable financial system.

• An increase in the reserve requirement ratio forces depository institutions to hold more reserves against their balance sheets, reducing
credit availability and lending. This leads to a contraction in deposits and a decrease in the money supply, allowing the central bank
greater control over deposit growth thus over the money supply (of which bank deposits are a significant portion) as part of its overall
macroeconomic objectives.
LIQUID ASSET MANAGEMENT
Taxation Reasons
Another reason for minimum requirements on DI liquid asset holdings is to force DIs to invest in government financial claims rather than
private sector financial claims.

A minimum required liquid asset reserve requirement allows governments to raise additional taxes from DIs holding cash in vaults or cash
reserves at the central bank (when there is only a small interest rate compensation paid). Central banks' profitability depends on reserve
requirement tax size, which is a levy on DIs. Inflation can increase the cost effect of low-interest reserve requirements.
THE COMPOSITION OF THE LIQUID ASSET PORTFOLIO

The composition of a FI's liquid asset portfolio, including cash and government securities, is influenced by earnings and
central bank minimum reserve requirements.
A 20% liquid assets ratio mandates a DI to hold $1 cash plus government securities for every $5 assets, while US
minimum requirements on DIs are cash-based and exclude government securities.
As a result, government securities are less useful as they are not included in DIs' reserves and yield lower promised
returns compared to loans.
Government securities holdings serve as a secondary or buffer reserve during liquidity crises, allowing quick cash
conversion due to deep markets' ability to quickly convert assets.
MANAGING LIQUID ASSETS OTHER THAN CASH

• Reserve requirements dictate the minimum cash amount a FI must maintain to meet liquidity needs due to deposit withdrawals.
• Since cash is a non-earning asset, a FI typically stores as little cash as possible to meet its liquid asset needs, with the remaining assets
typically stored in its security portfolio, for eg; holding T-bills
• Liquidity management for financial institutions involves managing their securities portfolio. FI managers must determine the optimal
combination of lower-yielding, liquid assets versus higher-yielding, less liquid assets. Short-term marketable securities are held for
immediate liquidity needs, while longer-term securities can be sold if liquidity needs are larger than expected.
• FIs are special in that they can mismatch the maturity of their assets and liabilities (issuing short-term deposits to fund long-term
assets).
• Liquidity risk, linked to operational risk, can severely constrain the liquidation of less liquid assets during a liquidity crisis, potentially
affecting the solvency of the financial institution.
• FIs maintain liquidity through securitization and loan sales.
• FIs can sell loans (or securitize loans) for liquidity to long-term investors, such as insurance companies. These loan sales provide a
stream of liquidity that can be used to fund new loan demand or deposit withdrawals. However, as seen during the financial crisis,
these securities, like other long-term securities, may have to be liquidated at fire-sale prices.
• If a FI removes loans from its balance sheet, it can use loan sales to pay off depositors, reducing its reserve requirement and required
capital.
LIABILITY MANAGEMENT
• Liquidity and liability management are interconnected, with liquidity risk control focusing on prudential accumulation
of liquid assets.
• The management of the DI's liability structure is crucial to minimize the need for significant liquid assets to cover
liability withdrawals. Excessive use of purchased funds in the liability structure can lead to a liquidity crisis if
investors lose confidence in the DI and refuse to roll over such funds.
• Technological advancements and increased demand for efficiency in financial transactions have reduced deposit costs
and transformed liquidity risk management, enabling customers to access deposit and brokerage accounts via personal
devices.
• Preauthorized payroll cheque debits get cash into FIs’ deposit accounts faster and with more predictability. These types of services have
changed the way liquidity management is viewed by FIs.
LIABILITY MANAGEMENT: FUNDING RISK AND COST

Constructing a low-cost, low-withdrawal-risk liability portfolio is challenging due to the fact that
the riskiest liabilities are often the least costly to the DI. A DI must balance low funding cost with
high withdrawal risk against high funding cost and low liquidity liabilities, like demand deposits,
which can be withdrawn without notice.
By contrast, a fixed-term five-year certificate of deposit has high funding costs but can be
withdrawn after paying a substantial interest rate penalty, inversely related to funding risk.
LIABILITY MANAGEMENT: CHOICE OF LIABILITY STRUCTURE

Demand Deposits
Withdrawal Risk

• Demand deposits issued by DIs have a high degree of withdrawal risk. Withdrawals can be instantaneous and largely expected by the DI manager, such as
pre-weekend cash withdrawals, or unexpected, as occur during economic crisis situations, so-called bank runs
Costs

• Demand deposits in the US have zero (0) explicit interest since the 1930s, but this does not mean that they don't provide costless funds or mechanisms to
control withdrawal risk.

• Despite no explicit interest paid on demand deposit accounts, competition among DIs and other FIs has led to the payment of implicit interest or payments
of interest-in-kind, on these accounts.
• In providing demand deposits that are chequable accounts, A DI must offer a range of services including chequebook provision, cheque clearing, and
statement sending, which can be costly due to the significant labour and capital resources involved.
• DIs charge fees for services, such as 10 cents per cheque cleared, and if fees don't cover the cost, depositors receive a subsidy or implicit interest payment.
• The payment of implicit interest allows the DI manager to mitigate deposit withdrawals, particularly if rates on competing instruments rise.

• The DI could reduce cheque-clearing fees, increasing implicit interest payments to depositors.
LIABILITY MANAGEMENT: CHOICE OF LIABILITY STRUCTURE

Interest-Bearing chequing (NOW) Accounts

Withdrawal Risk

• Since 1980, US banks have provided negotiable orders of withdrawal accounts (NOW accounts), which are chequable deposits with
interest and can be withdrawn on demand.

• These instruments differ from traditional demand deposits by requiring a minimum account balance for interest, and if it falls below
$500, the account converts to demand deposits status. NOW accounts, with explicit interest payments and minimum balance
requirements, may be less withdrawal-prone than demand deposits, but they remain highly liquid from the depositor's perspective.

Costs

• The DI manager can influence the withdraw ability of NOW accounts by paying implicit interest or fee subsidies such as not charging
the full cost of cheque clearance. They can also impact the yield paid to the depositor by varying the minimum balance requirement (If
the minimum balance requirement is lowered, say, from $500 to $250, a larger portion of a NOW account becomes subject to interest
payments and thus the explicit return and attractiveness of these accounts increases) and the explicit interest rate payment.
LIABILITY MANAGEMENT: CHOICE OF LIABILITY STRUCTURE

Other major Liabilities a DI manager can utilize to influence liquidity risk exposure through the
selection of a liability structure :
• Passbook Savings
• Repurchase Agreements
• Money Market Deposit Accounts (MMDAs)
• Retail Time Deposits and CDs
• Wholesale CDs
• Federal Funds
LIABILITY AND LIQUIDITY RISK MANAGEMENT
IN INSURANCE COMPANIES

• Insurance companies utilize various sources for liquidity, including FIs, to cover claims on
policies and unexpected surrenders, which represent potential future liabilities.
• Liquidity management in insurance companies ensures funds meet claims with premiums, but
a high frequency of claims can lead to asset liquidation at a lower market value. That is, (e.g.,
an unexpectedly severe hurricane season) could force insurers to liquidate assets at something
less than their fair market value.
• Insurance companies can reduce their exposure to liquidity risk by diversifying the
distribution of risk in the contracts they write.
• Insurance companies can manage liquidity by holding marketable assets like government
bonds and corporate stock, which can be quickly liquidated to cover claims when premium
income is insufficient.
RISK ANALYSIS AND
MANAGEMENT
THE END