By Ernest Bey
Monday, November 30, 2009 at 10:41am
The closing years of World War II, most of Europe, the U.K., Northern Africa, Baltic’s, Russia, and Asia were devastated. Millions of people were without homes and the basic needs of life. How can the world repair the damage caused by the most destructive war ever in history? Where was the money to rebuild on such a vast scale?
Inaugurated in July 1944, at a conference of 130 western world economists and politicians, held in Bretton Woods, New Hampshire, “the Bretton Woods Convention”, proposals were put forward by the principal architect, John Maynard Keynes, author of “The Economic Consequences of the Peace”, written in 1920. Keynes and his proposals were supported and endorsed by Harry Dexter White, United States Secretary of the Treasury. The heart of Keynes proposals were two basic principals: First, the Allies must rebuild the Axis countries, not exploit them as had been done after World War I. Second, a new international monetary system must be established, headed by a strong international banking system and a common world currency not tied to the gold standard. The principal agreements reached by 1947 by the Bretton Woods Convention were: 1. The United States Dollar replaced the Pound Sterling as the medium of international trade and the world reserve currency, however: 2. The USD was still tied to the gold standard and backed by Gold at $35 per ounce, the pre WWII level. 3. The Bretton Woods convention produced the Marshall Plan, the Bank for Reconstruction and Development (World Bank) the International Monetary Fund (IMF) and the Bank of International Settlements (BIS).
By 1961, the plans adopted by the Bretton Woods Convention of 1947 were succeeding beyond expectation, however U.S. dollars were in short supply as the U.S. was faced with a dwindling gold supply to back additional dollars. The solution was to recycle the current number of dollars back into the world commerce, which would solve the problem by avoiding the printing of more USD. A system was needed to draw the USD back into circulation through the private banking sector. The system was found in the centuries-old framework of Import/Export finance. This system hinged on having the world’s top banks extend the use of forfeit finance, not backed by gold, but by their own good faith and credit. This extension of credit would be backed by banking debentures of all kinds including Letters of Credit, bankers’ acceptances, bills of exchange and guarantees.
Laws, rules and procedures provided by the International chamber of Commerce, Paris, France, as already established and recognized by international accord for forfait financing, were adopted for these Bank Debentures and their use. The international banking sector was encouraged to issue Letters of Credit, Bank Guarantees and Bank Debentures in large denominations, at yields superior to U.S. Treasuries. This was to offset the increased costs to issuing banks due to the high yields accompanying the Bank debentures. Banking regulations within the countries involved were modified in such a way to encourage and/or allow the following: a. Reduced reserve requirements via offshore transactions. b. Support by the Central Banks, World Bank, International Monetary Fund and the Bank for International Settlements. c. Off-balance sheet accounting by the banks involved. d. Instruments to be legally ranked “pari passu” (on the same level) with depositor’s funds. e. The banks obtaining their depositor funds would be allowed to leverage these funds with the applicable central bank of the country of domicile in such a way as to obtain the equivalent of federal funds at a much lower cost. f. When these leveraged funds are blended with all other accessed funds, the overall blend rate cost of funds to the issuing bank is substantially diminished, thus off-setting the high yield given to attract the investor with substantial funds for deposit.
The bank for International Settlements (BIS) rules prohibits banks from buying the newly issued instruments from each other directly in the primary market. However, it does allow banks to buy and own other bank’s financial obligations as long as they are purchased from the secondary market. Therefore, the issuing banks must have third party Clients to process this business through. This ruling has created the investment opportunities we now enjoy in Bank Credit Instruments.
The Federal Reserve Board recognizes a tier of high quality banks, usually in the world’s top 100, which are authorized to deal in these instruments and these are called the Applicant Banks. The criteria for being on the Fed list includes the strength in normal banking ratios as well as countries in which the Fed desires to be active. It is clear that the largest supply of international USD is in Europe and this explains the dominance of European Banks on the Fed list. Major issuing banks then realized other benefits, other than funds recycling and redistribution. The Bank Credit Instruments provided bankers with a means to resolve other major banking problems, such as interest rate risks and meeting capital reserve requirements.
In 1971, the volume of world trading finally exceeded the volume of USD as the medium of exchange and exceeded the ability of the U.S. to support its currency with gold. The Nixon administration let the dollar float in the world markets, not tied to gold, but tied to the full faith and credit of the assets of the United States. The value of the dollar was now in the currency markets hands. Nixon deeded the Bank Credit Instruments as put in place by the Kennedy administration, in conjunction with the International Monetary Fund and the Bank for International Settlements to work hand in hand with the central banks of the Western countries to avoid a collapse of the dollar’s value. The principals of this system realized the following effects:
a. Issuing Bank Debentures would pull USD out of the private sector and exchange them for guarantees. b. Once the USD had been accessed, then the issuing banks could recycle them back into the world economy as loans. This process increased money supply. c. Alternately, the issuing banks could purchase the U.S. Treasuries from the Fed, thereby retiring the supply of dollars in the world market back into U.S. hands or selling the Treasuries to the Fed to increase the money supply.
Bank Debentures became the tool for the U.S. Government to control the amount of USD floating against other currencies and to help maintain the value of the dollar. Therefore, the fear of “run-away” inflation can be limited by controlling the number of USD available to the world market at any given time. At the present the Fed targets USD held in off shore and foreign banks, not resident in the USA for this “recycling”.
Today, the Bank Credit Instrument Trading Programs are increasingly used to support not only the enormous demand for USD, in particular, through the IMF and World Bank, but also the various nations that the Clinton administration has pledged to assist. These include the U.S. policies to “westernize the former USSR” and support other countries like Haiti, Bosnia, Somalia and Kuwait.
These Bank Credit Instrument programs designed under the Kennedy administration are still very effective to assist in recycling and redistributing USD to meet the world’s demand for commerce. Most importantly, through the Federal Reserve Bank, the U.S. Government uses these programs to control the dollar and its value in the world market. In summary, the use of these Bank Credit Instruments provides instant liquidity and safety. They are a principal factor, which has served to prevent another financial crisis in the world economies.
Bank Credit Instruments Issuance
WHY SHOULD SUCH INSTRUMENTS BE ISSUED?
To understand the logic behind the actual mechanics of the operation it is necessary to look at the ways in which a bank usually operates. The banks credit rating and status within society 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, debits and other liabilities showing a ratio of liquidity. Each jurisdiction of the world banking system has different minimum capital adequacy requirements and depending on the status of the individual bank, the ratio over assets that the bank can effectively trade can be as high as 20 times the minimum capital requirement. For every $100 held in capital the bank can frequently lend or obligate up to $1,000 to other clients or institutions against the cash on hand thanks to the multiplier ratio available from their central bank. Further, if the bank disposes of an asset, the resultant capital is able to be “leveraged” using the bank’s multiplier ratio, based on the minimum capital adequacy requirements.
THE ISSUANCE OF A BANK CREDIT INSTRUMENT (STANDBY LETTER OF CREDIT)
A bank receives an indication from a client that the client is willing to “buy from the bank a one year obligation, zero coupon, and effectively unsecured by any of the physical assets of the bank. The credit instrument is based solely on the “full faith and credit worthiness of the bank”.
Obviously the format of the credit instrument must be one that is acceptable in any jurisdiction and freely transferable, able to be settled at maturity in simple terms and is without restrictions other than its maturity conditions. The instrument that immediately comes to mind is the Documentary Letter of Credit or Standby Letter of Credit. However, as the issue is not trade or transaction related most of the terms and conditions do not apply. The simple “London Short Form” version of the Standby Letter of Credit is often utilized for this simple one-year “corporate debt” type obligation. The test is specific and does not contain any restrictions except the time when the credit is valid and can be presented for payment. It is in real terms a time payment instrument due on or after one year and one day from the date of issue, usually valid for a period of fifteen days from date of maturity.
Standby Letters of Credit also serve as substitutes for the simple or first demand guarantee. In practice, the Standby Letter of Credit functions almost identically to the first demand guarantee. Under both, the beneficiary’s claim is made payable on demand and without independent evidence of its validity. The two devices are both security devices issued in transactions not directly involving the sale of goods and they create the same type of problems.
STRUCTURE OF BANK PROFITABILITY
The blank piece of bank paper, i.e., the London Short Form, which is technically an asset of the bank valued at say 2 cents is now "issued” and the text added in to say “one hundred million US Dollar face value”, signed and sealed by the authorized bank officers. The question now is “what is the piece of paper worth?” Is it worth 2 cents or US $100 million? Bear in mind that it is completely unsecured by any tangible or real asset. In reality it has a “perceived value” of US $100 million in 366 days time based upon the “full faith and credit of the bank”, for our purposes always an A to AAA rated institution.
The next question, which now must be asked, is “will the bank honor its obligation when the bank note or credit is presented?” This will, of course, depend upon the reputation and credit worthiness of the issuer. Assuming a creditworthy institution we have now arrived at the “belief” that the “value” is US$100 million in 366 days time, the “Buyer” must now negotiate a price, or discount, which is acceptable to the Bank to cause it to “sell” the credit.
To arrive at a sales price one has to determine the accounting ramifications of the sale. The liability is US$100 million payable “next year”, and it is important to note that the reason for the one year and one day period is to take the liability into the next financial year, no matter when the credit is issued. The liability is held “off-balance sheet” and is technically a contingent liability, as it is not based upon any asset. On the other side of the model, the bank is to receive cash from the “sale of an asset”, i.e. the issued paper, and this cash is classified as capital assets that in turn are subject to the central bank borrowing multiplier of say, 10 times.
So in real terms the issuing bank is to receive say 80% of the face value upon sale, which is US$80 million cash on hand against a forward liability of US100 million in one year and one day’s time. The cash received, US$80 million, allows the bank to lend 10 times this amount under the bank’s multiplier ratio, so US$800 million is borrowed from the central bank at say, 3% discount rate interest, and this in turn is able to be lent “on balance sheet” against normal assets such as real estate, businesses, etc. If the interest rate is, for instance, 8% simple and the loans are short term (one year) to coincide with the liability, the income and return (without taking into account the principal sums loaned) from interest alone is equal to US$64 million.
At the end of the year the credit is due for payment against the cash on hand and the interest received, in other words, US$80 million plus US64 million which totals US$144 million income to the bank, less the US$100 million owed on the issued paper and the US$24 million interest owed to the central bank shows a gross profit of US$20 million or 20% yield on the original US$100M bank debenture paper issued.
US$ 80M from issuance of one-year paper US$ 64M from interest income on US$800M at 8% US$144M income.
US$100M owed to holder of the Bank Credit Instruments. US$ 24M owed to central bank on int. US$800M US$124M expense.
US$144M income US$124M expense/interest and principal US$ 20M profit to bank.
The reason for issuing the credit is now obvious. The resultant yield is well over the given discount and the bank is in a profitable position. Without risk they have achieved a greater asset yield than by any conventional means.
There is a greater underlying reason which is also indicated if an overview of the complete supply system is taken. To simplify the explanation, a flow chart has been drawn which shows the roles of each entity and the details given by an individual who represented the information as direct from the “Federal Pool” which will be outlined herein.
As most people are not aware, the Federal Reserve Bank is not a Federal Government entity or body, it is in fact a private, banking institution. It may well operate in a quasi-governmental manner but it is still under the control of private individuals and profit is still one motive for their activities.
If one assumes that the money supply requirements for a specific period shows a need to print, say US$100 million of new issue currency and the U.S. Treasury is required to issue same, the impact of the release of those “new” dollars in terms of inflation and market effect is quite strong. If, however, the U.S. Treasury, through the Federal Reserve Bank was asked to issue or “sell” those dollars for “cash”, the amount of the “new” dollars today is reduced by whatever amount is being yielded. If we take the case in question, suppose the Federal Reserve Bank had “contracted” with a major world bank to “issue” dollar denominated one-year paper in the amount of US$100 million and “sold” this paper through a secure network of entities so that the “sale” did not appear “on market” and that the “sale” was at a discount of say 80% of face value. The cash yield back to the U.S. Treasury would be US$80 million against a dollar credit of the same amount to the issuing bank, with the bank taking a US$100 million liability position at the maturity date.
The U.S. Treasury has now received US$80 million in cash back from the market/system and need only print, i.e., create reserves of US$20 million to meet its current obligation to the money supply. This is 20% of the original amount and as such, the inflationary impact on the system is greatly reduced. Of course, if the amount “sold” is greater than the money supply requirements, the U.S. Treasury has a reduction that allows lower interest rates to be maintained and/or controlled. The long-term position is not affected as the issuing bank has taken on the liability, not the U.S. Government. Further, the dollar credit is classed as “cash” for the purpose of capital adequacy compliance and not required to be physically “printed” and as such, a simple ledger entry is sufficient.
The off-market issuance and sale of Bank Credit Instruments are controlled by simple supply and demand techniques, and all U.S. Dollar denominated papers are “issued” through the Federal Reserve Bank. To do this, the Federal Reserve Bank enters into an understanding with the U.S. Treasury and the top 100 world banks, excluding state operated banks, most American banks, Third World banks and any other banks, which may have a capital/credit problems.
Each bank agrees to allow the Federal Reserve Bank to issue, on its behalf, a specific amount of U.S. dollar denominated paper or the alternative applies where the Federal Reserve Bank allocates a specific amount to each bank. The details are not published and no physical evidence has been made available. In any case, the result is that a specific volume of paper is available and the Federal Reserve Bank is now able to release it on demand.
The various bank paper is “pooled” together to give the total position for each year and it is from this “Federal Pool” that the supply contracts are issued. The existence of the “Federal Pool” is not confirmed by the Fed. However, various documents including GNMA transfer documents contain a “Pool Number”. The “grand master collateral contracts”, are effectively issued by the Federal Pool. It is indicated that these are usually issued in US$500 million units with each minimum denomination being US$100 million. In other words, the minimum order is US$500 million in US$100 million “tranches” (from the French verb trancher “to slice”).
One point that should be raised at this time, although the marketplace and issuance of these instruments are “unregulated”, the banks are effectively controlled by the BIS and self-imposed rules. As mentioned previously the participating banks are not allowed to purchase each other bank’s paper in the primary market, bank to bank purchases are only allowed in the secondary market. Otherwise the whole system would be subject to possible manipulation and abuse by a bank, or group of banks, entering into a form of “insider trading”. This would be detrimental to the system and participating banks prefer to compete head-to-head. Further, from the investor standpoint this rule has allowed the investment market for these instruments to flourish.
The entities that are the holders (Commitment Holders) of the “grand master collateral contracts” are commonly referred to as “cutting houses” as they usually reduce the size of the denominations, i.e., “cut down the size of the issuance”. Their commitments with the banks are frequently in the form of an option to buy an agreed upon amount of the paper per week or per month. A typical figure would be $100M to $500M per week yielding a $4 Billion to $20 Billion per year “commitment” based on the European banking industry typical 40 week trading year. The cutting houses then in turn “sell” or deliver commitments to wholesale brokers.
In both cases the cash payment or deposit is able to be called upon if an order is not met or paid for on time. If the contract is called for and the contract holder cannot pay, the contract holder would lose his contract and would be “blacklisted” in the system to prevent any new contract position. The rules are very simple, cash payment at all times. The trading in foreign exchange currency markets is accomplished the same way. It is the “honor system” backed up by the real fear of losing a very valuable “seat at the table” that keeps the brokers honest and the payments prompt.
It is assumed that each cutting house would normally issue, for instance, 50 delivery commitments or “sub-master commitments” at US$2.5 million each. Therefore, their deposit of US$100 million is now covered plus a reserve of US$25 million. The wholesale brokers are responsible for feeding the volume of instruments to the clients or customers who are at the retail or retail distribution level and then subsequently to the secondary market.
The issuing banks can be identified as the “manufacturers” of this product; in this case the product is bank paper. The Federal Reserve Bank can be identified as the “importer” (80% of face value). The Federal Pool can be identified as the “storage depot” (82.5% of face value) for all the products before sale and are responsible for the bulk release to the cutting house. The cutting houses can be identified as the “regional distributors” (85% of face value) and are responsible for the release of units to the local distributor. The wholesale brokers can be identified as the “local distributors” (87.5% of face value) who release units on demand to the “retail showrooms”.
The primary clients can be identified as the retail showrooms (89% of face value) that deliver the units to the “public buyers”. The public buyers exist in the secondary market (92-94% of face value), such as pension funds, high net worth individuals, fixed-income money managers, other bank’s etc., (for a bank to buy on the secondary market is not classed as contrary to the “insider trading” rule mentioned previously). The public buyers hold the instruments until maturity and gain the preferred yield from the discount against the face value (100%) from the issuing banks.
The biggest problem encountered regarding this matter is the contradictory and somewhat unusual attitude of the banks when any attempt is made to obtain any definitive documents or information regarding these activities. The very existence of these instruments has been denied at senior levels by bank officials. This is caused by the fear the bankers have of irritating major depositors that would be very upset to learn of this lucrative banking market and then demand higher yields on their deposits.
Bank Credit Instrument Distribution
The globalization and deregulation of the banking industry and financial markets have intensified competition from securities firms, insurance companies and pension funds. In response, banks have diversified and expanded the spectrum of banking activities. The increasing use of certain Bank Credit Instruments is one of the most important of these because of the enormous expansion in capital that it enables major banks to achieve without encumbering their balance sheet.
This business is one of the most confidential activities of major international banks today. The reasons for this secrecy are not difficult to understand. The banks are issuing private bonds to large investors (typically in the $100 million to $500 million range) at higher than market rates to augment their working capital. The banks refuse to disclose the existence of this “wholesale money market” for fear that their larger retail customers will try to negotiate higher deposit rates. In addition, the issuance of these notes represents a real liability to the banks, but one that is not reflected in its balance sheet i.e., “off-balance sheet”, accounting. Therefore, the banks are concerned that disclosure of this extent of these borrowings could reflect negatively on public perception of their financial soundness, credit worthiness and overall fairness to depositors.
The buying and selling of Bank Credit Instruments involves a chain of producers, wholesalers, retailers and customers, as mentioned before; analogous to that of many manufactured products. The “producer” in this case is the bank that issues the fresh paper.
The wholesaler is a “cutting house” that holds an “option” to buy fresh paper from the bank at steeply discounted rates. This option is normally obtained in return for a commitment by the option holder to purchase a fixed amount of fresh paper during a specified time period. A typical commitment, as mentioned previously, would be $100 to $500 million per week.
Obviously, the option holder cannot continue to make purchases of this type without substantial working capital and a resale-ready market for the paper it buys. One way the option holder can increase available working capital is by accepting investments from large investors in a bank credit instrument trading program. The investor gives the option holder (now called a trade manager) a limited power of attorney to utilize the investor’s funds as collateral solely for the purchase and sale of fresh paper. The process involves the issuance of a purchase order from the investor’s account to the issuing bank, in response to which the issuing bank issues an invoice for a fresh cut credit instrument at a particular price. After the investor’s bank authenticates and accepts the invoice, the credit instrument is exchanged for funds and is deposited into the investor’s account. This transaction is done entirely on a bank-to-bank basis without any involvement on the part of the investor. In many cases the same bank is used for the issuance of paper as for the deposit of investor’s funds.
Once the fresh paper has been issued, it must be quickly resold in volume. This is accomplished by pre-selling the notes to large investors looking for a long-term fixed return; especially insurance companies, pension funds, major corporations, trusts, notional governments and wealthy private parties. These investors may hold the paper until maturity or resell it in the secondary market once it is “seasoned”. Usually the trade manager enters into contractual arrangements with large securities firms to market the paper to these retail customers. This pre-selling of the notes is what virtually eliminates any market risk to these transactions.
The steps in the chain of distribution (investment) can be depicted as follows:
1.The investor proves availability of funds for purchase of bank credit instruments (proof of funds).
2.Bank issues fresh paper.
3.Option/Commitment Holder buys the paper with own funds or Trade Manager purchases paper with Investor’s funds through a Trading Program Account.
4.Securities firm contracts to buy the paper for resale or arrange for its direct sale to large retail (institutional) investors in the secondary market.
The distribution system works because it is financially attractive to each member of the chain. This requires that the sale price of the paper at each subsequent level be higher than the previous one and still attractive to each buyer relative to comparable competing investments. The following is an illustrative example:
Fresh cut paper is sold by issuing bank to the option holders for 80% of face value. The Option Holder resells the paper to an institutional investor at 94-95% of the face value. The margin of 14-15 points is shared by the option holder, the bank facilitating the transaction and the investor. The institutional investor then holds the note to maturity and receives the spread between purchase price and face value as well as annual interest payment of 7.5%.
In this example, the bank issuing the paper receives a rapid cash inflow for higher leverage lending at a very low cost. Since it “buys” the funds in very large blocks, the overhead costs are extremely low in comparison with the cost of accepting retail deposits and the bank has ability to augment its capital on short notice in order to support specific high profit margin business opportunities.
HOW BANKS PROFIT WITH THE MULTIPLIER RATIO IN MTN ISSUANCE
Let us take a hypothetical example of a bank that has an opportunity to lend $9 Billion for a low-risk major industrial infrastructure project. The bank decides to raise $1 Billion of additional capital through the issuance of its own Bank Credit Instruments (Medium Term Notes) and then to borrow eight times this amount from its central bank to raise the $9 Billion required for the loan. The following illustrates the steps takes:
Issuance of 125 - $10 million (face value), 10 year, 7.5% MTN at a price of 80% of face value generates: $1,000,000,000.
Borrowing from Central Bank (8 times multiplier ratio) $8,000,000,000 Total funds available for loan $9,000,000,000.
Expenses to Bank Interest paid by bank to holders of 125 – 10 year, 7.5% bank debentures 7.5% X 10Million X 125 X 10 years $937,500,000 Interest paid by bank to the Central Bank on borrowing at 3% X 8 Billion X 10 years $2,400,000,000 Total Interest Expense over 10 year Term $3,337,500,000 Income to Bank Revenues to bank from interest paid by borrower over 10 years on $9 Billion @ 7% for 10 years $6,300,000,000 Total interest expense $3,337,500,000.
NET PROFIT TO BANK IN TEN YEARS $2,962,500,000
As one can plainly see, the leverage allowed by the central banks allows for very profitable long term lending for member banks. The Bank Credit Instruments created in this example are the instruments which, are traded in the secondary market. In the example shown above, the investor would get a share of the 3-4% margin between the issuing price and resale price of the Bank Credit Instruments. The overall profit to the investor depends on three elements. They are the number of times which the investor’s capital can be turned over during a given period of time, i.e., the number of trades per year, the amount of “spread” or profit per trade and the presence or absence of leverage. The frequency of trades depends on the type of arrangements the trade manager has in place for reselling the paper that is issued. Taking into account the large number of international banking days, trading programs typically conduct between one and four trades per week for 40 weeks per year. Assuming two trades occur each week and each trade pays one percent to the investor, then the return to the investor will be 80 to 100% annually. If the yield per trade or the number of trades is higher, then the return could be proportionately greater.
Bank Credit Instrument Marketplace
By trading specifically selected, standard financial Bank Credit Instruments, an entity may obtain profit margins not normally heard of in the domestic stock; bond and futures markets without incurring the risk to invested capital normally associated with investing in these markets. The financial instruments to be selected for trading programs are standard Bank Credit Instruments issued by the top 100 rated world banks in accordance with International Chamber of Commerce rules. These Bank Credit Instruments may be bought from issuers at a discount, and then resold at a profit on the secondary market.
Since American Banks are prohibited by law (the Glass-Steagal Act) to sell these instruments for underwriting in the domestic markets and because regulatory procedures and requirements inhibit these transactions in the American securities markets these transactions are usually conducted in the Eurodollar Market, in places such as London, Zurich, Geneva, Luxembourg, Brussels, Hong Kong, etc. However, the institutional market in America does trade these instruments, and for all practical purposes, these transactions may be negotiated and arranged in the United States for subsequent completion and closing in the Eurodollar Market through foreign branches of domestic money center banks.
These financial instruments are only traded in very large amounts and therefore, the trading opportunities in this investment field are restricted to Governments, Trusts, Mutual Funds, Pension Plans, Large Corporations, Merchant Banks and high net worth individuals. It is for these reasons that only a few investment professionals and knowledgeable, sophisticated parties are aware of this lucrative and very safe investment opportunity.
The key to arranging a successful and profitable trading program is the guarantee of a steady supply of moderately priced Bank Credit Instruments. It is therefore most important that a purchase contract for the collateral supply is arranged with a supplier. Trading facilities must also be arranged with financial institutions for fiduciary services and access to the Eurodollar market, or through securities houses or institutional investment bankers in the United States and in Europe.
Since the trading activity involves Bank Credit Instruments at prices below the face value of the instruments, the purchase arrangements may be effected without the actual cash payment. Proof of funds for the purchase could be arranged through a line of credit at a major bank via issuance of a SWIFT Wire document or a Letter of Credit.
In order to collect payment, the supplier must provide and present his bank invoice showing the identity of the instruments, such as CUSIP numbers for 10 year Medium Term Notes, or bank registration numbers and safekeeping receipts for one year Standby Letters of Credit. When provided with this information, the financial institution is then able to arrange for the sale of the instruments in the Eurodollar market within hours.
With the use of the SWIFT Wire system, the transfer of funds is then arranged for same-day settlement so that the use of the original SWIFT Wire document of Letter of Credit is not necessary, leaving it free for re-use in the next transaction. Because of today’s banking telecommunications – Key Tested Telexes (or KTT’S) SWIFT Wire, etc., it is possible to arrange for more than one of these transactions per week. These programs usually continue for a period of twelve months, with typically a forty-week trading year, i.e., the actual period in which the paper trades.
Off-Balance Sheet Activities
The issue of bank credit and bank guarantee instruments has been a part of daily banking practice for many decades. The best known of these instruments is the commercial letter of credit, which is widely used, in foreign trade. The commercial letter of credit is a guarantee issued by the buyer’s bank to the seller’s bank. It ensures that if the buyer fails to pay or perform under the terms of the transaction, the buyer’s bank will assume the liability and pay the seller. Because these instruments are considered contingent liabilities of the bank (based on the potential default of the applicant), they are accounted for “off-balance sheet”.
A glimpse at the current magnitude of off-balance sheet banking was given in a recent press statement in which Deutsche Bank reported its off-balance sheet business at US$800 Billion in 1993 or roughly 2.4 times its on-balance sheet business. For Swiss and American banks, off-balance sheet operations are 7 to 30 times larger than on balance sheet activities.
Since the 1930’s and with dramatically increasing frequency during the last fifteen years, the largest western European banks (top European 25) have extended the use of off-balance sheet transactions to include issue and sale of various guaranteed senior bank obligations or credit instruments. These include Medium Term Notes (MTN) and one-year, zero coupon, standby letters of credit or (SLC). The medium term debentures are usually ten year notes carrying a 7.5%+ - coupon. These instruments are backed by the full faith and credit of the issuing bank.
Several factors have promoted the growth of off-balance sheet banking activities. First they provide a substantial source of additional capital for the banks. The banks augment their capital by issuing notes and are then able to borrow several times (5 to 10 times depending on the multiplier ratio of the country of domicile) from their central bank at lower interest rates. The higher interest paid on the notes is offset by the low interest rate on the much larger central bank borrowing. Second, fee-based issuance of debentures for third parties provides an increasing source of profits to the banks. In 1993, top German and Swiss banks reported record profits from off-balance sheet business, including fee-based trading which now represents their largest source of earnings.
Bank Credit Instruments in Conclusion
The use of Bank Credit Instruments as a medium or short-term investment is obvious. If one takes the differential between the “face” rice and the “present value” and moves a client’s funds into and out of the instruments on an active, regular basis the effective yield is substantial. The downside from trading in these instruments is nearly nil, if one retains strict protocol over the program structure and documentation.
A worst-case market risk scenario would be that a client would either not transact and therefore not be at risk or hold the instrument to maturity. If an instrument had been purchased and for whatever reason could not be onward “sold or discounted” the client who “held to maturity would automatically achieve a substantial yield (compared to other A-AAA rated paper) based on the maturity value against the discounted face value.
As can be readily seen from this report Bank Credit Instruments when handled by expert, ethical Program Managers and Traders are a safe and prudent investment. In the final analysis, it behooves prudent investors, in an effort to diversify the range of their holdings, to include investment in these instruments to offset other, higher risk portions of their portfolios. These instruments truly embody the best risk/reward ratio in today’s investment marketplace!
Senior Administrative Trustee
Senior Accounts Manager
Five Star Trust