Case
CALCULATING INCOME ON OFF-BALANCE-SHEET ACTIVITIES
Dudley National has issued the following offbalance-sheet items:
• A one-year loan commitment of $1 million with an up-front fee of 40 basis points. The back-end fee on the unused portion of the commitment is 55 basis points. The bank’s base rate on loans is 8 percent, and loans to this customer carry a risk premium of 2 percent. The bank requires a compensating balance on this loan of 10 percent to be placed in demand deposits and must maintain reserve requirements on demand deposits of 8 percent. The customer is expected to draw down 75 percent of the commitment at the beginning of the year.
• A one-year loan commitment of $500,000 with an up-front fee of 25 basis points. The back-end fee on the unused portion of the commitment is 30 basis points. Loans to this customer carry a risk premium of 2.5 percent. The bank will not require a compensating balance on this loan. The customer is expected to draw down 90 percent of the commitment at the beginning of the year.
• A three-month commercial letter of credit on behalf of one of its AA-rated customers who is planning to import $400,000 worth of goods from the Germany. The bank charges an upfront fee of 75 basis points on commercial letters of credit to AA-rated customers.
• A standby letter of credit to one its A-rated customers who is planning to issue $5 million of 270-day commercial paper for an effective yield of 5 percent. The corporation expects to save 50 basis points on the interest rate by using the SLC. The bank charges an up-front fee of 40 basis points on SLCs to A-rated customers to back the commercial paper issue.
a. What up-front fees does the bank earn on each of these?
b. What other income does the bank earn on these off-balance-sheet activities?
c. Calculate the returns on each of the off-balancesheet activities assuming that the takedowns on the loan commitments are at the expected percentage and the customers holding the letters of credit do not default on their obligations.
