​Case Study: Letters of Credit

Case Study: Letters of Credit

0:00
Hi everyone, my name is John Kornacki, the Financial Strategist here at the Federal Home Loan Bank of Boston. Thanks for joining us today for another edition of our case studies series, this one titled “Letters of Credit.”
0:16
So just to start off here, I want to provide an overview of what a letter of credit is, or LOC as we call it, just so you have some basic understanding, if you're not familiar with the product.
0:26
So, FHLBank Boston offers members LOCs to secure deposits made by state governments, municipalities, and other public instrumentalities, and provide credit support for tax exempt bonds.
0:39
And we're going to discuss the benefits in more detail later on in the presentation, but just as a high level, our LOCs support your liquidity asset, liability management, and housing and community and economic development activities.
0:56
In terms of the different types that we offer, we offer a variety of forms that can be tailored to meet the specifications of your deposit relationship, with terms available out to 10 years, as well as different structures. And you can see that I've listed the structures here on this slide.
1:14
There are various factors that can impact which type of letter of credit may best fit your needs, including the projected amount of fluctuations in your deposit balance and the overall size of the public unit deposit program.
1:31
In addition to securing public unit deposits, LOCs can provide support for bond issuance.
1:38
For example, construction companies partnering with state housing agencies may require an LOC from a highly rated entity in order to meet investor requirements, and that's where the FHLBank Boston can help members meet the needs of their customers.
1:55
And then in terms of product usage, I've listed out here a number of the purposes that our members can utilize LOCs.
2:04
The first one here is Securing Public Unit Deposits, and that's really going to be the focus of today's discussion.
2:09
And the reason is, many of our bank members have public unit deposits as part of their funding mix, and, you know, when you look at what's required for public unit deposits, many municipalities and public subdivision depositors often require financial institutions to secure these deposits and many of our members will pledge securities as collateral in order to do that.
2:34
And so the LOCs offer an alternative to pledging securities, and throughout this presentation we're going to talk about how there's benefits in doing that over pledging securities.
2:49
We're now going to focus on Public Unit Deposits.
2:52
As I mentioned, many of these deposits are required to be collateralized and we're going to compare pledging securities as collateral versus looking at LOCs to collateralize.
3:04
So, let's start off by looking at pledging securities first.3:07 The first point listed here says decreased on-balance sheet liquidity.
3:11
So, if you think about your liquidity ratio, you know that pledged securities detract from that ratio
3:18
as those are restricted because they are used to secure deposits.
3:23
We also know that in securing deposits, there are restrictions on the types of securities that are permitted.
3:29
So rather than owning securities that allow you to manage your balance sheet effectively, you're required to own securities that collateralize deposits. So that alone impacts the way you manage your investment portfolio.
3:46
The next point here is earnings impact.
3:49
We talked about how there are certain requirements in terms of the securities allowed as collateral.
3:55
Many of these securities are among the lowest yielding on your balance sheet, so if you're only purchasing those securities to collateralize deposits and not purchasing for anything else, then you may be limiting your earnings potential.
4:09
And then the last point here is operational burden.
4:12
The process of collateralizing deposits can be time consuming and can strain operations.
4:20
If we turn our attention over to letters of credit, we can discuss the alternative aspects of this product.
4:27
With LOCs,
4:28
these guarantee the FHLBank Boston will pay the public unit depositor upon demand
4:35
should a member default on the deposit.
4:38
This offers an efficient and flexible alternative that provides your customers with the security that they need by leveraging FHLBank Boston strong credit position.
4:52
The next point is on managing liquidity efficiently and we talked about how pledging securities encumbers those securities.
5:01
With LOCs, you can unburden those high-quality securities that would have been pledged
5:06
and in turn with LOCs you can use less liquid assets like residential and commercial loans as collateral.
5:16
And then the last point here is on optimizing earnings. We already talked about some of the drawbacks in pledging securities in terms of the types of securities required.
5:26
So, if your primary reason for purchasing securities is to collateralize deposits, then there may be an opportunity cost where you could be more efficient in managing those purchases.
5:39
The LOCs may allow you to reallocate into assets that better meet the earnings and asset liability needs of your organization.
5:52
So, we talked about in the last slide how pledging securities impacts your liquidity ratios.
5:59
And so, we're going to talk about [a] hypothetical scenario here where we look at the impact of using our LOC product in place of pledging securities.
6:11
So, if we look here, the current position of 11.61% for liquidity ratio and 51.64% for pledged securities.
6:20
So, what we're going to do is we're going to take this $20 million, and we're going to utilize our LOC product and we're also going to reduce our pledged securities from $111 million to $91 million.
6:33
So, … by utilizing the LOC product, we use some of our borrowing capacity at the FHLBank Boston, but in turn, what we see is a significant impact to our liquidity position.
6:47
For this particular member, it's going from 11.61% to 13.46% on their liquidity ratio, which is 185 basis point increase.
6:58
And then on unpledged securities, it's a reduction of from 51.64% to 42.36%.
7:06
So, what we're doing here is we're allowing our pledged securities to become unencumbered so they can contribute to the liquidity ratio rather than detracting from it.
7:18
And we're also able to use less liquid assets like residential and commercial loans for the collateral on the LOC product and free up more liquid assets that would normally be used to pledge securities.
7:34
So now going over to the earnings impact here, we also talked about how, if you're pledging securities for the sole purpose of collateralizing Public Unit Deposits, then there may be some opportunity costs lost in doing that strategy.
7:50
And this is where the LOC product … can help with that and so, we're using the same $20 million that we've talked about on the last slide, and we're freeing up those securities.
7:59
And in this scenario, we're going through a hypothetical situation where we free up the securities, and we invest in loans.
8:06
And so you can see here that … the yield on the securities is 1.7%, and the yield on loans is 3.72%. So, what we're doing is we're decreasing … the securities balance and increasing it into the loans balance because the assumption is that we're using our capital to invest in securities that are low yielding
8:28
rather than investing in the most efficient products for our balance sheet.
8:36
And so, you can see, the impact charts down here, we're seeing net interest margin goes from 2.99 to 3.02%.
8:45
And return on average assets goes from 0.64% to 0.67%.
8:51
So this is a very simplistic example, but like I said, when, if your sole purpose of purchasing these securities is for collateralizing Public Unit Deposits, then you may be giving up yield in other areas that could be used more effectively.
9:11
So now I've just listed a few additional resources here. We didn't go into a tremendous amount of detail on the types of types of letters of credit,
9:18
so, I've linked that to our website. So if you're curious to find more detail on that, also pricing, and then … forms and applications, so, if you are interested, please reach out to your RM or myself and we can dig deeper into this topic and see if this product makes sense for your institution.
9:41
​As always, thanks for listening. Here's my contact information. Again, always happy to discuss in more detail if you'd like so don't hesitate to reach out. Thank you.