Transcript Saunders Cornett Chapter 13

Chapter 13
Off-Balance Sheet
Risk
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Overview

13-2
This chapter discusses the risks associated
with off-balance-sheet activities. OBS
activities are often designed to reduce risks
through hedging with derivative securities
and other means. However, as several high
profile events have demonstrated, OBS risk
can be substantial. Regulatory policy has
been altered as a result of accounting
abuses and other unethical practices.
Off Balance Sheet Risks
Contingent assets
 Contingent liabilities
 Derivative Securities
Held Off the Balance Sheet:





Forward contracts
Futures contracts
Option contracts
Swap contracts
13-3
OBS Activities

Infamous cases:













Barings.
NatWest Bank
Midland Bank
Chase Manhattan
Union Bank of Switzerland
Metallgesellschaft.
Banker’s Trust.
CSFB/Orange County, CA.
Sumitomo Corp.
Long-Term Capital
AllFirst Bank/Allied Irish Bank
J.P. Morgan Chase & Citigroup
Amaranth Advisors
13-4
Banks and the Enron debacle

13-5
J.P. Morgan Chase and Citigroup

$2.25 billion loss via credit derivatives
Sarbanes-Oxley Act of 2002
 Disclosure requirements:


arrangements that “may” be of material concern
to the markets.
OBS Activities and Solvency



Off-balance-sheet assets
Off-balance-sheet liabilities
Valuation of OBS items:



Delta of an option
Notional value of an OBS item
Delta equivalent or Contingent asset value
= Delta × Face value of option
13-6
Valuation

True picture of net worth
Should include market value of on- and offbalance-sheet activities.
 E = (A – L) + (CA – CL)
Equity
= Assets – Liabilities + Contingent Assets –
Contingent Liabilities


Exposure to OBS risk just as important as
other risk exposures
13-7
13-8
Changes in OBS (Billions)
1992
Futures & Forwards
Swaps
Options
Credit Derivatives
Total
$4,780
2,417
1,568
—
8,765
2006
$13,788
74,438
24,447
6,569
119,243
Incentives to Increase OBS Activities

Losses on LDC loans and reduced margins
produced profit incentive.


13-9
Increases in fee income.
Avoidance of regulatory costs or taxes.



Reserve requirements.
Deposit insurance premiums.
Capital adequacy requirements.
Schedule L Activities
Loan commitments
 Letters of credit


LCs & SLCs
Futures, forwards, swaps and options
 When issued securities
 Loans sold


OBS only if sold without recourse
13-10
Schedule L OBS Activities

Loan commitments and interest rate risk:



13-11
If fixed rate commitment the bank is exposed to
interest rate risk.
If floating rate commitment, there is still
exposure to basis risk.
Take-down risk: Uncertainty of timing of
take-downs exposes bank to risk. Back-end
fees are intended to reduce this risk.
Other Risks with Loan Commitments
13-12
Credit risk: credit rating of the borrower may
deteriorate over life of the commitment
 Aggregate funding risk: During a credit
crunch, bank may find it difficult to meet all
of the commitments.


Banks may need to adjust their risk profile on
the balance sheet in order to guard against
future take-downs on loan commitments.
Commercial LCs and SLCs

Particularly important for foreign purchases.
If creditworthiness of the importer is
unknown to seller, or lower than the bank’s,


13-13
then gains available through using an LC.
SLCs often used to insure risks that need
not be trade related.


performance bond guarantees.
Property & casualty insurers also prominent in
selling SLCs.
Simple Letter of Credit Transaction
13-14
Derivative Contracts
13-15
Used by FIs for hedging purposes
 Or FIs acting as dealers


Big Three Dealers: J.P. Morgan Chase, Bank of
America, Citigroup.


87% of derivatives held by user banks
Futures, forwards, swaps and options.


Forward contracts involve substantial
counterparty risk
Other derivatives create far less default risk.
When Issued Trading

13-16
Commitments to buy and sell securities prior
to issue. Example: commitments taken in
week prior to issue of new T-bills.

The risk is that the bank may overcommit as
with Salomon Brothers in market for new 2-year
bonds in 1990. Caused the Treasury to revise
the regulations governing the auction of bills
and bonds.
Loans Sold

13-17
Exposure to risk from loans sold unless no
recourse


Ambiguity of no recourse qualification
Reputation effects may amplify the FI’s
contingent liabilities
Loans Sold With and Without Recourse
13-18
13-19
Schedule L and Nonschedule L OBS Risks
FIs other than banks may engage in many
of the OBS activities discussed so far.
 Banks have to report the five OBS activities
(discussed in preceding slides) each quarter
as part of Schedule L of the Call report.

Non-Schedule L Activities
13-20
Settlement Risk
 FedWire is domestic. CHIPS is international
and settlement takes place only at the end
of the day. Leaves the bank with intraday
exposure to settlement risk. During the day,
banks receive provisional messages only.
Non-Schedule L Risk: Affiliate Risk

13-21
Affiliate risk occurs when dealing with BHCs.


Creditors of failed affiliate may lay claim to
surviving bank’s resources.
Effects of source of strength doctrine.
The Role of OBS Activities
13-22
OBS activities are not always risk increasing
activities.
 In many cases they are hedging activities
designed to mitigate exposure to interest
rate risk, foreign exchange risk etc.
 OBS activities are frequently a source of fee
income, especially for the largest most
credit-worthy banks.

Pertinent Websites
American Banker www.americanbanker.com
Federal Reserve Bank www.federalreserve.gov
Bank of America www.bankofamerica.com
Citigroup www.citigroup.com
CHIPS www.chips.org
FDIC www.fdic.gov
J.P. Morgan/Chase www.jpmorganchase.com
NY Board of Trade www.nybot.com
OCC www.occ.treas.gov
U.S. Treasury www.ustreas.gov
13-23