Transcript Slide 1

CHAPTER 13
Off-Balance-Sheet Risk
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All Rights Reserved.
Overview
 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, OBS risk can be substantial.
OBS mortgage-backed securities were
instrumental in the financial crisis.
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Off-Balance-Sheet Risks
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Contingent assets
Contingent liabilities
Derivative securities
Held off the balance sheet:
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Forward contracts
Futures contracts
Option contracts
Swap contracts
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OBS Activities
 Some big losses on derivatives:
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Bankers Trust
Barings
NatWest Bank
Midland Bank
Chase Manhattan
Union Bank of Switzerland
Long-Term Capital
J.P. Morgan Chase & Citigroup
AllFirst Bank/Allied Irish Bank
Amaranth Advisors
Calyon Securities
Société Générale
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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 × Notional or face value of option
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Valuation
 True picture of net worth
– Should include market value of on- and
off-balance-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
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Derivative Contracts Held by Commercial
Banks (Billions)
1992
Futures & Forwards
Swaps
Options
Credit Derivatives
Total
$4,780
2,417
1,568
—
8,765
2009
$23,579
133,862
29,916
14,607
201,964
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Incentives to Increase OBS Activities
 Losses on LDC loans and reduced
margins produced profit incentive
– Increases in fee income
 Avoidance of regulatory costs or taxes
– Reserve requirements
– Deposit insurance premiums
– Capital adequacy requirements
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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
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Schedule L OBS Activities
 Loan commitments and interest rate
risk:
– 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
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Other Risks with Loan Commitments
 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
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Commercial LCs and SLCs
 Particularly important for foreign purchases
 If creditworthiness of the importer is unknown
to seller, or lower than the bank’s, 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
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Simple Letter of Credit Transaction
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Derivative Contracts
 Used by FIs for hedging purposes
 Or FIs acting as dealers
– Big Three Dealers: J.P. Morgan Chase,
Goldman Sachs, Bank of America
 Account for 80% of derivatives held by user
banks
 Futures, forwards, swapsm and options
– Forward contracts involve substantial
counterparty risk
 Other derivatives create far less default risk
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Derivatives &Credit Concerns
 Role of mortgage-backed securities in
the financial crisis
– Government seizure of Fannie Mae and
Freddie Mac, September 2008
– Hit because of their roles in subprime
market
 TARP funds to purchase toxic assets
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When Issued Trading
 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 over commit,
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
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Loans Sold
 Exposure to risk from loans sold unless
no recourse
– Ambiguity of no recourse qualification
– Reputation effects may amplify the FI’s
contingent liabilities
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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
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Non-Schedule L Activities
 Settlement risk
– FedWire is domestic
– CHIPS is international and settlement takes
place only at the end of the day
– Thus, leaves the bank with intraday
exposure to settlement risk
– During the day, banks receive provisional
messages only
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Affiliate Risk
 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
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The Role of OBS Activities
 In many cases, OBS activities are for
hedging exposure to interest rate,
foreign exchange, and other risks
 OBS activities are a source of fee
income, especially for the largest most
credit-worthy banks
 Changes in regulations controlling
derivatives in 2009
– Role of credit default swaps in financial
crisis
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Regulation of Derivatives Markets
 Four broad objectives:
– Prevent derivatives markets from posing
risk to the financial system
– Promote efficiency and transparency in
derivatives markets
– Prevent market abuses: market
manipulation, fraud, etc.
– Prevent marketing of OTC derivatives to
unsophisticated parties
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Pertinent Websites
Federal Reserve Bank
Bank of America
CHIPS
FDIC
Goldman Sachs
ICE Futures US
J.P. Morgan Chase
Comptroller of the
Currency
U.S. Dept. of Treasury
www.federalreserve.gov
www.bankofamerica.com
www.chips.org
www.fdic.gov
www.goldmansachs.com
www.theice.com
www.jpmorganchase.com
www.occ.treas.gov
www.ustreas.gov
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