CHAPTER 13

Off-Balance-Sheet Risk

Copyright © 2011 by The McGraw-Hill Companies, Inc. All Rights Reserved.McGraw-Hill/Irwin

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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

Contingent assets Contingent liabilities Derivative securities Held off the balance sheet:

– Forward contracts– Futures contracts– Option contracts– Swap contracts

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OBS Activities Some big losses on derivatives:

– 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 2009

Futures & Forwards

Swaps

Options

Credit Derivatives

Total

$4,780

2,417

1,568

—

8,765

$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 riskOther 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 1990Caused 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 WebsitesFederal Reserve Bank www.federalreserve.govBank of America www.bankofamerica.comCHIPS www.chips.orgFDIC www.fdic.gov Goldman Sachs www.goldmansachs.comICE Futures US www.theice.comJ.P. Morgan Chase www.jpmorganchase.comComptroller of the www.occ.treas.gov

CurrencyU.S. Dept. of Treasury www.ustreas.gov