Off balance sheet risk

Off-Balance Sheet Off-Balance Sheet RiskRisk

Chapter 13

© 2008 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, 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.

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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 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

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Banks and the Enron debacle

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.

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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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Changes in OBS (Billions)

1992 2006

Futures & Forwards

Swaps

Options

Credit Derivatives

Total

$4,780

2,417

1,568

—

8,765

$13,788

74,438

24,447

6,569

119,243

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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, 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.

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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 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.

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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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Loans Sold With and Without Recourse

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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. Leaves the bank with intraday exposure to settlement risk. During the day, banks receive provisional messages only.

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Non-Schedule L Risk: 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

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.