overview

Off-Balance Sheet Off-Balance Sheet RiskRisk

Chapter 13

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

K. R. Stanton

McGraw-Hill/Irwin

13-2

© 2006 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, as several recent events demonstrate, OBS risk can be substantial. Regulatory policy has been altered as a result of accounting abuses and other unethical practices.

McGraw-Hill/Irwin

13-3

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

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

McGraw-Hill/Irwin

13-4

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

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.

McGraw-Hill/Irwin

13-5

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

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

McGraw-Hill/Irwin

13-6

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

Valuation

True picture of net worth Should include market value of on- and off-

balance-sheet activities. E = (A – L) + (CA – CL)

Exposure to OBS risk just as important as other risk exposures

McGraw-Hill/Irwin

13-7

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

Changes in OBS (Billions)

1992 2003

Futures & Forwards

Swaps

Options

Credit derivatives

$4,780

2,417

1,568

—

$12,658

38,074

14,304

802

McGraw-Hill/Irwin

13-8

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

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.

McGraw-Hill/Irwin

13-9

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

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

McGraw-Hill/Irwin

13-10

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

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.

McGraw-Hill/Irwin

13-11

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

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.

McGraw-Hill/Irwin

13-12

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

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.

McGraw-Hill/Irwin

13-13

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

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.

McGraw-Hill/Irwin

13-14

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

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.

McGraw-Hill/Irwin

13-15

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

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

McGraw-Hill/Irwin

13-16

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

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.

McGraw-Hill/Irwin

13-17

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

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.

McGraw-Hill/Irwin

13-18

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

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.

McGraw-Hill/Irwin

13-19

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

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.

McGraw-Hill/Irwin

13-20

© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

Pertinent Websites

American Banker www.americanbanker.com

Federal Reserve Bank www.federalreserve.gov

Bank One Corp. www.bankone.com

Citigroup www.citigroup.com

CHIPS www.chips.org

FDIC www.fdic.gov

J.P. Morgan/Chase www.jpmorgan.com

NY Board of Trade www.nybot.com

OCC www.occ.treas.gov

U.S. Treasury www.ustreas.gov