chapter 11 off-balance-sheet activities. 11-2 overview this chapter discusses the type and nature of...
TRANSCRIPT
Chapter 11
Off-Balance-Sheet Activities
11-2
Overview • This chapter discusses the type and nature of banks’
off-balance sheet activities. • Off-balance sheet transactions are contingent
liabilities or assets.• We learn how these contingent assets or liabilities
can impact on an FI’s profitability.• We learn about Australian banks’ off-balance sheet
activities.• We learn about the different types of off-balance
sheet activities and their risks.• We examine how banks can use off-balance sheet
activities to reduce their risk exposures.
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and CornettSlides prepared by Maike Sundmacher
11-3
Some Big Losses on Derivatives• September–October 1994: Bankers Trust, Gibson
Greeting and Procter & Gamble.• February 1995: Barings Bank.• December 1996: NatWest Bank.• March 1997: Midland Bank and HSBC.• November 1997: Chase Manhattan.• January 1998: Union Bank, Switzerland (UBS).• August–September 1998: Long-Term Capital
Management.• December 2001–January 2002: Allied Irish Banks.
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and CornettSlides prepared by Maike Sundmacher
11-4
Off-Balance-Sheet Activities and FI Solvency
• Off balance sheet assets & liabilities:
– Appear ‘below the bottom line’ in financial statements.
– Contingent assets or liabilities,
– Potential for these assets and liabilities to produce negative or positive returns to the FI,
– Probability of moving onto the balance sheet < 1.
• Valuation of OBS items:
– Delta of an option, i.e. the change in the value of an option for a small unit change in the price of the underlying security.
– Notional value (face value, = F) of an OBS item.
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and CornettSlides prepared by Maike Sundmacher
11-5
Off-Balance-Sheet Activities and FI Solvency
• Valuation of OBS items (continued):
dS
dOd option an of delta
• Delta equivalent value = d × F• Delta varies with level of price of underlying
security, that is:
0 < d < 1.
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and CornettSlides prepared by Maike Sundmacher
11-6
Off-Balance-Sheet Activities and FI Solvency
Other OBS items with option features:• Loan commitments, i.e. option to borrow• Letters of credit, i.e. option to default.
• Including OBS items, the true net worth of an FI is:
E = (A – L) + (CA – CL)
Where:
CA = contingent assets,
CL = contingent liabilities.
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and CornettSlides prepared by Maike Sundmacher
11-7
Returns and Risks of OBS ActivitiesIncentives for increasing OBS activities in 1980s:• Additional fee income,• Avoidance of regulatory costs or taxes.
• In Australia, growth in OBS items has resulted in tracking system implemented by RBA in 1989.
• Four major types of OBS activities undertaken by Australian banks:– Commitments and other non-market-related items,– Direct credit substitutes,– Trade- and performance-related items,– Futures and forward contracts, swaps and options.
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and CornettSlides prepared by Maike Sundmacher
11-8
CommitmentsExamples:• Sale and repurchase agreements,• Assets sold with recourse,• Forward asset purchases,• Partly paid shares and securities,• Placements of forward deposits,• Underwriting facilities,• Standby lines of credit,• Redraw facilities,• Un-drawn credit card facilities.
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and CornettSlides prepared by Maike Sundmacher
11-9
Commitments• Commitments may incur back-end fee.• Interest rate risk:
– On fixed-rate loan commitments the bank is exposed to interest rate risk.
– On floating-rate commitments, there is still exposure to basis risk.
• Draw-down risk: – Uncertainty of timing of draw-downs exposes bank to risk.– Back-end fees are intended to reduce this risk.
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and CornettSlides prepared by Maike Sundmacher
11-10
Commitments• Credit risk:
– Credit rating of the borrower may deteriorate over the life of the commitment.
– Addressed through ‘adverse material change in conditions’ clause.
• Aggregate funding risk: – During a credit crunch, bank may find it difficult to
meet all of the commitments (compare to externality effect).– Bank may need to adjust its risk profile on the balance sheet
in order to guard against future draw-downs on loan commitments.
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and CornettSlides prepared by Maike Sundmacher
11-11
Direct Credit Substitutes and Trade- and Performance-Related Items
• Example of trade-related item: letters of credit (LCs).• Example of direct credit substitute: standby letters of
credit (SLCs).• Both are guarantees sold by an FI and thus
contingent liabilities.• LCs: bank underwrites the trade or commercial
performance of the LC buyer.• SLCs: cover contingencies that are potentially more
severe and less predictable.
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and CornettSlides prepared by Maike Sundmacher
11-12
Direct Credit Substitutes and Trade- and Performance-Related Items
Documentary Letters of Credit:
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and CornettSlides prepared by Maike Sundmacher
11-13
Direct Credit Substitutes and Trade- and Performance-Related Items
Standby Letters of Credit:• Insurance function.• Structure and type of risks covered different from
trade LCs and documentary LCs.• Examples:
– Performance bond guarantees,– Default guarantees.
• SLCs are direct ‘competitors’ to loan commitments.• SLCs often issued by general insurers.
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and CornettSlides prepared by Maike Sundmacher
11-14
Derivative Contracts: Futures, Forwards, Swaps and Options
• Futures, forwards, swaps and options.• Forward contracts leave the bank heavily exposed to
risk of default by counterparties.• Other derivatives create far less default risk.
• Interesting websites:– Sydney Futures Exchange (SFE):
www.sfe.com.au– Singapore Futures Exchange (SIMEX):
www.singaporeexchange.com
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and CornettSlides prepared by Maike Sundmacher
11-15
Forward Purchases
• Commitments to buy and sell securities before they are issued: ‘when issued (WI) trading’.
• Example: new issue of T-Notes announced by RBA.
• Banks who bid in the T-Notes auction can trade them before issue.
• Risk of ‘over-commitment’.
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and CornettSlides prepared by Maike Sundmacher
11-16
Loans Sold• FI originates loans and sells them to outside investors.
• Potential outside investors:
– Other banks,
– Insurance companies,
– Unit trusts,
– Corporations.
• Loans sold are an indication of FIs moving from asset-transformers to brokers.
• ‘No recourse’: loan buyer bears all default risk if loan goes bad.
• With recourse: long-term contingent credit risk for loan seller.
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and CornettSlides prepared by Maike Sundmacher
11-17
The Role of OBS Activities in Reducing Risk
• 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 can decrease an FI’s insolvency risk.• OBS activities are frequently a source of fee income,
especially for the largest, most credit-worthy banks.
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and CornettSlides prepared by Maike Sundmacher