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Off-Balance Sheet

Risk

Chapter 13

2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin

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Overview

This chapter discusses the risks associatedwith off-balance-sheet activities. OBS

activities are often designed to reduce risksthrough hedging with derivative securitiesand other means. However, as several highprofile events have demonstrated, OBS riskcan be substantial. Regulatory policy hasbeen altered as a result of accountingabuses 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. Bankers 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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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

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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 asother risk exposures

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Changes in OBS (Billions)

1992 2006

Futures & Forwards

SwapsOptions

Credit Derivatives

Total

$4,780

2,4171,568

8,765

$13,788

74,43824,447

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 tointerest 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 commitmentAggregate 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 isunknown to seller, or lower than the banks,

then gains available through using an LC.

SLCs often used to insure risks that neednot be trade related.

performance bond guarantees.

Property & casualty insurers also prominent inselling 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 ofAmerica, 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 inweek prior to issue of new T-bills.

The risk is that the bank may overcommit as

with Salomon Brothers in market for new 2-yearbonds in 1990. Caused the Treasury to revisethe regulations governing the auction of billsand 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 FIs

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 internationaland settlement takes place only at the endof 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 banks 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.

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Pertinent Websites

American Bankerwww.americanbanker.com

Federal Reserve Bank www.federalreserve.govBank of America www.bankofamerica.com

Citigroup www.citigroup.com

CHIPS www.chips.orgFDIC www.fdic.gov

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

NY Board of Trade www.nybot.comOCC www.occ.treas.gov

U.S. Treasury www.ustreas.gov

http://www.americanbanker.com/http://www.federalreserve.gov/http://www.bankofamerica.com/http://www.citigroup.com/http://www.chips.org/http://www.fdic.gov/http://www.jpmorganchase.com/http://www.nybot.com/http://www.occ.treas.gov/http://www.ustreas.gov/http://www.ustreas.gov/http://www.occ.treas.gov/http://www.nybot.com/http://www.jpmorganchase.com/http://www.fdic.gov/http://www.chips.org/http://www.citigroup.com/http://www.bankofamerica.com/http://www.federalreserve.gov/http://www.federalreserve.gov/http://www.americanbanker.com/