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Chapter 13

Off-Balance Sheet Risk

McGraw-Hill/Irwin

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

Overview

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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.

Off Balance Sheet Risks

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Contingent assets Contingent liabilities Derivative Securities Held Off the Balance Sheet:

Forward contracts Futures contracts Option contracts Swap contracts

OBS Activities

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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

Banks and the Enron debacle

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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.

OBS Activities and Solvency


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Off-balance-sheet assets Off-balance-sheet liabilities Delta of an option Notional value of an OBS item Delta equivalent or Contingent asset value = Delta Face value of option

Valuation of OBS items:


Valuation

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True picture of net worth


Should include market value of on- and offbalance-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

Changes in OBS (Billions) 1992 2006

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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

Incentives to Increase OBS Activities

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Losses on LDC loans and reduced margins produced profit incentive.

Increases in fee income.


Reserve requirements. Deposit insurance premiums. Capital adequacy requirements.

Avoidance of regulatory costs or taxes.

Schedule L Activities

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Loan commitments Letters of credit

LCs & SLCs

Futures, forwards, swaps and options When issued securities Loans sold

OBS only if sold without recourse

Schedule L OBS Activities

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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.

Other Risks with Loan Commitments

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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.

Commercial LCs and SLCs

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Particularly important for foreign purchases. If creditworthiness of the importer is unknown to seller, or lower than the banks,

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.

Simple Letter of Credit Transaction

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Derivative Contracts Used by FIs for hedging purposes Or FIs acting as dealers

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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.

When Issued Trading

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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.

Loans Sold

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Exposure to risk from loans sold unless no recourse


Ambiguity of no recourse qualification Reputation effects may amplify the FIs contingent liabilities

Loans Sold With and Without Recourse

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Schedule L and Nonschedule L OBS Risks

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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.

Non-Schedule L Activities

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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.

Non-Schedule L Risk: Affiliate Risk

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Affiliate risk occurs when dealing with BHCs.

Creditors of failed affiliate may lay claim to surviving banks resources. Effects of source of strength doctrine.

The Role of OBS Activities

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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.

Pertinent Websites
American Banker www.americanbanker.com Federal Reserve Bank www.federalreserve.gov Bank of America www.bankofamerica.com Citigroup www.citigroup.com CHIPS www.chips.org FDIC www.fdic.gov J.P. Morgan/Chase www.jpmorganchase.com NY Board of Trade www.nybot.com OCC www.occ.treas.gov U.S. Treasury www.ustreas.gov

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