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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. - PowerPoint PPT PresentationTRANSCRIPT
CHAPTER 13Off-Balance-Sheet Risk
Copyright © 2011 by 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, OBS risk can be substantial. OBS mortgage-backed securities were instrumental in the financial crisis.
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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 Some big losses on derivatives:
– Bankers Trust– Barings– NatWest Bank– Midland Bank– Chase Manhattan– Union Bank of Switzerland– Long-Term Capital– J.P. Morgan Chase & Citigroup– AllFirst Bank/Allied Irish Bank– Amaranth Advisors– Calyon Securities– Société Générale
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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 × Notional or 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 as other risk exposures
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Derivative Contracts Held by Commercial Banks (Billions)
1992 2009
Futures & ForwardsSwapsOptionsCredit Derivatives Total
$4,7802,4171,568
—8,765
$23,579133,862
29,91614,607
201,964
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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, Goldman Sachs, Bank of America Account for 80% of derivatives held by user
banks Futures, forwards, swapsm and options
– Forward contracts involve substantial counterparty riskOther derivatives create far less default risk
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Derivatives &Credit Concerns
Role of mortgage-backed securities in the financial crisis – Government seizure of Fannie Mae and
Freddie Mac, September 2008– Hit because of their roles in subprime
market TARP funds to purchase toxic assets
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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 over
commit, as with Salomon Brothers in market for new 2-year bonds in 1990Caused 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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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– Thus, leaves the bank with intraday
exposure to settlement risk– During the day, banks receive
provisional messages only
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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 In many cases, OBS activities are for
hedging exposure to interest rate, foreign exchange, and other risks
OBS activities are a source of fee income, especially for the largest most credit-worthy banks
Changes in regulations controlling derivatives in 2009– Role of credit default swaps in financial
crisis
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Regulation of Derivatives Markets Four broad objectives:
– Prevent derivatives markets from posing risk to the financial system
– Promote efficiency and transparency in derivatives markets
– Prevent market abuses: market manipulation, fraud, etc.
– Prevent marketing of OTC derivatives to unsophisticated parties
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Pertinent WebsitesFederal Reserve Bank www.federalreserve.govBank of America www.bankofamerica.comCHIPS www.chips.orgFDIC www.fdic.gov Goldman Sachs www.goldmansachs.comICE Futures US www.theice.comJ.P. Morgan Chase www.jpmorganchase.comComptroller of the www.occ.treas.gov
CurrencyU.S. Dept. of Treasury www.ustreas.gov