Transcript 4-_chap013_ppt_edited

CHAPTER 13
Off-Balance-Sheet Risk
McGraw-Hill/Irwin
Copyright © 2011 by 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, OBS risk can be substantial.
OBS mortgage-backed securities were
instrumental in the financial crisis.
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Off-Balance-Sheet Risks
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Contingent assets
Contingent liabilities
Derivative securities
Held off the balance sheet:
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Forward contracts
Futures contracts
Option contracts
Swap contracts
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OBS Activities
 Some big losses on derivatives:
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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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1. OBS Introduction
 Most of us are aware of on-balance-sheet activities
as they appear on an FI’s published asset and
liability balance sheet. However,
 OBSs are less obvious and often are invisible to all
but the best informed investor or regulator.
 In accounting, it appears “below the bottom line”.
(frequently just as footnotes to financial statements)
 They have a direct impact on the FI’s future
profitability and performance rather than the
current.
 From a valuation perspective, OBS assets and
liabilities have the potential to produce positive or
negative future cash flows.
 True value of a FI’s is not only Liab-Assets but also
includes off balance sheet items.
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2. OBS Activities and Solvency
 Off-balance-sheet assets & Off-balance-sheet liabilities
 Both of them are items or activities when a contingent
event occurs then the item or activity move on one of
the sides...
 Letter of credits or guarantees are the examples of off
balance sheet activities.
 If a customer default occur (who has been given a
guarante) , the FI’s contingent liability (its guarantee)
becomes an actual liability and it moves onto the
liability side of the balance sheet.
 The failure or near failure of some of the largest US FI’s
during the financial crisis can be attributed to risks
associated with OBS activities.
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2. OBS Activities and Solvency
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OBS Activities and Solvency
The question is that what is the probability of an contingent item
to move to asset or liability side of the balance sheet? Link?
Valuation of OBS items:
 OBS items are contingent and move onto the balance sheet
with a probability less than 1, therefore, their valuation is
difficult and often highly complex.
 As many of the OBSs involve option features, the most
common methodology has been to apply contingent
claims/options pricing theory models of finance.
 But one relatively simple way to estimate the value of an OBS
position is to calculate the delta of an option
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OBS Activities and Solvency
– Delta of an option:
It is the change in the value of an option for a unit
change in the price of the underlying security.
– Delta is between 0 and 1.
– The face value of an OBS item is called notional
value
Delta equivalent or Contingent asset value =
Delta × Face (notional) value of option
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OBS Activities and Solvency
Example: An FI has bought call options on bonds (it has an
OBS asset) with a notional value of 100 million and the delta is
calculated as .25*.
– *A 1 cent change in the price of the bonds underlying the call option
leads to a 0.25 cent change in the price of the option.
Then, the contingent asset value of this option is
= Delta × Face value of option
= .25 × 100 m $= 25 m $
*To calculate delta for the option, one needs an option pricing model such as Black
Scholes or a binomial model.
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OBS Activities and Solvency
– Loan commitments and LCs are also off balance
sheet activities that have option features.
– Holder of a loan commitment or credit line who
decides to draw on that credit line is exercising
an option to borrow.
– When the buyer of a guarante defaults, this
buyer is exercising a default option.
– Valuation of OBSs:
For Swaps, futures and forwards, a common
approach is to convert these positions into an
equivalent value of the underlying assets.
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The Reel Valuation of The Company
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So, we can approximately calculate the current or market value of
each OBS asset and liability and its effects on solvency.
The below panel shows that E(Net Worth) = Assets-Liabilities which is
10=100-90, [cap/asset ratio 10 pcnt.] however,
.
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The Reel Valuation of The Company
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True picture of net worth
Should include market value of on- and off-balance-sheet activities
Equity
= (Assets – Liabilities)+ (Contingent Assets –Contingent Liabilities)
E = (A – L) + (CA – CL)
= (100 – 90) + (50 – 55) = 5
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Contingent Liabilities are more than C. Assets
That decreases the equity
Exposure to OBS risk just as important as other risk exposures
Contingent assets and liabilities are contractual claims that directly impact the economic
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value of the FI.
3. Returns and Risks of Off-Balance Sheet
Activities
Incentives to Increase OBS Activities
 In the 1980s, losses on LDC loans and reduced
margins produced profit incentive
– By moving activities of the BS, banks hoped to earn more
fee income to offset declining margins or spreads on their
traditional lending business.
 Plus, they could avoid from regulatory costs or taxes
– Reserve requirements
– Deposit insurance premiums
– Capital adequacy requirements
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Returns and Risks of Off-Balance Sheet
Activities
 From 1992 to 2009, % 2,204 increase
 Largest 25 banks held 99.8 percent of the derivatives
outstanding.
 The phenomenal increase pushed the regulators to impose
capital requirements on such activities (came in 1993)
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Returns and Risks of Off-Balance Sheet
Activities
Schedule L Activities
Due to dramatic growth in OBS activities Fed introduced a
tracking scheme in 1983 called Schedule L (notional size and
variety of OBS activities are reported on quartery bases) as part
of their quarterly Call Reports.
 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 Activities
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Schedule L OBS Activities
 Loan commitments and interest rate risk:
– Loan commitment agreements are contractual
commitments by an FI to lend to a firm a certain maximum
amount (say, 10million $) at given interest rate term (say 12
percent). It also includes the lenght of time for this option.
– In return, FI may charge an up front fee (facility fee) of the
commitment size and the service provided by FI is to supply
the full loan amount at any time over the commitment
period.
– FI stand ready to supply the full 10mio USD at any time over
the commitment period, 1 year.
– At the ed of the term, FI may request a back end fee
(commitment fee) on any unused balances in the
commitment line at the end of the period.
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A Loan Commitment
FI must made the
funds ready at 0 time
until time 1
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If borrower takes down only 8mio over a year
and fee on unused commitment is ¼ percent ; then;
2,000,000*0,0025=5000 USD additional revenue will be generated.
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Commitment itself is not on the balance sheet, but when the borrower
draws on the commitment...
Loan commitments create at least four types of risks:
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Interest rate risks,
Takedown risk
Credit risk
Aggregate funding risk
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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 (cost of funds may rise and cost of funds may
consume the spread)
– If floating rate commitment, partially we can control risk by
following a a prime rate (if prime rate rises so does the cost
of commitment loans to the borrower)
but there is still exposure to basis risk (prime rate rises 1
percent but the cost of funds rises 1.25 percent; the spread
narrows by .25)
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Risks is coming from such that if prime rate and cost of
commitment interest rates rises in different percenteges..
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Schedule L OBS Activities
 Take-down risk
– Uncertainty of timing of take-downs exposes bank to risk
– Banks can never be sure when, within commitment period,
the borrower will demand the full cash, this leads to liquidity
risk..
– Back-end fees are intended to reduce this risk
 Credit risk:
– Credit rating of the borrower may deteriorate over life of
the commitment. If borrower is judged as an AAA credit
risk paying less interest. But, suppose over the 1year
commitment period the firm gets into diffuculty and rating
now is BBB. Still is is preset to the AA level !!!
– Adding “adverse material change in conditions clause”
allows FI to cancel or reprice a loan commitment.
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Other Risks with Loan Commitments
 Aggregate funding risk: During a credit crunch, bank may find
it difficult to meet all of the commitments (where demand is a
lot higher than the supply as spot loans to borrowers is
restricted)
– In difficult credit conditions, this aggregate commitment takedown effect
can increase the cost of funds above normal levels while many FIs
scramble for funds to meet their commitments to customers.
– 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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All these four risks, do these activities increase the insolvency exposure of FIs
engaging in such activities?
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Yes
But empirical studies show that safer banks have a greater tendency
to make loan commitments.
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3.2 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:
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Performance bond guarantees
Property & casualty insurers also prominent in selling SLCs
SLC’s help the corporates to enhance their credibility.
SLC’s and loan commitments are competing OBS
products.
– There are some risks associated with LCs and SLCs...
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Simple Letter of Credit Transaction
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3.3 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, swaps and options
– Forward contracts involve substantial counterparty risk
(counterparty may default on payment obligations, leaving
FI unhedged and having to replace the contract at today’s
interest rates, prices, etc.
– Other derivatives create far less default risk
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Forward contract are nonstandart and entered into bilaterally
Future contracts are standard and guaranteed by organized exchanges. If a party defaults, the
exchange assumes the defaulting party’s position and the payment obligation. (unless there is a
systematic risk, better than forwards)
For options it depents on whether OTC or standart
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Derivatives &Credit Concerns
 Empirical evidences show that derivatives generally
reduces FI risks or left it unaffected.
 But, the financial crisis showed something different.
 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
 Troubled Asset Relief Program (TARP) funds to
purchase toxic assets
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3.4 When Issued Trading
 Commitments to buy and sell securities prior to issue
(forward purchases)
– Example: Commitments taken in week prior to issue of new
T-bills
 Fıs benefit only if they gets all the bills it needs with
appropriate price and sells them with spread in forward WI
contracts.
– Making a mistake in interest rate calculation or playing
around the rules are not good !
 Caused the Treasury to revise the regulations governing the
auction of bills and bonds
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3.5 Loans Sold
 Exposure to risk from loans sold unless no
recourse
– FIs originate loans on their Balance Sheet and
instead of holding them to maturity, they sell
them to outside investors.
– Ambiguity of no recourse qualification
– Reputation effects may amplify the FI’s
contingent liabilities
***No recourse means that if the loan the FI sells
goes bad, the buyer of the loan must bear the full
risk of loss.
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4. 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
 Many other FIs like thrifts, insurance
companies, investment banks engage in
these activities i.e. Futures, forwards, swaps,
and options.
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Non-Schedule L Activities
 Settlement risk (intraday or within-day)
– 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
*This risk does not appear on balance sheet. The best
balance sheet can do is to summarize the end of day closing
positions. So this is a credit risk that does not appear on the
Balance Sheet
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Affiliate Risk
 Affiliate risk
– Occurs when dealing with Bank Holding Companies (whether
One-bank or Multiple-bank)
– In theory, corporate separateness requiers that a problem in Bank
1 should not effect Bank 2 in below MBHC if it does then this is
affiliate risk
– Creditors of failed affiliate may lay claim to surviving bank’s
resources
– Effects of source of strength doctrine (Bank 1 sources can be
used for Bank2 but courts do not want that)
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Affiliate Risk
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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
 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 Websites
Federal Reserve Bank
Bank of America
CHIPS
FDIC
Goldman Sachs
ICE Futures US
J.P. Morgan Chase
Comptroller of the
Currency
U.S. Dept. of Treasury
www.federalreserve.gov
www.bankofamerica.com
www.chips.org
www.fdic.gov
www.goldmansachs.com
www.theice.com
www.jpmorganchase.com
www.occ.treas.gov
www.ustreas.gov
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