Off Balance Sheet Risk

Chapter 13
Off- Balance Sheet Risk
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, 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.
2
Off-Balance Sheet Risks

Contingent assets and liabilities
Derivative Securities
Held Off the Balance Sheet:
Forward contracts
Futures contracts
Option contracts
Swap contracts
3
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
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.
5
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
6
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
7
Changes in OBS (Billions)

1992
2009
$ 4,780
$23,579
Swaps
2,417
133,862.0
Options
1,568
29,916.2
14,607.1
$ 8,765
$ 201, 964
Future and Forwards
Credit Derivatives
Total
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.
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
10
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.
11
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.
12
Commercial LCs and SLCs

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.
13
Simple Letter of Credit Transaction
14
Derivative Contracts
Used by FIs for hedging purposes
Or FIs acting as dealers
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.
15
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 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.
16
Loans Sold
Exposure to risk from loans sold unless no recourse
Ambiguity of no recourse qualification
Reputation effects may amplify the FIs contingent
liabilities
17
Loans Sold With and Without Recourse
18
Schedule L and Non-schedule 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.
19
Non-Schedule L Activities
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.
20
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.
21
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 creditworthy banks.
22
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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What are some examples of off-balance sheet activities discussed in the text?

What are some examples of off-balance sheet activities discussed in the text?

What regulatory changes resulted from accounting abuses and other unethical practices related to off-balance sheet activities?

What regulatory changes resulted from accounting abuses and other unethical practices related to off-balance sheet activities?

Chapter 13

Off- Balance Sheet Risk

Off-Balance Sheet Risks

Banks and the Enron debacle

OBS Activities and Solvency

Changes in OBS (Billions)

Future and Forwards

Incentives to Increase OBS

Schedule L OBS Activities

Other Risks with Loan Commitments

Commercial LCs and SLCs

Simple Letter of Credit Transaction

When Issued Trading

Loans Sold With and Without Recourse

Schedule L and Non-schedule L OBS Risks

Non-Schedule L Risk: Affiliate Risk

The Role of OBS Activities

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