CHAPTER 13 Off-Balance-Sheet Risk Copyright © 2011 by The McGraw-Hill Companies, Inc. All Rights Reserved.McGraw-Hill/Irwin

13-2 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.

13-3 Off-Balance-Sheet Risks  Contingent assets  Contingent liabilities  Derivative securities  Held off the balance sheet: –Forward contracts –Futures contracts –Option contracts –Swap contracts

13-4 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

13-5 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 × Notional or face value of option

13-6 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

13-7 Derivative Contracts Held by Commercial Banks (Billions) Futures & Forwards Swaps Options Credit Derivatives Total $4,780 2,417 1,568 — 8,765 $23, ,862 29,916 14, ,964

13-8 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

13-9 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

13-10 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

13-11 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

13-12 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

13-13 Simple Letter of Credit Transaction

13-14 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 risk  Other derivatives create far less default risk

13-15 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

13-16 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 1990  Caused the Treasury to revise the regulations governing the auction of bills and bonds

13-17 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

13-18 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

13-19 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

13-20 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

13-21 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

13-22 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

13-23 Pertinent Websites Federal Reserve Bank Bank of America CHIPS FDIC Goldman Sachs ICE Futures US J.P. Morgan Chase Comptroller of thewww.occ.treas.govwww.occ.treas.gov Currency U.S. Dept. of Treasury