Off-Balance Sheet Risk Chapter 13 © 2008 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, 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.

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  Infamous cases: Barings. NatWest Bank Midland Bank Chase Manhattan Union Bank of Switzerland Metallgesellschaft. Banker’s Trust. CSFB/Orange County, CA. Sumitomo Corp. Long-Term Capital AllFirst Bank/Allied Irish Bank J.P. Morgan Chase & Citigroup Amaranth Advisors

13-5 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.

13-6 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

13-7 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

13-8 Changes in OBS (Billions) Futures & Forwards Swaps Options Credit Derivatives Total $4,780 2,417 1,568 — 8,765 $13,788 74,438 24,447 6, ,243

13-9 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.

13-10 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

13-11 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.

13-12 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.

13-13 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.

13-14 Simple Letter of Credit Transaction

13-15 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.

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 overcommit as with Salomon Brothers in market for new 2-year bonds in 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 Loans Sold With and Without Recourse

13-19 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.

13-20 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.

13-21 Non-Schedule L Risk: 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.

13-22 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 credit-worthy banks.

13-23 Pertinent Websites American Banker Federal Reserve Bank Bank of America Citigroup CHIPS FDIC J.P. Morgan/Chase NY Board of Trade OCC U.S. Treasury