Chapter 11 Off-Balance-Sheet Activities

11-2 Overview This chapter discusses the type and nature of banks’ off-balance sheet activities. Off-balance sheet transactions are contingent liabilities or assets. We learn how these contingent assets or liabilities can impact on an FI’s profitability. We learn about Australian banks’ off-balance sheet activities. We learn about the different types of off-balance sheet activities and their risks. We examine how banks can use off-balance sheet activities to reduce their risk exposures. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

11-3 Some Big Losses on Derivatives September–October 1994: Bankers Trust, Gibson Greeting and Procter & Gamble. February 1995: Barings Bank. December 1996: NatWest Bank. March 1997: Midland Bank and HSBC. November 1997: Chase Manhattan. January 1998: Union Bank, Switzerland (UBS). August–September 1998: Long-Term Capital Management. December 2001–January 2002: Allied Irish Banks. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

11-4 Off-Balance-Sheet Activities and FI Solvency Off balance sheet assets & liabilities: –Appear ‘below the bottom line’ in financial statements. –Contingent assets or liabilities, –Potential for these assets and liabilities to produce negative or positive returns to the FI, –Probability of moving onto the balance sheet < 1. Valuation of OBS items: –Delta of an option, i.e. the change in the value of an option for a small unit change in the price of the underlying security. –Notional value (face value, = F) of an OBS item. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

11-5 Off-Balance-Sheet Activities and FI Solvency Valuation of OBS items (continued): Delta equivalent value = d × F Delta varies with level of price of underlying security, that is: 0 < d < 1. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

11-6 Off-Balance-Sheet Activities and FI Solvency Other OBS items with option features: Loan commitments, i.e. option to borrow Letters of credit, i.e. option to default. Including OBS items, the true net worth of an FI is: E = (A – L) + (CA – CL) Where: CA = contingent assets, CL = contingent liabilities. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

11-7 Returns and Risks of OBS Activities Incentives for increasing OBS activities in 1980s: Additional fee income, Avoidance of regulatory costs or taxes. In Australia, growth in OBS items has resulted in tracking system implemented by RBA in Four major types of OBS activities undertaken by Australian banks: –Commitments and other non-market-related items, –Direct credit substitutes, –Trade- and performance-related items, –Futures and forward contracts, swaps and options. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

11-8 Commitments Examples: Sale and repurchase agreements, Assets sold with recourse, Forward asset purchases, Partly paid shares and securities, Placements of forward deposits, Underwriting facilities, Standby lines of credit, Redraw facilities, Un-drawn credit card facilities. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

11-9 Commitments Commitments may incur back-end fee. Interest rate risk: –On fixed-rate loan commitments the bank is exposed to interest rate risk. –On floating-rate commitments, there is still exposure to basis risk. Draw-down risk: –Uncertainty of timing of draw-downs exposes bank to risk. –Back-end fees are intended to reduce this risk. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

11-10 Commitments Credit risk: –Credit rating of the borrower may deteriorate over the life of the commitment. –Addressed through ‘adverse material change in conditions’ clause. Aggregate funding risk: –During a credit crunch, bank may find it difficult to meet all of the commitments (compare to externality effect). –Bank may need to adjust its risk profile on the balance sheet in order to guard against future draw-downs on loan commitments. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

11-11 Direct Credit Substitutes and Trade- and Performance-Related Items Example of trade-related item: letters of credit (LCs). Example of direct credit substitute: standby letters of credit (SLCs). Both are guarantees sold by an FI and thus contingent liabilities. LCs: bank underwrites the trade or commercial performance of the LC buyer. SLCs: cover contingencies that are potentially more severe and less predictable. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

11-12 Direct Credit Substitutes and Trade- and Performance-Related Items Documentary Letters of Credit: Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

11-13 Direct Credit Substitutes and Trade- and Performance-Related Items Standby Letters of Credit: Insurance function. Structure and type of risks covered different from trade LCs and documentary LCs. Examples: –Performance bond guarantees, –Default guarantees. SLCs are direct ‘competitors’ to loan commitments. SLCs often issued by general insurers. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

11-14 Derivative Contracts: Futures, Forwards, Swaps and Options Futures, forwards, swaps and options. Forward contracts leave the bank heavily exposed to risk of default by counterparties. Other derivatives create far less default risk. Interesting websites: –Sydney Futures Exchange (SFE): –Singapore Futures Exchange (SIMEX): Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

11-15 Forward Purchases Commitments to buy and sell securities before they are issued: ‘when issued (WI) trading’. Example: new issue of T-Notes announced by RBA. Banks who bid in the T-Notes auction can trade them before issue. Risk of ‘over-commitment’. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

11-16 Loans Sold FI originates loans and sells them to outside investors. Potential outside investors: –Other banks, –Insurance companies, –Unit trusts, –Corporations. Loans sold are an indication of FIs moving from asset- transformers to brokers. ‘No recourse’: loan buyer bears all default risk if loan goes bad. With recourse: long-term contingent credit risk for loan seller. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

11-17 The Role of OBS Activities in Reducing Risk 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 can decrease an FI’s insolvency risk. OBS activities are frequently a source of fee income, especially for the largest, most credit-worthy banks. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher