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 recent events demonstrate, OBS risk can be substantial. Regulatory policy has been altered as a result of accounting abuses and other unethical practices.

3. 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

4. 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. True picture of net worth
Valuation
True picture of net worth
Should include market value of on- and off-balance-sheet activities.
E = (A – L) + (CA – CL)
Exposure to OBS risk just as important as other risk exposures

7. Changes in OBS (Billions)
1992
2003
Futures & Forwards
Swaps
Options
Credit derivatives
$4,780
2,417
1,568 —
$12,658
38,074
14,304
802

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.

9. Futures, forwards, swaps and options When issued securities Loans sold
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 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. Used by FIs for hedging purposes Or FIs acting as dealers
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.

14. 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.

15. Exposure to risk from loans sold unless no recourse
Ambiguity of no recourse qualification
Reputation effects may amplify the FI’s contingent liabilities

16. 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.

17. 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.

18. 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.

19. 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.

20. Pertinent Websites American Banker www.americanbanker.com
Federal Reserve Bank
Bank One Corp.
Citigroup
CHIPS
FDIC
J.P. Morgan/Chase
NY Board of Trade
OCC
U.S. Treasury