CHAPTER 13 Off-Balance-Sheet Risk Mc Graw-Hill Irwin Copyright

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 -2

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

OBS Activities § Some big losses on derivatives: – – – Bankers Trust Barings Nat. West Bank Midland Bank Chase Manhattan Union Bank of Switzerland Long-Term Capital J. P. Morgan Chase & Citigroup All. First Bank/Allied Irish Bank Amaranth Advisors Calyon Securities Société Générale 13 -4

1. OBS Introduction § Most of us are aware of on-balance-sheet activities as they appear on an FI’s published asset and liability balance sheet. However, § OBSs are less obvious and often are invisible to all but the best informed investor or regulator. § In accounting, it appears “below the bottom line”. (frequently just as footnotes to financial statements) § They have a direct impact on the FI’s future profitability and performance rather than the current. § From a valuation perspective, OBS assets and liabilities have the potential to produce positive or negative future cash flows. § True value of a FI’s is not only Liab-Assets but also includes off balance sheet items. 13 -5

2. OBS Activities and Solvency § Off-balance-sheet assets & Off-balance-sheet liabilities § Both of them are items or activities when a contingent event occurs then the item or activity move on one of the sides. . . § Letter of credits or guarantees are the examples of off balance sheet activities. § If a customer default occur (who has been given a guarante) , the FI’s contingent liability (its guarantee) becomes an actual liability and it moves onto the liability side of the balance sheet. § The failure or near failure of some of the largest US FI’s during the financial crisis can be attributed to risks associated with OBS activities. 13 -6

2. OBS Activities and Solvency 13 -7

OBS Activities and Solvency The question is that what is the probability of an contingent item to move to asset or liability side of the balance sheet? Link? Valuation of OBS items: § OBS items are contingent and move onto the balance sheet with a probability less than 1, therefore, their valuation is difficult and often highly complex. § As many of the OBSs involve option features, the most common methodology has been to apply contingent claims/options pricing theory models of finance. § But one relatively simple way to estimate the value of an OBS position is to calculate the delta of an option 13 -8

OBS Activities and Solvency – Delta of an option: It is the change in the value of an option for a unit change in the price of the underlying security. – Delta is between 0 and 1. – The face value of an OBS item is called notional value Delta equivalent or Contingent asset value = Delta × Face (notional) value of option 13 -9

OBS Activities and Solvency Example: An FI has bought call options on bonds (it has an OBS asset) with a notional value of 100 million and the delta is calculated as. 25*. – *A 1 cent change in the price of the bonds underlying the call option leads to a 0. 25 cent change in the price of the option. Then, the contingent asset value of this option is = Delta × Face value of option =. 25 × 100 m $= 25 m $ *To calculate delta for the option, one needs an option pricing model such as Black Scholes or a binomial model. 13 -10

OBS Activities and Solvency – Loan commitments and LCs are also off balance sheet activities that have option features. – Holder of a loan commitment or credit line who decides to draw on that credit line is exercising an option to borrow. – When the buyer of a guarante defaults, this buyer is exercising a default option. – Valuation of OBSs: For Swaps, futures and forwards, a common approach is to convert these positions into an equivalent value of the underlying assets. 13 -11

The Reel Valuation of The Company § § § So, we can approximately calculate the current or market value of each OBS asset and liability and its effects on solvency. The below panel shows that E(Net Worth) = Assets-Liabilities which is 10=100 -90, [cap/asset ratio 10 pcnt. ] however, . 13 -12

The Reel Valuation of The Company § True picture of net worth Should include market value of on- and off-balance-sheet activities Equity = (Assets – Liabilities)+ (Contingent Assets –Contingent Liabilities) E = (A – L) + (CA – CL) = (100 – 90) + (50 – 55) = 5 § Contingent Liabilities are more than C. Assets That decreases the equity Exposure to OBS risk just as important as other risk exposures Contingent assets and liabilities are contractual claims that directly impact the economic 13 -13 value of the FI.

3. Returns and Risks of Off-Balance Sheet Activities Incentives to Increase OBS Activities § In the 1980 s, losses on LDC loans and reduced margins produced profit incentive – By moving activities of the BS, banks hoped to earn more fee income to offset declining margins or spreads on their traditional lending business. § Plus, they could avoid from regulatory costs or taxes – Reserve requirements – Deposit insurance premiums – Capital adequacy requirements 13 -14

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Returns and Risks of Off-Balance Sheet Activities § From 1992 to 2009, % 2, 204 increase § Largest 25 banks held 99. 8 percent of the derivatives outstanding. § The phenomenal increase pushed the regulators to impose capital requirements on such activities (came in 1993) 13 -16

Returns and Risks of Off-Balance Sheet Activities Schedule L Activities Due to dramatic growth in OBS activities Fed introduced a tracking scheme in 1983 called Schedule L (notional size and variety of OBS activities are reported on quartery bases) as part of their quarterly Call Reports. § Loan commitments § Letters of credit – LCs & SLCs § Futures, forwards, swaps and options § When issued securities § Loans sold – OBS only if sold without recourse 13 -17

Schedule L Activities 13 -18

Schedule L OBS Activities § Loan commitments and interest rate risk: – Loan commitment agreements are contractual commitments by an FI to lend to a firm a certain maximum amount (say, 10 million $) at given interest rate term (say 12 percent). It also includes the lenght of time for this option. – In return, FI may charge an up front fee (facility fee) of the commitment size and the service provided by FI is to supply the full loan amount at any time over the commitment period. – FI stand ready to supply the full 10 mio USD at any time over the commitment period, 1 year. – At the ed of the term, FI may request a back end fee (commitment fee) on any unused balances in the commitment line at the end of the period. 13 -19

A Loan Commitment FI must made the funds ready at 0 time until time 1 § § If borrower takes down only 8 mio over a year and fee on unused commitment is ¼ percent ; then; 2, 000*0, 0025=5000 USD additional revenue will be generated. § Commitment itself is not on the balance sheet, but when the borrower draws on the commitment. . . Loan commitments create at least four types of risks: § § § Interest rate risks, Takedown risk Credit risk Aggregate funding risk 13 -20

Schedule L OBS Activities § Loan commitments and interest rate risk: – If fixed rate commitment, the bank is exposed to interest rate risk (cost of funds may rise and cost of funds may consume the spread) – If floating rate commitment, partially we can control risk by following a a prime rate (if prime rate rises so does the cost of commitment loans to the borrower) but there is still exposure to basis risk (prime rate rises 1 percent but the cost of funds rises 1. 25 percent; the spread narrows by. 25) – Risks is coming from such that if prime rate and cost of commitment interest rates rises in different percenteges. . 13 -21

Schedule L OBS Activities § Take-down risk – Uncertainty of timing of take-downs exposes bank to risk – Banks can never be sure when, within commitment period, the borrower will demand the full cash, this leads to liquidity risk. . – Back-end fees are intended to reduce this risk § Credit risk: – Credit rating of the borrower may deteriorate over life of the commitment. If borrower is judged as an AAA credit risk paying less interest. But, suppose over the 1 year commitment period the firm gets into diffuculty and rating now is BBB. Still is is preset to the AA level !!! – Adding “adverse material change in conditions clause” allows FI to cancel or reprice a loan commitment. 13 -22

Other Risks with Loan Commitments § Aggregate funding risk: During a credit crunch, bank may find it difficult to meet all of the commitments (where demand is a lot higher than the supply as spot loans to borrowers is restricted) – In difficult credit conditions, this aggregate commitment takedown effect can increase the cost of funds above normal levels while many FIs scramble for funds to meet their commitments to customers. – Banks may need to adjust their risk profile on the balance sheet in order to guard against future take-downs on loan commitments § All these four risks, do these activities increase the insolvency exposure of FIs engaging in such activities? § § Yes But empirical studies show that safer banks have a greater tendency to make loan commitments. 13 -23

3. 2 Commercial LCs and SLCs § Particularly important 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 SLC’s help the corporates to enhance their credibility. SLC’s and loan commitments are competing OBS products. There are some risks associated with LCs and SLCs. . . 13 -24

Simple Letter of Credit Transaction 13 -25

3. 3 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 w Account for 80% of derivatives held by user banks § Futures, forwards, swaps and options – Forward contracts involve substantial counterparty risk (counterparty may default on payment obligations, leaving FI unhedged and having to replace the contract at today’s interest rates, prices, etc. – Other derivatives create far less default risk – – – Forward contract are nonstandart and entered into bilaterally Future contracts are standard and guaranteed by organized exchanges. If a party defaults, the exchange assumes the defaulting party’s position and the payment obligation. (unless there is a systematic risk, better than forwards) For options it depents on whether OTC or standart 13 -26

Derivatives &Credit Concerns § Empirical evidences show that derivatives generally reduces FI risks or left it unaffected. § But, the financial crisis showed something different. § 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 § Troubled Asset Relief Program (TARP) funds to purchase toxic assets 13 -27

3. 4 When Issued Trading § Commitments to buy and sell securities prior to issue (forward purchases) – Example: Commitments taken in week prior to issue of new T-bills w Fıs benefit only if they gets all the bills it needs with appropriate price and sells them with spread in forward WI contracts. – Making a mistake in interest rate calculation or playing around the rules are not good ! w Caused the Treasury to revise the regulations governing the auction of bills and bonds 13 -28

3. 5 Loans Sold § Exposure to risk from loans sold unless no recourse – FIs originate loans on their Balance Sheet and instead of holding them to maturity, they sell them to outside investors. – Ambiguity of no recourse qualification – Reputation effects may amplify the FI’s contingent liabilities ***No recourse means that if the loan the FI sells goes bad, the buyer of the loan must bear the full risk of loss. 13 -29

4. 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 § Many other FIs like thrifts, insurance companies, investment banks engage in these activities i. e. Futures, forwards, swaps, and options. 13 -30

Non-Schedule L Activities § Settlement risk (intraday or within-day) – Fed. Wire 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 *This risk does not appear on balance sheet. The best balance sheet can do is to summarize the end of day closing positions. So this is a credit risk that does not appear on the Balance Sheet 13 -31

Affiliate Risk § Affiliate risk – Occurs when dealing with Bank Holding Companies (whether One-bank or Multiple-bank) – In theory, corporate separateness requiers that a problem in Bank 1 should not effect Bank 2 in below MBHC if it does then this is affiliate risk – Creditors of failed affiliate may lay claim to surviving bank’s resources – Effects of source of strength doctrine (Bank 1 sources can be used for Bank 2 but courts do not want that) 13 -32

Affiliate Risk 13 -33

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 § 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 -34

Pertinent Websites Federal Reserve Bank of America CHIPS FDIC Goldman Sachs ICE Futures US J. P. Morgan Chase Comptroller of the Currency U. S. Dept. of Treasury www. federalreserve. gov www. bankofamerica. com www. chips. org www. fdic. gov www. goldmansachs. com www. theice. com www. jpmorganchase. com www. occ. treas. gov www. ustreas. gov 13 -35