CHAPTER 16

Off-Balance-Sheet Risk

©McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
 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.

©McGraw-Hill Education. Ch 16-2

 Off-Balance-Sheet Risks
 Contingent assets
 Contingent liabilities
 Derivative securities held off the
balance sheet:
– Forward contract
– Futures contract
– Option
– Swap

©McGraw-Hill Education. Ch 16-3

 OBS Activities
 Some big losses on derivatives:
– Bankers Trust
– Barings
– NatWest Bank
– Midland Bank
– Chase Manhattan
– Union Bank of Switzerland
– Long-Term Capital Management
– J.P. Morgan Chase and Citigroup
– Allied Irish Bank
– Amaranth Advisors
– Calyon Securities
– Société Générale
– MF Global ©McGraw-Hill Education. Ch 16-4
 OBS Activities and Solvency
 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

©McGraw-Hill Education. Ch 16-5

 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
©McGraw-Hill Education. Ch 16-6
 Derivative Contracts Held by
Commercial Banks (Billions)
1992 2015
(first quarter)

Futures & forwards $4,780 $44,537

Swaps 2,417 117,711
Options 1,568 31,855
Credit derivatives — 9,017
Total 8,765 203,120
 Incentives to Increase OBS
Activities
 Losses on LDC loans and reduced
interest margins produced profit
incentive
– Increases in fee income
 Avoidance of regulatory costs or taxes
– Not levied on OBS activities:
 Reserve requirements
 Deposit insurance premiums
 Capital adequacy requirements
©McGraw-Hill Education. Ch 16-8
 Schedule L Activities
 Banks must report to Federal Reserve
as part of quarterly Call Reports
– Loan commitment
– Letters of credit
 Letters of credit and standby letters of credit
– Derivative contract
– When-issued trading
– Loans sold
 OBS only if sold without recourse

©McGraw-Hill Education. Ch 16-9

 Loan Commitments
 Interest rate risk
– If fixed-rate or variable-rate commitment,
the bank is exposed to interest rate risk
– If floating rate commitment, there is still
exposure to basis risk
 Takedown risk
– Uncertainty of timing of takedown on loan
commitment
– Back-end fees are intended to reduce this
risk
©McGraw-Hill Education. Ch 16-10
 Other Risks with Loan
Commitments
 Credit risk: Credit worthiness 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
– Compounded by externality effect and rising
interbank borrowing rates

©McGraw-Hill Education. Ch 16-11

 Commercial LCs and SLCs
 LCs are particularly important for foreign
purchases, though are used frequently for
domestic trade
– If creditworthiness of the importer is unknown to
seller or lower than the bank’s, then gains
available through using a LC
 SLCs often used to insure risks that are more
severe, less predictable and/or not trade
related:
– Performance bond guarantees
– P-C insurers also prominent in selling SLCs
©McGraw-Hill Education. Ch 16-12
Simple Letter of Credit
Transaction

©McGraw-Hill Education. Ch 16-13

 Derivative Contracts
 Used by FIs for hedging (and other)
purposes
 FIs can also be dealers of derivatives
– Four big dealer banks are J.P. Morgan
Chase, Citigroup, Goldman Sachs, and Bank
of America
 Account for > 90% of derivatives held by user banks
 Futures, forwards, swaps, and options
– Forward (and swap) contracts involve
substantial counterparty risk
 Other derivatives create far less default risk
©McGraw-Hill Education. Ch 16-14
 Derivatives and Credit Risk
Concerns
 Role of mortgage backed securities in
the financial crisis
– Two Bear Stearns funds filed for
bankruptcy, fall 2007
– Lehman Brothers filed for bankruptcy,
September 2008
– Merrill Lynch bought out by BofA
– AIG met with regulators to raise cash
 TARP funds to purchase “toxic” assets
©McGraw-Hill Education. Ch 16-15
 When Issued Trading
 Commitments to buy and sell securities
prior to issue
– Example: Commitments taken in week
prior to announcement of T-bill auction
results
– The risk is that the bank may overcommit,
as with Salomon Brothers in the market for
new two-year bonds in 1990

©McGraw-Hill Education. Ch 16-16

 Loans Sold
 FIs may take the role of loan broker
 Exposure to risk from loans sold unless
no recourse if loan goes bad
– Ambiguity of no recourse qualification
– Reputation effects may amplify the FI’s
contingent liabilities

©McGraw-Hill Education. Ch 16-17

 Schedule L and Non-
Schedule L OBS Risks
 FIs other than banks may engage in
many of the OBS activities discussed so
far
– E.g., Insurance companies, investment
banks, life insurers, etc.
 Banks have to report the five OBS
activities (discussed in preceding
slides) each quarter as part of
Schedule L in Call Report
©McGraw-Hill Education. Ch 16-18
 Non-Schedule L OBS Risks
 Settlement risk
– FedWire: domestic wire transfer network
 Owned by Federal Reserve
– CHIPS: international and private network
 Owned by approximately 50 member
banks
 For small portion of funds, settlement may
take place only at the end of the day,
resulting in intraday settlement risk

©McGraw-Hill Education. Ch 16-19

 Non-Schedule L OBS Risks
Continued
 Affiliate risk
– Occurs when dealing with holding
companies
Corporation that owns the shares
(usually more than 25%) of other
corporations
Creditors of failed affiliate may lay
claim to surviving bank’s resources
Source of strength doctrine
©McGraw-Hill Education. Ch 16-20
 Risk Reduction
 In many cases, OBS activities are for
hedging exposure to interest rate,
foreign exchange, and other risks
 OBS activities are a source of
noninterest income, especially for the
largest and most creditworthy FIs
 Changes in regulations controlling OTC
derivatives in 2009
– Role of CDS in financial crisis
©McGraw-Hill Education. Ch 16-21
 Regulation
 Increased 2009 regulation had 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.
– Ensure OTC derivatives are not
inappropriately marketed to unsophisticated
buyers
©McGraw-Hill Education. Ch 16-22
 Pertinent Websites
Federal Reserve Bank www.federalreserve.gov
CHIPS www.chips.org
FDIC www.fdic.gov
Goldman Sachs www.goldmansachs.com
ICE Futures US www.theice.com
J.P. Morgan Chase www.jpmorganchase.com
Comptroller of the www.occ.treas.gov
Currency
U.S. Dept. of Treasury www.ustreas.gov
©McGraw-Hill Education. Ch 16-23
Letter of Credit Transaction

©McGraw-Hill Education. Ch 16-24