Ch 13 Off-balance sheet risk Overview

Transcription

1 Ch 13 Off-balance sheet risk Overview This chapter discusses the risks associated with offbalance-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. Off Balance Sheet Risks Contingent assets Contingent liabilities Derivative Securities Held Off the Balance Sheet: Forward contracts Futures contracts Option contracts Swap contracts 13-1 OBS Activities and Solvency 13-2 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 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 1

2 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 Incentives to Increase OBS Activities 13-4 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. 2

3 Schedule L Activities 13-5 Loan commitments Letters of credit LCs & SLCs Futures, forwards, swaps and options When issued securities Loans sold OBS only if sold without recourse Loan Commitments -- Example 13-6 A FI has issued a one-year loan commitment of $2 million for an up-front fee of 25 basis points. The back-end fee on the unused portion of the commitment is 10 basis points. The FI requires a compensating balance of 5 percent as demand deposits. The FI s cost of funds is 6 percent, the interest rate on the loan is 10 percent, and reserve requirements on demand deposits are 8 percent. The customer is expected to draw down 80 percent of the commitment at the beginning of the year. 3

4 Loan Commitments Example (con t) What is the expected return on the loan without taking future values into consideration? Up-front fees = x $2,000,000= $ 5,000 Interest income = 0.10 x $1,600,000 = 160,000 Back-end fee = x $400,000= 400 Total = $165,400 Funds committed = $1,600,000 - $80,000 (compensating balances) + $6,400 (Reserve requirements on demand deposits) = $1,526,400. Expected rate of return = $165,400/$1,526,400 = % 2. What is the expected return using future values? That is, the net fee and interest income are evaluated at the end of the year when the loan is due? The only difference is that the up-front fee is estimated at year-end, i.e., $5,000 x 1.06 = $5,300. Thus, expected return = $165,700/$1,526,400 = %. Schedule L OBS Activities 13-8 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. 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. 4

5 Commercial LCs and SLCs 13-9 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. 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. 5

6 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. 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 Loans Sold With and Without Recourse 6

7 13-13 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. 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. 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. 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 creditworthy banks. 7