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Transcript of Fim Chap013
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7/30/2019 Fim Chap013
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Off-Balance Sheet
Risk
Chapter 13
2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin
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Overview
This chapter discusses the risks associatedwith off-balance-sheet activities. OBS
activities are often designed to reduce risksthrough hedging with derivative securitiesand other means. However, as several highprofile events have demonstrated, OBS riskcan be substantial. Regulatory policy hasbeen altered as a result of accountingabuses and other unethical practices.
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Off Balance Sheet Risks
Contingent assets
Contingent liabilities
Derivative Securities
Held Off the Balance Sheet:
Forward contracts
Futures contracts
Option contracts
Swap contracts
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OBS Activities
Infamous cases:
Barings. NatWest Bank Midland Bank Chase Manhattan Union Bank of Switzerland Metallgesellschaft. Bankers Trust. CSFB/Orange County, CA. Sumitomo Corp.
Long-Term Capital AllFirst Bank/Allied Irish Bank J.P. Morgan Chase & Citigroup Amaranth Advisors
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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.
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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
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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 asother risk exposures
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Changes in OBS (Billions)
1992 2006
Futures & Forwards
SwapsOptions
Credit Derivatives
Total
$4,780
2,4171,568
8,765
$13,788
74,43824,447
6,569
119,243
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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.
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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
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Schedule L OBS Activities
Loan commitments and interest rate risk:
If fixed rate commitment the bank is exposed tointerest 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.
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Other Risks with Loan Commitments
Credit risk: credit rating of the borrower may
deteriorate over life of the commitmentAggregate 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.
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Commercial LCs and SLCs
Particularly important for foreign purchases.
If creditworthiness of the importer isunknown to seller, or lower than the banks,
then gains available through using an LC.
SLCs often used to insure risks that neednot be trade related.
performance bond guarantees.
Property & casualty insurers also prominent inselling SLCs.
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Simple Letter of Credit Transaction
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Derivative Contracts
Used by FIs for hedging purposes
Or FIs acting as dealers
Big Three Dealers: J.P. Morgan Chase, Bank ofAmerica, 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.
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When Issued Trading
Commitments to buy and sell securities prior
to issue. Example: commitments taken inweek prior to issue of new T-bills.
The risk is that the bank may overcommit as
with Salomon Brothers in market for new 2-yearbonds in 1990. Caused the Treasury to revisethe regulations governing the auction of billsand bonds.
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Loans Sold
Exposure to risk from loans sold unless no
recourse Ambiguity of no recourse qualification
Reputation effects may amplify the FIs
contingent liabilities
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Loans Sold With and Without Recourse
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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.
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Non-Schedule L Activities
Settlement Risk
FedWire is domestic. CHIPS is internationaland settlement takes place only at the endof the day. Leaves the bank with intraday
exposure to settlement risk. During the day,banks receive provisional messages only.
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Non-Schedule L Risk: Affiliate Risk
Affiliate risk occurs when dealing with
BHCs. Creditors of failed affiliate may lay claim to
surviving banks resources.
Effects of source of strength doctrine.
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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.
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Pertinent Websites
American Bankerwww.americanbanker.com
Federal Reserve Bank www.federalreserve.govBank of America www.bankofamerica.com
Citigroup www.citigroup.com
CHIPS www.chips.orgFDIC www.fdic.gov
J.P. Morgan/Chase www.jpmorganchase.com
NY Board of Trade www.nybot.comOCC www.occ.treas.gov
U.S. Treasury www.ustreas.gov
http://www.americanbanker.com/http://www.federalreserve.gov/http://www.bankofamerica.com/http://www.citigroup.com/http://www.chips.org/http://www.fdic.gov/http://www.jpmorganchase.com/http://www.nybot.com/http://www.occ.treas.gov/http://www.ustreas.gov/http://www.ustreas.gov/http://www.occ.treas.gov/http://www.nybot.com/http://www.jpmorganchase.com/http://www.fdic.gov/http://www.chips.org/http://www.citigroup.com/http://www.bankofamerica.com/http://www.federalreserve.gov/http://www.federalreserve.gov/http://www.americanbanker.com/