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Chapter. 13. Off-Balance-Sheet Activities. Overview.

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  1. Chapter 13 Off-Balance-Sheet Activities

  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.

  3. OBS Activities • Infamous cases: • Barings. • Metallgesellschaft. • Banker’s Trust. • CSFB/Orange County, CA. • Sumitomo Corp.

  4. 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

  5. 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.

  6. Returns and Risks of OBS Activities • Loan commitments • Letters of credit • LCs & SLCs • Futures, forwards, swaps and options • When issued securities • Loans sold • OBS only if sold without recourse

  7. 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.

  8. 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.

  9. 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 there are gains available through using an LC. • SLCs often used to insure risks that need not be trade related. May include performance bond guarantees. Property & casualty insurers are also prominent in selling SLCs.

  10. Derivative Contracts • Futures, forwards, swaps and options. • Forward contracts leave the bank heavily exposed to risk of default by counterparties. • Other derivatives create far less default risk.

  11. 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 1990. Caused the Treasury to revise the regulations governing the auction of bills and bonds.

  12. 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 each quarter as part of Schedule L of the Call report.

  13. 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.

  14. 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.

  15. 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.

  16. Pertinent Websites • For more information visit: Federal Reserve Bank www.federalreserve.gov Bank One Corp. www.bankone.com Citigroup www.citigroup.com CHIPS www.chips.org Web Surf

  17. Pertinent Websites J.P. Morgan/Chase www.jpmorgan.com NY Board of Trade www.nybot.com OCC www.occ.treas.gov U.S. Treasury www.ustreas.gov Web Surf

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