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  1. 1. 13. Off Balance Sheet Activity (OBSA) I. Overview One of the major developments since the 1992 full implementation of the Basel agreement is the increase in off balance sheet activity. 1. Definition: Bank financing activity/transactions that do not appear on the balance sheet. 2. Influencing factors in the shift of bank activity: • Capital requirements: Moving assets off balance sheet can reduce capital requirements and improve capital adequacy • Alternative revenue streams: OBSA is generally fee based revenue, reducing bank reliance on interest income (return on rate spreads) • Availability of public financing: Bank – client relationships eroded with the corporate shift to public financing and banks needed alternative sources of income. Reduced competitiveness forced the shift. • Expertise: Banks have a natural expertise in risk management, a skill that they can offer to companies through derivative contracts • Risk exposure: Can reduce bank risk – certain activities involve the selling of risk • Government support: Securitization through GSE’s encourages removal of risk from bank balance sheets. Major Sources of non-interest (fee) income for banks: • Service charges on deposits: $22B (ATM, Insuf funds, check writing etc.) • Income from trust activities: $21B (fiduciary activities between principal and agents) • Trading income: $10B (largest banks only, particularly in secondary market for which they are market makers) • Other: $91B Income growth rates at Banks: Non-interest: 19.23% annual Interest related: 2.84% annual Asset growth rate at banks: 5.49% 3. In moving to OBSA, banks no longer rely on relationship with clients, but use their reputation. II. Regulatory concerns:
  2. 2. 1. Are the OBSA properly assessed for risk with respect to capital adequacy? 2. Will increased reliance on fee based services reduce bank incentive to resolve the problem of private information in financial markets • Moral hazard • Adverse selection • Market for lemons 3. Will bank monitoring suffer through the packaging and selling of loan risk (securitization) – Will banks be unwilling to renegotiate loans in Chapter 11 if the underlying risk is removed from their balance sheets. Potential Dilemma for banks: If regulators increase capital requirements or limit their activity, will they be able to remain competitive in the Derivatives/OBSA markets?  Firms like GE Capital and AMEX participate in these same markets but do not have (or want) a bank charter, so they might then have an advantage over their regulated banking competitors. III. Types of OBS Activity 1. Securitization: The pooling and packaging of loans with similar characteristics by financial intermediaries for sale as securities backed by the cashflows of the underlying loans. • Credit enhanced claims • Mortgages are most common Asset securitization process: 1. Originate 2. Sell 3. Service Q: There are 4 major components to loan syndication. Which of these 4 is not absent in the asset securitization process?  Remove the “monitoring” step associated with loan syndication. The process and the players: Loan Origination: Banks (and GSE’s) provide the funds (principal) for various types of loans (auto, credit card, home, college etc.)  Originator might also service the loan, collecting payments Loan Purchaser: The loans are bought from the bank by a trust or affiliate (removed from bank B/S)  Citibank will sell a group of auto loans to a trust, perhaps and affiliate so Salomon Smith Barney Loan Packaging: An investment bank advises the trust and underwrites a securities issuance
  3. 3.  Salomon Smith Barney Guarantor: Provides insurance for the issuance, either partial or wholly.  Credit enhancer  GSE has implicit gov’t backing for home and student loans  Firm like Travelers might insure a CAR in case of default Investors: Buy the newly created securities made up of a collection of loans. Note: In the traditional role, banks are associated in the securitization process only at the origination step (selling of the loans). The financial modernization act of 1999 has made securitization more attractive to banks that have affiliate operations in investment banking and insurance, the other principal participants in the securitization process. Considerations for securitization: Size considerations: The fees associated with underwriting require minimum securities issuances in the neighborhood of $50Million. Small banks are generally unable to pool assets of this magnitude unless affiliated with a banker’s bank Recourse: In the process of securitization, it matters what recourse investors have on the originator. If there is recourse then the originated loans are not effectively removed form the B/S Risk Exposure: Diversification of a large number of loans is the tool to reduce risk, replacing monitoring activity by banks. Q: What are the moral hazard implications of this shift? Can markets break down? Think about the consequences of the Mirant bankruptcy Collateralized Debt Obligations (CDO): Debt can be either loans or bonds (CLO’s and CBO’s)  Mortgage backed securities (MBS) – a.k.a. Collateralized Mortgage Obligations (CMO’s)  Collateralized Automobile Receivables (CARS) – packaging auto loans into debt securities  Certificates for Amortizing Revolving Debts (CARDS) – packaging credit card receivables into debt securities (not backed by collateral) These securities can also be enhanced by implicit government guarantee (e.g. Fredie Mac, Fannie Mae, Ginnie Mae) – FHA and Student loans. John Reed, former chairman of Citigroup: “Securitization is the substitution of more efficient public capital markets for less efficient, higher-cost financial intermediaries in the funding of debt instruments.” Q: Why are the benefits to banks of securitizing loans?
  4. 4. • Increased liquidity of financing (public markets price activity in secondary markets) • Fee income is earned – more stable than interest rate spreads • No intermediation taxation – 0% interest reserve requirements avoided • Removes moral hazard and adverse selection problems – passed on to end-investors Q: What are the costs of securitizing loans • Bank monitoring reduced…banks have sold off risk to diversified investors in the market. • Where do investors have recourse? Originator, credit enhancer, none? • Small business and non conforming loans are difficult to securitize Large banks dominate the securitization business, but banker’s banks are pooling resources to create larger lending networks and allow community banks to participate. 2. Credit Related Activities: These are not loans, but only commitments to make loans or provide financial backing. Banks charge fees for these arrangements. Letter of Credit (LOC): Guarantee provided by a bank that vouches for a client’s creditworthiness • Bank guarantees payment • Can be used by firm to buy goods and services that are received before payment Example: • Importer places order with exporter for goods • Letter of credit by importer’s bank is provided to exporter • Fee is paid to bank by importer for this service • Exporter ships goods to importer & presents shipping documents to importer’s bank • Importer’s bank pays exporter from importers account Standby Letter of Credit (SLC): An agreement to provide credit contingent upon the occurrence of a particular event (e.g. if client cannot roll over commercial paper it draws on SLC) Loan commitments (LC): Formal agreement between a bank and borrower to provide a fixed amount of credit for a specific period Credit enhancer: Financial institution will provide a government guarantee or LOC to enhance a pool of assets prior to securitization 3. Derivatives: Contracts whose value is derived from some underlying assets such as a commodity, interest rate, stock or bond. Derivatives are generally used for hedging activities, and when positions are aggregated, there are no winners or losers (zero sum game). Only the underlying asset ‘creates’ value, not the derivative contract itself:  Financial institutions make money on writing and selling the contracts  Simply trade risks with counterparties.
  5. 5. Derivative contracts – Exchange traded: Standard derivative contracts which are frequent enough that adequate liquidity is generated when traded on a secondary exchange such as the (CBOE, AMEX etc.)  Futures (Treasuries, interest rate, gold)  Options on futures (Currency, bonds, indexes, corn…)  Credit derivatives Credit Derivative: Similar to an insurance contract - $ 1 Trillion market  Is similar to insurance in that it pays when a “credit event” occurs  Different from insurance in that it is not based on the losses of the insured.  since the payout is well defined, these contracts can be traded in secondary markets  These contracts are often combined with securitized obligations as credit enhancement (see above)  Hedge funds are among the biggest buyers Derivative contracts – Privately negotiated: For non-standard client needs that cannot be met in public markets do to size, liquidity, or specificity of the contract.  Interest rate swaps  FX swaps  Forward contracts (commodities, currencies, rates) Swaps: are agreements between two parties to exchange exposure to a specific risk. Interest rates and foreign exchange are the two most common risks. Counter party risk: Banks facilitate swap agreements for a fee (match two parties). When one party defaults on their commitment, the bank pays.  This is what happened to Refco Derivative Securities: Structured and stripped securities and securities with option like characteristics.  Treasury strips (IO’s & PO’s)  Yield curve notes  Callable/putable bonds and convertible securities IV. Value at Risk (VAR): A technique of measuring risk exposure using the market value of a portfolio (the potential gain or loss of a portfolio). Q: When is VAR used?  To help determine capital adequacy VAR is an amount that represents the maximum expected loss in the event of a worse case scenario. This event may never happen, but what if it did? Banks need a tool to measure what their exposure to this risk is.
  6. 6. Example: “there is a 1% chance that a line of business will lose $25 million next month.” Components to VAR: 1. Spot market prices of assets (mark to market) 2. Estimated volatilities or assets 3. Correlation between asset values over time (standard deviation) 4. Time horizon for estimation and confidence intervals VAR can be used to evaluate: • Loan portfolios • Credit risk • Foreign exchange risk The correlation between assets gives the covariance matrix, the determinant of the level of diversification of assets.  As the number of non-correlated assets increase in a portfolio, the less idiosyncratic risk (asset specific risk) there is. If there are enough assets, then only systematic (market) risk remains.  However, assets (loans) are frequently correlated since borrowers are faced with the same systematic (economic) conditions. Problems with VAR: Measuring risk based on portfolio theory and the covariance matrix, and not using time proven techniques based on relationships with clients. VAR tries to measure risk based on estimates of rare or infrequent events (default) which is an imprecise science, which might lead to misleading precision and a bad hedging position  LTCM: Bet on the spread between Russian bonds and US Treasuries, and lost all equity in their highly leveraged portfolio when the Russians defaulted. It was the perfect hedge until default… Finance more so a social science than a physical science, and VAR focuses on techniques of the latter. Q: VAR is more information (mathematical model) but is this better than no information?  False information might lead to greater risk taking Loss Shifting: Individual credit quality may be lost in the portfolio management approach, whereby the covariance matrix takes care of specific risk though diversification. Banks might become Lax with 1. Analysis and decision-making: adverse selection problem…are banks making good determinations with borrower type knowing that they are just going to sell off the risk associated with the loan?
  7. 7. 2. Structure of the loan 3. Monitoring: will it become a lost art? Diversification is replacing monitoring, but there is a moral hazard implication 4. Damage limitation: Citigroup allowed Mirant to default and made no effort to repackage loans since the bank faced little risk from the firm’s failure.