13. Off Balance Sheet Activity (OBSA)
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
• 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
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
• 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:
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
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:
Q: There are 4 major components to loan syndication. Which of these 4 is not absent in the asset
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
Citibank will sell a group of auto loans to a trust, perhaps and affiliate so Salomon Smith
Loan Packaging: An investment bank advises the trust and underwrites a securities issuance
Salomon Smith Barney
Guarantor: Provides insurance for the issuance, either partial or wholly.
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
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
Q: Why are the benefits to banks of securitizing loans?
• 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
• 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
Financial institutions make money on writing and selling the contracts
Simply trade risks with counterparties.
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 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
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
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.
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
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
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?
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.