Off balance sheet

11
Other risks: Off-Balance-Other risks: Off-Balance-
Sheet riskSheet risk
Saunders and CornettSaunders and Cornett
www.StudsPlanet.comwww.StudsPlanet.com

22
Off-balance-sheet risks can be substantial.Off-balance-sheet risks can be substantial.
Barings bank case; Enron debacleBarings bank case; Enron debacle
Ethical dilemmas resulted in regulatoryEthical dilemmas resulted in regulatory
reactions in 2002:reactions in 2002:
OBS transactions between Citigroup, J.P.OBS transactions between Citigroup, J.P.
Morgan Chase, and Enron under “specialMorgan Chase, and Enron under “special
purpose entities” help Enron disguise itspurpose entities” help Enron disguise its
debt. Sarbanes-Oxley Act:debt. Sarbanes-Oxley Act:
Disclosure requirementsDisclosure requirements: “total picture in a: “total picture in a
single location”.single location”.

arrangements that “may” be of material concernarrangements that “may” be of material concern
to the markets.to the markets.

33
Reverse Purchase AgreementReverse Purchase Agreement
The purchase of securities with theThe purchase of securities with the
agreement to sell them at a higher price atagreement to sell them at a higher price at
a specific future date.a specific future date.
For the party selling the security (andFor the party selling the security (and
agreeing to repurchase it in the future) it isagreeing to repurchase it in the future) it is
a repo; for the party on the other end ofa repo; for the party on the other end of
the transaction (buying the security andthe transaction (buying the security and
agreeing to sell in the future) it is a reverseagreeing to sell in the future) it is a reverse
repurchase agreement.repurchase agreement.

44
Special Purpose Entities orSpecial Purpose Entities or
vehiclesvehicles
Are used to isolate financial riskAre used to isolate financial risk
A corporation can use such a vehicle to financeA corporation can use such a vehicle to finance
a large project without putting the entire firm ata large project without putting the entire firm at
risk.risk.
SPE/SPVs: Securitization SPVs.SPE/SPVs: Securitization SPVs.
Apart from securitizations, SPVs are often usedApart from securitizations, SPVs are often used
for many purposes. One common purpose is tofor many purposes. One common purpose is to
use them for what is known as "synthetic leases"use them for what is known as "synthetic leases"
- a device by which assets are acquired under- a device by which assets are acquired under
an off balance sheet lease from the vehicle thatan off balance sheet lease from the vehicle that
funds them with debt.funds them with debt.

55
OBS Activities and SolvencyOBS Activities and Solvency

Contingent assets and liabilities: off balanceContingent assets and liabilities: off balance
sheet assets and liabilities that potentially cansheet assets and liabilities that potentially can
produce positive or negative future cash flowsproduce positive or negative future cash flows
for the FI. It can influence the futurefor the FI. It can influence the future
profitability and solvency of a FI.profitability and solvency of a FI.

Off-balance-sheet assets: an item that when aOff-balance-sheet assets: an item that when a
contingent event occurs moves onto the assetcontingent event occurs moves onto the asset
side of the BS.side of the BS.

Off-balance-sheet liabilities: an item that whenOff-balance-sheet liabilities: an item that when
a contingent event occurs moves onto thea contingent event occurs moves onto the
liability side of the BS.liability side of the BS.

66
OBS Activities and Solvency (cont.)OBS Activities and Solvency (cont.)
Valuation of OBS items:Valuation of OBS items:

Delta of an option: the change in the value of anDelta of an option: the change in the value of an
option for a unit change in the price of the underlyingoption for a unit change in the price of the underlying
security.security.

Ex:Ex:

Also: 0<d<1Also: 0<d<1

Notional value of an OBS item is the face value of anNotional value of an OBS item is the face value of an
OBS item.OBS item.

Delta equivalent or Contingent asset valueDelta equivalent or Contingent asset value
= Delta × Face value of option= Delta × Face value of option

77
ValuationValuation
Net worth with on-off balance sheetNet worth with on-off balance sheet
activitiesactivities

Should include market value of on- and off-Should include market value of on- and off-
balance-sheet activities.balance-sheet activities.

E = (A – L) + (CA – CL)E = (A – L) + (CA – CL)

A is assets, L is liabilities, CA is contingentA is assets, L is liabilities, CA is contingent
assets, and CL is contingent liabilities.assets, and CL is contingent liabilities.

88
Schedule L ActivitiesSchedule L Activities
Loan commitments: an agreement toLoan commitments: an agreement to
make loans up to a stated amount at amake loans up to a stated amount at a
given interest rate in the future.given interest rate in the future.
Letters of creditLetters of credit

LCs & Standby LCsLCs & Standby LCs
Futures, forwards, swaps and optionsFutures, forwards, swaps and options
When issued securitiesWhen issued securities
Loans soldLoans sold

OBS only if sold with recourseOBS only if sold with recourse

99
Schedule L OBS ActivitiesSchedule L OBS Activities
Loan commitments: interest rate risk:Loan commitments: interest rate risk:

If fixed rate commitment the bank is exposed toIf fixed rate commitment the bank is exposed to
interest rate risk.interest rate risk.

If floating rate commitment, there is still exposure toIf floating rate commitment, there is still exposure to
basis riskbasis risk. The variable spread between a lending rate. The variable spread between a lending rate
and a borrowing rate.and a borrowing rate.
Take-down riskTake-down risk: Uncertainty of timing of take-: Uncertainty of timing of take-
downs exposes bank to risk. Back-end feesdowns exposes bank to risk. Back-end fees
(commitment fees on any unused commitment(commitment fees on any unused commitment
at the end of the period) are intended to reduceat the end of the period) are intended to reduce
this risk.this risk.
Td rate: take down rate is loans that actually areTd rate: take down rate is loans that actually are
drawn upon.drawn upon.
9www.StudsPlanet.comwww.StudsPlanet.com

1010
Other Risks with LoanOther Risks with Loan
CommitmentsCommitments
Credit risk: credit rating of the borrowerCredit risk: credit rating of the borrower
may deteriorate over life of themay deteriorate over life of the
commitmentcommitment
Aggregate funding risk: During a creditAggregate funding risk: During a credit
crunch, bank may find it difficult to meet allcrunch, bank may find it difficult to meet all
of the commitments.of the commitments.

Banks may need to adjust their risk profile onBanks may need to adjust their risk profile on
the balance sheet in order to guard againstthe balance sheet in order to guard against
future take-downs on loan commitments.future take-downs on loan commitments.

1111
When Issued TradingWhen Issued Trading
Commitments to buy and sell securities prior toCommitments to buy and sell securities prior to
issueissue. It exposes FIs to future interest rate risk.. It exposes FIs to future interest rate risk.
Much like a forward contract.Much like a forward contract.
Example: commitments taken in week prior toExample: commitments taken in week prior to
issue of new T-bills. Large banks sell yet to beissue of new T-bills. Large banks sell yet to be
issued T-bills for forward delivery to theissued T-bills for forward delivery to the
secondary market at a small margin above thesecondary market at a small margin above the
price they are expected to pay at the primaryprice they are expected to pay at the primary
auction.auction.

The risk is that the bank may overcommit as withThe risk is that the bank may overcommit as with
Salomon Brothers in market for new 2-year bonds inSalomon Brothers in market for new 2-year bonds in
1990. Caused the Treasury to revise the regulations1990. Caused the Treasury to revise the regulations
governing the auction of bills and bonds.governing the auction of bills and bonds.

1212
Loans SoldLoans Sold
Exposure to risk from loans sold unless noExposure to risk from loans sold unless no
recourserecourse
Recourse is the seller of the assets retainsRecourse is the seller of the assets retains
the risk if default happens. Japanesethe risk if default happens. Japanese
financial crisis: securitized loans often hasfinancial crisis: securitized loans often has
recourse agreement on. Banks have hugerecourse agreement on. Banks have huge
exposure to credit losses.exposure to credit losses.

Ambiguity of no recourse qualification:Ambiguity of no recourse qualification:
Reputation effects may make the FI’s willingReputation effects may make the FI’s willing
to take back bad loans sold even if it is a noto take back bad loans sold even if it is a no
recourse loan sale.recourse loan sale.

1313
The Role of OBS ActivitiesThe Role of OBS Activities
OBS activities are not always riskOBS activities are not always risk
increasing activities.increasing activities.
In many cases they are hedging activitiesIn many cases they are hedging activities
designed to mitigate exposure to interestdesigned to mitigate exposure to interest
rate risk, foreign exchange risk etc.rate risk, foreign exchange risk etc.
OBS activities are frequently a source ofOBS activities are frequently a source of
fee income, especially for the largest mostfee income, especially for the largest most
credit-worthy banks.credit-worthy banks.

1414
Chapter 14: Operational riskChapter 14: Operational risk
Sources of Operational RiskSources of Operational Risk
 Technology: system failureTechnology: system failure
 Employees: human error, internal fraudEmployees: human error, internal fraud
 Customer relationships: contractualCustomer relationships: contractual
disputes with customersdisputes with customers
 Capital assets: fire or other disastersCapital assets: fire or other disasters
resulted in capital lossresulted in capital loss
 External risks: internet fraud, Phishing,External risks: internet fraud, Phishing,
taxation, legal risk, etctaxation, legal risk, etc

1515
Importance of TechnologyImportance of Technology
EfficientEfficient technological basetechnological base can result in:can result in:

Lower costsLower costs
Through improved allocation of inputs.Through improved allocation of inputs.

Increased revenuesIncreased revenues
Through wider range of outputs.Through wider range of outputs.

Earnings before taxes = (Interest income -Earnings before taxes = (Interest income -
Interest expense) + (Other income -Interest expense) + (Other income -
Noninterest expense) - Provision for loanNoninterest expense) - Provision for loan
losseslosses

1616
Impact on Wholesale BankingImpact on Wholesale Banking
Improvements to cash management:Improvements to cash management:
Controlled disbursement accountsControlled disbursement accounts
Account reconciliationAccount reconciliation
Electronic data interchangeElectronic data interchange
Electronic funds transferElectronic funds transfer
Verification of IdentitiesVerification of Identities
Electronic initiation of letters of creditElectronic initiation of letters of credit
E-commerceE-commerce
Etc.Etc. www.StudsPlanet.comwww.StudsPlanet.com

1717
Effects of Technology on Revenues & CostsEffects of Technology on Revenues & Costs
Investments in technology are riskyInvestments in technology are risky

PotentiallyPotentially negativenegative NPV projects due toNPV projects due to
uncertainty and potential competitiveuncertainty and potential competitive
responsesresponses

Potential agency conflicts:Potential agency conflicts:
Growth-oriented investments may not maximizeGrowth-oriented investments may not maximize
shareholder’s valueshareholder’s value
Losses on technological investments can weakenLosses on technological investments can weaken
an FIan FI

1818
Effects of Technology on RevenuesEffects of Technology on Revenues
and Costsand Costs
Revenue effects:Revenue effects:

Facilitates cross-marketingFacilitates cross-marketing

Increases innovationIncreases innovation

Service quality effectsService quality effects
Survival of small banks and value of “human touch”Survival of small banks and value of “human touch”
Consumer reluctance to apply for mortgage on theConsumer reluctance to apply for mortgage on the
webweb
Cost effects:Cost effects:

Technological improvementsTechnological improvements
Shift in cost curve.Shift in cost curve.

1919
Effects on Costs (continued)Effects on Costs (continued)
Economies of scaleEconomies of scale

Optimal size depends on shape of averageOptimal size depends on shape of average
cost curve.cost curve.
AC
Size Size
AC AC
Size

2020
Effects on Costs (continued)Effects on Costs (continued)
Economies of scopeEconomies of scope

Multiple outputs may provide synergies inMultiple outputs may provide synergies in
production.production.
Diseconomies of scopeDiseconomies of scope

Specialization may have cost benefits inSpecialization may have cost benefits in
production and delivery of some FI servicesproduction and delivery of some FI services

2121
Controlling Operational RiskControlling Operational Risk
Loss prevention:Loss prevention:

Training, development, review of employeesTraining, development, review of employees
Loss control:Loss control:

Planning, organization, back-upPlanning, organization, back-up
Loss financing:Loss financing:

External insuranceExternal insurance
Loss insulation:Loss insulation:

FI capitalFI capital

2222
Optimal Risk ManagementOptimal Risk Management
Cost
RME
Cost of problems
Cost of risk
management
Total cost

2323
Chapter 15 Foreign exchange risksChapter 15 Foreign exchange risks
Sources of FX RiskSources of FX Risk
Spot positions denominated in foreignSpot positions denominated in foreign
currencycurrency
Forward positions denominated in foreignForward positions denominated in foreign
currencycurrency
Net exposure = (FX assets - FX liab.) +Net exposure = (FX assets - FX liab.) +
(FX bought - FX sold)(FX bought - FX sold)
Some decline in FX exposure as a resultSome decline in FX exposure as a result
of the Asian, Russian and Argentinianof the Asian, Russian and Argentinian
crisescrises www.StudsPlanet.comwww.StudsPlanet.com

2424
FX Risk ExposureFX Risk Exposure
Greater exposure to a foreign currencyGreater exposure to a foreign currency
combined with greater volatility of thecombined with greater volatility of the
foreign currency implies greater DEAR.foreign currency implies greater DEAR.
Dollar loss in currencyDollar loss in currency ii
== [Net exposure in foreign currency[Net exposure in foreign currency ii in $] × Shockin $] × Shock
(Volatility) of the exchange rate(Volatility) of the exchange rate

2525
Interest Rate Parity TheoremInterest Rate Parity Theorem
Equilibrium condition is that there shouldEquilibrium condition is that there should
be no arbitrage opportunities availablebe no arbitrage opportunities available
through lending and borrowing acrossthrough lending and borrowing across
currencies. This requires thatcurrencies. This requires that
1+r(domestic)1+r(domestic) == FF
[1+r (foreign)] S[1+r (foreign)] S

Difference in interest rates will be offset by theDifference in interest rates will be offset by the
expected change in exchange rates.expected change in exchange rates.

2626www.StudsPlanet.comwww.StudsPlanet.com

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