Off balance sheet

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Other risks: Off-Balance-Other risks: Off-Balance-Sheet riskSheet risk

Saunders and CornettSaunders and Cornett

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Off-balance-sheet risks can be substantial.Off-balance-sheet risks can be substantial. Barings bank case; Enron debacleBarings bank case; Enron debacleEthical dilemmas resulted in regulatory Ethical 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 “special Morgan Chase, and Enron under “special purpose entities” help Enron disguise its purpose 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 concern arrangements that “may” be of material concern

to the markets.to the markets.


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Reverse Purchase AgreementReverse Purchase Agreement

The purchase of securities with the The purchase of securities with the agreement to sell them at a higher price at agreement to sell them at a higher price at a specific future date. a specific future date.

For the party selling the security (and For the party selling the security (and agreeing to repurchase it in the future) it is agreeing to repurchase it in the future) it is a repo; for the party on the other end of a repo; for the party on the other end of the transaction (buying the security and the transaction (buying the security and agreeing to sell in the future) it is a reverse agreeing to sell in the future) it is a reverse repurchase agreement. repurchase agreement.


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Special Purpose Entities or Special Purpose Entities or vehiclesvehicles

Are used to isolate financial riskAre used to isolate financial riskA corporation can use such a vehicle to finance A corporation can use such a vehicle to finance a large project without putting the entire firm at a large project without putting the entire firm at risk. risk. SPE/SPVs: Securitization SPVs. SPE/SPVs: Securitization SPVs. Apart from securitizations, SPVs are often used Apart from securitizations, SPVs are often used for many purposes. One common purpose is to for 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 that an off balance sheet lease from the vehicle that funds them with debt. funds them with debt.


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OBS Activities and SolvencyOBS Activities and Solvency

Contingent assets and liabilities: off balance Contingent assets and liabilities: off balance sheet assets and liabilities that potentially can sheet assets and liabilities that potentially can produce positive or negative future cash flows produce positive or negative future cash flows for the FI. It can influence the future for 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 a Off-balance-sheet assets: an item that when a contingent event occurs moves onto the asset contingent event occurs moves onto the asset side of the BS.side of the BS.

Off-balance-sheet liabilities: an item that when Off-balance-sheet liabilities: an item that when a contingent event occurs moves onto the a contingent event occurs moves onto the liability side of the BS.liability side of the BS.


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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 an Delta of an option: the change in the value of an

option for a unit change in the price of the underlying option 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 an Notional 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


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Valuation Valuation

Net worth with on-off balance sheet Net 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 contingent A is assets, L is liabilities, CA is contingent

assets, and CL is contingent liabilities.assets, and CL is contingent liabilities.


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Schedule L ActivitiesSchedule L Activities

Loan commitments: an agreement to Loan commitments: an agreement to make loans up to a stated amount at a make 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 sold Loans sold OBS only if sold with recourseOBS only if sold with recourse


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Schedule L OBS ActivitiesSchedule L OBS ActivitiesLoan commitments: interest rate risk:Loan commitments: interest rate risk:

If fixed rate commitment the bank is exposed to If fixed rate commitment the bank is exposed to interest rate risk.interest rate risk.

If floating rate commitment, there is still exposure to If 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 fees downs 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 reduce at the end of the period) are intended to reduce this risk.this risk.

Td rate: take down rate is loans that actually are Td rate: take down rate is loans that actually are drawn upon.drawn upon.

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Other Risks with Loan Other Risks with Loan CommitmentsCommitments

Credit risk: credit rating of the borrower Credit risk: credit rating of the borrower may deteriorate over life of the may deteriorate over life of the commitmentcommitment

Aggregate funding risk: During a credit Aggregate funding risk: During a credit crunch, bank may find it difficult to meet all crunch, bank may find it difficult to meet all of the commitments.of the commitments. Banks may need to adjust their risk profile on Banks may need to adjust their risk profile on

the balance sheet in order to guard against the balance sheet in order to guard against future take-downs on loan commitments.future take-downs on loan commitments.


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When Issued TradingWhen Issued TradingCommitments to buy and sell securities prior to Commitments 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 to Example: commitments taken in week prior to issue of new T-bills. Large banks sell yet to be issue of new T-bills. Large banks sell yet to be issued T-bills for forward delivery to the issued T-bills for forward delivery to the secondary market at a small margin above the secondary market at a small margin above the price they are expected to pay at the primary price they are expected to pay at the primary auction.auction. The risk is that the bank may overcommit as with The risk is that the bank may overcommit as with

Salomon Brothers in market for new 2-year bonds in Salomon Brothers in market for new 2-year bonds in 1990. Caused the Treasury to revise the regulations 1990. Caused the Treasury to revise the regulations governing the auction of bills and bonds.governing the auction of bills and bonds.


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Loans SoldLoans SoldExposure to risk from loans sold unless no Exposure to risk from loans sold unless no recourserecourseRecourse is the seller of the assets retains Recourse is the seller of the assets retains the risk if default happens. Japanese the risk if default happens. Japanese financial crisis: securitized loans often has financial crisis: securitized loans often has recourse agreement on. Banks have huge recourse 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 willing Reputation effects may make the FI’s willing

to take back bad loans sold even if it is a no to take back bad loans sold even if it is a no recourse loan sale.recourse loan sale.


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The Role of OBS ActivitiesThe Role of OBS Activities

OBS activities are not always risk OBS activities are not always risk increasing activities. increasing activities.

In many cases they are hedging activities In many cases they are hedging activities designed to mitigate exposure to interest designed to mitigate exposure to interest rate risk, foreign exchange risk etc.rate risk, foreign exchange risk etc.

OBS activities are frequently a source of OBS activities are frequently a source of fee income, especially for the largest most fee income, especially for the largest most credit-worthy banks.credit-worthy banks.


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Chapter 14: Operational riskChapter 14: Operational risk

Sources of Operational Risk Sources of Operational Risk Technology: system failureTechnology: system failure Employees: human error, internal fraudEmployees: human error, internal fraud Customer relationships: contractual Customer relationships: contractual

disputes with customersdisputes with customers Capital assets: fire or other disasters Capital 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

Efficient Efficient 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 loan Noninterest expense) - Provision for loan losseslosses


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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.


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Effects of Technology on Revenues & CostsEffects of Technology on Revenues & Costs

Investments in technology are riskyInvestments in technology are risky Potentially Potentially negative negative NPV projects due to NPV projects due to

uncertainty and potential competitive uncertainty and potential competitive responsesresponses

Potential agency conflicts:Potential agency conflicts:Growth-oriented investments may not maximize Growth-oriented investments may not maximize

shareholder’s valueshareholder’s valueLosses on technological investments can weaken Losses on technological investments can weaken

an FIan FI


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Effects of Technology on Revenues and Effects of Technology on Revenues and CostsCosts

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 the Consumer reluctance to apply for mortgage on the webweb

Cost effects:Cost effects: Technological improvementsTechnological improvements

Shift in cost curve.Shift in cost curve.


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Effects on Costs (continued)Effects on Costs (continued)

Economies of scaleEconomies of scale Optimal size depends on shape of average Optimal size depends on shape of average

cost curve.cost curve.

AC

Size Size

AC AC

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Effects on Costs (continued)Effects on Costs (continued)

Economies of scopeEconomies of scope Multiple outputs may provide synergies in Multiple outputs may provide synergies in

production.production.

Diseconomies of scopeDiseconomies of scope Specialization may have cost benefits in Specialization may have cost benefits in

production and delivery of some FI servicesproduction and delivery of some FI services


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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


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Optimal Risk ManagementOptimal Risk ManagementCost

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 foreign Spot positions denominated in foreign currencycurrency

Forward positions denominated in foreign Forward positions denominated in foreign currencycurrency

Net exposure = (FX assets - FX liab.) + (FX Net exposure = (FX assets - FX liab.) + (FX bought - FX sold)bought - FX sold)

Some decline in FX exposure as a result of Some decline in FX exposure as a result of the Asian, Russian and Argentinian crisesthe Asian, Russian and Argentinian crises


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FX Risk ExposureFX Risk Exposure

Greater exposure to a foreign currency Greater exposure to a foreign currency combined with greater volatility of the combined with greater volatility of the foreign currency implies greater DEAR.foreign currency implies greater DEAR.

Dollar loss in currency Dollar loss in currency ii

= = [Net exposure in foreign currency [Net exposure in foreign currency ii in $] × Shock in $] × Shock (Volatility) of the exchange rate(Volatility) of the exchange rate


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Interest Rate Parity TheoremInterest Rate Parity Theorem

Equilibrium condition is that there should Equilibrium condition is that there should be no arbitrage opportunities available be no arbitrage opportunities available through lending and borrowing across through lending and borrowing across currencies. This requires that currencies. 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 the Difference in interest rates will be offset by the

expected change in exchange rates. expected change in exchange rates.


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Business

Off balance sheet