Professional Documents
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McGraw-Hill/Irwin
Overview
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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 high profile events have demonstrated, OBS risk can be substantial. Regulatory policy has been altered as a result of accounting abuses and other unethical practices.
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Contingent assets Contingent liabilities Derivative Securities Held Off the Balance Sheet:
OBS Activities
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Infamous cases:
Barings. NatWest Bank Midland Bank Chase Manhattan Union Bank of Switzerland Metallgesellschaft. Bankers Trust. CSFB/Orange County, CA. Sumitomo Corp. Long-Term Capital AllFirst Bank/Allied Irish Bank J.P. Morgan Chase & Citigroup Amaranth Advisors
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Off-balance-sheet assets Off-balance-sheet liabilities Delta of an option Notional value of an OBS item Delta equivalent or Contingent asset value = Delta Face value of option
Valuation
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Schedule L Activities
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Futures, forwards, swaps and options When issued securities Loans sold
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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.
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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.
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Particularly important for foreign purchases. If creditworthiness of the importer is unknown to seller, or lower than the banks,
SLCs often used to insure risks that need not be trade related.
performance bond guarantees. Property & casualty insurers also prominent in selling SLCs.
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Derivative Contracts Used by FIs for hedging purposes Or FIs acting as dealers
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Forward contracts involve substantial counterparty risk Other derivatives create far less default risk.
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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.
Loans Sold
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Ambiguity of no recourse qualification Reputation effects may amplify the FIs contingent liabilities
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FIs other than banks may engage in many of the OBS activities discussed so far. Banks have to report the five OBS activities (discussed in preceding slides) each quarter as part of Schedule L of the Call report.
Non-Schedule L Activities
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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.
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Creditors of failed affiliate may lay claim to surviving banks resources. Effects of source of strength doctrine.
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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.
Pertinent Websites
American Banker www.americanbanker.com Federal Reserve Bank www.federalreserve.gov Bank of America www.bankofamerica.com Citigroup www.citigroup.com CHIPS www.chips.org FDIC www.fdic.gov J.P. Morgan/Chase www.jpmorganchase.com NY Board of Trade www.nybot.com OCC www.occ.treas.gov U.S. Treasury www.ustreas.gov
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