BFC3170 MANAGEMENT OF

FINANCIAL INTERMEDIARIES
Off-balance-sheet Risk

HASSAN NAQVI

monash.edu
Reminder
• Major assignment due: Thursday, 16th May, 2pm
• 2500 word limit
• Moodle and hard copy
 Recap
• Book value vs market value of capital
• Leverage ratio
• Basel accords
• Pillar 1: Capital adequacy
• Pillar 2: Supervision
• Pillar 3: Disclosure
• Capital adequacy ratios
• Common equity Tier (CET) 1 capital ratio
• Tier 1 capital risk-based ratio
• Total capital risk-based ratio
• Risk weights
• Risk weighted assets
• Capital buffers
Learning objectives

• Gain an appreciation of the different types of off-

balance-sheet activities used by FIs.
• Discover how these activities can impact the
performance and solvency of an FI.
• Gain an understanding of the risks and returns
associated with off-balance-sheet activities.
• Learn about the ways off-balance-sheet
activities are used by FIs.
• Learn how off-balance-sheet activities can
reduce the risk of FI balance sheets.
Outline

• Introduction
• Off-balance-sheet (OBS) activities and FI
solvency
• Returns and risks of OBS activities
• Summary
Introduction

• On-balance-sheet activities appear on FI’s

published balance sheets
• Off-balance-sheet (OBS) activities ‘invisible’
• ‘Below the bottom line’, e.g. in footnotes
• Contingent assets and liabilities
– OBS asset: contingent asset (CA)
– OBS liability: contingent liability (CL)
• Affect future rather than current balance sheet
• OBS items impact future profitability and solvency
=> Efficient management of OBS risk is critical
Introduction

• OBS assets and liabilities have potential to produce

positive or negative future cash flows
• Fees from OBS activities => non-interest income
• OBS instruments (e.g. forwards, futures, options
and swaps) can be used to manage risks, e.g.
interest rate risk, credit risk, etc.
• Losses from OBS mortgage-backed securities =>
GFC
• True picture of net worth
– Should include market value of on- and off-balance-sheet
activities
Introduction

• Incentive to increase OBS activities

– Generate additional income
– Avoid regulatory costs or taxes
 Reserve requirements
 Deposit insurance premiums
 Capital adequacy requirements
Introduction
OBS activities and FI solvency

• OBS asset: an item or activity that moves into asset

side of balance sheet when a contingent event occurs
• OBS liability: an item or activity that moves into
liability side of balance sheet when a contingent event
occurs
• E.g. letters of credit, standby letters of credit
• Failure or near failure of Global FIs in GFC due to risks
associated with OBS activities
• E.g. Lehman brothers, Bear Stearns, Merrill Lynch,
RBS, Citi, AIG
• Losses from falling value of mortgages and MBS over
US$1 trillion in GFC
OBS activities and FI solvency
OBS activities and FI solvency

• Off-balance-sheet assets and liabilities

– Contingent assets or liabilities
– Potential for these assets and liabilities to produce
negative or positive returns to the FI
– Probability of moving onto the balance sheet < 1
OBS activities and FI solvency

Valuation of OBS items

• OBS items have option like features => use
option pricing theory to value OBS items
• Delta of an option, that is, the change in the
value of an option for a small unit change in the
price of the underlying security
• Notional value (face value = F) of an OBS item
OBS activities and FI solvency

Valuation of OBS items

dO
d = delta of an option =
dS

• Delta equivalent value = d × F

• Delta varies with level of price of underlying security,
that is:
0<d<1
• If the FI sold an option it would be valued as a
contingent liability
OBS activities and FI solvency

Valuation of OBS items: Example

• FI bought call options on bonds (i.e. OBS asset)
• Face/notional value of options, F = $100m
• Delta, d = 0.25
• Delta equivalent value = 0.25 x 100 = $25m
OBS activities and FI solvency

Other OBS items with option features

• Loan commitments, that is, option to borrow
• Letters of credit, that is, option to default

• Including OBS items, the true net worth of an FI

is:
E = (A – L) + (CA – CL)
Where:
CA = contingent assets
CL = contingent liabilities
Returns and risks of OBS activities

• In Australia, growth in OBS items has resulted in

tracking system implemented by RBA in 1989.
– In 2010 and 2013 OBS activities grew to $15 trillion and
$23 trillion respectively.

• Four major types of OBS activities undertaken by

Australian banks:
– Commitments and other non-market-related items
– Direct credit substitutes
– Trade- and performance-related items
– Futures and forward contracts, swaps and options.
Returns and risks of OBS activities
Returns and risks of OBS activities
Loan commitments
• Commitment to make a loan up to a stated
amount at a given interest rate in the future
• Upfront fee: Fee charged for making funds
available through loan commitment
• Back-end fee: Fee imposed on unused
component of loan commitment
Returns and risks of OBS activities

Risks associated with loan commitments

• Interest rate risk
– On fixed-rate loan commitments the bank is exposed to
interest rate risk
– On floating-rate commitments, there is still exposure to
basis risk
• Basis risk: the variable spread between a
lending rate and borrowing rate, or
between any two interest rates
Returns and risks of OBS activities

Risks associated with loan commitments

• Draw-down risk
– Uncertainty of timing of draw-downs exposes bank to
risk
– Back-end fees are intended to reduce this risk
• Credit risk
– Credit rating of the borrower may deteriorate over the
life of the commitment
– Addressed through ‘adverse material change in
conditions’ clause
Returns and risks of OBS activities

Risks associated with loan commitments

• Aggregate funding risk
– During a credit crunch, bank may find it difficult to meet
all of the commitments (compare to externality effect)
– Bank may need to adjust its risk profile on the balance
sheet in order to guard against future draw-downs on
loan commitments
Returns and risks of OBS activities
Letters of credit
• Documentary letters of credit (LCs)
– Contingent guarantees to underwrite the trade or commercial
performance

– Widely used in both domestic and international trade

• Standby letters of credit (SLCs)

– Cover contingencies potentially more severe and uncertain
than those covered by documentary letters of credit

• Both expose to default risk

Returns and risks of OBS activities

Documentary letters of credit

Returns and risks of OBS activities

Standby letters of credit

• Insurance function.
• Structure and type of risks covered different from
trade LCs and documentary LCs.
• FIs may issue SLCs to cover contingencies that are
potentially more severe, less predictable or frequent
and not necessarily trade related.
• Examples:
– Performance bond guarantees (like real estate development)
– Default guarantees (on corporate bonds)
• SLCs are direct ‘competitors’ to loan commitments.
Returns and risks of OBS activities

Standby letters of credit

• SLCs often issued by general insurers.
• Foreign banks are taking an increased share in
Australian market.
• The seller of SLC must have a better credit rating
than the customer. Higher credit ratings not only
make the guarantor more attractive from the
buyer’s perspective, but also make the guarantor
more competitive in that its cost of funds is lower
than less creditworthy FIs.
Returns and risks of OBS activities

Derivative contracts
• Used by FIs for hedging purposes
• Or FIs acting as dealers
– Big Three Dealers: JPMorgan Chase, Bank of America,
Citigroup
 87 per cent of derivatives held by user banks
• Futures, forwards, swaps and options
– Forward contracts involve substantial counterparty risk
– Other derivatives create far less default risk
– Market risk
Returns and risks of OBS activities
Forward purchases and sale of “when-issued”
securities
• Commitments to buy and sell securities before
they are issued: ‘when issued (WI) trading’

• Example: new issue of T-notes announced by

RBA

• Banks who bid in the T-notes auction can trade

them before issue through forward sales

• Risk of ‘over-commitment’
Returns and risks of OBS activities
Returns and risks of OBS activities
Loans sold
• FI originates loans and sells them to outside investors.
• Potential outside investors:
– Other banks
– Insurance companies
– Unit trusts
– Corporations.
• Loans sold are an indication of FIs moving from asset
transformers to brokers.
• ‘No recourse’: loan buyer bears all default risk if loan goes
bad.
• With recourse: long-term contingent credit risk for loan
seller.
The role of OBS activities in reducing risk

• 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 can decrease an FI’s insolvency risk.
• Possibility of ‘under-hedging’ due to regulatory costs
• OBS activities are frequently a source of fee income,
especially for the largest, most creditworthy banks.
Summary
• Discussed the type and nature of banks’ off-
balance-sheet activities.
• Off-balance-sheet transactions are contingent
liabilities or assets.
• We learned how these contingent assets or liabilities
can impact an FI’s profitability.
• We learned about Australian banks’ off-balance-
sheet activities.
• We learned about the different types of off-balance-
sheet activities and their risks.
• We examined how banks can use off-balance-sheet
activities to reduce their risk exposures.