FINC 403

BANK MANAGEMENT

Session 11 –OFF BALANCE SHEET (OBS) ACTIVITY RISK

Lecturer: Dr. Lord Mensah, UGBS

Contact Information: lmensah@ug.edu.gh

College of Education
School of Continuing and Distance Education
2016/2017 – 2018/2019
 Session Overview
At the end of the session, the student will be able to
• examine the various OBS activities
• discuss the effect of OBS activities on an FI’s risk exposure,
return performance, and solvency
• describe the different types of OBS activities and the risks
associated with each
• discuss on the role of OBS activities in reducing the risk of a
Bank
 Session Outline
The key topics to be covered in the session are as follows:
• OBS activity and Bank Solvency
• Returns and Risk of OBS
• Major types of OBS
 Reading List
• Log onto the UG Sakai LMS course site:
http://sakai.ug.edu.gh/XXXXXXXXX
• Watch the Videos for Session 11 –
• Read Chapter 6 of the recommended book: Rose and
Hudgins (2010)
• Visit the Chat Room and discuss the Forum question
for Session 11
• Complete the Individual Assignment for Session 11
Topic One

OBS ACTIVITY AND BANK SOLVENCY

 OBS activities and Bank Solvency
• An item or activity is an off-balance-sheet asset if,
– when a contingent event occurs, the item or activity moves
onto the asset side of the balance sheet
• An item or activity is an OBS liability if,
– when the contingent event occurs, the item or activity
moves onto the liability side of the balance sheet
• E.g. letters of credit and standby letters of credit
 Valuation of OBS
• Since off-balance-sheet items are contingent assets
and liabilities and move onto the balance sheet with
a probability less than 1,
– their valuation is difficult and often highly complex
• OBS items involve option features:
– most common methodology has been to apply contingent
claims/option pricing theory models of finance.
• Use delta of an option
– sensitivity of an option’s value to a unit change in the price
of the underlying security
– the delta of an option lies between 0 and 1
• Which is then multiplied by the notional value of the
option’s position.
 Example
• Suppose a Bank has bought call options on bonds
(i.e., it has an OBS asset) with a face or notional
value of GHS 100 million and the delta is calculated
at .25
– Then the contingent asset value of this option position
would be GHS 25 million
– The delta equivalent or contingent asset value = delta X
face value of option = .25X GHS 100 million = GHS 25
million
 Examples of OBS
• Loan commitment and Credit line
– the holder of a loan commitment or credit line who
decides to draw on that credit line is exercising an option
to borrow
– when the buyer of a guaranty defaults, this buyer is
exercising a default option
• Swaps, options, futures, and forwards
– a common approach is to convert these positions into an
equivalent value of the underlying assets
Effect of OBS on FI Solvency
• Panel A:
– the market value of the stockholders’ equity stake in the FI
is 10

– the ratio of the FI’s capital to assets (or capital–assets

ratio) is 10 percent.
• Regulators and FIs often use the latter ratio as a
simple measure of solvency
• Panel B: A truer picture of the FI’s economic solvency
should consider the market value of both its visible
on-balance-sheet and OBS activities

• Contingent assets and liabilities are contractual

claims that directly impact the economic value of the
FI
Topic Two

RETURNS AND RISK OF OBS

 Returns and Risk of OBS
• Rising losses on loans increased interest rate
volatility and squeezed interest margins for
– on-balance-sheet lending
• Nonbank competition induces many large
commercial banks to seek profitable OBS activities
• Moving activities off the balance sheet, banks hoped
to
– earn more fee income to offset declining margins
– spreads on their traditional lending business
• At the same time, they could avoid
– regulatory costs or taxes,
– reserve requirements
– deposit insurance premiums,
– and capital adequacy requirements
• All not levied on off-balance sheet activities.
• Banks had both earnings and regulatory tax-
avoidance incentives to move activities off their
balance sheets
 Growth of derivative OBS

• Regulators impose capital requirements on such

activities and explicitly recognize FIs’ solvency risk
exposure from pursuing such activities
Topic Three

MAJOR TYPES OF OBS

Major types of OBS activities
• Loan commitments.
• Standby letters of credit and letters of credit.
• Futures, forward contracts, swaps, and options.
• When-issued securities.
• Loans sold
 Loan Commitments
• A loan commitment agreement is a contractual
commitment by an FI to lend to a firm a certain
maximum amount (say, $10 million) at given interest
rate terms (say, 12%)
– most commercial and industrial loans comes in this form
• Characteristics:
– length of time,
– up-front fee (or facility fee) of, say, 1/8 % of the
commitment size, or $12,500 in this example
– back-end fee (or commitment fee)
 Example

• If the borrower takes down only $8 million in funds

over the year and the fee on unused commitments is
¼ percent,
– the FI will generate additional revenue of ¼ percent times
$2 million, or $5,000.
• Summary of the structure of this loan commitment
Promised return on loan commitment
 Risk on Loan Commitment
• Interest rate risk:
– contingent risk emanating from the fact that the FI pre-
commits to make loans
• Control this risk is by making commitment rates float
with spot loan rates,
– for example, by indexing loan commitments to the prime
rate
– Indexing loan commitment does not totally eradicate
interest rate risk on loan commitments (basis risk)
• Takedown Risk: The FI is expose to a degree of future
liquidity risk or uncertainty
– Not sure during the commitment period, the borrower will
demand the full $10 million or some proportion thereof in cash
• Credit Risk: FIs also face a degree of contingent credit
risk in setting the interest rate on a loan commitment
– preset risk premium
– Migration in credit rating
– adverse material change in conditions clause(usually last resort)
• Aggregate Funding Risk
Commercial Letters of Credit
 Standby Letters of Credit
• Standby letters of credit perform an insurance
function similar to that of commercial and trade
letters of credit.
• However, the structure and type of risks covered are
different.
• FIs may issue SLCs to cover contingencies that are
potentially more severe, less predictable or frequent,
and not necessarily trade related.
 Risk of LC and SLC
• The risk to an FI in selling a letter of credit is that the
buyer of the LC may fail to perform as promised
under a contractual obligation
 Derivatives
• forward contracts: nonstandard contracts between
two parties to deliver and pay for an asset in the
future
• Futures contract: standardized contract guaranteed
by organized exchanges to deliver and pay for an
asset in the future
• An option gives the holder the right, but not the
obligation, to buy (a call option) or sell (a put option)
an underlying asset at a pre-specified price for a
specified time period
• A swap is an agreement between two parties (called
counterparties ) to exchange specified periodic cash
flows in the future based on some underlying
instrument or price
– (e.g., a fixed or floating rate on a bond or note)
Credit Risk with Derivative Securities
• Default (or credit) risk increases with the time to
maturity of the contract and the fluctuation of
underlying prices, interest rates, or exchange rates
Forward Purchases and Sales of When-
Issued Securities

• When-issued (WI) trading: enter into commitments

to buy and sell securities before issue
• Risks Associated with When-Issued Securities
– Interest rate risk
 Loan Sales
• Banks and other FIs originate loans on their balance
sheets, but rather than holding them to maturity,
they quickly sell them to outside investors
– Loan brokers
• Outside investors include other banks, insurance
companies, mutual funds, and even corporations
 Trial Questions
• What are the four risks related to loan
commitments?
• What is the major difference between a commercial
letter of credit and a standby letter of credit?
• What is meant by counterparty risk in a forward
contract?
• Which is more risky for an FI, loan sales with
recourse or loan sales without recourse