Off-Balance-Sheet

Risk
Chapter 16
 Introduction
One of the most important choices facing an FI
manager is the relative scale of an FI’s on- and
off-balance-sheet (OBS) activities.
Most of us are aware of on- balancesheet
activities because they appear on an FI’s
published asset and liability balance sheets. For
example, an FI’s deposits and holdings of bonds
and loans are on-balance-sheet activities.
In accounting terms, off-balance-sheet items usually
appear “below the bottom line,” frequently just as
footnotes to financial statements.
In economic terms, however, off-balance-sheet
items are contingent assets and liabilities that
affect the future, rather than the current, shape of an
FI’s balance sheet.
They have direct impact on firms future profitability
and therefore their risk should be controlled.
FIs use some OBS activities (especially forwards,
futures, options, and swaps) to reduce or manage
their interest rate risk, foreign exchange risk, and
credit risk.
Major Types of Off-Balance-Sheet
Activities
Schedule L Activities*
Loan commitment Contractual commitment to make a loan up to a stated amount
at a given interest rate in the future.
Letters of credit Contingent guarantees sold by an FI to underwrite the performance
of the buyer of the guaranty.
Derivative contract Agreement between two parties to exchange a standard
quantity of an asset at a predetermined price at a specified date in the future.
When-issued trading Trading in securities prior to their actual issue.
Loans sold Loans originated by an FI and then sold to other investors that (in some
cases) can be returned to the originating institution in the future if the credit quality of
the loans deteriorates.
Non–Schedule L Activities*
Settlement risk Intraday credit risk, such as that associated with CHIPS wire
transfer activities.
Affiliate risk Risk imposed on one holding company affiliate as a result of the
potential failure of the other holding company affiliates.
The true value of an FI’s capital or net worth is not
simply the difference between the market value of
assets and liabilities on its balance sheet, but also
reflects the difference between the current market
value of its off-balance-sheet or contingent assets
and liabilities.
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.
Conversely, 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
Derivative Securities Held Off the Balance
Sheet of FIs
Forward contract An agreement between a buyer and a seller at time 0 to
exchange a nonstandardized asset for cash at some future date. The details of
the asset and the price to be paid at the forward contract expiration date are
set at time 0. The price of the forward contract is fixed over the life of the
contract.
Futures contract An agreement between a buyer and a seller at time 0 to
exchange a standardized asset for cash at some future date. Each contract
has a standardized expiration and transactions occur in a centralized market.
The price of the futures contract changes daily as the market value of the
asset underlying the futures fluctuates.
Option A contract that gives the holder the right, but not the obligation, to
buy or sell the underlying asset at a specified price within a specified period
of time.
Swap An agreement between two parties to exchange assets or a series of
cash flows for a specific period of time at a specified interval
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.
Because many off-balance-sheet items involve
option features, the most common methodology
has been to apply contingent claims/ option
pricing theory models of finance.
one relatively simple way to estimate the value of
an OBS position in options is by calculating the
delta of an option
delta of an option —the sensitivity of an option’s value
to a unit change in the price of the underlying security,
which is then multiplied by the notional value of the
option’s position. (The delta of an option lies between 0
and 1.)
Delta is the ratio that compares the change in the price of
an asset, usually marketable security, to the
corresponding change in the price of its derivative. For
example, if a stock option has a delta value of 0.65, this
means that if the underlying stock increases in price by
$1 per share, the option on it will rise by $0.65 per share,
all else being equal.
Thus, suppose an FI has bought call options on bonds
(i.e., it has an OBS asset) with a face or notional value
of $100 million and the delta is calculated at 0.25
Derivative Contracts: Futures,
Forwards, Swaps, and Options
FIs can be either users of derivative contracts for
hedging and other purposes or dealers that act as
counterparties in trades with customers for a fee.
Contingent credit risk is likely to be present when
FIs expand their positions in forwards, futures,
swaps, and option contracts.
This risk relates to the fact that the
counterparty to one of these contracts may default
on payment obligations, leaving the FI unhedged
and having to replace the contract at today’s interest
rates, prices, or exchange rates.
Further, such defaults are most likely to occur
when the counterparty is losing heavily on the
contract and the FI is in the money on the contract.
This type of default risk is much more serious for
forward (and swap) contracts than for futures
contracts.
forward contracts are nonstandard contracts
entered into bilaterally by negotiating parties such
as two FIs, and all cash flows are required to be
paid at one time (on contract maturity). Thus, they
are essentially over-the-counter (OTC)
arrangements with no external guarantees should
one or the other party default on the contract
futures contracts are standardized contracts
guaranteed by organized exchanges such as the
New York Futures Exchange.
Futures contracts, like forward contracts, are
commitments to deliver foreign exchange (or
some other asset) at some future date.
If a counterparty defaults on a futures contract,
however, the exchange assumes the defaulting
party’s position and the payment obligations.
Thus, unless a systematic financial market
collapse threatens the exchange itself, futures are
essentially default risk free
 Option
An option is a contract that gives the holder the
right, but not the obligation, to buy (a call option)
or sell (a put option) an underlying asset at a
prespecified price for a specified time period.
Option contracts can also be purchased or sold
by an FI, trading either over the counter (OTC) or
bought/sold on organized exchanges.
If the options are standardized options traded on
exchanges, such as bond options, they are
virtually default risk free.
 swap
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).
Similar to options, swaps are OTC instruments
normally susceptible to counterparty risk.
If interest rates (or foreign exchange rates) move a
lot, one party can be faced with considerable
future loss exposure, creating incentives to default
Credit Risk Concerns with Derivative Securities

In general, default (or credit) risk on OTC

contracts increases with the time to maturity of the
contract and the fluctuation of underlying prices,
interest rates, or exchange rates.
Credit risk occurs because of the potential for the
counterparty to default on its payment obligations
under a derivative contract, a situation that would
require the FI to replace the contract at the current
market price and rate potentially at a loss
This risk is most prevalent in OTC rather than
exchange-traded derivative contracts,
e.g., collateralized debt obligations (CDOs or
CMOs). OTC contracts typically are
nonstandardized or unique contracts that do not
have external guarantees from an
organized exchange. Defaults on these contracts
usually occur when the FI stands
to gain and the counterparty stands to lose