CHAPTER 13

OFF-BALANCE-SHEET RISK
Off-Balance-Sheet Risk
Prepared by:
LUCY RATNA NUGRAHENI - RENNY FADHILAH - FAHMI YUSUF EFFENDI

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All Rights Reserved.
 Overview
 https://www.investopedia.com/terms/o/off-bala
nce-sheet-obs.asp

13-2
 Overview
 OBS activities are often designed to reduce
risks through hedging with derivative securities
and other means.
 However, OBS risk can be substantial. OBS
mortgage-backed securities were instrumental
in the financial crisis.

13-3
 Off-Balance-Sheet Risks

 Contingent assets
 Contingent liabilities
 Derivative securities
 Held off the balance sheet:
– Forward contracts
– Futures contracts
– Option contracts
– Swap contracts
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 1. OBS Introduction
 In accounting, it appears “below the bottom line”. (frequently
just as footnotes to financial statements)
 From a valuation perspective, OBS assets and liabilities have
the potential to produce positive or negative future cash
flows.
 True value of a FI’s is not only Liab-Assets but also includes
off balance sheet items.

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 2. OBS Activities and Solvency

 Off-balance-sheet assets & Off-balance-sheet liabilities are items or

activities when a contingent event occurs then the item or activity
move on one of the sides...
 Letter of credits or guarantees are the examples of off balance sheet
activities.
 If a customer default occur (who has been given a guarante) , the
FI’s contingent liability (its guarantee) becomes an actual liability
and it moves onto the liability side of the balance sheet.
 The failure or near failure of some of the largest US FI’s during the
financial crisis can be attributed to risks associated with OBS
activities.

13-6
 OBS Activities and Solvency

The question is that what is the probability of an contingent item to move

to asset or liability side of the balance sheet? Link?
Valuation of OBS items:
OBS items are contingent and move onto the balance sheet with a probability
less than 1, therefore, their valuation is difficult and often highly complex.
relatively simple way to estimate the value of an OBS position is to calculate
the delta of an option

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 OBS Activities and Solvency

– Delta of an option:
It is the change in the value of an option for a unit
change in the price of the underlying security.
– Delta is between 0 and 1.
– The face value of an OBS item is called notional value

The Delta Equivalent or Contingent

Asset Value
= delta x face value of option
=dxf
d : Delta of an option
dO : Change in the option’s price
Notional Value Of an OBS Item (F)
dS : Change in price of underlying security
The face value of an OBS item.

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 OBS Activities and Solvency

Example: An FI has bought call options on bonds (it has an OBS asset)
with a notional value of 100 million and the delta is calculated as .25*.
–*A 1 cent change in the price of the bonds underlying the call option leads to a 0.25
cent change in the price of the option.

Then, the contingent asset value of this option is

= Delta × Face value of option
= .25 × 100 m $= 25 m $

*To calculate delta for the option, one needs an option pricing model such as Black Scholes or a
binomial model.

13-9
 OBS Activities and Solvency

– Loan commitments and LCs are also off balance sheet

activities that have option features.
– 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 guarante defaults, this buyer is
exercising a default option.
– Valuation of OBSs:
For Swaps, futures and forwards, a common approach is to
convert these positions into an equivalent value of the
underlying assets.

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 The Reel Valuation of The Company

 So, we can approximately calculate the current or market value of each OBS asset
and liability and its effects on solvency.
 The below panel shows that E(Net Worth) = Assets-Liabilities which is 10=100-
90, [cap/asset ratio 10 pcnt.] however,

 .

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 The Reel Valuation of The Company

 True picture of net worth

Should include market value of on- and off-balance-sheet activities
Equity = (Assets – Liabilities)+ (Contingent Assets –Contingent Liabilities)

E = (A – L) + (CA – CL) Contingent Liabilities are more than C. Assets

= (100 – 90) + (50 – 55) = 5 That decreases the equity
Exposure to OBS risk just as important as other risk exposures
 Contingent assets and liabilities are contractual claims that directly impact the economic value of the FI.
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 3. Returns and Risks of Off-Balance Sheet
Activities
Incentives to Increase OBS Activities
In the 1980s, losses on LDC loans and reduced margins
produced profit incentive
– By moving activities of the BS, banks hoped to earn more fee income
to offset declining margins or spreads on their traditional lending
business.
Plus, they could avoid from regulatory costs or taxes
– Reserve requirements
– Deposit insurance premiums
– Capital adequacy requirements

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13-14
 Returns and Risks of Off-Balance Sheet
Activities

 From 1992 to 2009, % 2,204 increase

 Largest 25 banks held 99.8 percent of the derivatives outstanding.
 The phenomenal increase pushed the regulators to impose capital
requirements on such activities (came in 1993)

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Returns and Risks of Off-Balance Sheet Activities
Schedule L Activities
Due to dramatic growth in OBS activities Fed introduced a tracking scheme in
1983 called Schedule L (notional size and variety of OBS activities are
reported on quartery bases) as part of their quarterly Call Reports.
Loan commitments
Letters of credit
– LCs & SLCs
Futures, forwards, swaps and options
When issued securities
Loans sold
– OBS only if sold without recourse

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Schedule L Activities

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 Schedule L OBS Activities
 Loan commitments and interest rate risk:
– Loan commitment agreements are contractual commitments by an FI
to lend to a firm a certain maximum amount (say, 10million $) at
given interest rate term (say 12 percent). It also includes the lenght of
time for this option.
– In return, FI may charge an up front fee (facility fee) of the
commitment size and the service provided by FI is to supply the full
loan amount at any time over the commitment period.
– FI stand ready to supply the full 10mio USD at any time over the
commitment period, 1 year.
– At the ed of the term, FI may request a back end fee (commitment fee)
on any unused balances in the commitment line at the end of the
period.

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 A Loan Commitment
FI must made the
funds ready at 0 time
until time 1

 If borrower takes down only 8mio over a year

 and fee on unused commitment is ¼ percent ; then; 2,000,000*0,0025=5000 USD
additional revenue will be generated.

 Commitment itself is not on the balance sheet, but when the borrower draws
on the commitment...
 Loan commitments create at least four types of risks:
 Interest rate risks,
 Takedown risk
 Credit risk
 Aggregate funding risk
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 Schedule L OBS Activities
 Loan commitments and interest rate risk:
– If fixed rate commitment, the bank is exposed to interest rate risk
(cost of funds may rise and cost of funds may consume the spread)
– If floating rate commitment, partially we can control risk by
following a a prime rate (if prime rate rises so does the cost of
commitment loans to the borrower)
but there is still exposure to basis risk (prime rate rises 1 percent but
the cost of funds rises 1.25 percent; the spread narrows by .25)
–
Risks is coming from such that if prime rate and cost of commitment
interest rates rises in different percenteges..

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 Schedule L OBS Activities
 Take-down risk
– Uncertainty of timing of take-downs exposes bank to risk
– Banks can never be sure when, within commitment period, the
borrower will demand the full cash, this leads to liquidity risk..
– Back-end fees are intended to reduce this risk
 Credit risk:
– Credit rating of the borrower may deteriorate over life of the
commitment. If borrower is judged as an AAA credit risk paying less
interest. But, suppose over the 1year commitment period the firm gets
into diffuculty and rating now is BBB. Still is is preset to the AA
level !!!
– Adding “adverse material change in conditions clause” allows FI to
cancel or reprice a loan commitment.

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 Other Risks with Loan Commitments
 Aggregate funding risk: During a credit crunch, bank may find it difficult
to meet all of the commitments (where demand is a lot higher than the
supply as spot loans to borrowers is restricted)
– In difficult credit conditions, this aggregate commitment takedown effect can increase the
cost of funds above normal levels while many FIs scramble for funds to meet their
commitments to customers.
– Banks may need to adjust their risk profile on the balance sheet in order to
guard against future take-downs on loan commitments
 All these four risks, do these activities increase the insolvency exposure of FIs engaging
in such activities?
 Yes
 But empirical studies show that safer banks have a greater tendency to make loan
commitments.

13-22
 3.2 Commercial LCs and SLCs
 Particularly important for foreign purchases
 If creditworthiness of the importer is unknown to seller, or
lower than the bank’s, then gains available through using an
LC
 SLCs often used to insure risks that need not be trade related:
– Performance bond guarantees
– Property & casualty insurers also prominent in selling SLCs
– SLC’s help the corporates to enhance their credibility.
– SLC’s and loan commitments are competing OBS products.
– There are some risks associated with LCs and SLCs...

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 Commercial Letter of Credit
Contingent guarantees sold by an FI to underwrite the trade or commercial
performance of the buyer of the guaranty.

13-24
 3.3 Derivative Contracts
 Used by FIs for hedging purposes or
 FIs acting as dealers
– Big Three Dealers: J.P. Morgan Chase, Goldman Sachs, Bank of America
 Account for 80% of derivatives held by user banks
 Futures, forwards, swaps and options
 Forward contract
– An agreement between a buyer and a seller at time 0 to exchange a nonstandardized asset for cash at some future date.

 Futures contract
– An agreement between a buyer and a seller at time 0 to exchange a standardized asset of cash at some future date.

 Option
– A contract that gives the holder the right, but not the obligation, to buy or sell the underlying asset a specified price within a
specified period of time.

 Swap
– An agreement between two parties to exchange asset or a series of cash flows for a specific period of time at specified interval.

13-25
 Derivatives &Credit Concerns

 Empirical evidences show that derivatives generally reduces

FI risks or left it unaffected.
 But, the financial crisis showed something different.
 Role of mortgage-backed securities in the financial crisis
– Government seizure of Fannie Mae and Freddie Mac, September 2008
– Hit because of their roles in subprime market
 Troubled Asset Relief Program (TARP) funds to purchase
toxic assets

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 3.4 When Issued Trading

 Commitments to buy and sell securities prior to issue (forward

purchases)
– Example: Commitments taken in week prior to issue of new T-bills
 Fıs benefit only if they gets all the bills it needs with appropriate price and
sells them with spread in forward WI contracts.
– Making a mistake in interest rate calculation or playing around the
rules are not good !
 Caused the Treasury to revise the regulations governing the auction of bills
and bonds

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 3.5 Loans Sold

 Exposure to risk from loans sold unless no recourse

– FIs originate loans on their Balance Sheet and instead of
holding them to maturity, they sell them to outside
investors.
– Ambiguity of no recourse qualification
– Reputation effects may amplify the FI’s contingent
liabilities
***No recourse means that if the loan the FI sells goes bad,
the buyer of the loan must bear the full risk of loss.

13-28
 4. Nonschedule L OBS Risks
 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
 Many other FIs like thrifts, insurance companies,
investment banks engage in these activities i.e.
Futures, forwards, swaps, and options.

13-29
 Non-Schedule L Activities

 Settlement risk (intraday or within-day)

– FedWire is domestic
– CHIPS is international and settlement takes place only at
the end of the day
– Thus, leaves the bank with intraday exposure to settlement
risk
– During the day, banks receive provisional messages only
*This risk does not appear on balance sheet. The best balance sheet can
do is to summarize the end of day closing positions. So this is a credit
risk that does not appear on the Balance Sheet

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 Affiliate Risk
 Affiliate risk
– Occurs when dealing with Bank Holding Companies (whether One-bank or
Multiple-bank)
– In theory, corporate separateness requiers that a problem in Bank 1 should not
effect Bank 2 in below MBHC if it does then this is affiliate risk
– Creditors of failed affiliate may lay claim to surviving bank’s resources
– Effects of source of strength doctrine (Bank 1 sources can be used for Bank2
but courts do not want that)

13-31
Affiliate Risk

13-32
 The Role of OBS Activities
 In many cases, OBS activities are for hedging exposure to interest
rate, foreign exchange, and other risks
 OBS activities are a source of fee income, especially for the largest
most credit-worthy banks
 Changes in regulations controlling derivatives in 2009
 Four broad objectives:
– Prevent derivatives markets from posing risk to the financial system
– Promote efficiency and transparency in derivatives markets
– Prevent market abuses: market manipulation, fraud, etc.
– Prevent marketing of OTC derivatives to unsophisticated parties

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TECHNOLOGY and OTHER OPERATIONAL RISKS

13-34
 Overview
 Factors affecting operational returns and risks
 Importance of optimal management and control
of labor, capital, and other input sources and
their costs
 Technology and its impact on risk and return
 Examples: Risks resulting from innovations in
IT and effects of terrorist attacks on key
technologies

Ch 17-35
 Sources of Operational Risk
 Technology
– Technological failure and deteriorating systems
 Employees
– Human error and internal fraud
 Customer relationships
– Contractual disputes
 Capital assets
– Destruction by fire or other catastrophes
 External
– External fraud

Ch 17-36
 Technology & Profitability
 Computers, audio and visual communication systems, and
other information systems which can be applied to an FI’s
production of services.
 Efficient technological base can result in:
– Lower costs
 Through improved allocation of inputs
– Increased revenues
 Through wider range of outputs

Ch 17-37
 Impact of Technology
 Interest income can be increased
– Through wider array of outputs or cross selling
 Interest expense can be decreased
– Through improved access to markets for liabilities
 Fedwire, CHIPS

Ch 17-38
 Impact of Technology
 Other income can be increased
– Through electronic handling of fee generating
OBS activities such as LCs and derivatives
 Noninterest expenses can be reduced
– Through improved efficiency of back office
operations using technology
 Especially true for securities-related activities

Ch 17-39
 Impact on Wholesale Banking
 Controlled disbursement accounts
 Account reconciliation
 Wholesale and electronic lockbox
 Funds concentration
 Electronic funds transfer
 Check deposits services
 Electronic initiation of letters of credit
 Treasury management software
 Electronic data interchange
 Electronic billing
 Verification of identities
 Assistance to small business entering
into e-commerce
 Online customer-facing technologies
 Cloud computing
 Facilitation of business-to-business e-
commerce
Ch 17-40
 Impact on Retail Banking
 Automated teller machines (ATMs)
 Point-of-sale (POS) debit cards
 Preauthorized debits/credits
 Smart cards (store-value cards)
 Online banking
 Mobile banking
 Tablet banking
 Integration of online, offline, and
mobile channels
 Financial planning services
 Instant “micro mobile loans”
 Loyalty programs
Ch 17-41
 ADVANCED TECHNOLOGY REQUIREMENTS

1. Integration of online, mobile, and tablet technologies.

2. Provision of integrated, multichannel business information.
3. Cloud computing.
4. Increased reliance on message centers to replace e-mail communication.
5. Technology used for security issues
6. Data backup and disaster recovery

Ch 17-42
 Effects of Technology on Revenues & Costs

 Investments in technology are risky

– Potentially negative NPV projects due to
uncertainty and potential competitive responses
– Service quality and convenience
 Inability of ATMs to interact with customers as humans
can
 Example: Customers compare mortgage rates online,
but only 2% close online
 Virtual FIs operating branch offices
∙ Example: ING Direct

Ch 17-43
 Effects of Technology on Revenues & Costs

 Evidence shows the impact of regulation on

the value of technological innovations
– Branching restrictions in U.S. affect the value of
cash management services, for example
– Less valuable in Europe where comparable
restrictions are absent

Ch 17-44
 Effects of Technology on Revenues & Costs

 Revenue effects:
– Facilitates cross-marketing
 Mixed success
∙ Example: Citigroup and insurance
– Increases innovation

Ch 17-45
 Technology and Costs
 For larger FIs the scale and array of potential
technology investments is greater
– Potential average cost advantage for larger FIs
 Economies of scale
 Potential elimination of smaller banks?
– Technological investments are risky
 Potential diseconomies of scale

Ch 17-46
 Effects on Costs (continued)
 Economies of scope
– Multiple outputs may provide synergies in
production
– FI size may affect potential gains and losses from
IT investment
 Diseconomies of scope
– Specialization may have cost benefits in
production and delivery of some FI services

Ch 17-47
 Testing for Economies of Scale and Scope

 Production approach:
– Views FI as producing output of services using
inputs of labor and capital
– C = f(y,w,r)
 Intermediation approach:
– Includes funds used to produce intermediated
services among the inputs
– C = f(y,w,r, k)

Ch 17-48
 Empirical Findings
 Evidence of economies of scale for banks up to the
$10 billion to $25 billion range
 X-inefficiencies may be more important
 Inconclusive evidence on scope
 Recent studies using a profit-based approach find that
large FIs tend to be more efficient in revenue
generation
 Potential long term gains from innovation
– Cashless payments system?

Ch 17-49
 Technology and Evolution of the Payments System

 Use of electronic transactions higher in other

countries
– Usage of checks rapidly becoming obsolete
– Checks cleared using electronic funds transfer
– E-money virtually non-existent in the US
 Facilitates foreign currency transactions on the internet
 Not FDIC insured

Ch 17-50
 U.S. Payments System
– U.S. reluctance to abandon the use of checks
– U.S. payments system
– FedWire
– Clearing House Interbank Payments System
(CHIPS)
– Combined value of transactions often more than $5
trillion per day

Ch 17-51
 Web Resources
 For more information on the Clearing House
Interbank Payments System, visit:
CHIPS www.chips.org

Ch 17-52
 Wire Transfer System Risks
 Daylight overdraft risk
– FedWire settlement at 6:30 EST
– Banks commonly ran daylight overdrafts
 50 basis point interest rate introduced for daylight
overdrafts
– Regulation J guarantees payment finality of wire
transfer messages by the Fed
 Fed bears the risk
– Regulation F sets exposure limits to individual
correspondent banks
Ch 17-53
 Risks (continued)
 International Technology Transfer Risk
 Crime and Fraud Risk
– Fraud risk, especially from FI employees
– Riggs National Bank transactions with Saudis
– Costs of complying with Patriot Act

Ch 17-54
 Risks (continued)
 Regulatory Risk
– Technology facilitates avoidance of regulation by
locating in least regulated state or country
 Citigroup credit card operations in South Dakota
 South Dakota and Delaware liberal in terms of usury
ceilings and other regulatory controls
 Cayman Islands

Ch 17-55
 Risks (continued)
 Tax Avoidance
– Internal pricing mechanisms to shift profits to low tax
regimes
– UBS AG: the Hong Kong connection
 Competition Risk: nonfinancial firms
– GMs credit card operation
– AT&T
– Industrial loan corporations (ILCs)
 Technology allows locating in Utah where regulation is more
favorable
 Requirement to register ILCs as bank holding companies, 2009

Ch 17-56
 Other Operational Risks
 Employees
– Turnover
– Key personnel
– Fraud
– Errors
– Rogue trading
– Money laundering
– Confidentiality breach
 Example: Theft of code by ex-Goldman programmer
– Revelation of ethical problems via email exchanges

Ch 17-57
 Technology Risks
 Programming error
 Model risk
 Mark-to-market error
 Management information
 IT/Telecommunications systems outage
 Technology provider failure
 Contingency planning
Ch 17-58
 Customer Relationship Risks
 Contractual disagreement
 Dissatisfaction from poorly performing
technology
 Default

Ch 17-59
 Capital Asset Risk
 Safety
 Security
 Operating costs
 Fire/flood

Ch 17-60
 External Risks
 External fraud
 Taxation risk
 Legal risk
 War
 Market collapse
 Reputation risk
 Relationship risk
Ch 17-61
 Controlling Operational Risk
 Loss prevention:
– Training, development, review of employees
 Loss control:
– Planning, organization, back-up
 Loss financing:
– External insurance
 Loss insulation:
– FI capital

Ch 17-62
 Regulatory Issues
 1999 Basel Committee on Banking Supervision
noted the importance of operational risks
 Follow up report
Required capital:
– Basic Indicator Approach
– Standardized Approach
– Advanced Measurement Approach
 Consumer protection issues
Ch 17-63
 Other Concerns
 Efforts to expand consumer acceptance of
web-based services frustrated by scams
– Identity theft concerns
 Vulnerability of online credit card usage

Ch 17-64