This chapter has emphasized that OBS activities may add to the riskiness of an FI’s activities. Indeed, most contingent assets and liabilities have various charac- teristics that may accentuate an FI’s default and/or interest rate risk exposures.
Even so, FIs use some OBS instruments—especially forwards, futures, options, and swaps—to reduce or manage their interest rate risk, foreign exchange risk, and credit risk exposures in a manner superior to what would exist in their absence. 35 When used to hedge on-balance-sheet interest rate, foreign exchange, and credit risks, these instruments can actually work to reduce FIs’ overall insolvency risk. 36 Although we do not fully describe the role of these instruments as hedging vehicles
33 Nevertheless, the attempts by regulators to impose the source of strength doctrine appear to have had an adverse effect on the equity values of bank holding companies operating with a larger number of sub- sidiaries. Also, the number of subsidiaries of bank holding companies has fallen each year since 1987, the first year in which the Fed tried to impose the source of strength doctrine (Hawkeye BanCorp of Iowa).
34 A good example is the failure of Drexel Burnham Lambert in February 1991. For a good discussion of affiliate risk in this case, see W. S. Haraf, “The Collapse of Drexel Burnham Lambert: Lessons for Bank Regulators,” Regulation, Winter 1991, pp. 23–25.
35 As we discuss in Chapter 23, there are strong tax disincentives to using derivatives for purposes other than direct hedging.
36 For example, the London International Financial Futures and Options Exchange (LIFFE) introduced in 2001 a swapnote, which is a futures contract whose settlement price is based on swap market rates.
Swapnotes provide an effective mechanism for FIs to hedge interest rate risk with minimal basis risk (see Chapter 25).
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in reducing an FI’s insolvency exposure until Chapters 23 through 25, you can now recognize the inherent danger in the overregulation of OBS activities and instruments. For example, the risk that a counterparty might default on a forward foreign exchange contract risk is very small. It is probably much lower than the insolvency risk an FI faces if it does not use forward contracts to hedge its foreign exchange assets against undesirable fluctuations in exchange rates. (See Chapters 15 and 23 for some examples of this.)
Despite the risk-reducing attributes of OBS derivative securities held by FIs, the expanded use of derivatives has caused many regulators to focus on the risk- increasing attributes of these securities and the possible detrimental effect the risk may have on global financial markets. The result has been an increase in the amount of regulation proposed for these activities. For example, the Derivatives Safety and Soundness Supervision Act (DSSSA) of 1994 mandated increased regulatory oversight for FIs holding derivative securities, including increased regulation of capital, disclosure, and accountability; enhanced supervision of risk management processes; and additional reporting requirements. Also in 1994, the General Accounting Office (GAO) released a report to Congress on derivative use by FIs and the regulatory actions needed to ensure the integrity of the financial system. The GAO specifically recommended that derivative activi- ties of unregulated securities and insurance firm affiliates of banking organiza- tions be brought under the purview of one or more existing regulatory bodies.
Despite these rules and regulations passed in the early 1990s, huge losses on derivative securities by FIs such as Bankers Trust (in 1994), Barings (in 1995), and Long Term Capital Management (in 1998) have resulted in the call for addi- tional regulation. Partially as a result of these concerns, the regulatory costs of hedging have risen (e.g., through the imposition of special capital requirements or restrictions on the use of such instruments [see Chapter 20]). As a result, FIs may have a tendency to underhedge, thereby increasing, rather than decreasing, their insolvency risk.
Finally, fees from OBS activities provide a key source of noninterest income for many FIs, especially the largest and most creditworthy ones. The importance of noninterest incomes for large banks is shown in Table 16–1 in Chapter 16. Thus, increased OBS earnings can potentially compensate for increased OBS risk expo- sure and actually reduce the probability of insolvency for some FIs. 37
While recognizing that OBS instruments may add to the riskiness of an FI’s activities, explain how they also work to reduce the overall insolvency risk of FIs.
Other than hedging and speculation, what reasons do FIs have for engaging in OBS activities?
1.
2.
Concept Questions Concept Questions
This chapter showed that an FI’s net worth or economic value is linked not only to the value of its traditional on-balance-sheet activities but also to the contingent asset and liability values of its off-balance-sheet activities. The risks and returns of several off-balance-sheet items were discussed in detail: loan commitments; commercial
37 In addition, by allowing risk-averse managers to hedge risk, derivatives may induce the managers to follow more value-maximizing investment strategies. That is, derivatives may allow manager–stockholder agency conflicts over the level of risk taking to be reduced.
Summary Summary
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Chapter 13 Off-Balance-Sheet Risk 395
and standby letters of credit; derivative contracts such as futures, options, and swaps; forward purchases; sales of when issued securities; and loans sold. In all cases, it is clear that these instruments have a major impact on the future profitabil- ity and risk of an FI. Two other risks associated with off-balance-sheet activities—
settlement risk and affiliate risk—were also discussed. The chapter concluded by pointing out that although off-balance-sheet activities can be risk increasing, they can also be used to hedge on-balance-sheet exposures, resulting in lower risks as well as generating fee income to the FI.
Classify the following items as (1) on-balance-sheet assets, (2) on-balance- sheet liabilities, (3) off-balance-sheet assets, (4) off-balance-sheet liabilities, or (5) capital account.
Loan commitments.
Loan loss reserves.
Letter of credit.
Bankers acceptance.
Rediscounted bankers acceptance.
Loan sales without recourse.
Loan sales with recourse.
Forward contracts to purchase.
Forward contracts to sell.
Swaps.
Loan participations.
Securities borrowed.
Securities lent.
Loss adjustment expense account (PC insurers).
Net policy reserves.
How does one distinguish between an off-balance-sheet asset and an off-balance-sheet liability?
Contingent Bank has the following balance sheet in market value terms (in millions of dollars).
Assets Liabilities
Cash $ 20 Deposits $220
Mortgages 220 Equity 20
Total assets $240 Total liabilities and equity $240
In addition, the bank has contingent assets with $100 million market value and contingent liabilities with $80 million market value. What is the true stockholder net worth? What does the term contingent mean?
Why are contingent assets and liabilities like options? What is meant by the delta of an option? What is meant by the term notional value?
An FI has purchased options on bonds with a notional value of $500 million and has sold options on bonds with a notional value of $400 million. The purchased options have a delta of 0.25, and the sold options have a delta of 0.30.
1.
a.
b.
c.
d.
e.
f.
g.
h.
i.
j.
k.
l.
m.
n.
o.
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3.
4.
5.
Questions and Problems Questions and Problems
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What is (a) the contingent asset value of this position, (b) the contingent liabil- ity value of this position, and (c) the contingent market value of net worth?
What factors explain the growth of off-balance-sheet activities in the 1980s through the early 2000s among U.S. FIs?
What role does Schedule L play in reporting off-balance-sheet activities?
Refer to Table 13–5 . What was the annual growth rate over the 14-year pe- riod 1992–2006 in the notional value of off-balance-sheet items compared with on-balance-sheet items? Which contingencies have exhibited the most rapid growth?
What are the characteristics of a loan commitment that an FI may make to a customer? In what manner and to whom is the commitment an option?
What are the various possible pieces of the option premium? When does the option or commitment become an on-balance-sheet item for the FI and the borrower?
A FI makes a loan commitment of $2.5 million with an up-front fee of 50 basis points and a back-end fee of 25 basis points on the unused portion of the loan.
The takedown on the loan is 50 percent.
What total fees does the FI earn when the loan commitment is negotiated?
What are the total fees earned by the FI at the end of the year, that is, in fu- ture value terms? Assume the cost of capital for the FI is 6 percent.
A FI has issued a one-year loan commitment of $2 million for an up-front fee of 25 basis points. The back-end fee on the unused portion of the commitment is 10 basis points. The FI requires a compensating balance of 5 percent as de- mand deposits. The FI’s cost of funds is 6 percent, the interest rate on the loan is 10 percent, and reserve requirements on demand deposits are 8 percent.
The customer is expected to draw down 80 percent of the commitment at the beginning of the year.
What is the expected return on the loan without taking future values into consideration?
What is the expected return using future values? That is, the net fee and interest income are evaluated at the end of the year when the loan is due.
How is the expected return in part (b) affected if the reserve requirements on demand deposits are zero?
How is the expected return in part (b) affected if compensating balances are paid a nominal interest rate of 5 percent?
What is the expected return using future values but with the compensating balance placed in certificates of deposit that have an interest rate of 5.5 per- cent and no reserve requirements, rather than in demand deposits?
Suburb Bank has issued a one-year loan commitment of $10,000,000 for an up-front fee of 50 basis points. The back-end fee on the unused portion of the commitment is 20 basis points. The bank requires a compensating balance of 10 percent to be placed in demand deposits, has a cost of funds of 7 percent, will charge an interest rate on the loan of 9 percent, and must maintain reserve requirements on demand deposits of 10 percent. The customer is expected to draw down 60 percent of the commitment.
What is the expected return on this loan?
What is the expected annual return on the loan if the draw-down on the commitment does not occur until the end of six months?
6.
7.
8.
9.
a.
b.
10.
a.
b.
c.
d.
e.
11.
a.
b.
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Chapter 13 Off-Balance-Sheet Risk 397
How is an FI exposed to interest rate risk when it makes loan commitments?
In what way can an FI control for this risk? How does basis risk affect the implementation of the control for interest rate risk?
How is an FI exposed to credit risk when it makes loan commitments? How is credit risk related to interest rate risk? What control measure is available to an FI for the purpose of protecting against credit risk? What is the realistic op- portunity to implement this control feature?
How is an FI exposed to takedown risk and aggregate funding risk? How are these two contingent risks related?
Do the contingent risks of interest rate, takedown, credit, and aggregate fund- ing tend to increase the insolvency risk of an FI? Why or why not?
What is a letter of credit? How is a letter of credit like an insurance contract?
A German bank issues a three-month letter of credit on behalf of its customer in Germany, who is planning to import $100,000 worth of goods from the United States. It charges an up-front fee of 100 basis points.
What up-front fee does the bank earn?
If the U.S. exporter decides to discount this letter of credit after it has been accepted by the German bank, how much will the exporter receive, assum- ing that the interest rate currently is 5 percent and that 90 days remain be- fore maturity? ( Hint: To discount a security, use the time value of money formula, PV = FV [(1 − (days to maturity/365)].)
What risk does the German bank incur by issuing this letter of credit?
How do standby letters of credit differ from commercial letters of credit? With what other types of FI products do SLCs compete? What types of FIs can issue SLCs?
A corporation is planning to issue $1 million of 270-day commercial paper for an effective annual yield of 5 percent. The corporation expects to save 30 basis points on the interest rate by using either an SLC or a loan commitment as col- lateral for the issue.
What are the net savings to the corporation if a bank agrees to provide a 270-day SLC for an up-front fee of 20 basis points (of the face value of the loan commitment) to back the commercial paper issue?
What are the net savings to the corporation if a bank agrees to provide a 270-day loan commitment to back the issue? The bank will charge 10 basis points for an up-front fee and 10 basis points for a back-end fee for any un- used portion of the loan. Assume the loan is not needed, and that the fees are on the face value of the loan commitment.
Should the corporation be indifferent to the two alternative collateral meth- ods at the time the commercial paper is issued?
Explain how the use of derivative contracts such as forwards, futures, swaps, and options creates contingent credit risk for an FI. Why do OTC contracts carry more contingent credit risk than do exchange-traded contracts? How is the default risk of OTC contracts related to the time to maturity and the price and rate volatilities of the underlying assets?
What is meant by when issued trading? Explain how forward purchases of when issued government T-bills can expose FIs to contingent interest rate risk.
12.
13.
14.
15.
16.
17.
a.
b.
c.
18.
19.
a.
b.
c.
20.
21.
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Distinguish between loan sales with and without recourse. Why would banks want to sell loans with recourse? Explain how loan sales can leave banks ex- posed to contingent interest rate risks.
The manager of Shakey Bank sends a $2 million funds transfer payment mes- sage via CHIPS to the Trust Bank at 10 am. Trust Bank sends a $2 million funds transfer message via CHIPS to Hope Bank later that same day. What type of risk is inherent in this transaction? How will the risk become reality?
Explain how settlement risk is incurred in the interbank payment mechanism and how it is another form of off-balance-sheet risk.
What is the difference between a one-bank holding company and a multibank holding company? How does the principle of corporate separateness ensure that a bank is safe from the failure of its affiliates?
Discuss how the failure of an affiliate can affect the holding company or its affiliates even if the affiliates are structured separately.
Defend the statement that although off-balance-sheet activities expose FIs to several forms of risks, they also can alleviate the risks of FIs.
Web Questions
Go to the FDIC Web site at www.fdic.gov and find the total amount of un- used commitments and letters of credit and the notional value of interest rate swaps of FDIC-insured commercial banks for the most recent quarter available using the following steps. Click on “Analysts.” From there click on “Statistics on Banking.” Next click on “Assets and Liabilities” and “Run Report.” Select “Total Unused Commitments,” then “Letters of Credit,” and finally “Derivatives” to get the relevant data. This will bring the three files onto your computer that contain the relevant data. What is the dollar value increase in these amounts over the second-quarter 2006 values reported in Table 13–5 ?
Go to the Web site of the Office of the Comptroller of the Currency at www .occ.treas.gov and update Table 13–6 using the following steps. Click on
“Publications.” Click on “Qrtrly. Derivative Fact Sheet.” Click on the most recent date. Under “Bookmarks,” click on “Tables.” This will bring the file onto your computer that contains the relevant data. What is the dollar value increase in these values over those reported in Table 13–6 ?
Pertinent Web Sites
American Banker www.americanbanker.com Bank of America www.bankofamerica.com Board of Governors of the Federal Reserve www.federalreserve.gov
Citigroup www.citigroup.com
Clearing House InterBank Payment System www.chips.org Federal Deposit Insurance Corp. www.fdic.gov 22.
23.
24.
25.
26.
27.
28.
29.
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Chapter 13 Off-Balance-Sheet Risk 399
J. P. Morgan Chase www.jpmorganchase.com New York Board of Trade www.nybot.com
Office of the Comptroller of the Currency www.occ.treas.gov U.S. Treasury www.ustreas.gov
Chapter Notation
View Chapter Notation at the Web site to the textbook ( www.mhhe.com/
saunders6e ).
Appendix 13A A Letter of Credit Transaction
View Appendix 13A at the Web site for this textbook (www.mhhe.com/
saunders6e)
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400
Chapter Fourteen
Foreign Exchange Risk