Other risks: Off-Balance-Sheet risk

1. 1 Other risks: Off-Balance-Sheet risk Saunders and Cornett

2. 2 Off-balance-sheet risks can be substantial. Barings bank case; Enron debacle Ethical dilemmas resulted in regulatory reactions in 2002: OBS transactions between Citigroup, J.P. Morgan Chase, and Enron under �special purpose entities� help Enron disguise its debt. Sarbanes-Oxley Act: Disclosure requirements: �total picture in a single location�. arrangements that �may� be of material concern to the markets.

3. 3 Reverse Purchase Agreement The purchase of securities with the agreement to sell them at a higher price at a specific future date. For the party selling the security (and agreeing to repurchase it in the future) it is a repo; for the party on the other end of the transaction (buying the security and agreeing to sell in the future) it is a reverse repurchase agreement.

4. 4 Special Purpose Entities or vehicles Are used to isolate financial risk A corporation can use such a vehicle to finance a large project without putting the entire firm at risk. SPE/SPVs: Securitization SPVs. Apart from securitizations, SPVs are often used for many purposes. One common purpose is to use them for what is known as "synthetic leases" - a device by which assets are acquired under an off balance sheet lease from the vehicle that funds them with debt.

5. 5 OBS Activities and Solvency Contingent assets and liabilities: off balance sheet assets and liabilities that potentially can produce positive or negative future cash flows for the FI. It can influence the future profitability and solvency of a FI. Off-balance-sheet assets: an item that when a contingent event occurs moves onto the asset side of the BS. Off-balance-sheet liabilities: an item that when a contingent event occurs moves onto the liability side of the BS.

6. 6 OBS Activities and Solvency (cont.) Valuation of OBS items: Delta of an option: the change in the value of an option for a unit change in the price of the underlying security. Ex: Also: 0<d<1 Notional value of an OBS item is the face value of an OBS item. Delta equivalent or Contingent asset value = Delta � Face value of option

7. 7 Valuation Net worth with on-off balance sheet activities Should include market value of on- and off-balance-sheet activities. E = (A � L) + (CA � CL) A is assets, L is liabilities, CA is contingent assets, and CL is contingent liabilities.

8. 8 Schedule L Activities Loan commitments: an agreement to make loans up to a stated amount at a given interest rate in the future. Letters of credit LCs & Standby LCs Futures, forwards, swaps and options When issued securities Loans sold OBS only if sold with recourse

9. 9 Schedule L OBS Activities Loan commitments: interest rate risk: If fixed rate commitment the bank is exposed to interest rate risk. If floating rate commitment, there is still exposure to basis risk. The variable spread between a lending rate and a borrowing rate. Take-down risk: Uncertainty of timing of take-downs exposes bank to risk. Back-end fees (commitment fees on any unused commitment at the end of the period) are intended to reduce this risk. Td rate: take down rate is loans that actually are drawn upon.

10. 10 Other Risks with Loan Commitments Credit risk: credit rating of the borrower may deteriorate over life of the commitment Aggregate funding risk: During a credit crunch, bank may find it difficult to meet all of the commitments. Banks may need to adjust their risk profile on the balance sheet in order to guard against future take-downs on loan commitments.

11. 11 When Issued Trading Commitments to buy and sell securities prior to issue. It exposes FIs to future interest rate risk. Much like a forward contract. Example: commitments taken in week prior to issue of new T-bills. Large banks sell yet to be issued T-bills for forward delivery to the secondary market at a small margin above the price they are expected to pay at the primary auction. The risk is that the bank may overcommit as with Salomon Brothers in market for new 2-year bonds in 1990. Caused the Treasury to revise the regulations governing the auction of bills and bonds.

12. 12 Loans Sold Exposure to risk from loans sold unless no recourse Recourse is the seller of the assets retains the risk if default happens. Japanese financial crisis: securitized loans often has recourse agreement on. Banks have huge exposure to credit losses. Ambiguity of no recourse qualification: Reputation effects may make the FI�s willing to take back bad loans sold even if it is a no recourse loan sale.

13. 13 The Role of OBS Activities 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 are frequently a source of fee income, especially for the largest most credit-worthy banks.

14. 14 Chapter 14: Operational risk Sources of Operational Risk Technology: system failure Employees: human error, internal fraud Customer relationships: contractual disputes with customers Capital assets: fire or other disasters resulted in capital loss External risks: internet fraud, Phishing, taxation, legal risk, etc

15. 15 Importance of Technology Efficient technological base can result in: Lower costs Through improved allocation of inputs. Increased revenues Through wider range of outputs. Earnings before taxes = (Interest income - Interest expense) + (Other income - Noninterest expense) - Provision for loan losses

16. 16 Impact on Wholesale Banking Improvements to cash management: Controlled disbursement accounts Account reconciliation Electronic data interchange Electronic funds transfer Verification of Identities Electronic initiation of letters of credit E-commerce Etc.

17. 17 Effects of Technology on Revenues & Costs Investments in technology are risky Potentially negative NPV projects due to uncertainty and potential competitive responses Potential agency conflicts: Growth-oriented investments may not maximize shareholder�s value Losses on technological investments can weaken an FI

18. 18 Effects of Technology on Revenues and Costs Revenue effects: Facilitates cross-marketing Increases innovation Service quality effects Survival of small banks and value of �human touch� Consumer reluctance to apply for mortgage on the web Cost effects: Technological improvements Shift in cost curve.

19. 19 Effects on Costs (continued) Economies of scale Optimal size depends on shape of average cost curve.

20. 20 Effects on Costs (continued) Economies of scope Multiple outputs may provide synergies in production. Diseconomies of scope Specialization may have cost benefits in production and delivery of some FI services

21. 21 Controlling Operational Risk Loss prevention: Training, development, review of employees Loss control: Planning, organization, back-up Loss financing: External insurance Loss insulation: FI capital

22. 22 Optimal Risk Management

23. 23 Chapter 15 Foreign exchange risks Sources of FX Risk Spot positions denominated in foreign currency Forward positions denominated in foreign currency Net exposure = (FX assets - FX liab.) + (FX bought - FX sold) Some decline in FX exposure as a result of the Asian, Russian and Argentinian crises

24. 24 FX Risk Exposure Greater exposure to a foreign currency combined with greater volatility of the foreign currency implies greater DEAR. Dollar loss in currency i = [Net exposure in foreign currency i in $] � Shock (Volatility) of the exchange rate

25. 25 Interest Rate Parity Theorem Equilibrium condition is that there should be no arbitrage opportunities available through lending and borrowing across currencies. This requires that 1+r(domestic) = F [1+r (foreign)] S Difference in interest rates will be offset by the expected change in exchange rates.

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