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Lecture 8: Off- balance- sheet risk - Coggle Diagram
Lecture 8: Off- balance- sheet risk
Introduction
Off- balance sheet (OBS) activities are recorded in
footnotes
, below the bottom lines
OBS affect
future
rather than current balance sheet
Fees from OBS activities =>
non- interest income
True picture of net worth
should include on and off- balance sheet activities :
E = (A - L) + (CA - CL)
Losses from OBS
mortgage- backed securities
=> GFC
Incentives to increase OBS activities
generate additional income
avoid regulatory costs or taxes
reserve requirement
deposit insurance premiums
capital adequacy requirements
Major types
of OBS activities
Derivative contract
Loans sold
Letter of credit: option to default
Loan commitments: option to borrow
OBS activities and FI solvency
OBS asset (
contingent assets - CA
): an item or activity that
moves into asset side
of a balance sheet when when a
contingent event occurs
OBS liability (
contingent liabilities - CL
): moves into
liability side
(
probability
of moving into the balance sheet
< 1
- same for CA)
large derivatives trading losses (p.10)
Valuation of OBS items
use
option pricing theory
to value OBS items
delta of an option
: change in the value of an option for a small unit change in price of the underlying security
sold an option (
put option
) =>
contingent liability
(might be exercised)
buy an option (
call option
) =>
contingent asset
Returns and risks of OBS activities
Loan commitments
Upfront fee: fee charged for
making fund available
Back- end fee: fee imposed on
unused components
of loan commitment
Risks
Interest rate risk
fixed- rate
loan commitment: bank exposed to
interest rate risk
floating- rate
loan commitment: exposed to
basis risk
draw- down risk
uncertainty of timing of
drawn- down
reduce the risk using
back- end fee
credit risk
reduce using: "
adverse material change in conditions
" clause: FI can
cancel or reprice
loan commitment if credit ratings of borrower deteriorate
aggregate funding risk (p.21)
likely exercised during
time of crisis
might be difficult to meet all loan commitments
adopt lower risk portfolio
=> in order to meet all off- balance sheet obligations
Letters of credit
Documentary letters of credit (LCs) - diagram page 23
Standby letters of credit (SLCs)
insurance function
cover contingencies that are potentially
more severe, less predictable
direct
competitors
to loan commitments (p.25)
seller must have better
credit ratings
than customers
both expose to
default risk
Derivative contracts
Forward contract: counter party risk
Market risk
Forward purchases and sale of "
when- issued securities
"
commitments to buy and sell securities
before they are issued
risk of
over- commitment
(p.28)
Loans sold
FI originates loans and sells them to outside investors
FIs moving from assets transformers to
brokers
no recourse: buyer bears all the default risk
with recourse
: long- term contingent
credit risk
for seller (FIs)
The role of OBS activities in reducing risk
In many case: mitigate exposure to interest rate risk
can decrease FI's
insolvency risk
a source of fee income