• Wilfrid Laurier University

• BU 433

Chapter Sixteen

Off-Balance-Sheet Risk

Learning Objectives

LO1: Discuss the effect of OBS activities on an FI's risk exposure, return, performance, and

solvency.

LO2: Discuss the different types of OBS activities and the risks associated with each.

LO3: Discuss the role of OBS activities in reducing the risk of an FI.

Chapter Outline

Introduction

Off-Balance-Sheet Activities and FI Solvency

Returns and Risks of Off-Balance-Sheet Activities

The Major Types of OBS Activities

· Loan Commitments

· Commercial Letters of Credit and Standby Letters of Credit

· Derivative Contracts: Futures, Forwards, Swaps, and Options

· Forward Purchases and Sales of When-Issued Securities

· Loans Sold

Other OBS Risks

· Settlement Risk

· Affiliate Risk

The Role of OBS Activities in Reducing Risk

Appendix 16A: A Letter of Credit Transaction

Web Questions

Go to OSFI’s website at osfi-bsif.gc.ca to update Table 16–5. Click on “Banks.” Click on

“Financial Data—Banks.” Click on “Quarterly” and use the drop-down menu to choose “BCAR

Derivative Components.” Submit your request and then answer the following questions from the

spreadsheet that pops up. What is the notional value increase in total derivatives reported by the

banks since Table 16–4 was prepared? Click on “Monthly” and find the latest consolidated

balance sheet for the banks. How does the growth in reported OBS derivatives compare with the

growth in on-balance-sheet assets for the banks over the same time period?

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Solutions for End-of-Chapter Questions and Problems: Chapter Sixteen

1. Classify the following items as either (1) on-balance-sheet assets, (2) on-balance-sheet

liabilities, (3) off-balance-sheet assets, (4) off-balance-sheet liabilities, or (5) capital

account.

Classification

a. Loan commitments 3

b. Loan loss reserves 5

c. Letter of credit 2

d. Bankers acceptance 2

e. Rediscounted bankers acceptance 2

f. Loan sales without recourse None of the above.

g. Loan sales with recourse 3

h. Forward contracts to purchase 3

I. Forward contracts to sell 4

j. Swaps 4 (for liability swaps)

k. Loan participations 1

l. Securities borrowed 3

m. Securities lent 4

n. Loss adjustment expense account (P&C insurers) 2

2. How does one distinguish between an off-balance-sheet asset and an off-balance-sheet

liability?

Off-balance-sheet activities or items are contingent claim contracts. An item is classified as an

off-balance-sheet asset when the occurrence of the contingent event results in the creation of an

on-balance-sheet asset. An example is a loan commitment. If the borrower decides to exercise the

right to draw down on the loan, the FI will incur a new asset on its portfolio. Similarly, an item is

an off-balance-sheet liability when the contingent event creates an on-balance-sheet liability. An

example is a standby letter of credit (LC). In the event that the original payer of the LC defaults,

then the FI is liable to pay the amount to the payee, incurring a liability on the right-hand side of

its balance sheet.

3. 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 & 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?

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Net worth = (240-220) + (100-80) = $40 million. The term contingent means an event that may

or may not happen. In financial economics, the term is used in conjunction with the result given

that some event does occur.

4. 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?

Contingent assets and liabilities may or may not become on-balance-sheet assets and liabilities in

a manner similar to the exercise or non-exercise of an option. In each case the realization of the

event is contingent or dependent on the occurrence of some other event. The delta of an option is

the sensitivity of an option’s value for a unit change in the price of the underlying security. The

notional value represents the amount of value that will be placed in play if the contingent event

occurs. The notional value of a contingent asset or liability is the amount of asset or liability that

will appear on the balance sheet is the contingent event occurs.

5. 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. What are (a) the contingent asset value of

this position, (b) the contingent liability value of this position, and (c) the contingent

market value of net worth?

a. The contingent asset value is $500 million x 0.25 = $125 million.

b. The contingent liability value is $400 million x 0.30 = $120 million.

c. The contingent market value of net worth is $125 million - $120 million = $5 million.

6. What factors explain the growth of off-balance-sheet activities in the 1980s through the

early 2000s among FIs?

The narrowing of spreads on on-balance-sheet lending in a highly competitive market and large

loan losses by commercial banks gave impetus to seek other sources of income in the 1980s. Offbalance-sheet activities represented one avenue. In addition, off-balance-sheet assets and

liabilities were not subject to capital requirements (or, for U.S. banks, reserve requirements,

increasing the effective returns on these activities. In the 1990s and early 2000s, increased

revenue from trading activities was a major impetus to the increases in OBS activities.

Proprietary trading (i.e., trading for their own account) became a significant source of revenue

for many global banks, leading to an increase in off-balance sheet activity. For the first time ever,

OBS activities fell in late 2008 with the fallout from the financial crisis. However, growth of

OBS securities was quickly seen again in early 2009.

7. What are the characteristics of a loan commitment that an FI may make to a customer? In