Chapter 16: Off-Balance-Sheet Risk Flashcards
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. Similarly, an item is an off-balance-sheet liability when the contingent event creates an on-balance-sheet liability.
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.
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.
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?
When a bank makes a fixed-rate loan commitment, it faces the likelihood that interest rates may increase during the intervening period. This reduces its net interest income if the borrower decides to take down the loan.
The bank can partially offset this loan by making variable rate loan commitments.
However, this still does not protect it against basis risk, that is, if lending rates and the cost of funds of the bank do not increase proportionately.
How is the 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 opportunity to implement this control feature?
An FI is exposed to credit risk, because the credit quality of a borrower could decline during the intervening period of the loan commitment. When an FI makes a loan commitment, it is obligated to deliver the loan. Although most loan commitments today contain a clause releasing an FI from its obligations in the event of a significant decline in credit quality, the FI may not be inclined to use it for fear of reputation concerns.
Interest rate risk is related to credit risk because default risks are much higher during periods of increasing interest rates. When interest rates rise, firms have to generate higher rates of return. Thus, FIs making loan commitments are subject to both risks in periods of rising interest rates.
Do the contingent risks of interest rate, takedown, credit, and aggregate funding tend to increase the insolvency risk of an FI? Why or why not?
These risk elements all can have adverse effects on the solvency of an FI. While they need not occur simultaneously, there is a fairly high degree of correlation between them. For example, if rates rise, funding will become shorter, takedowns will likely increase, credit quality of borrowers will become lower, and the value of the typical FI will shrink.
What is an LC? How is an LC like an insurance contract?
Like most insurance contracts, a letter of credit is like a guarantee or a put. It essentially gives the holder the right to receive payment from the FI in the event that the original purchaser of the product defaults on the payment. Like the seller of any guarantee, the FI is obligated to pay the guarantee holder at the holder’s request.
How do SLCs differ from commercial LCs? With what other types of FI products do SLCs compete? What types of FIs can issue SLCs?
Standby letters of credit usually are written for contingency situations that are less predictable and that have more severe consequences than the LCs written for standard commercial trade relationships. Often SLCs are used as performance guarantees for projects over extended periods of time, or they are used in the issuance of financial securities such as municipal bonds or commercial paper. Banks and property and casualty (P&C) insurance companies are the primary issuers of SLCs.
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?
Credit risk occurs because of the potential for the counterparty to default on payment obligations, a situation that would require the FI to replace the contract at the current market prices and rates.
OTC contracts typically are non-standardized or unique contracts that do not have external guarantees from an organized exchange.
Defaults on these contracts usually will occur when the FI stands to gain and the counterparty stands to lose, i.e., when the contract is hedging the risk exactly as the FI hoped. Thus, default risk is higher when the volatility of the underlying asset is higher.
What is meant by WI trading? Explain how forward purchases of WI government T-Bills can expose FIs to contingent interest rate risk.
The purchase or sale of a security before it is issued is called when issued trading. When an FI purchases T-bills on behalf of a customer prior to the actual weekly auctioning of securities, it incurs the risk of underpricing the security. On the day the T-bills are allotted, it is possible that because of high demand, the prices may be much higher than what the FI has forecasted. It then may be forced to purchase them at higher prices, which means lower interest rates.
Distinguish between loan sales with and without recourse. Why would banks want to sell loans with recourse? Explain how loan sales can leave banks exposed to contingent interest rate risks.
When FIs sell loans without recourse, the buyers of the loans accept the risk of non-repayment by the borrower. In other words, the loans are completely off the books of the FI. In the case of loans sold with recourse, FIs are still legally responsible for the payment of the loans to the seller in the event the borrower defaults.
FIs are willing to sell such loans because they obtain better prices and also because it allows them to remove the assets from their balance sheets. FIs are more likely to sell such loans with recourse if the borrower of the loan is of good credit standing.
When interest rates increase, there is a higher likelihood of loan defaults and a higher probability that the FI will have to buy back some of the loans. This may be the case even for sales of loans without recourse because banks are reluctant not to take back loans for reputation concerns.
Defend the statement that although off-balance-sheet activities expose FIs to several forms of risks, they also can alleviate the risks of banks.
Although an FI is exposed to interest rate, foreign exchange, credit, liquidity, and other risks, it also can use these risks to help alleviate its overall risk, if used judiciously. For example, the use of options and futures can reduce the volatility of earnings if hedged with the appropriate amount. Such hedging can be incorporated in an FI’s overall portfolio so that both trading and hedging activities can be pursued independently while still reducing the total exposure of the FI. It is also possible to offset the exposures of on-and off-balance-sheet activities. For example, it is possible that decreases in interest rates could lead to increased exposures for some assets (reinvestment risks), but they could be offset by off-balance-sheet liabilities. Thus, regulation of off-balance-sheet activities should recognize the positive effects of these instruments in helping ameliorate the total exposure of the FI.
